BAC leverage

[ERICOPOLY]

However, I'd argue that 2013 was not such a time for BAC. What was so special about BAC in 2013? Volatility halved compared to 2012. Well, it halved again in 2014 – my bad. The fact that the BAC warrants are now extraordinarily cheap doesn't mean that they were extraordinarily expensive back in 2013

 

Warrants were decimated in 2011 when the stock dropped to $5.  The warrants were just $2 at the time. 

 

Despite the fact that volatility in late 2011 was twice as high as it was in 2013.

 

Can't you now see that skewness trumps everything!

 

Even when volatility soared in 2011, the warrant premium still got crushed.

[ERICOPOLY]

In fact...

 

The warrant premium is HIGHER today in this LOW volatility environment...

 

compared to late 2011 in a VERY HIGH volatility environment.

 

 

The premium TODAY is $2.77

The premium THEN was $2

 

Yet, at the same time... THREE YEARS of time value have been destroyed.  It was a 7 year warrant in late 2011 and now it's just 4 years left.

 

It's about time now for you to reassert your opinion that it was all due to falling volatility.  ::)

[Sunrider]

Funny Nico - I think I made your point in a similar guise two (?) years ago --- probably still in the original BAC thread. As did others (Hielko?) Cost of leverage is basically just a re-cast of implied volatility (and all the other factors that go into the price of an option, whether that's via a model or just what somebody in the market feels they are willing to trade at).

 

I don't exactly recall Eric to ever acknowledge this - not that this matters too much but that's probably why your patience is similarly tried by Eric's posting. Many members here jumped on his ideas and treated them as the holy grail --- fortunately for them, his calls proved right ... but in the end we must acknowledge that it is as you said, they were specific calls (in this case) on how the price of BAC will move and, indirectly, what IV will do (as well, as actually, the market and perception which influences skewness, preference for put/calls, etc. etc.).

 

So Eric, well done to you. Please do realise though that at times you come across as a right royal git in your posts, which has led others to stop posting in these threads because they couldn't be bothered any more with disentangling for you what the cost of leverage really means (I see from your posts over the last year that your thinking also evolved and you gradually related it to the usual factors one looks at in option pricing, which is great).

 

There are many members here that are very smart (and some clearly also very au fait with option pricing models) - just because their view (or risk assessment) differs from yours doesn't mean they are silly, etc. I for one, did see a different trajectory as a distinct possibly at the time, which included BAC not rising till closer to expiry  .... and I did worry a lot about what would happen if IV (not stock vol ... they are distinct!) would drop and at what rate that may happen. All of that goes into your cost of leverage calc ... just in one go. There are many scenarios in which your rolls would've lost money compared to holding the longs with the same stock price at expiry of the warrants - what irks me is that you never acknowledged that much or gave credit to the people who tried to highlight that what you discussed as instrument selection is not only that, but also very much a call on the future development of a host of factors.

 

To everyone else that likes the cost of leverage concept ... remember it's a shortcut, and a shortcut only ... in effect a summary measure. As with most things in investing, if you're right about the direction and the timing of the move you will make money (but that's nothing new, is it)?

 

Merry Christmas to all of you.

 

P.S.: On a second read I see that this message may be misunderstood - no disrespect meant here and I truly do mean it when I say "well done for you". I see the cost of leverage translation as a useful tool and I guess the point of this post is to remind you, Eric, and everyone else who cares to think about it carefully that what we control is process, not outcomes. I will re-read most if not all of your posts on the cost of leverage over the holidays to see whether it leads me to change my allocations to common, calls and warrants in BAC and other TARP stocks.

 

[ERICOPOLY]

Cost of leverage is basically just a re-cast of implied volatility (and all the other factors that go into the price of an option, whether that's via a model or just what somebody in the market feels they are willing to trade at).

 

I don't exactly recall Eric to ever acknowledge this

 

Of course volatility is used in option pricing.  I've never said otherwise.

 

What I've said is that the option premium gets inflated when the warrant is near the money, and decimated as the option goes out of the money.

 

The option premium was only $2 during high volatility in December 2011!  That happened because it was far out of money, not because volatility dropped.  Rather, that happened when volatility soared.

 

Later, in 2013, the premium was $5.65 despite a much lower implied volatility.  That was a huge spike in premium despite lower volatility (compared to Dec 2011).

 

The risk isn't higher implied volatility.  It's the combination with a flat-lined stock price.

 

[ERICOPOLY]

There are many members here that are very smart (and some clearly also very au fait with option pricing models) - just because their view (or risk assessment) differs from yours doesn't mean they are silly, etc.

 

 

In short, the warrants were a method of getting no leverage early on when the stock swings to $20, and then after that you'd get your leveraged return mostly from a deep-in-the-money option that is decaying to expiry on a mostly fully valued stock.  And the much heralded dividend feature would put your dividends into the mostly fully valued stock.

 

But guys...

Are you the kind of people that normally wait to put on your leverage until most of the return to full value?

