BAC leverage

[ERICOPOLY]

What do you calculate the cost of leverage being for the BAC B warrants?  Trading 0.72 with a strike price of 30.79.

 

With the current dividends included, ~20%.  They have to go a long way to be in the money.  That being said, once they are in, the growth is explosive.

 

We discussed the B warrants previously.

 

My mental model for that is to think of it like you are mortgaging your common stock at a very high loan to value.  That explains the very high rate of interest for the money borrowed.

 

There is very high risk of default.  Payment in full happens if the stock goes up very high, and partial default occurs if it only goes up part of the way.  In the event that payment in full does not happen, they foreclose on your common shares and take your equity as compensation for interest not paid.

 

So that's my mental model for the B warrants.

[Mephistopheles]

Eric, thanks for replying to my posts from earlier. I had another question. Have you considered the issue of capital gains tax for the options rolling strategy vs. buying the warrants. For taxable accounts, option holders will have to pay capital gains taxes every year (and regular income taxes for this year since they will end up holding the option <1 year) until 2020, starting next year. But if you hold the warrant for the entire 6 year period, you won't have to pay any capital gains taxes until 2020. Right now the warrants cost 12.77% and the $12 strike option costs 10.62%. But with the benefit for warrant holders in taxable accounts, would you say that the options strategy is still the clear winner?

[ERICOPOLY]

Eric, thanks for replying to my posts from earlier. I had another question. Have you considered the issue of capital gains tax for the options rolling strategy vs. buying the warrants. For taxable accounts, option holders will have to pay capital gains taxes every year (and regular income taxes for this year since they will end up holding the option <1 year) until 2020, starting next year. But if you hold the warrant for the entire 6 year period, you won't have to pay any capital gains taxes until 2020. Right now the warrants cost 12.77% and the $12 strike option costs 10.62%. But with the benefit for warrant holders in taxable accounts, would you say that the options strategy is still the clear winner?

 

 

This is why I mentioned "portfolio" margin.

 

Instead of buying the calls in your taxable account, just use a margin loan to buy more common and use puts to hedge.

 

You won't have the capital gains tax headache by rolling the puts along.

 

Taxes are not an issue with this approach.

 

I'm paying less than a 1% interest rate using Interactive Brokers.  I think I worked out my cost of leverage to be roughly 10.75%, so that is a good deal cheaper than 13% annualized cost in the warrants.  There's room for a little bit of interest rate increases.

 

One risk is Interactive Brokers deciding to suddenly charge 3% for margin interest.  They could do that of course, even if the Fed doesn't alter the rates. 

 

 

 

 

[Mephistopheles]

Eric, thanks for replying to my posts from earlier. I had another question. Have you considered the issue of capital gains tax for the options rolling strategy vs. buying the warrants. For taxable accounts, option holders will have to pay capital gains taxes every year (and regular income taxes for this year since they will end up holding the option <1 year) until 2020, starting next year. But if you hold the warrant for the entire 6 year period, you won't have to pay any capital gains taxes until 2020. Right now the warrants cost 12.77% and the $12 strike option costs 10.62%. But with the benefit for warrant holders in taxable accounts, would you say that the options strategy is still the clear winner?

 

 

This is why I mentioned "portfolio" margin.

 

Instead of buying the calls in your taxable account, just use a margin loan to buy more common and use puts to hedge.

 

You won't have the capital gains tax headache by rolling the puts along.

 

Taxes are not an issue with this approach.

 

I'm paying less than a 1% interest rate using Interactive Brokers.  I think I worked out my cost of leverage to be roughly 10.75%, so that is a good deal cheaper than 13% annualized cost in the warrants.  There's room for a little bit of interest rate increases.

 

One risk is Interactive Brokers deciding to suddenly charge 3% for margin interest.  They could do that of course, even if the Fed doesn't alter the rates. 

 

 

 

 

 

Ah I see, that makes sense..thanks again!

[ERICOPOLY]

So far since this thread began, the common stock has appreciated 12% and the "A" warrants have appreciated around 6.5%. 

 

Explanation:

 

The cost of leverage in the warrants has dropped to 10.7% annualized from 13%. 

 

The computation:

You have $13.44 to buy 1 share of stock at today's close.

You spend $5.96 for 1 warrant at today's close.

You have $7.48 left in cash ($13.44 - $5.96 = $7.48)

$7.48 grows to $13.30 (the strike) in 5.67 years at 10.7% annualized rate (the cost of leverage)

 

[bobp]

If you hadn't started this they'd be around$7. You're killing them!  >:(  :) :D That's multiple smileys because I'm not up on smiley etiquette.

[ERICOPOLY]

If you hadn't started this they'd be around$7. You're killing them!  >:(  :) :D That's multiple smileys because I'm not up on smiley etiquette.

