BAC leverage

[gary17]

Hi Eric

I realize you indicated that the strike adjustment for the warrants is simply so that the warrant holders don't get diluted...  But if I look at this formula ,

 

warrant price = BAC commons - strike of $13.26 + total dividend above $0.01

 

I can't help but wondering, just mathematically, warrant holders seem to benefit more. 

 

If we assume the common is at $25 and the dividend paid is $1.  Before the payment of dividend, Warrant should be

 

$25 - 13.26 = $11.74

 

After the $1 dividend the warrants should be worth $25 - $13.26 + 1 = $12.74

 

That's a $12.74 / $11.74 = 8% gain

 

For the common holder, they are making $1 / $25 = 4% only. 

 

So while the intent of the strike adjustment is for anti-dilution; in my mind the 'benefit' is given to the warrant holders up front because they technically haven't paid the money to actually own the full BAC commons yet...  Perhaps this is the flawed way of thinking that you mentioned.  But I'm seeing it like this....

 

Gary

 

The warrant is a synthetically leveraged portfolio.  You are comparing it to unleveraged portfolio of common.

 

A $1 price movement results in a higher % impact when leveraged vs unleveraged.

 

So instead, compare it to a leveraged common stock portfolio.  Use the same degree of leverage as the warrant.

 

Thanks -

 

 

To others:  Yes, the questions were asked in the BAC Warrants thread... just saw....; my apologies, I just read the prospectus again...  the strike price adjustment is :

 

new strike = old strike -  (share price of record date - difference in dividend over $0.01) / (share price of record date)

 

So if from now until 2019 they pay out $2 in dividend and just for argument sake this yields 5% (assume BAC = $2 / 0.05 = $40

 

so new strike estimate = $13.26 - (40 - 1.99)/(40) =  $13.26 - 0.95 = $12.31   

 

So in 2019 warrants could be $40 - $12.31 = $27.69 

 

Not very accurate, but I just wanted a sense of where they might be.

 

[Mephistopheles]

Eric, I have a few questions.

 

1) When you talk about skewness, you mean that as the stock moved higher than $13.30, the decrease in the value of the embedded put was greater than the increase in the value of the call, correct? And the reason for this is simply because investors in general are more likely long than short, and therefore like to buy puts and sell calls to hedge, affecting the prices as such?

 

2) How do you think of deep out of the money calls? So for example, the $30 strike Jan. 16 call has a cost of leverage of 70%. I can understand in common sense terms why it's that high, but how does it fit into your model that cost of leverage decreases the further the stock is from the strike? Obviously it isn't the case here. Why or why isn't it 70% at $30 Jan '16 cheap?

 

3) What would have happened had BAC fell $4 from the $13.30 strike rather than rise like it did?

 

4) We have focused on 6 year warrant vs. 2 year option. Aside from taxes and transaction fees, why not employ this strategy with any duration option? So if the price is right, why not roll a one week option over and over until you find a better price for a different duration? One objection I can think of to this strategy is that you are never locked in for any rate for a significant period of time; would you agree with that?

 

The way I like to think about these things is in more of a borrowing/lending fashion. The $30 call is 70% cost because you are borrowing so much for so little equity. All that leverage has a price. And the opposite is true for deep in the money calls. And that's why the cost falls as the stock goes higher, because your leverage is decreasing. It makes sense in a common sense way but I get confused when thinking of "skewness", "implied volatility", etc.

 

Thanks.

[ni-co]

Eric, I have a few questions.

 

1) When you talk about skewness, you mean that as the stock moved higher than $13.30, the decrease in the value of the embedded put was greater than the increase in the value of the call, correct? And the reason for this is simply because investors in general are more likely long than short, and therefore like to buy puts and sell calls to hedge, affecting the prices as such?

