BAC leverage

[ERICOPOLY]

Example:

 

The $10 BAC puts (2015) are bid at nearly 10% of strike.

 

The $25 SHLD puts (2015) are bid at nearly 10% of strike.

 

So at those strikes they both cost the same for insuring a dollar of risk.

 

So I can swap $10 BAC downside risk for $25 SHLD downside risk.

 

So, worst case, I might get put SHLD after a 50% decline from it's current price.

 

But I get protection from a 20% decline in BAC.

 

This is a brilliant example.  Just curious, in the above example do you pick out SHLD randomly?  My guess is no.. I think you found it because it has a relatively high time value.  If so, I wonder if you use a particular website to filter these high time value names.

 

I have been following the entire thread.  Thanks for the great knowledge dispensed.  An elegant and rational way to think about options and leverage.

 

SHLD has been heavily shorted for years (it's expensive to borrow the shares for shorting it, so the shorts use the puts in the options market).  This puts a lot of pressure on the price of SHLD puts.

 

I know many people on the board "can't get comfortable with BAC" because it's a black box they say, and some of them like SHLD perhaps, so I wanted to point out that you can take the downside of SHLD after a 50% decline and swap it for a 20% decline risk of BAC.

 

So being a pussy isn't an excuse.  You don't have to take the risk of BAC in order to take it's upside.  Of course, you have to be able to stomach the downside of SHLD.

 

[ERICOPOLY]

 

 

Here is what you do.

 

1)  Go put 100% of your portfolio in BAC common stock.

2)  Purchase at-the-money puts to protect 90% of the BAC position

3)  Write puts on other securities such that you now have 90% downside in those other names

 

Reg-T rules treated this as 1.9x downside I believe, even though it's really only 1x downside.

 

The cash from writing puts on a diversified basket of names finances the puts that protect the concentrated BAC position.

 

Fascinating discussion.

 

I understand that you're essentially converting your downside in BAC into downside in a diversified position (say an index) , but what if the market does go down substantially, wouldn't the short index put be exposed? If I am not mistaken, the long put hedges the underlying, but you end up with a large unhedged long position on the index?

 

You still have 100% downside risk.  It's just not concentrated in 1 name anymore.

 

And be careful writing puts -- make sure that you aren't leveraged in the situation where 100% of your puts get assigned.

[ERICOPOLY]

I can purchase Nov 2013 puts on BAC (to ensure they expire this year) and finance them with Jan 2014 puts on other things (maybe SHLD).

 

Later, when the Dec 2013 puts on BAC come out, I'll roll the Nov puts into the Dec puts.  I'm pretty sure they'll issue the series that ends on Dec 31st, like they always do.

 

That way, I can then close out the SHLD puts at market open on the first trading day of 2014.

 

I (expect to) take the losses on the BAC puts in 2013, and the gains on the SHLD puts in 2014.

 

Given the large amount of short-term capital gains I just booked from selling my BAC warrants, I can use a good tax write-off.

 

The SHLD puts I write will be short-term gains as well, but I push them out a year (okay, a couple of days) where my tax bracket might be lower.  And if I do this every year, I might never pay those taxes.

 

 

EDIT:  Yes, there is a risk of crash at market open in 2014.  So, a bit more than a month before the BAC puts expire, I purchase a new series of them.  Then after the SHLD puts expire I write more (to finance the BAC puts purchased in November).  That way there is a lock protecting the window of time over the New Year holiday. 

 

Question:  Is it necessary to purchase the 2014 BAC puts a full month before those 2013 BAC puts expire?  I'm doing it that way because I presume otherwise there would be a wash sale rule problem with not using those losses in 2013.

[ERICOPOLY]

Just curious, in the above example do you pick out SHLD randomly?  My guess is no.. I think you found it because it has a relatively high time value.  If so, I wonder if you use a particular website to filter these high time value names.

 

I don't use a website.  I'm not sure it would help anyway, as you really need to be careful what shares you might get assigned if puts are exercised.  So better just to stick to what you think is already undervalued (usually those puts are likely high premium due to the uncertainty).

