BAC leverage

[ERICOPOLY]

 

what about for jan 2015 calls? comparning btw 7,10,12 strikes. i have notice the 12 strikes price movement has been larger recently relative to the 10s and 7s.

 

 

 

I'm afraid I don't understand.  Can you tell me what the price movements were that you saw? 

[hyten1]

eric it might be nothing

 

for example today the  10 calls premium move up 0.175 per share, while the 12 calls premium move up 0.21 per share

 

prob just fluctuating or more buyer vs seller.

 

EDIT: i guess the general large questions is as the strike price move up, how does each of the premium react to the change in price in the common. i think there is some formula for this with option theory.

 

 

hy

 

 

what about for jan 2015 calls? comparning btw 7,10,12 strikes. i have notice the 12 strikes price movement has been larger recently relative to the 10s and 7s.

 

 

 

I'm afraid I don't understand.  Can you tell me what the price movements were that you saw?

[ERICOPOLY]

eric it might be nothing

 

for example today the  10 calls premium move up 0.175 per share, while the 12 calls premium move up 0.21 per share

 

prob just fluctuating or more buyer vs seller.

 

EDIT: i guess the general large questions is as the strike price move up, how does each of the premium react to the change in price in the common. i think there is some formula for this with option theory.

 

 

hy

 

 

what about for jan 2015 calls? comparning btw 7,10,12 strikes. i have notice the 12 strikes price movement has been larger recently relative to the 10s and 7s.

 

 

 

I'm afraid I don't understand.  Can you tell me what the price movements were that you saw?

 

First, volatility increased, and that's an input into the formula that moves premium prices.

 

That's "skewness" that causes at-the-money to move (in absolute dollar terms) more than out-of-the-money, for a given input of volatility.  A change in volatility will have a "skewed" impact on the range of strikes.

 

But in relative dollar terms the opposite happened -- the premiums of further out strikes increase by a higher percentage.  For example, 2 cents is 100% greater than 1 cent, but 3 cents is 50% greater than 2 cents.  But anyways... more obvious statements from me  :D

 

 

 

[Studesy]

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?

 

That's my experience with my BMO RSP account too.

 

 

Then you guys can participate:

 

Example

1)  Buy SHLD common (take SHLD downside)

2)  Write SHLD covered call (collect premium)

3)  Buy BAC call with premium from step 2

 

 

So comparing this to the example of hedging the BAC common it would look something like this??

 

 

Taxable Account:

 

1) Buy 2 BAC common  = -$24

2)Buy 2 BAC $10 Put    = -$2

3) Sell 2 SHLD $25 Put = +$2

 

cash outlay = $24

 

 

Registered account (where you can't sell puts):

 

1)Buy 1 SHLD common    = -$50

2) Sell 1 SHLD $25 Call    =$26

3)Buy 2 BAC common        = -$24

4) Buy 2 BAC $10 Puts      =-$2

 

cash outlay= $50

 

So as long as the SHLD common gets called from you at $25...then you cash outlay is essentially equivalent to that of the non-reg account.  In other words this strategy would be the same as if the puts written in the non-reg account were cash covered.

 

BTW..I know the prices arent accurate...just an example.

[Studesy]

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?

 

That's my experience with my BMO RSP account too.

 

 

Then you guys can participate:

 

Example

1)  Buy SHLD common (take SHLD downside)

2)  Write SHLD covered call (collect premium)

3)  Buy BAC call with premium from step 2

 

 

So comparing this to the example of hedging the BAC common it would look something like this??

 

 

Taxable Account:

 

1) Buy 2 BAC common  = -$24

2)Buy 2 BAC $10 Put    = -$2

3) Sell 2 SHLD $25 Put = +$2

 

cash outlay = $24

 

 

Registered account (where you can't sell puts):

 

1)Buy 1 SHLD common    = -$50

2) Sell 1 SHLD $25 Call    =$26

3)Buy 2 BAC common        = -$24

4) Buy 2 BAC $10 Puts      =-$2

 

cash outlay= $50

 

So as long as the SHLD common gets called from you at $25...then you cash outlay is essentially equivalent to that of the non-reg account.  In other words this strategy would be the same as if the puts written in the non-reg account were cash covered.