 

2) How do you think of deep out of the money calls? So for example, the $30 strike Jan. 16 call has a cost of leverage of 70%. I can understand in common sense terms why it's that high, but how does it fit into your model that cost of leverage decreases the further the stock is from the strike? Obviously it isn't the case here. Why or why isn't it 70% at $30 Jan '16 cheap?

 

3) What would have happened had BAC fell $4 from the $13.30 strike rather than rise like it did?

 

4) We have focused on 6 year warrant vs. 2 year option. Aside from taxes and transaction fees, why not employ this strategy with any duration option? So if the price is right, why not roll a one week option over and over until you find a better price for a different duration? One objection I can think of to this strategy is that you are never locked in for any rate for a significant period of time; would you agree with that?

 

The way I like to think about these things is in more of a borrowing/lending fashion. The $30 call is 70% cost because you are borrowing so much for so little equity. All that leverage has a price. And the opposite is true for deep in the money calls. And that's why the cost falls as the stock goes higher, because your leverage is decreasing. It makes sense in a common sense way but I get confused when thinking of "skewness", "implied volatility", etc.

 

Thanks.

 

+1 Thanks, this is basically my argument formulated much more succinctly.

[ERICOPOLY]

I think it would be better if I use live numbers to explain the skewness risk...

 

Today's Jan 2016 pricing...

 

$17 strike put for $1.52 is 8.9% of strike 

$15 strike put for 0.84 is 5.6% of strike

$12 strike put for 0.31 is 2.6% of strike

$10 strike put for 0.17 is 1.7% of strike

 

So do you see the pattern?  An at-the-money put has a lot of value because it protects all of your equity, but a very far out of the money put has practically no value -- because it doesn't protect a huge chunk of your equity.

 

The difference in pricing between the $12 and the $17 is 630 basis points. 

 

So....

 

The moral of the story is that for a stock where...

1) you think it is very undervalued (and at high risk of a large revaluation within a couple of years)

2) somebody offers you at-the-money options for a very, very, very long term with no discount for skewness risk

3) the initial volatility priced into the put is relatively high

 

... run like hell!  :D

 

That 630 basis points is multiplied across every remaining year left in the warrant.  The longer the term, the greater your pain.

 

A 30 yr warrant if it got hit by 630 basis points per year would cost you...  189%

 

These movements from skewness greatly dominate -- everything else is dwarfed.

 

Which is why for very long term at-the-money warrants you should demand a margin of safety to account for skewness risk.  ni-co has been saying completely the opposite.

 

NOTE:  I deviated in this post to save time, expressing the premiums as a % of strike rather than as the contribution to cost of leverage.  Just being lazy. 

[ERICOPOLY]

2) How do you think of deep out of the money calls? So for example, the $30 strike Jan. 16 call has a cost of leverage of 70%. I can understand in common sense terms why it's that high, but how does it fit into your model that cost of leverage decreases the further the stock is from the strike? Obviously it isn't the case here. Why or why isn't it 70% at $30 Jan '16 cheap?

 

That's a misunderstanding of my message. 

 

It gets cheaper to roll an initially at-the-money put after the stock breaks hard either up or down further away from strike.  For example, if you own the 2015 $17 strike put today and you wish to roll it out to 2016 $17 strike put, it will cost you an extra $1.25.

 

$1.25 is 7.35% of $17.

 

Okay, but lets say the stock plunges to $5 per share tomorrow morning before you roll it.  You existing put will be very deeply in the money, and you'll likely be paying only 25 cents or something in additional premium when you trade it for the 2016.

 

Skewness is what would drive the premium for the extra 12 months down to only 0.25 from 1.25 initially.

 

So that's why a greatly lower stock price would make my cost of leverage cheaper. 

 

You talked about calls in your question, but in every call there is a hidden put.  Same principle applies -- rolling an out-of-the-money call is cheaper than rolling an at-the-money call.  Entirely due to the value of it's hidden put.

[gary17]

I like Your explanation with real numbers!  for people like me it's easier to understand , thanks. 