 

Maybe you think BAC has a nearer-term catalyst but the others have solid downside (but no catalyst).  That might be a reason to go "all in" on BAC upside but swap it's downside for that of others.

[hyten1]

eric your statement "And be careful writing puts -- make sure that you aren't leveraged in the situation where 100% of your puts get assigned."

 

how do you prevent 100% of your puts get assign? if the strike price hits its assign, unless you spread out the write to different securities and different strikes is that what you mean?

[ERICOPOLY]

eric your statement "And be careful writing puts -- make sure that you aren't leveraged in the situation where 100% of your puts get assigned."

 

how do you prevent 100% of your puts get assign? if the strike price hits its assign, unless you spread out the write to different securities and different strikes is that what you mean?

 

You can't prevent stocks from going lower, unless you are Bernanke.  :P

 

All I'm saying is make sure you are swapping insurance on $1 of stock for insurance on $1 of another stock.

 

Let's say you want to purchase puts at-the-money on BAC, but you want to finance it with puts on Berkshire.  You'll need to write in-the-money puts on Berkshire because that's the only way $1 of Berkshire risk is going to fully pay for $1 of BAC risk.

 

But that's fine if you think Berkshire is backed by that "Buffett put" that others talked about and can only increase significantly value from here over the term of the put.

 

The market isn't stupid most of the time -- you'll have to either lose a bit of money on financing the BAC puts or you'll have to accept the consequences of writing in-the-money puts on stocks that the market thinks are lower risk.

 

 

 

[ERICOPOLY]

Anyways, Berkshire is a certainty.  BAC is an uncertainty.

 

Even if you write in-the-money puts on Berkshire, it's a certainty that even if you get assigned the shares you'll be made whole if you patiently hold the stock long enough.

 

That's a way that I suppose you could have gone 100% into BAC in December 2011 when it was at $5.  You would simply have hedged it at-the-money with proceeds from writing in-the-money Berkshire puts. 

 

And today you would have been made whole even if BAC had gone to zero.

 

You would merely have lost the opportunity cost of missing out on the Berkshire gain (your gain after getting assigned on Berkshire mostly went to paying off the cost of the expensive BAC put).

 

[LC]

All I'm saying is make sure you are swapping insurance on $1 of stock for insurance on $1 of another stock.

...

The market isn't stupid most of the time -- you'll have to either lose a bit of money on financing the BAC puts or you'll have to accept the consequences of writing in-the-money puts on stocks that the market thinks are lower risk.

Aha! This was what I was most curious about and I was having difficulty wording my question. So you do acknowledge that the swapping of risk is not a "perfect" hedge. Either you will pay additionally to ensure that you swap in a 1:1 ratio, or you have to accept something like 0.9:1 coverage.

 

That is where this becomes so very complicated to me. Because now you are choosing from among the multitude of put options to write which will both give you an attractive downside (something like SHLD or BRK) AND whose cost will allow you to swap risk in a relatively 1:1 manner.

 

Thanks again Eric!

[kmukul]

Thanks Eric, Prasad and everyone else on this board, you guys are awesome..

 

Eric i have a question, Why not buy slightly in the money calls of BAC like 10$ when the stock is 12$ that way your cost of leverage will be even lower then 10%.

 

Bac has gone up a lot.. and AIG hasnt so may be we can write BAC calls and collect premium and put it into AIG. Aig is pretty much over value then BAC at current price.

[ERICOPOLY]

Eric i have a question, Why not buy slightly in the money calls of BAC like 10$ when the stock is 12$ that way your cost of leverage will be even lower then 10%.

 

Doing that raises your downside risk because the implicit put is at a lower strike.  It leverages your downside (slightly).

 

Had I used those $10 calls in my arguments from the beginning, I would have been called out by the many sharp people on this board.

 

 

[kmukul]

Example:

 

The $10 BAC puts (2015) are bid at nearly 10% of strike.

 

The $25 SHLD puts (2015) are bid at nearly 10% of strike.

 

So at those strikes they both cost the same for insuring a dollar of risk.

 

So I can swap $10 BAC downside risk for $25 SHLD downside risk.

