BAC leverage

[ourkid8]

Hi Eric, I am actually one of those suckers who currently hold a large warrant position BUT at the same time I took a significant position in BAC leaps.  I just sold my first batch today of Jan 2015 at a 100% gain and the returns are SIGNIFICANTLY better then the warrants.  (I should have swaped my warrants for leaps at that time...)Thanks a lot for your help on this.  My next batch of leaps expire in Jan 2016 which is already up significantly and I am hoping for more!!!  :-) 

 

Tks,

S

 

I started this thread when common was at $12 and warrant at $5.65.

 

Today, common up 47% and warrant up 26.5%.

 

Ouch.

 

hi Eric... do you think the warrants are attractively priced now - or may be put another way the cost of leverage is now "cheap"?

 

I find little to criticize today.

[ERICOPOLY]

The warrants are actually a nice defensive tool if purchased today.  A move back down towards $15 would spike the volatility premium which would cushion the blow given the longer duration.  And the dividend protection is a big part of the leverage cost that people have been so willing to prepay for -- dividend will likely be increased.

 

Precisely the opposite mentality of when I started the thread.

[ni-co]

The warrants are actually a nice defensive tool if purchased today.  A move back down towards $15 would spike the volatility premium which would cushion the blow given the longer duration.  And the dividend protection is a big part of the leverage cost that people have been so willing to prepay for -- dividend will likely be increased.

 

Precisely the opposite mentality of when I started the thread.

 

They were then, too. Nothing changed.

[ERICOPOLY]

The warrants are actually a nice defensive tool if purchased today.  A move back down towards $15 would spike the volatility premium which would cushion the blow given the longer duration.  And the dividend protection is a big part of the leverage cost that people have been so willing to prepay for -- dividend will likely be increased.

 

Precisely the opposite mentality of when I started the thread.

 

They were then, too. Nothing changed.

 

Everything changed for me. 

 

13% cost of leverage declined to 5%.  That was the risk then which I clearly defined.  So not only did it cost 13% a year since then, but you've had an added 32% cost tacked on to it from the remaining 4 years declining from 13% a year down to 5%.

 

Well, you aren't taking that risk anymore today with it already at 5% and supported in part by the rising dividend.

 

The LEAPS never carried that risk, so it was a no-brainer to go with the lower-risk LEAPS.

 

The warrants didn't make a nice defensive tool either back then because you would lose as much as $5.65 per share if stock hit zero.  The LEAPS had less money at risk and thus less risky if price dropped sharply.

 

 

[ERICOPOLY]

Using industry lingo, a big price drop would have clobbered the warrant premium due to "skewness".

 

It showed it's ugly face when the stock shot up, and would have shown itself similarly if stock had instead declined.

 

That's because the stock traded near the warrant strike back then.

 

Today, it would move TOWARDS the warrant strike and thus "skewness" would be favorable this time around. 

 

TOWARDS is favorable, AWAY is negative.

 

Starting near the warrant strike leaves only NEGATIVE possibility.

 

So today is very different from then.

[ni-co]

The warrants are actually a nice defensive tool if purchased today.  A move back down towards $15 would spike the volatility premium which would cushion the blow given the longer duration.  And the dividend protection is a big part of the leverage cost that people have been so willing to prepay for -- dividend will likely be increased.

 

Precisely the opposite mentality of when I started the thread.

 

They were then, too. Nothing changed.

 

Everything changed for me. 

 

13% cost of leverage declined to 5%.  That was the risk then which I clearly defined.  So not only did it cost 13% a year since then, but you've had an added 32% cost tacked on to it from the remaining 4 years declining from 13% a year down to 5%.

 

Well, you aren't taking that risk anymore today with it already at 5% and supported in part by the rising dividend.

 

The LEAPS never carried that risk, so it was a no-brainer to go with the lower-risk LEAPS.

 

The warrants didn't make a nice defensive tool either back then because you would lose as much as $5.65 per share if stock hit zero.  The LEAPS had less money at risk and thus less risky if price dropped sharply.

 

This risk you defined is largely dependent on how volatility and interest rates are developing. I think this is a flawed way of looking at options, especially under the assumption of not having a strong opinion on the development of these two variables.

