BAC leverage

[ERICOPOLY]

And if I successfully select undervalued stocks that soar and stay that way, the cost of the non-recourse financing will be extremely cheap... this is because once the stock has appreciated substantially the cost of rolling the puts goes down.  It's only expensive for the initial time period until the stock soars.  Then it gets really cheap afterwards.

 

And the whole time it's non-recourse.  I mean, these puts cost less money than BAC is generating on a per-share basis.  So with patience, the strategy will pay off.

 

Eric, thanks - just curious though, and apologies if you already explained this in this long thread - how does this compare to simply buying Jan 2016 calls? 

 

That's the whole idea -- I'm reconstructing a call using common stock and puts.  This is in a taxable account.

 

Try rolling appreciated calls --  oops, it's a taxable capital gain when you sell one series to buy the next.

 

I intend to write off my worthless puts against gains taken elsewhere.  I just need to be sure that when I roll them I don't create wash sales.

 

 

[ERICOPOLY]

You say you are doing this in a margin account.  The question is this: Does your broker match the puts and calls, or are you just working it out that way on a one to one basis?

 

The broker matches the puts with the margined common stock (you said "calls" but I'm not using calls). 

 

It's a portfolio margin account where they net out the risk, which gives more margining power because you don't really have any downside below the strike price except for the value of the put option premium.

 

There are two types of margin accounts:  Reg-T, and "Portfolio Margin".  The first one is the default for margin accounts.  The second one you have to request for approval, which is what I did.

 

So if I have common stock matched up with a $12 strike put, they effectively give me the same margining power as if I'd had a $12 strike call instead.  They are looking at margin risk on a netted out basis.  This wasn't possible before when I had the "Reg-T" default margin account.

[gary17]

And if I successfully select undervalued stocks that soar and stay that way, the cost of the non-recourse financing will be extremely cheap... this is because once the stock has appreciated substantially the cost of rolling the puts goes down.  It's only expensive for the initial time period until the stock soars.  Then it gets really cheap afterwards.

 

And the whole time it's non-recourse.  I mean, these puts cost less money than BAC is generating on a per-share basis.  So with patience, the strategy will pay off.

 

ah-ha - that's the part i missed. 

 

so what you are saying is:

 

1  if i had just bot the $3.55 call and BAC worth more and more over time, I'd have to sell the call and buy future calls (if I still want to hold BAC) - and this kind of sell results in a capital gain tax

 

2  on the other hand i could keep holding the commons and i can keep creating this artificial call option by replacing more expensive puts with cheaper puts and since the puts would have lost money there is no capital gain tax........     

 

so effectively it's a way of not having to pay the taxes on the hedging part........  because at some point if you want to exit the position you'll still end up with a tax bill on the commons....... right?

 

now if i have a tax-free account , i think it make sense to just buy calls..................

 

thanks!

 

 

 

 

 

Eric, thanks - just curious though, and apologies if you already explained this in this long thread - how does this compare to simply buying Jan 2016 calls? 

 

That's the whole idea -- I'm reconstructing a call using common stock and puts.  This is in a taxable account.

 

Try rolling appreciated calls --  oops, it's a taxable capital gain when you sell one series to buy the next.

 

I intend to write off my worthless puts against gains taken elsewhere.  I just need to be sure that when I roll them I don't create wash sales.

[ERICOPOLY]

so effectively it's a way of not having to pay the taxes on the hedging part........  because at some point if you want to exit the position you'll still end up with a tax bill on the commons....... right?

 

Regarding the selling of the common...

 

I might gradually roll the strike up to ever-higher prices over the years, and spend the money from capital gains tax-free. 

 

For example, why sell the stock and use the after-tax proceeds to buy a house when instead I can just hedge with a put and borrow against the shares?  The bank's earnings will exceed the cost of financing these puts, and maybe I'll just keep rolling out the tax bill until I die when it's tax free.

 

 

 

 

[gary17]

hahhahaa  i love this - better be careful Obama is reading this  8)

 

okay without getting into politics too much here , but i may already have, i think he is a good man and doing the right things for America but at the same time i do appreciate why those who are better at managing money can see government creating inefficiencies / wastes  -    where is the right balance remains to be seen. 

[Uccmal]

Eric, If I may.  I have about 80% of my BAC Leaps hedged via puts at an assortment of expiry dates and strikes.  Anyway, that isn't my question. 