 

BTW..I know the prices arent accurate...just an example.

 

Just looked at this again and I see why Eric said to purchase the put instead of the common with the hedge.  If you bought 2 - 2015 $12 LEaps @ $2 each....you are hedged the same but have cash left over which makes up for the cash outlay difference.

[Sunrider]

I'm simply working off the statements made initially (look at a fixed amount to invest and do it in a way that gives you 1.5x leverage, defined as 1.5x as many shares as simply putting that money into common would yield; secondly, choose the instruments to achieve this that gives you the lowest cost of doing that; thirdly do this in comparison to a 2018 expiry and costs, etc. defined by using the warrants as the benchmark).

 

 

sunrider

 

I think the risk profile btw margin vs option are just not the same (also one is non-recourse the other isn't).

 

with the option strategy if you want 1.5x leverage the inital capital outlay is lower vs the margin method.

 

for example lets say you want to put $100k into BAC, to get to 1.5x leverage using margin you will have to borrow 50k at let say 2% or whatever (you say you leave some cash behind etc to cover the cost if margin call happens) that means you will need more than 100k, how much do you leave behind? 10k? 20k? 30k?, 40k? to cover potential margin call and interest payment.

 

with an option strategy it cleaner and simplier you buy 100k of BAC, lets say that gets you 10k shares (at $10 per share) you will then need (lets say the call you want to buy is at $2 a share) additional $2 x 5k shares = $10k. That is it.

 

i guess i just don't see how the margin way would be better? you say because it has 2% interest? but you are borrowing 50k. also its recourse, so you say you leave some money behind? that is additional capital (opportunity cost).

 

also for me it is not just finding the lower leverage cost, other factors come into play as well (non recourse, capital allot for it etc etc). honestly as for the exact levearge cost btw the 2 i have no computed.

 

i hope i didn't misunderstood what you meant?

 

hy

 

 

Erm yes - see the rest of the thread - depending on how certain you are, choose more or less leverage. Eric's point was in the first place that you'd be silly to pay up for optionality past the first year point because he expects the stock to have appreciated markedly. He got to that in a somewhat novel way through his cost of leverage. So all I'm saying is that: given these assumptions, the starting point, etc. the above (take some cash, lever it with a cheap margin loan and fill the margin call if you have to) should be the cheaper option.

 

By the way margin call = loss on Eric's option roll, methinks. The examples of non-recourse finance = mortgage in the other thread would back this up: don't satisfy your margin call, lose your equity. Only that you'd probably want to satisfy some of the margin call, to maintain the desired level of leverage. That would be the equivalent to him rolling options - in the worst case having a full loss on the options - and then using the money kept on the side to buy options again.

 

Eric - what's your view here? Are we missing anything that throws this out?

 

Thanks - C.

 

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.

 

I don't think anyone can be 100% certain of that.

[ERICOPOLY]

I'm simply working off the statements made initially (look at a fixed amount to invest and do it in a way that gives you 1.5x leverage, defined as 1.5x as many shares as simply putting that money into common would yield; secondly, choose the instruments to achieve this that gives you the lowest cost of doing that; thirdly do this in comparison to a 2018 expiry and costs, etc. defined by using the warrants as the benchmark).

 

The statements made initially were comparing two forms of non-recourse leverage.  You are completely changing the subject now.  By definition, non-recourse comes at a price -- you have eliminated that price.  Sure, but you can save money by not having fire insurance on your home while you are at it.

 

We believe the stock should be much higher in 6 years, but we don't believe the path will necessarily be linear.  There may be a horrendous recession/crisis along the way.

 

PS:  Expiry is January 2019 for the "A" warrants -- not 2018.

 

 

[valueorama]

Eric,

  I have been watching this thread with interesting. Here is my question for you.

 

  Why are restricting yourself to warrants/synthetic warrants(aka leaps+hedges)?