 

Not sure that first one is smiling.

 

But today the warrants are trading down 1.85%  at $5.85.  That's only a 4.4% gain since I started the thread.  And when I started the thread, that was after I had been selling quite a few of my own -- and I was getting a price around $5.80 when I started (when the stock was $12).

 

The stock is now up nearly 3x the rate of return as the warrants! 

 

 

[stahleyp]

Eric, what kind of cost of leverage for the warrants would be at before you're interested again?

[racemize]

I also note the cost of leverage on the LEAPs has come down a lot.

 

When we started, I think 12's were at 8-10% (ranged all the way up to 12%) and the 10's were at 6-8% (getting up to 10%).

 

Now 12's are at 7% and 10's are at 4% (versus the BAC-A's at 10.5%).

[ERICOPOLY]

Eric, what kind of cost of leverage for the warrants would be at before you're interested again?

 

I'm just a hack.  I thought 13% was completely absurd and so I took action.

 

10.7% still seems steep in this low interest rate environment, but not nearly as bad.  I mean, they've already lopped 230 basis points off of the interest rate.  I doubt the next 12% appreciation for the common will be this painful for the warrants.

 

I still like the option of adjusting the strike price when rolling, and the warrants don't have that because you are getting married to the strike price for the entire duration.  I think that's pretty limiting and if anything it should "warrant" (pun intended) a discount vs the LEAPS, not a premium!

 

 

 

[ERICOPOLY]

So my thinking is that the warrants will continue to experience a painful drag as they go into the money.  I'm not sure at what point that effect slows to white noise, but I feel pretty safe in predicting that it's effect will likely be largely played out by the time the stock is at $20.

 

 

[racemize]

So my thinking is that the warrants will continue to experience a painful drag as they go into the money.  I'm not sure at what point that effect slows to white noise, but I feel pretty safe in predicting that it's effect will likely be largely played out by the time the stock is at $20.

 

that makes a lot of sense to me.  I'm surprised at how much this cost of leverage value moves for all the various choices (particularly these LEAPs)--I thought it would be a bit more rational/constant on the longer dated ones...

[compoundinglife]

During March and April I converted the converted the A warrant and common positions in my retirement accounts to notional LEAP positions based on Eric's explanation in this thread. So far so good. I still have A warrants in my health savings account and taxable accounts tempted to trade each one in for a call and put.

 

Interesting reference point:

 

I bought some of my A Warrants on 11/23/2011 ($2.47) and 12/20/2011(2.04).

 

The first batch I have %137.9 gain vs the common having a %160 (5.20 to 13.51) gain at current price

 

The second batch I have %186.4 gain vs the common having a %165 (5.10 to 13.51) gain at current price

 

[Ross812]

Does anyone see a problem with using a vertical bull spread to reduce the price of the leverage?

 

Say buy the '15 $10's and sell the '15 $20's for a net debt of 3.75.

 

At 13.45 the cost of $1000 dollars of leverage is ~2%.

 

Obviously you lose upside if BAC goes above $20 but you would still make 2.6x your money...

[ERICOPOLY]

So my thinking is that the warrants will continue to experience a painful drag as they go into the money.  I'm not sure at what point that effect slows to white noise, but I feel pretty safe in predicting that it's effect will likely be largely played out by the time the stock is at $20.

 

that makes a lot of sense to me.  I'm surprised at how much this cost of leverage value moves for all the various choices (particularly these LEAPs)--I thought it would be a bit more rational/constant on the longer dated ones...

 

The LEAPS have experienced drag too, mostly due to skewness.  But you didn't pay for 6 years of leverage, so not as bad!

 

The LEAPS+common approach has added positive leverage since this thread began, vs the warrants that have added negative leverage.

 

The people owning the warrants were effectively owning 6 years of capitalized borrowing costs.  230 basis points of capitalized borrowing costs (multiplied by 6 years!) just got vaporized by Mr. Market.  That's a tough hit to absorb (therefore the underperformance vs the common).

 

 

 

[ERICOPOLY]

Does anyone see a problem with using a vertical bull spread to reduce the price of the leverage?

 

Say buy the '15 $10's and sell the '15 $20's for a net debt of 3.75.

 

At 13.45 the cost of $1000 dollars of leverage is ~2%.

 

Obviously you lose upside if BAC goes above $20 but you would still make 2.6x your money...

 

I like it, but it's too bad the BAC premiums for the out-of-the-money calls aren't higher.

 

I still have a lot of MBI but I've written calls to pay for my BAC puts.  For example, the MBI $21 strike call finances the $12 strike BAC put.