 

Do you normally sell when the margin of safety gets thin, or is that when you like to start adding your leverage?

 

You don't think I realize that smart people like you can allow their fears to drive them to make silly plans? 

 

You guys can't tell me that you didn't know that option premiums are always thin for in-the-money options.  You knew that to be true even for the warrants because you witnessed the warrant premium at only $2 in Dec 2011 when the stock was at $5 and implied volatility was very high.  You could see that the delta was $3.65 (compared to when this thread began when it was $5.65 and at-the-money in a lower volatility environment) and that the same thing was going to happen to the premium pricing if the stock rose near $20.

 

So it was not going to begin to offer you leveraged returns until it got well into the money.

 

But you guys tend to want to be in undervalued stocks and participate in the swing to fair value.  You never get excited about the opportunities to be leveraged in stocks without much margin of safety.

 

Because of the very large amount of premium to be eroded, the warrant would need to be greatly in the money before it could get much advantage over straight common.

 

So that's primarily why I called you guys silly.  Your psychology was driving you to behave in a manner akin to leveraging a stock without much margin of safety. 

 

But you didn't see it that way because your fears over holding a short term option were driving your thinking.

 

I specifically made this point well before the shares took off -- this isn't hindsight.  I even mentioned that towards the end of the warrants term you'd be too scared to see it through to the end for the very reason that you guys keep mentioning.

[ERICOPOLY]

Regarding psychology...

 

You got too caught up in the timeframe of the warrant to recognize that you were unconsciously choosing to leverage up on the stock movements that occur after the return to intrinsic value.

 

Once I recognized that the warrant was effectively going to do just that, it became completely disinteresting to me. 

 

What was interesting to me was finding a way to leverage the return to fair value.  Even though it carried the risk of the price going higher when rolling, it offered so many things in return.

[ERICOPOLY]

So lets take the LEAPS completely out of the discussion and focus instead on the psychological point I just mentioned..

 

How interested are you guys in leveraging up on fully valued banks using 6 year warrants that are deep-in-the-money?  Is that your style of investing?

 

Is it a more attractive idea to leverage up on a deeply undervalued stock that is presently at-the-money with a huge warrant premium?

 

Both are largely the same when the huge premium is big enough to wipe out the rise to IV!

[ERICOPOLY]

So you effectively gave up your value investing hat and became leveraged GARP investors.

 

You got sucked into this unwittingly because all you were focused on is TIME.

 

That's why I kept calling it dumb/silly/stupid to buy them.

 

Value investors (if done right) make most of their gains as the discount in the stock price is lifted.  That's precisely what you are not gaining leverage on here because that will get offset by MTM losses on the warrant premium as it goes deeper into the money.

[ERICOPOLY]

So if I had left it at just that, I think I might have grabbed your attention.

 

But instead, I had to go and suggest a method of using shorter duration options to gain leverage on the rise to fair value... and that's all you heard apparently because it was an opportunity to fluff your feathers about prudence.

[ERICOPOLY]

Keep this in your head while you are reading this thread again from the beginning...

 

Each time I get accused (by Hielko, Sunrider, ni-co, and more) of making "path dependent" and "volatility assumptions" and so therefore I cannot call the warrants "overvalued".

 

THEY KEEP QUIET when Buffett makes the same claim about his long term put liability being overpriced due to how Black-Scholes uses short term volatility in the pricing of long term options.

 

Guys, go challenge Buffett at the annual meeting -- tell him he can't call it "mispriced" without making path dependent stock price assumptions and similar regarding future volatility.

 

Buffett doesn't make that argument about short term options.  Only long term ones, and if you probe him I'm sure you'll get an answer that to you looks like "path dependence and assumptions about future volatility".

 

Then you guys can all tell him that he's wrong and you are right -- and how you've all been trying to tell him if only he would listen.  And then add that hoards of knowledgeable people who also know as much as you are just being silent yet don't agree with me/him. 

 

[ERICOPOLY]

ni-co asked me about the dividends...

The dividend assumptions were priced into the warrant upfront.

 

So you paid for the dividend upfront.  Nothing is for free.

 

But your prepaid dividends would be worth twice as much if reinvested at $12 versus at $24.

 

So your prepaid dividend premium craters in value as the stock soars, versus if you had just invested them directly into the stock back when it was at $12.

 

That's also worth thinking about.  It's not a bad idea to invest your dividends while the stock is deeply depressed, versus later on after it doubles or more.

 

That's a decent argument for avoiding salesmen who offer you dividend protection premiums on synthetically leveraged instruments for deeply undervalued stocks.  The premiums should get clobbered MTM by a large swing up in the stock price.  Well, I think it's obvious that the dividend protection has more value at lower stock prices than at higher stock prices.  Does anyone disagree with that? 

 

The premium of prepaid estimated dividends is only worth half as much at $24 versus at $12.  No?  So you should ask for a discount right?  Or is that "path dependence" to ask for a discount?

[thepupil]

Eric, you're right. Go enjoy life, take the muskmobile for a spin and move on to something else.