  Why not go for just Leaps + cash without any common and hedges?

 

valueorama.

[ERICOPOLY]

  Why not go for just Leaps + cash without any common and hedges?

 

I'm not worried about the downside of the common.

 

I'm worried about the perils of leverage.

 

So I'm only hedging the leverage.

 

EDIT:  And it's not LEAPS+Hedges.  The LEAPS contain the hedge.

 

[Mephistopheles]

I spent several hours over the last few days reading this entire thread, and I must say I learned so much more about options than I have anywhere else. I do have several questions for Eric or anyone can be so kind to answer them. Thanks in advance, and pardon my ignorance.

 

1. What is exactly meant by implied volatility in non-mathematical terms? Why are options more expensive for stocks with higher IV? Is it just because a more volatile stock is more likely to reach a certain strike price than a non-volatile stock, all else being equal? For us value investors, isn’t all that matters is what we think the intrinsic value of BAC is, or what we think it will sell for in 2019, so who cares what the implied volatility is and how it affects the option/warrant price in the short term, as long as the intrinsic value doesn’t change?

 

2. What is this concept of an imbedded put in the calls and the warrants? Why is this put going to put a damper on the value of the warrant as we get closer to the expiration date?

 

3. Which strike price for the option should we choose to compare with the warrant strategy? Eric, I know you are long $10 and $12 calls, but why those strikes in particular? Did you choose these because they were ATM, or because they are close to the warrant price, or because they had the lowest cost of leverage out of all the strikes? When you rollover, it will be into ATM options, correct? Why choose those to rollover, and can you still compare those to the warrants (even if the strikes of the options are much different than the option strike)?

 

4. Eric, you say that one advantage of the option over the warrant is that the cost of leverage is sure to come down, and so when you roll over you will get to pay even less than 10%. But isn’t it true that you will also be selling the current LEAPS you own at a less than 10% cost of leverage, so wouldn’t that make it a wash in terms of saving on the leverage cost?

 

5. I understand that the options strategy is superior to the warrants strategy because 10% is cheaper than 13%. But when you say that the 13% is likely to come down by a lot as uncertainty is reduced, why does that even matter? If we believe the stock will be worth at least $25 at expiration, then wouldn’t this leverage re-pricing just be a short term movement? In other words, if the cost comes down to say, 5%, from 13%, then the market assumes that the stock needs to gain only 5% annualized until 2019. Wouldn’t this 5% # be extremely conservative, assuming the stock has moved up the expected 13%/year up to that point? I can see that if the stock were to move up by a large amount within a short amount of time, then the cost of leverage should be re-priced downwards in order to accommodate for the large gain that has already been achieved (and keep the break-even at $25); but in this scenario the warrants would gain by a lot too.

 

 

 

[ERICOPOLY]

1. What is exactly meant by implied volatility in non-mathematical terms? Why are options more expensive for stocks with higher IV? Is it just because a more volatile stock is more likely to reach a certain strike price than a non-volatile stock, all else being equal? For us value investors, isn’t all that matters is what we think the intrinsic value of BAC is, or what we think it will sell for in 2019, so who cares what the implied volatility is and how it affects the option/warrant price in the short term, as long as the intrinsic value doesn’t change?

 

You might purchase the at-the-money calls with $12 strike for $2.  You benefit greatly if the shares decline to $7 (you can dump the calls and just buy the common).  For a highly volatile stock this gives options an increased strategic value.  You might derive the expected or "implied" volatility from the premium people are paying for the options.  There would be no sense in paying a big premium for them if a large movement in the stock weren't expected -- thus, the volatility is implied by the premium the market is paying.

 

 

2. What is this concept of an imbedded put in the calls and the warrants? Why is this put going to put a damper on the value of the warrant as we get closer to the expiration date?

 

A long call is similar to owning the common and hedging with a put. Due to skewness, the put declines in value as the price of the stock moves away from the strike price.  Just take a look at the price of out-of-the-money puts versus at-the-money puts.  The at-the-money are always the most expensive relative to the strike price.  For example, if at-the-money puts cost 20% of strike price, then far out-of-the-money puts might cost just 3%.