 

By your way of framing it, you are glossing over the risk of owning shorter duration LEAPs over longer duration warrants. Your "cost of leverage" difference between LEAPs and warrants is highly dependent on how volatility develops over time. You implicitly make the assumption that volatility either stays the same or is declining, because you'd need to pay up to roll-over those LEAPs if volatility increased. The same is true in the scenario of levering the equity and owning the comparable put, because you own the same roll-over risk. Owning that risk – and the risk of dividend increases – is what you were paid for by owning the LEAPs over the warrants. That said, it's a good idea to diversify between durations.

 

My way to look at it has always been: Intrinsic value of BAC: $30-$40; so, under the assumption that stocks reach their IV over the longer term (3-5 years), IV of the warrants = ~$17-$27. The potential upside was then and is now 140-280% compared to owning the equity outright with now 70%-130% (then 110-180%) upside. My main risk is the limited duration of options, i.e. that BAC won't reach its IV until expiration. This risk increases over time, because day-to-day volatility becomes more important the closer the expiration date is coming. Of course, there is an offsetting effect of BAC's business working for me. But, in the end, I want to have as much time as possible.

[ERICOPOLY]

The warrants are actually a nice defensive tool if purchased today.  A move back down towards $15 would spike the volatility premium which would cushion the blow given the longer duration.  And the dividend protection is a big part of the leverage cost that people have been so willing to prepay for -- dividend will likely be increased.

 

Precisely the opposite mentality of when I started the thread.

 

They were then, too. Nothing changed.

 

Everything changed for me. 

 

13% cost of leverage declined to 5%.  That was the risk then which I clearly defined.  So not only did it cost 13% a year since then, but you've had an added 32% cost tacked on to it from the remaining 4 years declining from 13% a year down to 5%.

 

Well, you aren't taking that risk anymore today with it already at 5% and supported in part by the rising dividend.

 

The LEAPS never carried that risk, so it was a no-brainer to go with the lower-risk LEAPS.

 

The warrants didn't make a nice defensive tool either back then because you would lose as much as $5.65 per share if stock hit zero.  The LEAPS had less money at risk and thus less risky if price dropped sharply.

 

This risk you defined is largely dependent on how volatility and interest rates are developing. I think this is a flawed way of looking at options, especially under the assumption of not having a strong opinion on the development of these two variables.

 

By your way of framing it, you are glossing over the risk of owning shorter duration LEAPs over longer duration warrants. Your "cost of leverage" difference between LEAPs and warrants is highly dependent on how volatility develops over time. You implicitly make the assumption that volatility either stays the same or is declining, because you'd need to pay up to roll-over those LEAPs if volatility increased. The same is true in the scenario of levering the equity and owning the comparable put, because you own the same roll-over risk. Owning that risk – and the risk of dividend increases – is what you were paid for by owning the LEAPs over the warrants. That said, it's a good idea to diversify between durations.

 

My way to look at it has always been: Intrinsic value of BAC: $30-$40; so, under the assumption that stocks reach their IV over the longer term (3-5 years), IV of the warrants = ~$17-$27. The potential upside was then and is now 140-280% compared to owning the equity outright with now 70%-130% (then 110-180%) upside. My main risk is the limited duration of options, i.e. that BAC won't reach its IV until expiration. This risk increases over time, because day-to-day volatility becomes more important the closer the expiration date is coming. Of course, there is an offsetting effect of BAC's business working for me. But, in the end, I want to have as much time as possible.

 

Let's say we were back at the point where this thread started...

 

Instead of paying 13% a year until 2019 for the warrant... 

 

... the phone rings...  it's Brian Moynihan!  He is offering to swap your 2019 warrants for a new class of warrants with the same strike and terms, except the new expiration has been moved all the way out to the year 2040!  Another 21 years!

 

... but the pricing remains the same... the cost of leverage is still going to be 13% a year, so you will be coughing up a lot of cash as part of the deal.

 

In your haste, you take it based on the logic you laid out above...

 

Can you comment now on how happy you are or would you like to reverse this deal?

 

Is it a lower risk deal as you've argued because duration is longer?

[ERICOPOLY]

By our way of framing it, you are glossing over the risk of owning shorter duration LEAPs over longer duration warrants. Your "cost of leverage" difference between LEAPs and warrants is highly dependent on how volatility develops over time. You implicitly make the assumption that volatility either stays the same or is declining, because you'd need to pay up to roll-over those LEAPs if volatility increased.