 

You say you are doing this in a margin account.  The question is this: Does your broker match the puts and calls, or are you just working it out that way on a one to one basis?

 

None of my options are actually marginable with TD.  They just eat up alot of cash.

 

I agree, with BAC in particular, the cost of the puts is easily covered when the stock prices rise rapidly.  The worst case scenario is if BAC stays for 2 yrs. at around this price.  Now, even that scenario has a couple of assumptions:

1) I don't do anything such as rolling things further out in the interim, which for me is unlikely.

2) That BACs price stays at $14 continuously for two years - the probability of that is likely closing on zero. 

 

Bump...

 

Eric?

 

You say you are doing this in a margin account.  The question is this: Does your broker match the puts and calls, or are you just working it out that way on a one to one basis?

[hyten1]

eric, interesting

 

i guess you have to be careful and watch it fairly closely. a bad scenario is if the stock doesn't move much for a while

 

you spent the money on the puts and when the time comes for the puts to expire your puts will be worthless (assuming the stock is above your put) then will you continue to purchase puts?

 

sorry i am thinking out loud, just looking for the negative/downside to this.

 

i guess ideally the cost of puts should be less and maybe you need to lower your strike. i guess at the end of the day it'll be hard to match 1 to 1 (1 commen with 1 share of puts) and you'll obviously need to borrow a fraction of what you have in value.

 

hy

 

so effectively it's a way of not having to pay the taxes on the hedging part........  because at some point if you want to exit the position you'll still end up with a tax bill on the commons....... right?

 

Regarding the selling of the common...

 

I might gradually roll the strike up to ever-higher prices over the years, and spend the money from capital gains tax-free. 

 

For example, why sell the stock and use the after-tax proceeds to buy a house when instead I can just hedge with a put and borrow against the shares?  The bank's earnings will exceed the cost of financing these puts, and maybe I'll just keep rolling out the tax bill until I die when it's tax free.

[ERICOPOLY]

Eric, If I may.  I have about 80% of my BAC Leaps hedged via puts at an assortment of expiry dates and strikes.  Anyway, that isn't my question. 

 

You say you are doing this in a margin account.  The question is this: Does your broker match the puts and calls, or are you just working it out that way on a one to one basis?

 

None of my options are actually marginable with TD.  They just eat up alot of cash.

 

I agree, with BAC in particular, the cost of the puts is easily covered when the stock prices rise rapidly.  The worst case scenario is if BAC stays for 2 yrs. at around this price.  Now, even that scenario has a couple of assumptions:

1) I don't do anything such as rolling things further out in the interim, which for me is unlikely.

2) That BACs price stays at $14 continuously for two years - the probability of that is likely closing on zero. 

 

Bump...

 

Eric?

 

You say you are doing this in a margin account.  The question is this: Does your broker match the puts and calls, or are you just working it out that way on a one to one basis?

 

See reply #476 above.  I just buy the puts trading online, and then I buy the common a moment later -- there is no other special communication between me and the broker.

[ERICOPOLY]

i guess you have to be careful and watch it fairly closely. a bad scenario is if the stock doesn't move much for a while

 

That's the primary thing I worry about.

 

Similarly, you might take out a business loan to expand your production... what if the economy tanks and the anticipated demand never comes?  You still need to keep paying interest on that debt.

 

In all matters of business, that's the worry with debt... can you afford to service it while you wait for things to work out?

 

However, it remains the only non-recourse form of leveraging stocks.  So there is no other game in town.  Fairfax doesn't use their float to leverage stocks, they use it to leverage bonds... so nobody can pull that one up as a counterexample.

[gary17]

Eric

just a few more questions if i may

 

'non recourse' = secured debt ....  so you are saying the commons + put is non-recourse in that there's a collateral which is the put against the borrowing for buying commons... right?

 

just to expand on what hyten1 is saying - the worst thing that could happen to this setup is if there's very little movement in the stock price until 2016 .... in the $12 - $14 range in which case the commons (if bot at $14) hasn't increased in price and the hedge has been spent with no real use to it.....    if the price drops a lot, then it was right to hedge and if the price moves up a lot then the cost of hedge is trivial  - so in the end  this form of 'call' option works best if we expect significant volatility to the up or down side and less effectiv if it stays the same..... 