 

so I've heard the warrants have an 'implied put' built into it.......... 

 

how do i calculate what that 'implied put' is ? 

 

and it seems like from the recent discussions here that these warrants now have the discount for 'skewness' --  would you agree ? 

 

thanks , Gary

 

I think it would be better if I use live numbers to explain the skewness risk...

 

Today's Jan 2016 pricing...

 

$17 strike put for $1.52 is 8.9% of strike 

$15 strike put for 0.84 is 5.6% of strike

$12 strike put for 0.31 is 2.6% of strike

$10 strike put for 0.17 is 1.7% of strike

 

So do you see the pattern?  An at-the-money put has a lot of value because it protects all of your equity, but a very far out of the money put has practically no value -- because it doesn't protect a huge chunk of your equity.

 

The difference in pricing between the $12 and the $17 is 630 basis points. 

 

So....

 

The moral of the story is that for a stock where...

1) you think it is very undervalued (and at high risk of a large revaluation within a couple of years)

2) somebody offers you at-the-money options for a very, very, very long term with no discount for skewness risk

3) the initial volatility priced into the put is relatively high

 

... run like hell!  :D

 

That 630 basis points is multiplied across every remaining year left in the warrant.  The longer the term, the greater your pain.

 

A 30 yr warrant if it got hit by 630 basis points per year would cost you...  189%

 

These movements from skewness greatly dominate -- everything else is dwarfed.

 

Which is why for very long term warrants you should demand a margin of safety to account for skewness risk.  ni-co has been saying completely the opposite.

[ERICOPOLY]

I like Your explanation with real numbers!  for people like me it's easier to understand , thanks. 

 

so I've heard the warrants have an 'implied put' built into it.......... 

 

how do i calculate what that 'implied put' is ? 

 

and it seems like from the recent discussions here that these warrants now have the discount for 'skewness' --  would you agree ? 

 

thanks , Gary

 

I think it would be better if I use live numbers to explain the skewness risk...

 

Today's Jan 2016 pricing...

 

$17 strike put for $1.52 is 8.9% of strike 

$15 strike put for 0.84 is 5.6% of strike

$12 strike put for 0.31 is 2.6% of strike

$10 strike put for 0.17 is 1.7% of strike

 

So do you see the pattern?  An at-the-money put has a lot of value because it protects all of your equity, but a very far out of the money put has practically no value -- because it doesn't protect a huge chunk of your equity.

 

The difference in pricing between the $12 and the $17 is 630 basis points. 

 

So....

 

The moral of the story is that for a stock where...

1) you think it is very undervalued (and at high risk of a large revaluation within a couple of years)

2) somebody offers you at-the-money options for a very, very, very long term with no discount for skewness risk

3) the initial volatility priced into the put is relatively high

 

... run like hell!  :D

 

That 630 basis points is multiplied across every remaining year left in the warrant.  The longer the term, the greater your pain.

 

A 30 yr warrant if it got hit by 630 basis points per year would cost you...  189%

 

These movements from skewness greatly dominate -- everything else is dwarfed.

 

Which is why for very long term warrants you should demand a margin of safety to account for skewness risk.  ni-co has been saying completely the opposite.

 

There are only two costs to the cost of leverage -- the implied put and an interest rate forecast.  You can back out the interest rate assumptions (maybe using 4 yr bond yields as a proxy) and the rest would be the put.

 

There isn't much skewness risk to discount today because $13 strike puts are relatively useless and priced as such.

 

So that very reason is why I like the warrants -- the value of the implied put would soar in a market crash.

 

See, if the stock goes up 10% a year from here until expiry, you'll make a spread of 5% a year over the present cost of leverage.

 

However, if instead the stock drops back to $12 again in a crash next week, you'll likely see the warrants go back to 13% cost of leverage again.  So multiplied by 4 years, that would cushion your fall by 32%. 