 

You could put on 2x leverage this way in your portfolio without any friction from options decay.  Worst comes to worst, you've amplified your downside by roughly 10% (the hit you take as BAC goes back to $12) and you've capped your gains on MBI at $21.  But this is January 2014 expiry, so if MBI gets near $21 towards the end of the year I'll bet the calls can be bought back very cheap and the 2015s could then be written for additional upside.

 

Remember that story about Rick Guerin and how leverage hurt him?  Well.... he didn't structure his leverage such that the maximum hit was 10% from 2x leverage  ;D

[ERICOPOLY]

One can also write the BAC call (in addition to the MBI) and therefore the premium from the two of them can easily cover the cost of the BAC $13 strike 2014 put.  I think you can get there with the $16 strike BAC call and the $21 strike MBI call.

 

Then you have 2x leverage upside and essentially all of the MBI downside in addition to 35 cents of BAC downside.

 

Both can rise 15% and you have a 30% return.  Unfortunately, your max return is capped at 37.5% for MBI and for BAC it's capped at 19.7%.  That leaves your maximum return (both of them combined) at 57.2% -- still, it's only until January so if you were hungering for more gains that dry spell won't last forever  :)

 

[stahleyp]

Eric, are you still hedged with IWM? thanks in advance! :)

[ERICOPOLY]

Eric, are you still hedged with IWM? thanks in advance! :)

 

Yes and no.  I sold the Jan 14 $100s (premium value rose as they neared strike) and kept the Jan 15 $75 strike.

 

The primary reason is that I've reached an agreement with my landlord for a 3 year purchase option -- so I no longer have any pressing needs for cash.  The secondary reason is the desire to lock in the rising premium in the option as it neared the $100 strike.  The third reason is tax loss selling -- the tax authorities shared 52% of my losses on this one. 

 

I might get around to it today -- I want to grab some SPY puts to replace a portion of it.  I can do this without it being a wash sale because it's a different index.

[Straddle]

Does anyone see a problem with using a vertical bull spread to reduce the price of the leverage?

 

Say buy the '15 $10's and sell the '15 $20's for a net debt of 3.75.

 

At 13.45 the cost of $1000 dollars of leverage is ~2%.

 

Obviously you lose upside if BAC goes above $20 but you would still make 2.6x your money...

 

I'm doing a few bull call spreads on BAC. I launched my first spread 2 months ago (long the 12 Jan 2015 - short 15 jan 2015). Once the spot price crosses over the breakeven price of the spread you'll easily get double digit (or tripple digit) returns. The problem is the amount of money to spend on these spreads, since they're more risky then the DITM calls. I'm combining a long position in DITM calls with OTM bull call spreads right now.

[Ross812]

Over the past couple days I sold my BAC A Warrants and bought an equal notational stake using vertical bull spreads on BAC. I bought the Jan '15 $10 calls and sold the Jan '15 $20 calls for a net debt of $3.7 making my borrowing costs 1.6%. I am reasoning that the warrants are going to lag the stock price until the stock price is somewhere around $20. The only problem I see with this is if the stock price approaches $20 before Jan 2015, the $20 calls will appreciate faster than the DITM $10 calls, I may lock myself into rolling the leaps forward which will still be very profitable. In the mean time I have a nice slug of cash as the vertical spreads were 37% cheaper than the A warrants... 

[meiroy]

 

Ericopoly,

 

Could you elaborate on how you look at the cost of puts, in general?

 

Thanks.

 

[ERICOPOLY]

 

Ericopoly,

 

Could you elaborate on how you look at the cost of puts, in general?

 

Thanks.

 

The cost of my BAC puts are the cost of insurance to eliminate the recourse nature of my margin loan.  So I look at that cost on an annualized basis because that's the only way my mind is trained to value interest expense.

[Mephistopheles]

Eric, I have a question re: the strategy from the beginning of this thread. I had dumped my warrants and bought options due to the cheaper cost of leverage, back when the stock was at $12 and the Jan '15 $12 strike calls were at $2.10. The cost of leverage for the option at the time was roughly 12%. Now, the stock is at $13.83 (up 15%), the option is at $3.11 (up 48%), and the COL has come down to 7%. I understand why this is so mathematically; but in simplistic terms, can you explain why the COL has come down so much while the option has gained so much more than the stock? You advocated against owning the warrants because of the high COL, which you said was bound to come down, implying that the warrant will under perform the stock in that time. Well then why has the option outperformed the stock (by a large margin) while the COL has come down so much? The COL for the warrant has come down too, but that one as you said has under performed the stock. So why doesn't this logic apply to the option?

 

Thanks in advance!

[merkhet]

Mephistopheles, there's less time left on the option and therefore the drop in the cost of leverage doesn't hurt as much.