 

So as the stock price rises, I'd expect the value of the $13.30 strike put in the warrant to decline (due to skewness).  But skewness causes it's price to change at a faster % rate than the common.

 

 

3. Which strike price for the option should we choose to compare with the warrant strategy? Eric, I know you are long $10 and $12 calls, but why those strikes in particular? Did you choose these because they were ATM, or because they are close to the warrant price, or because they had the lowest cost of leverage out of all the strikes? When you rollover, it will be into ATM options, correct? Why choose those to rollover, and can you still compare those to the warrants (even if the strikes of the options are much different than the option strike)?

 

$10 and $12 were the closest to at-the-money when I bought them.  I prefer at-the-money so that my "loan" is non-recourse.

 

I will likely choose at-the-money when I rollover in order to lock in my gains (protect from a pullback).  The funny thing is that I expect the cost of at-the-money puts to decline as the uncertainty is lifted and when it trades closer to book value.  Yet today the cost of the at-the-money put is similar to what the warrants cost if viewed on an annualized basis.

 

So not only will I benefit from having that put strike being at higher stock prices when I roll to at-the-money, but I expect it to cost me less.  Given those two things, I can't imagine why anyone prefers the warrants.

 

 

4. Eric, you say that one advantage of the option over the warrant is that the cost of leverage is sure to come down, and so when you roll over you will get to pay even less than 10%. But isn’t it true that you will also be selling the current LEAPS you own at a less than 10% cost of leverage, so wouldn’t that make it a wash in terms of saving on the leverage cost?

 

I don't care that the first two years cost me 10% annualized.  That seems fine to me.  Given a 3% dividend rate, that would be roughly the same as the 13% annualized cost of leverage in the warrants.

 

It's the next four years after that which are at issue. 

 

 

5. I understand that the options strategy is superior to the warrants strategy because 10% is cheaper than 13%.

 

That isn't the case.  The 10% may very well be 13% if a 3% dividend is paid.  The price issue is that the options strategy is expected to be much cheaper once the uncertainty in the stock is lifted.  Plus, you can move up the strikes to lock in gains.

 

 

 

But when you say that the 13% is likely to come down by a lot as uncertainty is reduced, why does that even matter?

 

More profits if you pay less for the cost of the leverage.  Of course, you get more for your money too if you can move up the strike of the at-the-money put on future rolls.  The value of this maneuver will be more obvious to you if the stock then pulls back quite a bit after one of these rolls.

 

 

Wouldn’t this 5% # be extremely conservative, assuming the stock has moved up the expected 13%/year up to that point?

 

Four years ago during a period of uncertainty, Wells Fargo was $8 and today it's closing in on $40.  Yet today it costs only something like 5% annualized for a WFC at-the-money put. 

 

So I don't think you can rely on large price movements to justify continued high cost of leverage.  The high cost of leverage is associated with a period of uncertainty, and after that uncertainty is lifted it goes back to normal leverage cost.

 

The uncertainty today is whether or not BAC will pull off this reduction in expenses.  This will result in a one-time repricing of the stock's valuation.  After that, no more uncertainty premium in the options.  Anyhow, that's my opinion -- perhaps others have another theory on what is causing the uncertainty discount.

 

 

[rkbabang]

You might purchase the at-the-money calls with $12 strike for $2.  You benefit greatly if the shares decline to $7 (you can dump the calls and just buy the common).  For a highly volatile stock this gives options an increased strategic value.  You might derive the expected or "implied" volatility from the premium people are paying for the options.  There would be no sense in paying a big premium for them if a large movement in the stock weren't expected -- thus, the volatility is implied by the premium the market is paying.

 

Hi Eric, please excuse my ignorance here, but how would you benefit by dumping the $12 calls and buying the common if the common went down to $7.  Wouldn't the $12 calls be close to valueless, especially if close to expiration when the stock plummets?