 

In other words, you likely have the same downside risk as the unleveraged common in a big crash back down to $12, but you have leveraged upside if the stock returns more than 5% a year from here.

 

So... before it was nearly impossible to win and now it's much harder to lose.

 

These warrants don't carry skewness risk when stock price is already very askew relative to warrant strike.

[ERICOPOLY]

3) What would have happened had BAC fell $4 from the $13.30 strike rather than rise like it did?

 

The warrant holders would be no better off.  They are just sort of stuck.

 

However, I could take advantage of this gift-from-market-gods by rolling my puts to a lower strike.  Or by keeping the strike at $12 and use skewness to my benefit by getting a better price when rolling.

 

Just like I can take advantage of the recent price rise by rolling to a higher strike or rolling my $12 puts inexpensively.  Same difference.

 

Example of rolling to lower strike after stock has declined by $4 from $12 to $8...

1) purchase new $8 strike put and sell the initial $12 put, thereby locking in the profit on the $12 put.  It will get even more exciting later when stock rallies up to $12 and you either roll your $8 strike put up to $12 again, or use skewness to your benefit and get a cheap premium rolling the $8 strike put along

2) The lower the stock goes, the better it gets.  This is why the warrants should have been cheaper, they had less optionality and thus were less valuable in times of stock price volatility

 

 

[ERICOPOLY]

4) We have focused on 6 year warrant vs. 2 year option. Aside from taxes and transaction fees, why not employ this strategy with any duration option? So if the price is right, why not roll a one week option over and over until you find a better price for a different duration? One objection I can think of to this strategy is that you are never locked in for any rate for a significant period of time; would you agree with that?

 

The problem with short term options is that their cost of leverage is normally too high for my taste. 

 

For example, February 2015 BAC $17 put is 43 cents, and the Jan 2016 is $1.52.  The first two months costs 43 cents, and the next 11 months cost only $1.09. 

 

That last 11 months comes at roughly 2.5 times the price of the first two months for 5.5 times longer duration.  The shorter duration call carries more expensive cost of leverage by a country mile.  Are you paying attention ni-co?  ;)

 

The longer dated put has a lower cost of leverage than the shorter dated put.  I get a bit of a discount for taking on skewness risk.

 

Which is why the warrants were such a lousy deal -- the cost of leverage was not only high, but it was the same as with the 2 year options.

 

BAC was very volatile, a 1 or 2 yr option was plenty of time to camp out waiting for the stock to move up or down.  And those 2 year options carried the same cost of leverage as with the warrants, so you weren't paying a premium for the flexibility.

 

Optionality is valuable, and shorter duration options have more optionality.  That's why they are more expensive.  Clear?

[ERICOPOLY]

The way I like to think about these things is in more of a borrowing/lending fashion. The $30 call is 70% cost because you are borrowing so much for so little equity. All that leverage has a price. And the opposite is true for deep in the money calls.

 

Precisely as I've explained it in the past.  We agree.

 

The $30 call is effectively a $30 strike put married to a share of common.

 

The option premium is the little bit of skin in the game...  Additional payment to the lender comes in the form of the eroding put as the stock increases... if it ever does.  He has a huge profit share in exchange for accepting such a small premium.  Maybe he is Rumpelstiltskin???

 

The tiny premium is the straw that he will spin into gold in return for your first born child.

[gary17]

See, if the stock goes up 10% a year from here until expiry, you'll make a spread of 5% a year over the present cost of leverage.

 

However, if instead the stock drops back to $12 again in a crash next week, you'll likely see the warrants go back to 13% cost of leverage again.  So multiplied by 4 years, that would cushion your fall by 32%. 

 

In other words, you likely have the same downside risk as the unleveraged common in a big crash back down to $12, but you have leveraged upside if the stock returns more than 5% a year from here.

 

Thanks -

 

What do you mean by earning 5% spread over the present cost of leverage?  So the present cost of leverage is about 5%.  I'm not used to the financial terms...