[ERICOPOLY]

'non recourse' = secured debt ....  so you are saying the commons + put is non-recourse in that there's a collateral which is the put against the borrowing for buying commons... right?

 

The put gives me the right to sell the stock at $12, no matter how low the stock is trading.  I put the trade on when the stock was at $12, so I had none of my own equity in it, thus the trade has no recourse against my own equity (the only cash of my own that I sunk into the deal was for the cost of the put, which I regard as part of the cost of the "non-recourse" financing).

 

 

so in the end  this form of 'call' option works best if we expect significant volatility to the up or down side and less effectiv if it stays the same.....

 

Right.  And here is something else to chew on...  you can write covered calls to defray the cost of the put.  But that might get expensive if the stock soars above the strike price on the calls.

 

But the $25 strike 2016 call is selling for 30 cent bid.  You can write that call and use it to pay for roughly 1/2 of the incremental cost of rolling to the 2016 $12 strike put from the 2015 $12 strike put.

 

I'm just a bit greedy -- I want to see if the stock can spike up to $16 or so over the next 4 months, then roll to the $12 strike put for less incremental cost, and write the $25 strike call for more than 30 cents.  But that's my greed -- maybe it will never happen.

[gary17]

'non recourse' = secured debt ....  so you are saying the commons + put is non-recourse in that there's a collateral which is the put against the borrowing for buying commons... right?

The put gives me the right to sell the stock at $12, no matter how low the stock is trading.  I put the trade on when the stock was at $12, so I had none of my own equity in it, thus the trade has no recourse against my own equity (the only cash of my own that I sunk into the deal was for the cost of the put, which I regard as part of the cost of the "non-recourse" financing).

 

So if i'm buying the commons at $14 then I should be buying $14 puts to make this totally non-recourse............?

 

or may be take a bit of a gamble buy the $14 put when the commons is at $15 or higher ...

 

or may be buy $12 puts and then roll to $14 put when things get cheaper.......

 

[ERICOPOLY]

I'm just explaining what I did and what I'm thinking about doing... but I have my own risk tolerance and it may not be right for you.  I'm completely OKAY with losing the entire put premium, you have to be if you play this game.

 

Note than I'm an amateur, self-taught, etc... etc...  We may very well be on the edge of a bad recession that could eat up all of their earnings for a couple of years.  Or it could earn $2 a share and still be priced at $12 in two years.  That would be only 6x earnings but that multiple happened to the market index back in 1981 or 1982...

 

So don't ask me what you should do.  Hell if I know.

[gary17]

Thanks - i'm well aware of the risks - didn't mean to ask you what i should do - i guess what I was trying to ask is if i want to setup this 'call' option - which so far makes sense to me - then is that how 'rolling' works...

 

i think i'm ready for the recession.  we had a good run.  but just hard to believe they could go back to the 09 levels - if they did, i'm not sure if all these stress tests meant anything.  but i guess anything could happen  8)

[gary17]

Eric

been thinking about this artificial call option that you have described

i guess in addition to the risk that the price doesn't move much....  the other factor is that this call option is more 'expensive' to setup than a regular call option in that more money is locked in

 

if we go back to my earlier example......

 

the artificial call option will cost about $15,000 to setup whereas a regular call option for the same 1000 share exposure only costs $3500

 

So it would appear that while there's the tax benefit, it greatly reduces the purchase power of the cash....    is that not the case......... ???   

 

 

Let's say I have $10,000 and want to borrow $4,000 to buy 1000 shares of BAC at $14/share today. 

And I buy the $12 strike put for $1.32 - so my total cost is $14 + $1.32 = $15.32 /share

Let's assume upside of $20 so my upside is $5ish / share or 50% based on the initial $10,000 investment less some interests on the borrowed money.

Let's assume downside is it goes below $12 and I end up losing $3.32/share or $3320 which is like a 33% loss. 

 

So how is this different from buying $12 strike call for $3.55 today -  for 1,000 shares my cost is only $3550.  No interest since i'm not borrowing money. 

[ERICOPOLY]

The A warrant is now down to about 7% annualized cost of leverage. 

 

So the average annualized cost has now come down by approximately 600 bps.

 

The good news is that it can't continue at this pace for much longer without going negative.