[ERICOPOLY]

You might purchase the at-the-money calls with $12 strike for $2.  You benefit greatly if the shares decline to $7 (you can dump the calls and just buy the common).  For a highly volatile stock this gives options an increased strategic value.  You might derive the expected or "implied" volatility from the premium people are paying for the options.  There would be no sense in paying a big premium for them if a large movement in the stock weren't expected -- thus, the volatility is implied by the premium the market is paying.

 

Hi Eric, please excuse my ignorance here, but how would you benefit by dumping the $12 calls and buying the common if the common went down to $7.  Wouldn't the $12 calls be close to valueless, especially if close to expiration when the stock plummets?

 

Being down $5 on the common is worse than being down a maximum of $2 on the calls.  That's what I meant. 

 

So the non-recourse approach to leverage wins in this case versus the guy who tries to saves money buying stock on margin and paying only margin interest.

 

[Mephistopheles]

Eric, thanks for your reply and detailed explanation. I get most of what you're saying, but am still having difficulty understanding everything clearly.

 

 

Four years ago during a period of uncertainty, Wells Fargo was $8 and today it's closing in on $40.  Yet today it costs only something like 5% annualized for a WFC at-the-money put. 

 

So I don't think you can rely on large price movements to justify continued high cost of leverage.  The high cost of leverage is associated with a period of uncertainty, and after that uncertainty is lifted it goes back to normal leverage cost.

 

The uncertainty today is whether or not BAC will pull off this reduction in expenses.  This will result in a one-time repricing of the stock's valuation.  After that, no more uncertainty premium in the options.  Anyhow, that's my opinion -- perhaps others have another theory on what is causing the uncertainty discount.

 

 

 

This is what I don't fully understand. I'm not saying that large stock price movements justify the cost of leverage (COL). What I'm saying is that the probable value of the common in 2019 justifies the cost, whether or not there is uncertainty. You're saying that when uncertainty is lifted, the COL will drop; and so then by definition you are also saying that the break-even price will come down from $25, correct? If the warrant gets repriced to an 8.5% COL from the current 12.5%, it would sell for $4.25, and the break-even price would be $20.23.

 

Or do you mean something like this: If we assume that all the uncertainty clears tomorrow, and the stock and the warrant both jump 25%, then the new COL would be 10.2% (sustaining the break-even price).

 

What I'm trying to ask is: Aside from the fact that options and margin are cheaper than the warrants, why would the lack of uncertainty reduce the break-even price of $25 (or the COL of 12.5% in other words), which is already a conservative number?

 

Most likely I'm just missing something. Are you saying that for all options/warrants, this whole "uncertainty" factor increases break even points? Shouldn't it be the other way around? If a bank/stock look healthier (more certain), shouldn't the break-even price increase?

[ERICOPOLY]

Most likely I'm just missing something. Are you saying that for all options/warrants, this whole "uncertainty" factor increases break even points?

 

People pay a premium for a hedge when uncertainty is higher.  That will increase the cost of leverage, and in doing so it will increase the point at which the option/warrant breaks even with the common.  The common sense explanation is that price of the common stock will be more volatile during periods of uncertainty, so people want to buckle up.  Turbulence drives the cost of hedges.

 

 

Shouldn't it be the other way around? If a bank/stock look healthier (more certain), shouldn't the break-even price increase?

 

Less turbulent times make it less likely that the hedges embedded in the options will be useful, thus their premiums decline as traders lose interest in them.  The captain turns off the seatbelt sign and you can move about the cabin freely.  People aren't clutching their seat-belts anymore.

 

 

 

[Mephistopheles]

 

Most likely I'm just missing something. Are you saying that for all options/warrants, this whole "uncertainty" factor increases break even points?

 

People pay a premium for a hedge when uncertainty is higher.  That will increase the cost of leverage, and in doing so it will increase the point at which the option/warrant breaks even with the common.  The common sense explanation is that price of the common stock will be more volatile during periods of uncertainty, so people want to buckle up.  Turbulence drives the cost of hedges.

 

 

Shouldn't it be the other way around? If a bank/stock look healthier (more certain), shouldn't the break-even price increase?