 

--

 

Anyway, sounds like this is one possibility:

 

  $17.5 x 1.1^4yr = $25                  a 43% upside

  warrant go from $7 --> $12.4    so a 76% upside

 

or

  $17.5 --> $12        a 31% downside

warrants go from $7 -> $ 4 to get to 13% cost of levg.    a 42% downside

 

So I get what you are saying now - warrants at this price gives you more to the upside while only slightly worse or about the same as the downside risks....

 

 

 

 

[ERICOPOLY]

What do you mean by earning 5% spread over the present cost of leverage? 

 

You borrow money for 5% interest rate, and you invest the proceeds in an asset that returns 10%.

 

The spread is the profit.

[ni-co]

Yes, I paid attention. First off, I don't argue with you here because of disrespect. I'm respecting your opinion highly and I'm profiting from this discussion immensely. It's only that I'm looking from a slightly different angle, I guess. Actually, having discussed it I'm not sure whether there is a right or wrong way to look at it. It might be a matter of taste, but let's see.

 

Thinking about our discussion here I went back to my initial post and thought about how I got into this fight. Why am I of the opinion that nothing (or better: very little) has changed and you that everything has changed? It obviously has to do with how we think about valuing options. Neither of us does it the EMH way.

 

You are valuing them very precisely by taking into account not only the IV of the stock, but also the most likely market action. My method is messier but I think it's easier to handle and I tend to think a bit less risky – though that's up for debate. I don't care too much about cost of leverage and the relative value of the warrants; I don't care about short term price movements (I'm thinking of less than 1-2 years). When I'm looking for margin of safety in warrants, I'm looking for 3 factors:

 

1. What is my best guess of the intrinsic value of the underlying stock?

2. What's the difference between the break even point of the warrant and the intrinsic value? (Has to be huge ;) )

3. How much time do I have to having it played out?

 

I think you might argue that it's no. 2 where cost of leverage comes into play. As the lower the cost of leverage, the lower the price of the warrant and thereby the break-even point. At this point, I agree with you.

 

However, no. 3 is much more important to me. As I follow Joel Greenblatt's theory that it takes the market usually 1-3 years to recognize the fair value of a stock, sometimes a bit longer, a 5 year warrant is much, much less risky to me than, say, 1 or 2 year LEAPs. As I consider movements within this timeframe to be largely random, I'm having a very hard time buying such LEAPs and taking those risks (exeption: catalysts with given dates like spin-offs etc.).

 

So, what does this mean for BAC warrants? When I bought the warrants they had about 5 years left until expiration. Now they've got 4 years left. Price is unchaged. Presuming the same IV for BAC's stock, I consider the warrants to carry largely the same risk/reward at this level. If anything, risk went up by a notch because of the time passed. As you might immediately notice, there is one factor that I don't use when valuing the warrants and this is the current market price of the stock. It doesn't matter to me. Why? Because I don't own the equity. I own the call or the equity and the put if you will. So, equity going up, price of put gowing down means to me: same risk. This is where we disagree, I guess.

[ERICOPOLY]

So, equity going up, price of put gowing down means to me: same risk. This is where we disagree, I guess.

 

Well, we disagree because the idea was just plain stupid -- to choose an instrument that was leveraged but which would not provide a decent leveraged return for you if stock movement to IV occurred suddenly (in the first year or two).

 

You might as well have just held the common all along with the idea that you would swap it for the warrant after the revaluation.  Or if the stock remained flat during that time, swap the common for the warrant after the decay had occurred and skewness risk had lessened (fewer years remaining).

 

Now you're stuck leveraging into a deep-in-the-money stock that is much closer to fair value and time is running out.  Imagine in two years from now if the stock is at $22.  Seriously, would you normally leverage almost 2:1 into a mostly fairly valued stock with a deep-in-the-money put that expires in just two years?