 

That's the risk as I laid it out early in this thread.  You are saying that I overlooked this?

[ERICOPOLY]

The whole point of owning them was to get a leveraged return...

 

...but a near-term stock spike destroys the return due to skewness as stock moves far away from strike.

 

So it was just a mistake to own these because you were in the stock on the belief the stock would rise a lot!

 

And the longer the duration, the bigger the mistake.  Had there been another 4 years before expiry (if they were 14 year warrants) then there would be yet another 32% hit today (64% total!)...  that 64% is in addition to the 13% annual cost thus far.  So a total cost of roughly 84%.

 

That 64% is a lot to pay for your worry and concern over interest rates and rolling at higher volatility.

 

The greater risk was always the duration... the longer the duration, the worse your profits would be if the common rose (or declined!) by a lot.  The skewness drives the premium decline and it just ripples across all the remaining years in the warrant.

[stahleyp]

Eric, are you back in the warrants now?

[ERICOPOLY]

Eric, are you back in the warrants now?

 

It would make sense in my RothIRA if I had any money there, but I don't.

[ni-co]

The warrants are actually a nice defensive tool if purchased today.  A move back down towards $15 would spike the volatility premium which would cushion the blow given the longer duration.  And the dividend protection is a big part of the leverage cost that people have been so willing to prepay for -- dividend will likely be increased.

 

Precisely the opposite mentality of when I started the thread.

 

They were then, too. Nothing changed.

 

Everything changed for me. 

 

13% cost of leverage declined to 5%.  That was the risk then which I clearly defined.  So not only did it cost 13% a year since then, but you've had an added 32% cost tacked on to it from the remaining 4 years declining from 13% a year down to 5%.

 

Well, you aren't taking that risk anymore today with it already at 5% and supported in part by the rising dividend.

 

The LEAPS never carried that risk, so it was a no-brainer to go with the lower-risk LEAPS.

 

The warrants didn't make a nice defensive tool either back then because you would lose as much as $5.65 per share if stock hit zero.  The LEAPS had less money at risk and thus less risky if price dropped sharply.

 

This risk you defined is largely dependent on how volatility and interest rates are developing. I think this is a flawed way of looking at options, especially under the assumption of not having a strong opinion on the development of these two variables.

 

By your way of framing it, you are glossing over the risk of owning shorter duration LEAPs over longer duration warrants. Your "cost of leverage" difference between LEAPs and warrants is highly dependent on how volatility develops over time. You implicitly make the assumption that volatility either stays the same or is declining, because you'd need to pay up to roll-over those LEAPs if volatility increased. The same is true in the scenario of levering the equity and owning the comparable put, because you own the same roll-over risk. Owning that risk – and the risk of dividend increases – is what you were paid for by owning the LEAPs over the warrants. That said, it's a good idea to diversify between durations.

 

My way to look at it has always been: Intrinsic value of BAC: $30-$40; so, under the assumption that stocks reach their IV over the longer term (3-5 years), IV of the warrants = ~$17-$27. The potential upside was then and is now 140-280% compared to owning the equity outright with now 70%-130% (then 110-180%) upside. My main risk is the limited duration of options, i.e. that BAC won't reach its IV until expiration. This risk increases over time, because day-to-day volatility becomes more important the closer the expiration date is coming. Of course, there is an offsetting effect of BAC's business working for me. But, in the end, I want to have as much time as possible.

 

Let's say we were back at the point where this thread started...

 

Instead of paying 13% a year until 2019 for the warrant... 

 

... the phone rings...  it's Brian Moynihan!  He is offering to swap your 2019 warrants for a new class of warrants with the same strike and terms, except the new expiration has been moved all the way out to the year 2040!  Another 21 years!

 

... but the pricing remains the same... the cost of leverage is still going to be 13% a year, so you will be coughing up a lot of cash as part of the deal.

 

In your haste, you take it based on the logic you laid out above...

 

Can you comment now on how happy you are or would you like to reverse this deal?

 

Is it a lower risk deal as you've argued because duration is longer?