 

Less turbulent times make it less likely that the hedges embedded in the options will be useful, thus their premiums decline as traders lose interest in them.  The captain turns off the seatbelt sign and you can move about the cabin freely.  People aren't clutching their seat-belts anymore.

 

 

 

Ok I think I know what you're saying. The value of the embedded put would decrease, therefore the warrant would be worth less. I guess another way to look at it is: when there is less turbulence, people will be more willing to accept recourse leverage, which will help shrink the gap between non-recourse and recourse.

 

I think I basically get it. I've never thought of options this way. Thanks for all your help!

[ERICOPOLY]

Ok I think I know what you're saying. The value of the embedded put would decrease, therefore the warrant would be worth less.

 

Something like that.  Basically if you straight-line depreciate the warrant, it costs 13% annually for the leverage.  But if company really impresses people over the next two years with the expense reduction plan, then the remaining put's value may depreciate an additional amount due to lifting of the uncertainty premium.

 

Thus, over two years it could cost far more than 13% annually.  Maybe close to 20% annually over the next two years.

 

After all, once the stock trades at intrinsic value you might be inclined to want to sell your BAC position.  Perhaps that happens in two years.  So it might happen on a timeline where you've suffered a significant hit to the put's premium -- this will eat into your gains when you sell.

 

 

[Mephistopheles]

Something like that.  Basically if you straight-line depreciate the warrant, it costs 13% annually for the leverage.  But if company really impresses people over the next two years with the expense reduction plan, then the remaining put's value may depreciate an additional amount due to lifting of the uncertainty premium.

 

Thus, over two years it could cost far more than 13% annually.  Maybe close to 20% annually over the next two years.

 

After all, once the stock trades at intrinsic value you might be inclined to want to sell your BAC position.  Perhaps that happens in two years.  So it might happen on a timeline where you've suffered a significant hit to the put's premium -- this will eat into your gains when you sell.

 

 

Wait now I'm confused again. I was following what you were saying, about the put decreasing in value due to the lift of the uncertainty premium, but then why would the COL increase (from 13 to 20% or so)? Wouldn't it come down in that case, to more in line of a normal leverage cost?

 

You said earlier:

 

"The high cost of leverage is associated with a period of uncertainty, and after that uncertainty is lifted it goes back to normal leverage cost."

 

 

[racemize]

Something like that.  Basically if you straight-line depreciate the warrant, it costs 13% annually for the leverage.  But if company really impresses people over the next two years with the expense reduction plan, then the remaining put's value may depreciate an additional amount due to lifting of the uncertainty premium.

 

Thus, over two years it could cost far more than 13% annually.  Maybe close to 20% annually over the next two years.

 

After all, once the stock trades at intrinsic value you might be inclined to want to sell your BAC position.  Perhaps that happens in two years.  So it might happen on a timeline where you've suffered a significant hit to the put's premium -- this will eat into your gains when you sell.

 

 

Wait now I'm confused again. I was following what you were saying, about the put decreasing in value due to the lift of the uncertainty premium, but then why would the COL increase (from 13 to 20% or so)? Wouldn't it come down in that case, to more in line of a normal leverage cost?

 

You said earlier:

 

"The high cost of leverage is associated with a period of uncertainty, and after that uncertainty is lifted it goes back to normal leverage cost."

 

He's saying that when it comes down, you would have effectively paid 20% for the first two years--e.g., instead of 13% annually, it might be 20% for the first two years and then 8% for the remaining 4 (these are just exemplary figures, probably not accurate).  Thus, it would come down afterwards.

[ERICOPOLY]

Something like that.  Basically if you straight-line depreciate the warrant, it costs 13% annually for the leverage.  But if company really impresses people over the next two years with the expense reduction plan, then the remaining put's value may depreciate an additional amount due to lifting of the uncertainty premium.

 

Thus, over two years it could cost far more than 13% annually.  Maybe close to 20% annually over the next two years.

 

After all, once the stock trades at intrinsic value you might be inclined to want to sell your BAC position.  Perhaps that happens in two years.  So it might happen on a timeline where you've suffered a significant hit to the put's premium -- this will eat into your gains when you sell.