 

And I said this towards the beginning of the thread!  I said that skewness would destroy the leveraged returns on the first big revaluation, and then you'd be too chickenshit to continue to hold it when the stock is fully valued with just a year or two remaining and the strike is only $13 (or less after dividend adjustments).

 

So it's a pointless trade...

1)  you make nothing from your leverage on a big jump early on...

2)  you take the risk of complete wipeout if the stock crashes back to strike at expiry

3)  you prepay for a $13 put for that last year or two even though if the stock has recovered by then you'll never have the guts to continue holding on.  That's because you don't normally leverage into fully valued stocks with relatively short-term options on a deep-in-the-money basis

 

None of that is said with hindsight.  I said it all upfront.  It was all wholly predictable.

 

1)  Why be leveraged at that point in time if any big gains from such leverage would be wiped out?  That's completely pointless.  What were you thinking?  Worse than that, you took the risk of underperforming the common on such a move.

 

At the start of the thread I pointed to the way a bank with less uncertainty (Wells Fargo) was valued, and how it's in-the-money warrants were valued.  The risk of BAC clearing up the uncertainty (settling lawsuits, running off bad loans and reducing expenses, retaining earnings to boost capital) was that the stock would rise as a result and BAC's implied volatility would drop (irrespective of VIX).  Add skewness to that, and you just got your ass kicked.

 

[ERICOPOLY]

a 5 year warrant is much, much less risky to me than, say, 1 or 2 year LEAPs.

 

A 2 yr LEAP can be extended indefinitely by rolling.  I can roll that thing along for the rest of my life.

 

You rushed in and locked in all 6 years when it was at-the-money and with high implied volatility, I decided to dip my toe in knowing that I would only come out worse off if the volatility had gone even higher on successive rolls and if the stock were still near strike each time.  I took that minor risk in exchange for being rewarded if the stock did in fact move.  Compare that to your risk where you would not benefit from any such move.

 

You made a conscious choice to give up any big price spike in the first year or two in exchange for participation in future returns after that.  However by your own admission you will deem it too risky to continue to hold the position during it's final two years.  Thus, you'll never get paid for all this risk you took on!

 

The price of the non-recourse leverage is the only consideration, not the duration.  Durations can be extended.  You were happy to pay 13% year for years 3,4,5,6, and I passed because those prices absolutely sucked under the scenario that you and I decided to get leveraged for back when the stock was at $12 -- we both decided to leverage at that time because we were unwilling to wait two more years for fear that the stock would climb and get away from us... the very scenario under which you would not get paid anyhow. 

[ERICOPOLY]

In other words, it was all just a very elaborate illusion.

 

They looked like "6 year" warrants, but all the gains from them will come during the final couple of years.  So if you can't stomach holding a two year deep-in-the-money option then you'll never profit from the leverage within these warrants.  You'll sell them just when they begin to offer some upside.

 

So they are effectively the same risk profile as 2 year deep-in-the-money options on fully-valued stock price due to the fact that they don't begin to outperform the common until that time.

 

And you can find in-the-money 2 year options on Berkshire Hathaway if that game pleases you.  But that sounds like a bad Rick Guerin story.

[ni-co]

What you're saying is simply false. You can't roll it until infinity because in the Black/Scholes model, which is the basis for any standard option pricing model, volatility increases only with the square-root of time and not linearly. The longer the duration of a warrant the larger usually the mispricing if a stock is severely undervalued.

 

You, my friend, are making predictions about the way volatility develops. You prove nothing when your guess turns out to be correct. And I just can't understand why you call people stupid who are not willing to make guesses about the way volatility is developing. You can't deny that you are taking additional risk by doing this. It's simply not as easy as you make it sound. And that's the whole thing I'm taking issue with.

[ERICOPOLY]

And that's why the cost falls as the stock goes higher, because your leverage is decreasing.

 

I think of the put as insurance.