 

EDIT:  5 years remaining.  600 bps per remaining year.  This has cost you 3,000 basis points.

[ERICOPOLY]

Eric

been thinking about this artificial call option that you have described

i guess in addition to the risk that the price doesn't move much....  the other factor is that this call option is more 'expensive' to setup than a regular call option in that more money is locked in

 

if we go back to my earlier example......

 

the artificial call option will cost about $15,000 to setup whereas a regular call option for the same 1000 share exposure only costs $3500

 

So it would appear that while there's the tax benefit, it greatly reduces the purchase power of the cash....    is that not the case......... ???   

 

 

Let's say I have $10,000 and want to borrow $4,000 to buy 1000 shares of BAC at $14/share today. 

And I buy the $12 strike put for $1.32 - so my total cost is $14 + $1.32 = $15.32 /share

Let's assume upside of $20 so my upside is $5ish / share or 50% based on the initial $10,000 investment less some interests on the borrowed money.

Let's assume downside is it goes below $12 and I end up losing $3.32/share or $3320 which is like a 33% loss. 

 

So how is this different from buying $12 strike call for $3.55 today -  for 1,000 shares my cost is only $3550.  No interest since i'm not borrowing money. 

 

I'm sorry but I don't understand how you come to the conclusion that buying common+put costs more than buying the call.

[gary17]

Doesn't cost more - but requires more capital for the same exposure.

 

I f I want to long 1000 shares - the January 16 call option at the time was only $3.32/share... so the total cost is only about $3320.

 

Wouldn't you need a lot more money to get the same 1000 share exposure with commons & puts? I.e., you need a lot more money tied up.

[ERICOPOLY]

Doesn't cost more - but requires more capital for the same exposure.

 

I f I want to long 1000 shares - the January 16 call option at the time was only $3.32/share... so the total cost is only about $3320.

 

Wouldn't you need a lot more money to get the same 1000 share exposure with commons & puts? I.e., you need a lot more money tied up.

 

 

I don't have this trouble in my portfolio margin account.  That's the only type of account where I would employ the strategy of using margined common+puts.

[gary17]

Even with a margin account you still need to have some of your funds , no?

how much would they let you leverage?

 

When I did the math the conclusion is i can get the same setup as the call option - but it means more money or margin availability tied up to set this thing up.............    but it's not without benefit - if you roll it carefully like you suggested, then it's a very long term LEAP that doesn't expire......... in a sense......

[ERICOPOLY]

Even with a margin account you still need to have some of your funds , no?

how much would they let you leverage?

 

I need to have "some of my funds" if I'm buying calls -- I believe the amounts to be the same, could be wrong so you should not take me too seriously.

 

Keep in mind I'm saying "portfolio" margin account, not just "margin account".

 

I would never employ what I'm doing in a "Reg-T" margin account.

 

 

[Uccmal]

Even with a margin account you still need to have some of your funds , no?

how much would they let you leverage?

 

I need to have "some of my funds" if I'm buying calls -- I believe the amounts to be the same, could be wrong so you should not take me too seriously.

 

Keep in mind I'm saying "portfolio" margin account, not just "margin account".

 

I would never employ what I'm doing in a "Reg-T" margin account.

 

 

 

Gary,  To my knowledge, a portfolio margin acct. is only in the US.  You are in Canada, if I recall.

[gary17]

May be that explains why I've been so confused.....    Yes, I am based in Canada.

What's the difference between the two types of account?

 

Sounds like from what Eric is describing the portfolio account allows greater margin... so there's less own funding involved...        :-[

[fareastwarriors]

Spreading The Word About Portfolio Margin

 

http://www.investopedia.com/articles/optioninvestor/09/portfolio-margin.asp

 

There is an article on investopedia. I'm not sure how useful it is. Good luck!

[yitech]

May be that explains why I've been so confused.....    Yes, I am based in Canada.

What's the difference between the two types of account?

 

Sounds like from what Eric is describing the portfolio account allows greater margin... so there's less own funding involved...        :-[

 

Gary,

 

I think Eric mentioned about this a few times before.

In a portfolio margin account, margin requirement is the same for call vs long stock+put (in other words, a synthetic call).

I am also using IB's portfolio margin.

He's using losses from puts to reduce taxes from capital gains elsewhere and delay capital gains on the common whereas simply using call may incur short-term tax if sold within a year.