 

So, worst case, I might get put SHLD after a 50% decline from it's current price.

 

But I get protection from a 20% decline in BAC.

 

 

EDIT:  I guess it's obvious, but I meant to say the worst I can suffer from BAC is a 20% decline.  It no longer matter how far it drops beyond that point.

 

Wow this is amazing find. Is Mr Market really so dumb to offer this opportunity? Or is there more to it?

[ERICOPOLY]

Example:

 

The $10 BAC puts (2015) are bid at nearly 10% of strike.

 

The $25 SHLD puts (2015) are bid at nearly 10% of strike.

 

So at those strikes they both cost the same for insuring a dollar of risk.

 

So I can swap $10 BAC downside risk for $25 SHLD downside risk.

 

So, worst case, I might get put SHLD after a 50% decline from it's current price.

 

But I get protection from a 20% decline in BAC.

 

 

EDIT:  I guess it's obvious, but I meant to say the worst I can suffer from BAC is a 20% decline.  It no longer matter how far it drops beyond that point.

 

Wow this is amazing find. Is Mr Market really so dumb to offer this opportunity? Or is there more to it?

 

Of course we will only know for sure who is so dumb with hindsight.

[kmukul]

Eric i have a question, Why not buy slightly in the money calls of BAC like 10$ when the stock is 12$ that way your cost of leverage will be even lower then 10%.

 

Doing that raises your downside risk because the implicit put is at a lower strike.  It leverages your downside (slightly).

 

Had I used those $10 calls in my arguments from the beginning, I would have been called out by the many sharp people on this board.

 

Thanks for your response, but i would rather buy 10$ call even if though implicit put is at lower strike as my cost of financing which is real goes down also my delta improves a little bit, Other then the argument with the board is it not the right way to think?

[Studesy]

Example:

 

The $10 BAC puts (2015) are bid at nearly 10% of strike.

 

The $25 SHLD puts (2015) are bid at nearly 10% of strike.

 

So at those strikes they both cost the same for insuring a dollar of risk.

 

So I can swap $10 BAC downside risk for $25 SHLD downside risk.

 

So, worst case, I might get put SHLD after a 50% decline from it's current price.

 

But I get protection from a 20% decline in BAC.

 

 

EDIT:  I guess it's obvious, but I meant to say the worst I can suffer from BAC is a 20% decline.  It no longer matter how far it drops beyond that point.

 

Wow this is amazing find. Is Mr Market really so dumb to offer this opportunity? Or is there more to it?

 

Of course we will only know for sure who is so dumb with hindsight.

 

Eric...I assume you only use this strategy in your taxable accounts... unless the tax-free account rules are different in the US.  In Canadian tax-free accounts (RRSP, TFSA) ...we cannot sell naked puts. 

[ERICOPOLY]

Example:

 

The $10 BAC puts (2015) are bid at nearly 10% of strike.

 

The $25 SHLD puts (2015) are bid at nearly 10% of strike.

 

So at those strikes they both cost the same for insuring a dollar of risk.

 

So I can swap $10 BAC downside risk for $25 SHLD downside risk.

 

So, worst case, I might get put SHLD after a 50% decline from it's current price.

 

But I get protection from a 20% decline in BAC.

 

 

EDIT:  I guess it's obvious, but I meant to say the worst I can suffer from BAC is a 20% decline.  It no longer matter how far it drops beyond that point.

 

Wow this is amazing find. Is Mr Market really so dumb to offer this opportunity? Or is there more to it?

 

Of course we will only know for sure who is so dumb with hindsight.

 

Eric...I assume you only use this strategy in your taxable accounts... unless the tax-free account rules are different in the US.  In Canadian tax-free accounts (RRSP, TFSA) ...we cannot sell naked puts.

 

I have, in the past, sold cash-covered puts in my RothIRA and used the premiums collected to buy calls.

 

Mostly, it's exactly the same.

[kmukul]

eric this i am sure is a newbie question

 

i assume when you roll to higher at-the-money strikes. you keep the number of contract constant not the dollar value right so as the stock price goes up (assuming that is what happens) you roll to ever higher at-the-money strikes with each subsequent roll you take some money off?