 

So the way I would phrase it is that high-deductible insurance is a lot cheaper than no-deductible insurance.

 

A far-out-of-the-money put (embedded in a deep-in-the-money call) has a tremendously large "co pay", so the insurance comes very cheap.

 

An at-the-money put embedded in an at-the-money call has no deductable and no co-payment, so therefore it is far more expensive.

 

This is priced like insurance, because that's what it is.

[ERICOPOLY]

It's simply not as easy as you make it sound. And that's the whole thing I'm taking issue with.

 

Really?  I said that my risk is (relative to just buying the warrant) higher than 13% cost of leverage on successive rolls.

 

And in exchange for that risk I have more valuable optionality and less skewness risk.

 

You take issue with that?

 

 

[ERICOPOLY]

The longer the duration of a warrant the larger usually the mispricing if a stock is severely undervalued.

 

Yep, it was severely mis-priced because you paid at-the-money premiums for a very undervalued stock that wasn't terribly likely to stay that way.  It locked you in to that pricing for a very long term despite it being a more likely than not temporary condition.

 

The stock undervaluation tipped the scales of probability that a large move in skewness was in the cards.  But you were getting no discount for this because the model knows nothing about equities undervaluation.  And you were most greatly exposed to this because your warrants were at-the-money.

 

I already have argued this! 

[ni-co]

The longer the duration of a warrant the larger usually the mispricing if a stock is severely undervalued.

The stock undervaluation tipped the scales of probability that a large move in skewness was in the cards.  But you were getting no discount for this because the model knows nothing about equities undervaluation.  And you were most greatly exposed to this because your warrants were at-the-money.

 

I already have argued this!

 

Yes, but, what you don't see, is that this is exactly the reason why taking shorter durations doesn't give you better risk adjusted returns. It increases your expected returns, but it also significantly increases your risk. You don't know in advance how BAC's volatility develops. You just guess. But it depends on so many factors that I'd say: I'd rather not try it. All I do by buying the warrant is potentially leaving money on the table. What you were doing is increasing your risk of blowing up with this position.

[LC]

FYI great (if not heated) discussion: I am learning here.

[ni-co]

FYI great (if not heated) discussion: I am learning here.

 

Thanks! I'm learning, too.

 

Eric, one question: Why do you think Warren Buffett was so stupid to demand in the money BAC calls with 10 years til expiration instead of simply insisting on cheaper preferreds? After all, he could have rolled standard LEAPs. I guess that any investment bank would gladly provide him with a sufficient amount. It must have been a time of really low volatility when he received those warrants…

[ERICOPOLY]

FYI great (if not heated) discussion: I am learning here.

 

Thanks! I'm learning, too.

 

Eric, one question: Why do you think Warren Buffett was so stupid to demand in the money BAC calls with 10 years til expiration instead of simply insisting on cheaper preferreds? After all, he could have rolled standard LEAPs. I guess that any investment bank would gladly provide him with a sufficient amount. It must have been a time of really low volatility when he received those warrants…

 

He didn't prepay a premium.

 

He didn't take on any skewness risk.

 

You did !!!!!!!!!!!!!!!!!!

 

!!!!!!!!!!!!!!!

 

!!!!!!!!!!!!!!

 

Are you sure you are not just fucking around with me?

 

[ERICOPOLY]

Yes, but, what you don't see, is that this is exactly the reason why taking shorter durations doesn't give you better risk adjusted returns. It increases your expected returns, but it also significantly increases your risk.

 

The risk to the LEAPS is that I lose 13% annualized for 2 years (same as your average cost in the warrant).

 

Now, if the stock plunges or soars, my premium will fall by a much smaller absolute dollar amount than your warrant premium.

 

I have less on the table to lose from price swings.  You had so much on the table that it completely wiped out your leveraged gains and then some.

 

So how come you lost more premium if your approach is absolutely less risky genius?