 

 

Wait now I'm confused again. I was following what you were saying, about the put decreasing in value due to the lift of the uncertainty premium, but then why would the COL increase (from 13 to 20% or so)? Wouldn't it come down in that case, to more in line of a normal leverage cost?

 

You said earlier:

 

"The high cost of leverage is associated with a period of uncertainty, and after that uncertainty is lifted it goes back to normal leverage cost."

 

He's saying that when it comes down, you would have effectively paid 20% for the first two years--e.g., instead of 13% annually, it might be 20% for the first two years and then 8% for the remaining 4 (these are just exemplary figures, probably not accurate).  Thus, it would come down afterwards.

 

 

Yes, that's how I meant it.

[Mephistopheles]

Something like that.  Basically if you straight-line depreciate the warrant, it costs 13% annually for the leverage.  But if company really impresses people over the next two years with the expense reduction plan, then the remaining put's value may depreciate an additional amount due to lifting of the uncertainty premium.

 

Thus, over two years it could cost far more than 13% annually.  Maybe close to 20% annually over the next two years.

 

After all, once the stock trades at intrinsic value you might be inclined to want to sell your BAC position.  Perhaps that happens in two years.  So it might happen on a timeline where you've suffered a significant hit to the put's premium -- this will eat into your gains when you sell.

 

 

Wait now I'm confused again. I was following what you were saying, about the put decreasing in value due to the lift of the uncertainty premium, but then why would the COL increase (from 13 to 20% or so)? Wouldn't it come down in that case, to more in line of a normal leverage cost?

 

You said earlier:

 

"The high cost of leverage is associated with a period of uncertainty, and after that uncertainty is lifted it goes back to normal leverage cost."

 

He's saying that when it comes down, you would have effectively paid 20% for the first two years--e.g., instead of 13% annually, it might be 20% for the first two years and then 8% for the remaining 4 (these are just exemplary figures, probably not accurate).  Thus, it would come down afterwards.

 

 

Yes, that's how I meant it.

Ok thank you! I'm going to think about it and try to wrap my head around it. I know it must be simple but I'm having trouble grasping it.

[racemize]

Eric, I'm very close to having a spreadsheet that models what your strategy is (I think anyway), so that I can compare it to the warrants under various scenarios.  But, from your replies, I'm a little unsure how you deal with a some situations:

 

Let's say you have an initial leverage of 1.2. 

 

Scenario 1-stock goes up:

You've said that if the stock price goes up, the leverage will go down, e.g., to 1.15.  In that case, I believe you said you would keep the leverage at 1.15 instead of 1.2 on the roll.  Accordingly, that will mean that with the gains you would buy some common and a lesser #of options on the roll, correct?

 

Scenario 2-stock goes down:

If the stock goes down, would you hold the leverage at 1.2, or would you increase it? 

 

 

So, did I get scenario 1 right, and what happens in scenario 2?

[Mephistopheles]

Eric, what is a good way of calculating the # of shares and options you need to fit a certain amount of leverage you want to take on? So for example, if I want 1.5x on a $100,000 portfolio, then how do I compute in a simple way the split between shares and options? Thanks

[racemize]

Eric, what is a good way of calculating the # of shares and options you need to fit a certain amount of leverage you want to take on? So for example, if I want 1.5x on a $100,000 portfolio, then how do I compute in a simple way the split between shares and options? Thanks

 

I've got formulas for that in the spreadsheet I posted (see the third sheet which takes in the prices and desired leverage).  PM me if you need more specific info.

[Mephistopheles]

Eric, what is a good way of calculating the # of shares and options you need to fit a certain amount of leverage you want to take on? So for example, if I want 1.5x on a $100,000 portfolio, then how do I compute in a simple way the split between shares and options? Thanks

 

I've got formulas for that in the spreadsheet I posted (see the third sheet which takes in the prices and desired leverage).  PM me if you need more specific info.

 

Wow race, you've done a superb job with that spreadsheet. Thanks for sharing!