 

Hyten...I believe you are correct.....that is how the gains are locked in.

 

That isn't exactly my plan.

 

Okay, suppose you start out with 1.5x leverage -- you initially hedge the 0.5x.

 

Later the stock doubles and the account is now leveraged 1.25x.

 

When I roll, I plan to hedge only .25x.

 

So I'm only interested in hedging the amount "borrowed". 

 

Over time, the amount "borrowed" becomes a smaller percentage of the pie -- but nonetheless, I always hedge the absolute dollar amount initially "borrowed" at ever roll.

 

As long as the stock is rising, this means fewer and fewer contracts on successive rolls.

 

Dont you lose money everytime you roll? i think this is sort of hidden cost with options. For example if you roll BAC 7$ call to 10$ call today you should get 3$ but if you look at the quotes you will get more like 2.7-2.8$ by rolling

[ERICOPOLY]

eric this i am sure is a newbie question

 

i assume when you roll to higher at-the-money strikes. you keep the number of contract constant not the dollar value right so as the stock price goes up (assuming that is what happens) you roll to ever higher at-the-money strikes with each subsequent roll you take some money off?

 

Hyten...I believe you are correct.....that is how the gains are locked in.

 

That isn't exactly my plan.

 

Okay, suppose you start out with 1.5x leverage -- you initially hedge the 0.5x.

 

Later the stock doubles and the account is now leveraged 1.25x.

 

When I roll, I plan to hedge only .25x.

 

So I'm only interested in hedging the amount "borrowed". 

 

Over time, the amount "borrowed" becomes a smaller percentage of the pie -- but nonetheless, I always hedge the absolute dollar amount initially "borrowed" at ever roll.

 

As long as the stock is rising, this means fewer and fewer contracts on successive rolls.

 

Dont you lose money everytime you roll? i think this is sort of hidden cost with options. For example if you roll BAC 7$ call to 10$ call today you should get 3$ but if you look at the quotes you will get more like 2.7-2.8$ by rolling

 

You are borrowing more money at $10 than at $7.  So you have to account for that.

 

Shave 20-30 cents off of $3 to account for the interest costs on that $3 you are borrowing.

[Studesy]

Example:

 

The $10 BAC puts (2015) are bid at nearly 10% of strike.

 

The $25 SHLD puts (2015) are bid at nearly 10% of strike.

 

So at those strikes they both cost the same for insuring a dollar of risk.

 

So I can swap $10 BAC downside risk for $25 SHLD downside risk.

 

So, worst case, I might get put SHLD after a 50% decline from it's current price.

 

But I get protection from a 20% decline in BAC.

 

 

EDIT:  I guess it's obvious, but I meant to say the worst I can suffer from BAC is a 20% decline.  It no longer matter how far it drops beyond that point.

 

Wow this is amazing find. Is Mr Market really so dumb to offer this opportunity? Or is there more to it?

 

Of course we will only know for sure who is so dumb with hindsight.

 

Eric...I assume you only use this strategy in your taxable accounts... unless the tax-free account rules are different in the US.  In Canadian tax-free accounts (RRSP, TFSA) ...we cannot sell naked puts.

 

I have, in the past, sold cash-covered puts in my RothIRA and used the premiums collected to buy calls.

 

Mostly, it's exactly the same.

 

Makes sense.  Unfortunately in Canadian registered accounts we can't do that.  Can only buy puts & calls.....can only sell covered calls.  Cana anyone else from Canada verify that I am correct on this?

[ERICOPOLY]

It's also important not to be deceived by the seemingly cheap leverage in deep-in-the-money calls.

 

The at-the-money calls are discounted to account for the anticipated dividends (if any).

 

Let's say for example a $10 stock is paying a 30 cent dividend and you have a $3 strike deep-in-the-money call.  You miss out on the dividend for all of your "in-the-money" cash tied up in the option.  So you can't simply compute the cost of leverage as the premium you are paying along for the $3 strike -- you have to also consider the yield you are missing out on by having so much cash tied up in a deep-in-the-money call.