 

I don't think you're overlooking anything, but you're glossing over the risk and make it seem like a no-brainer when it is (was) actually not. Your argument is a bit like saying: "I'd rather own 10 year treasury notes over 2 year notes because you're getting paid 2.2% instead of 0.5%.

 

I see your point but it doesn't change my opinion on that. You can't just ignore the risk of owning shorter durations simply because you expect a sharp move upwards. Let's say you'd owned the Dec 14 LEAPs back then and – God forbid – there is another large lawsuit and multi-billion $ fine for BAC or new capital requirements that make the stock tank for 12 a few months. Wouldn't you rather have owned more expensive options with 3 or 5 years time to maturity instead of "cheap" 2014 LEAPs?

 

I'm not sure whether I understand your example. Yes, I would have taken the deal when my expectation would have been that BAC would grow 20% annually until 2040. In a sense, your example makes it even clearer to me that I wouldn't want to own shorter term LEAPs and rolling them over every year or two during the whole period, thereby taking the risk of losing the premium – and with it my whole investment – at some point in time between now and 2040.

 

Would I reverse that Moynihan deal and instead take it today with the same conditions? Of course! But this is just hindsight bias. Yes, the warrants have become more attractive – I don't want to argue with that at all. But this has nothing to do with cost of leverage or the price of the LEAPs – it's simply the result of volatility decreasing in recent months.

[compoundinglife]

The warrants are actually a nice defensive tool if purchased today.  A move back down towards $15 would spike the volatility premium which would cushion the blow given the longer duration.  And the dividend protection is a big part of the leverage cost that people have been so willing to prepay for -- dividend will likely be increased.

 

Precisely the opposite mentality of when I started the thread.

 

They were then, too. Nothing changed.

 

Everything changed for me. 

 

13% cost of leverage declined to 5%.  That was the risk then which I clearly defined.  So not only did it cost 13% a year since then, but you've had an added 32% cost tacked on to it from the remaining 4 years declining from 13% a year down to 5%.

 

Well, you aren't taking that risk anymore today with it already at 5% and supported in part by the rising dividend.

 

The LEAPS never carried that risk, so it was a no-brainer to go with the lower-risk LEAPS.

 

The warrants didn't make a nice defensive tool either back then because you would lose as much as $5.65 per share if stock hit zero.  The LEAPS had less money at risk and thus less risky if price dropped sharply.

 

This risk you defined is largely dependent on how volatility and interest rates are developing. I think this is a flawed way of looking at options, especially under the assumption of not having a strong opinion on the development of these two variables.

 

By your way of framing it, you are glossing over the risk of owning shorter duration LEAPs over longer duration warrants. Your "cost of leverage" difference between LEAPs and warrants is highly dependent on how volatility develops over time. You implicitly make the assumption that volatility either stays the same or is declining, because you'd need to pay up to roll-over those LEAPs if volatility increased. The same is true in the scenario of levering the equity and owning the comparable put, because you own the same roll-over risk. Owning that risk – and the risk of dividend increases – is what you were paid for by owning the LEAPs over the warrants. That said, it's a good idea to diversify between durations.

 

My way to look at it has always been: Intrinsic value of BAC: $30-$40; so, under the assumption that stocks reach their IV over the longer term (3-5 years), IV of the warrants = ~$17-$27. The potential upside was then and is now 140-280% compared to owning the equity outright with now 70%-130% (then 110-180%) upside. My main risk is the limited duration of options, i.e. that BAC won't reach its IV until expiration. This risk increases over time, because day-to-day volatility becomes more important the closer the expiration date is coming. Of course, there is an offsetting effect of BAC's business working for me. But, in the end, I want to have as much time as possible.

 

Let's say we were back at the point where this thread started...

 

Instead of paying 13% a year until 2019 for the warrant... 

 

... the phone rings...  it's Brian Moynihan!  He is offering to swap your 2019 warrants for a new class of warrants with the same strike and terms, except the new expiration has been moved all the way out to the year 2040!  Another 21 years!

 

... but the pricing remains the same... the cost of leverage is still going to be 13% a year, so you will be coughing up a lot of cash as part of the deal.

 

In your haste, you take it based on the logic you laid out above...

 

Can you comment now on how happy you are or would you like to reverse this deal?