[rkbabang]

Eric, you're right. Go enjoy life, take the muskmobile for a spin and move on to something else.

 

I think you are correct as well, but since I am thoroughly enjoying this thread, I'd encourage you not to move on unless/until you are finished.

 

[krazeenyc]

Eric, you're right. Go enjoy life, take the muskmobile for a spin and move on to something else.

 

I think you are correct as well, but since I am thoroughly enjoying this thread, I'd encourage you not to move on unless/until you are finished.

 

+1

[ERICOPOLY]

Depends, as always, on whether another person is going to claim that it's not predictable for an at-the-money option premium to all but disappear as it goes deep into the money. 

 

As long as we've exhausted the list of posters willing to make that claim, we should be good.

[bennycx]

Man... this is exactly why we can't have a decent discussion... always ends up like that

[ERICOPOLY]

Yep, somebody (me) says something (risk from volatility when rolling if stock remains roughly flat)

Somebody else then says I glossed over it

I say it again

They reiterate their claim

I say it again

Somebody new pops up and says I don't understand that very same thing

I say it again

They reiterate their claim

 

over and over and over again.

 

Then a new one arrives. 

 

Whack a mole.

[LC]

Depends, as always, on whether another person is going to claim that it's not predictable for an at-the-money option premium to all but disappear as it goes deep into the money. 

 

As long as we've exhausted the list of posters willing to make that claim, we should be good.

 

Wouldn't it be better off to just buy the deep ITM option in the first place, in terms of minimizing premium paid? I guess the downside to that is you need more capital for the same exposure.

[ERICOPOLY]

Depends, as always, on whether another person is going to claim that it's not predictable for an at-the-money option premium to all but disappear as it goes deep into the money. 

 

As long as we've exhausted the list of posters willing to make that claim, we should be good.

 

Wouldn't it be better off to just buy the deep ITM option in the first place, in terms of minimizing premium paid? I guess the downside to that is you need more capital for the same exposure.

 

As long as it's a long term warrant, yes.

 

[ERICOPOLY]

My reasoning there is that if the stock goes into reverse, the warrant's premium will soar as it approaches it's strike price.

 

Therefore, it puts on the brakes.

 

You'd probably suffer much like the un-leveraged common even though your upside is leveraged.

 

So the reverse of what just happened to our BAC warrants.

[LC]

What about 2 year LEAPS? I remember buying some of the $12-strike ITM call options because the "cost of leverage" at the time was like, 5%. The ATM leaps had a more expensive cost of leverage (maybe 7% iirc).

 

Obviously the ATM leaps were more profitable as the stock marched upwards, but how were they a better buy despite the higher cost of leverage? The only reason I can think of is because you can get greater exposure per $.

[racemize]

you get different leverage for each strike price. This is why I calculate some kind of leverage metric to show how much leverage you are getting relative to the cost of leverage, for each warrant/option.

[ERICOPOLY]

What about 2 year LEAPS? I remember buying some of the $12-strike ITM call options because the "cost of leverage" at the time was like, 5%. The ATM leaps had a more expensive cost of leverage (maybe 7% iirc).

 

Obviously the ATM leaps were more profitable as the stock marched upwards, but how were they a better buy despite the higher cost of leverage? The only reason I can think of is because you can get greater exposure per $.

 

My main goal in life when I began this thread was to step out from in front of the freight train that was about to clobber the BAC warrants if the stock soared.  I wanted to leverage that outcome and outperform the common.

 

That risk doesn't exist anymore today in the deep-in-the-money warrant and so I prefer the warrant for it's downside (it's inexpensive embedded put will soar in a crash) and fixed interest rates and fixed volatility.

 

To my amusement, when I decided to get out of the way of the freight train, I couldn't believe that the at-the-money options were priced as they were relative to the warrants.  A great way to pick up non-recourse leverage relatively cheaply compared to the favorable upside in the stock.  I didn't even have to pay a premium for the shorter-dated LEAPS, something I was stunned at.

 

[ERICOPOLY]

For shorter dated, I prefer to just go at-the-money so it's non-recourse if it goes south.  I don't find it worthwhile to go deeper into the money on shorter dated options to save pennies of leverage costs. 

 

For very long dated warrants, going deeper in the money is a lot safer because it trades closer to the unleveraged common portfolio when stock price declines toward strike.  Then, at that time after the decline, dump the warrant and buy the at-the-money LEAP again (assuming the warrant is priced once again like last time).

 

Then if the stock soars, switch back to the warrant.

 

Repeat again and again if possible.

[ERICOPOLY]

A reminder that when this thread began, the deep-in-the-money WFC warrant had a cost of leverage of roughly 5%.

 

That was 5% in the VIX environment of 2013.  Not today's VIX.

 

One of my arguments then was that once BAC's cloud of uncertainty cleared and stock rose it would be difficult to see why BAC's warrant would be priced any different.

 

This I suppose is one of the reasons why I get so impatient when people try to blame it all on the lower VIX of today. 

 

The 5% warrant cost was 2013 pricing!