 

Anyways, that's obvious to some people but others can be fooled for a period of time.

 

It's much easier to compare leverage across strikes when the company is not expected to pay any dividends.

[Sunrider]

Hi Eric

 

Please also see my question re clarification in the other thread (General board).

 

I'm still struggling to fully follow your reasoning (not with respect to what you consider cheap or expensive, that's fairly clear) but if I go back right to the beginning you said you're simply looking for the lowest cost of leverage.

 

If that is so, then why are you using options at all? Why not just buy 150 worth of shares for every 100 you actually want to invest (or the same on share numbers) and get IB to finance that leverage for you at about 1.something%? Wouldn't a margin loan always be below the 9% or similar your calculation would yield on pretty much any option (I think so because in the option you're paying for uncertainty, with the margin loan you're not really).

 

Thanks - C.

[Studesy]

Hi Eric

 

Please also see my question re clarification in the other thread (General board).

 

I'm still struggling to fully follow your reasoning (not with respect to what you consider cheap or expensive, that's fairly clear) but if I go back right to the beginning you said you're simply looking for the lowest cost of leverage.

 

If that is so, then why are you using options at all? Why not just buy 150 worth of shares for every 100 you actually want to invest (or the same on share numbers) and get IB to finance that leverage for you at about 1.something%? Wouldn't a margin loan always be below the 9% or similar your calculation would yield on pretty much any option (I think so because in the option you're paying for uncertainty, with the margin loan you're not really).

 

Thanks - C.

 

I think the options are used because they provide non recourse leverage. Would be the equivalent of borrowing to buy the additional 500 shares and then buy put options to protect a certain amount of downside. That's what Eric was talking about the embedded put in the leaps.

[racemize]

Incidentally, at this point, the cost of leverage for the A warrants is 11.81% versus 2015 12's of 10.56%, so most of this conversation has disappeared.

 

I personally just switched my B warrants to the 2015 10's, which has a cost of leverage of 6.72%.

 

Addendum:

Also, note that if you buy the 2015 12's instead of the 2015 10s, you are betting on it reaching 16.55 in the time frame.  That gets a bit high for me!

[hyten1]

just an observation i too have also been thinking about the advantages and disadvantages between the varies strike prices, especially the 12,10 and 7s for 2015 BAC calls

 

one thing to keep in mind, buying these call options doesn't not mean you have to wait until maturity, one thing about the higher strike is obviously the lower cost premium, but also the premium's move are larger. meaning if the stock move up or down the change to the 12s will be greater ... i think.

 

so if you think there is going to be some catalyst that moves the stock before the call matures and in relatively short order, you would want the higher strike calls... i think.

 

not withstanding the cost of leverage.

 

 

[Sunrider]

Hmm - but if I understood this correctly, the whole strategy is predicated on the fact that you are 100% certain that BAC will be much higher in 2018 than it is today (say above 24 or whatever the 'switch over' point is). So if that's the case you truly should not care about the non-recourse nature and simply go for the cheapest leverage?

 

Thanks - C.

 

Hi Eric

 

Please also see my question re clarification in the other thread (General board).

 

I'm still struggling to fully follow your reasoning (not with respect to what you consider cheap or expensive, that's fairly clear) but if I go back right to the beginning you said you're simply looking for the lowest cost of leverage.

 

If that is so, then why are you using options at all? Why not just buy 150 worth of shares for every 100 you actually want to invest (or the same on share numbers) and get IB to finance that leverage for you at about 1.something%? Wouldn't a margin loan always be below the 9% or similar your calculation would yield on pretty much any option (I think so because in the option you're paying for uncertainty, with the margin loan you're not really).

 

Thanks - C.

 

I think the options are used because they provide non recourse leverage. Would be the equivalent of borrowing to buy the additional 500 shares and then buy put options to protect a certain amount of downside. That's what Eric was talking about the embedded put in the leaps.

[hyten1]

sunrider

 

what about margin calls as the stock swing?

 

if you borrow on margin, the stock drops, trigger margin call you would be force to sell to cover margins

 

option doesn't have that problem (this is when non recourse helps)

 

i think?

 

hy