 

Is it a lower risk deal as you've argued because duration is longer?

 

I don't think you're overlooking anything, but you're glossing over the risk and make it seem like a no-brainer when it is (was) actually not.

 

I see your point but it doesn't change my opinion on that. You can't just ignore the risk of owning shorter durations simply because you expect a sharp move upwards. Let's say you'd owned the Dec 14 LEAPs back then and – God forbid – there is another large lawsuit and multi-billion $ fine for BAC or new capital requirements that make the stock tank for 12 a few months. Wouldn't you rather have owned more expensive options with 3 or 5 years time to maturity instead of "cheap" 2014 LEAPs?

 

I'm not sure whether I understand your example. Yes, I would have taken the deal when my expectation would be that BAC will grow 20% annually until 2040. In a sense your example makes it even clearer to me that I wouldn't want to own shorter term LEAPs and rolling them over several times during the whole period, thereby taking the risk of losing the premium during some time between now and 2040.

 

Would I reverse that Moynihan deal and instead take it today with the same conditions? Of course! But this is just hindsight bias. Yes, the warrants have become more attractive – I don't want to argue with that at all. But this has nothing to do with cost of leverage or the price of the LEAPs – it's simply the result of volatility decreasing in recent months.

 

Alot of this probably depends on the event and the magnitude of the impact on the price. But, let's say that it brought the price down to $1. Yes you would have more time on the warrants. But you woud also have taken a much larger (unrealized) loss because the outlay of capital for the warrants was greater to maintain the same notional value. At this point with the leaps you would take your smaller loss (realized) and roll into the next latest expiration as it becomes available at much cheaper prices now. Your invested capital is still lower than the warrants. If the price were depressed for a long time you could keep rolling over and likely still be under the price difference between the warrants and leaps.

 

At least that is my understanding of the case Eric is putting forward.

[stahleyp]

Eric, are you back in the warrants now?

 

It would make sense in my RothIRA if I had any money there, but I don't.

 

Admittedly, I think it's smart that your ballsy era is over....though, I admired it a lot.  8)

[ni-co]

Alot of this probably depends on the event and the magnitude of the impact on the price. But, let's say that it brought the price down to $1. Yes you would have more time on the warrants. But you woud also have taken a much larger (unrealized) loss because the outlay of capital for the warrants was greater to maintain the same notional value. At this point with the leaps you would take your smaller loss (realized) and roll into the next latest expiration as it becomes available at much cheaper prices now. Your invested capital is still lower than the warrants. If the price were depressed for a long time you could keep rolling over and likely still be under the price difference between the warrants and leaps.

 

At least that is my understanding of the case Eric is putting forward.

 

Yes, and I question the wisdom of doing that. What would your "cost of leverage" be once you'd lost your whole investment at some point in time? To me this goes back to the question of why Eric is ignoring the implied put value of the warrants. If you could sell this put, your cost of leverage would equal the risk free rate. So what's the point in owning the levered equity and a put over the warrant? It's not cheaper. If it were it'd be arbitraged away because you'd have a risk free return above the corresponding treasuries.

[ERICOPOLY]

Let's say you'd owned the Dec 14 LEAPs back then and – God forbid – there is another large lawsuit and multi-billion $ fine for BAC or new capital requirements that make the stock tank for 12 a few months. Wouldn't you rather have owned more expensive options with 3 or 5 years time to maturity instead of "cheap" 2014 LEAPs?

 

I specifically commented early in this thread that the LEAPS are not likely to be better if the stock remained flat the entire time.  So you should go for the warrants if you expect the stock to be flatlined without violent swings.

 

So then you mention the possibility of unexpected negative events...  on that topic, keep in mind that the warrants declined to $2 in 2011 when stock hit $5. Anyone could have rolled $12 strike LEAPS very inexpensively at the time because the stock was so far from strike  Volatility was extremely high at the time.  So ironically, even though the warrant holders had locked in a calmer volatility environment, they still got their asses handed to them when volatility spiked coupled with actual heavy price movement in the stock.  This is because the skewness is such a powerful force. 

 

You keep mentioning spiking volatility but that's really only going to be the driving risk to the LEAPS if we are unfortunate to have a stagnant stock price.  Anytime the stock breaks hard up or down, skewness becomes the overpowering risk.  So actual large stock price volatility (up or down) made the warrants the worse choice.

 

So the warrants become a great way to leverage into a stock that is fully priced and a low risk business model.  They are best for stocks that lack any expectation of big moves.  So the models that priced these warrants were probably influenced by an EMT mindset that can't properly price them for "undervalued" situations that would clobber them with skewness on large upwards movements.. 

[ERICOPOLY]

So the warrants become a great way to leverage into a stock that is fully priced and a low risk business model.  They are best for stocks that lack any expectation of big moves.  So the models that priced these warrants were probably influenced by an EMT mindset that can't properly price them for "undervalued" situations that would clobber them with skewness on large upwards movements..

 

Adding to that comment...

 

And the problem in this case was that with 13% cost of leverage, the volatility priced into the warrant was already pretty high.  It was high because people perceived an elevated probability of big stock price movement given all the uncertainty at the time.  So you weren't exactly getting a ton of protection from spiking volatility given that relatively high level already priced in all the way to 2019.

 

So it was contrarian to go against the crowd by choosing the instrument most likely to be clobbered by any such expected price volatility  :D

[gary17]

So $17000 buys 1000 BAC shares over the last 2 weeks - 

 

in 2018 this could be worth $35000!

 

$17000 could also have bought 2400 warrants at about $7.05.... 

 

In 2018, if the shares are at $35 and assuming $1 adjustment to the strike... the warrants theoretically should be worth $35 - $12 = $23

 

2400 x $23 = $55,000

 

I see... Warrants more attractive :) 

 

Am I the only one here who is prepared to exercise the warrants ?  I feel it forces me to save to pay for the BAC shares at $12 or so when it is time.. and hopefully by then the dividends could be fairly attractive at about $2 or so. 

 

Gary

 

 

Edit: i meant 2018 not 2015

 

 

 

[ERICOPOLY]

Am I the only one here who is prepared to exercise the warrants ?  I feel it forces me to save to pay for the BAC shares at $12 or so when it is time..

 

Here is what I would do if you wish to stay with BAC when warrant matures...

 

Use portfolio margin to purchase the underlying shares and hedge your margin loan with BAC puts.  You won't be locked into the low strike straightjacket anymore and you can go with a much higher strike.

[ERICOPOLY]

Would I reverse that Moynihan deal and instead take it today with the same conditions? Of course! But this is just hindsight bias.

 

Hindsight bias?

 

Why don't you price out what that warrant would cost and compare it to the $12 price of the common stock.

 

The common carries an implicit strike of $0, vs your $13.30 on the warrant.

 

:) :) :)

[gary17]

You won't be locked into the low strike straightjacket anymore and you can go with a much higher strike.

 

What do you mean by this... sorry you are quite a few steps ahead...

 

And how much can one leverage in a portfolio margin account ?  (I don't have one).  Another option I could look into is to use home equity which is also non-recourse loan (sort of) and yes, buy puts to protect the downside. 

[ERICOPOLY]

You won't be locked into the low strike straightjacket anymore and you can go with a much higher strike.

 

What do you mean by this... sorry you are quite a few steps ahead...

 

And how much can one leverage in a portfolio margin account ?  (I don't have one).  Another option I could look into is to use home equity which is also non-recourse loan (sort of) and yes, buy puts to protect the downside.

 

The portfolio margin account looks at you total "net" exposure on the common sense logic that you can always pay off the loan in a market crash by exercising puts.

 

So if you use $12 of margin loan to exercise the warrant... buy a put contract with at least as high as a $12 strike. 

 

You could for example go for a $30 strike and borrow another $18 to spend on hookers and blow -- a form of "cash out refinance".  It's done all the time with real estate.

 

Research the matter with Interactive Brokers.

 

Just don't use Reg-T margin as there is no netting out of risk from the puts and you'll get a margin call!!!

[ERICOPOLY]

Yes, and I question the wisdom of doing that. What would your "cost of leverage" be once you'd lost your whole investment at some point in time?

 

It doesn't change the cost of leverage.

 

Just like the interest expense that Fairfax incurs on the bonds used to finance the buyout of ORH.  They lose 100% of the interest costs.  Same with at-the-money LEAPS premium.  Return realized on the underlying investment isn't a cost of the leverage.

 

To me this goes back to the question of why Eric is ignoring the implied put value of the warrants.

 

And you base this statement of non-fact on what?  This entire thread is dedicated to the valuation of the non-recourse leverage.  The put is the "non". 

 

That's why I compare it to put+margin versus margin alone.  Yeah, I see, you think I do that BECAUSE I'm ignoring that the warrant also has a put component.  Nice! :)

 

 

So what's the point in owning the levered equity and a put over the warrant?

 

To avoid the expected massacre of the embedded put due to skewness if the common stock price moves sharply away from the strike price of the warrant's put.  And... given that it was at-the-money to begin with, the hit will be most severe and only negative (it can only move further from strike).

[gary17]

You won't be locked into the low strike straightjacket anymore and you can go with a much higher strike.

 

What do you mean by this... sorry you are quite a few steps ahead...

 

And how much can one leverage in a portfolio margin account ?  (I don't have one).  Another option I could look into is to use home equity which is also non-recourse loan (sort of) and yes, buy puts to protect the downside.

 

The portfolio margin account looks at you total "net" exposure on the common sense logic that you can always pay off the loan in a market crash by exercising puts.

 

So if you use $12 of margin loan to exercise the warrant... buy a put contract with at least as high as a $12 strike. 

 

You could for example go for a $30 strike and borrow another $18 to spend on hookers and blow -- a form of "cash out refinance".  It's done all the time with real estate.

 

Research the matter with Interactive Brokers.

 

Just don't use Reg-T margin as there is no netting out of risk from the puts and you'll get a margin call!!!

 

LOL  thanks - yes, I gathered from earlier discussions that Reg-T margin is to stay away from -  so I've used my home equity loan since I can't get Portfolio Margin account in Canada.  However, I should be able to do this in another country thanks to my dual citizenship :)       

 

--

 

Let's see if I could follow the math here:

 

So using the $35 BAC share example with the Warrants at $23 and the strike at $12

 

Since I own the warrants (not borrowed money) at $23, my 'equity' is $23000

Then I borrow in a Portfolio M account $12,000 so I now have 1000 shares of BAC valued at $35000. 

 

Now, I go buy some high strike puts... let's say $30 puts..  how much would a put that's $5 cheaper than the $35 share cost then?  Let's say $1  just based on the Jan 2017  $13 ask at "0.90" to project what the options market would be like then... not accurate but just a projection.... 

 

So I now have $1000 on the insurance..... 

 

Recap:

 

1000 bac shares

dividend = $2000

cost = $23,000 + $500 insurance every year      (<-- $1 puts was 2 years out)

 

Return = $1500 / $23000 = 6%

But wait, I actually only paid $7.05 for those warrants so the cost is $7,050 so

$1500 / $7050 =  21% 

 

So a 21% dividend with protection to the downside.....   

 

Did I get this right????????

 

Edit: I miss the interest costs --  So may be IB would charge 3% on $12,000 that's $360/yr

 

 

 

 

 

 

 

 

 

 

[ERICOPOLY]

See, the thing is... if you paid 13% a year cost of leverage for a BAC warrant expiring in 2040... and the stock surged after 1 year to $18 (as it did earlier this year) and due primarily to skewness the cost of leverage dropped to 7% (as it did at that time)...

 

You'd be suffering a 6% hit for every year remaining.

 

Thus, since I tacked 21 years onto the life if the warrant in the Moynihan example, you can multiply 21 by 6.

 

So by taking Moynihan's deal, you exposed yourself to an additional 126% cost of leverage for that first year.

 

So... it was early 2014 with 26 years left on the warrant before expiry.  That's a total of 156% in addition to the 13% from the one year passage of time.

 

169% total cost for one year of leverage!  Yet the common only went up by 50%  ???

 

And you would take this deal you said... because you would hate to take the risk of higher volatility premiums when rolling... which I argue would only happen if the stock remained relatively flat... a stock that you believed would return 20% a year... you would gladly take on the risk of 169% cost for year one because you worry that after 2 years when the first LEAPS expire the volatility or interest rates might be higher.  Yet one thing that boosts BAC's earnings (and stock) is rising rates.  And higher stock kills the value of the warrant's put due to skewness!