BAC leverage

[LC]

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).

 

Yes fantastic, this is exactly what I was sensing intuitively when observing the price movements of these instruments, but you are far better at communicating what is happening.

 

This is caused by the skewness you were talking about earlier with ni-co? I presume if so, the effect is magnified by the time of the instruments.

 

I.e. buying the 2-year ITM leap, selling after the stock declines, and buying the 1 year ATM leap will have a less pronounced effect than using the warrant + call option instead.

[ERICOPOLY]

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.

 

Rumpelstiltskin.

 

Think about the potential cost of the "first born son" when looking at cost of leverage comparing at-the-money puts compared to out-of-the-money puts. 

 

The deep-in-the-money calls have out-of-the-money puts.  These puts are priced like straw, and the price of turning the straw into gold is that you have to give up your first born child (the intrinsic option value that you are risking).

 

It's very, very, very different to compare the cost of in-the-money leaps leverage to at-the-money.

 

It's comparing (less) recourse leverage to non-recourse leverage.

 

Or comparing high-deductible insurance to no-deductible insurance.

 

Actually, I think you know all of this.  I just worry that people will somehow think that's how I look at cost of leverage since I initially raised the topic. 

 

[ERICOPOLY]

And for very, very long term warrants, what is deep-in-the-money today is (somewhat) effectively at-the-money many years down the road.  By this I mean that a long passage of time lifts the trading range of a good business.

 

Just like a $14 tangible book value today is more like a $30 tangible book in forward looking (10 years) terms.

 

So I'm okay with going deep-in-the-money on a much longer term warrant.  The very long period of time reduces the probability of the first-born-child payment.  Yet at the same time the put buffers you against near term crashes down to near strike. 

 

A bit like discounting a future value to the present (similar concept).

 

[ERICOPOLY]

The absolute size of the first-born-child is what primarily drives the option premium so low that it becomes priced like straw.

 

I think this Rumplestiltskin analogy will be familiar enough for people to understand.

 

That's skewness.  The bigger the value of the first-born-child, the more cheap the straw becomes.  Once the child is extremely valuable, no amount of volatility spike is going to make much difference to the price of the straw versus where it was priced initially at-the-money.  Small changes, but not much.  If 1 penny doubles to 2 pennies, so what!

[yitech]

I do agree with Eric that the high premium(or cost of leverage) Warrant A holders had to pay (vs other TARP warrants) to get the extra upside offset a lot of undervaluation inherent in BAC.

But any idea Fed not raising rates in 2015 may do to the Jan 2016 LEAPs?

It seems most analysts have baked in the expectation that NIM would expand in their EPS forecast. I know this sounds somehow short term-ish, but 2016 LEAPs becomes short-term instruments eventually.

 

David Rosenberg seems to believe rate hike will be postponed:

http://finance.yahoo.com/video/fed-not-raising-rates-2015-213500573.html

[kmukul]

Hi Eric,

First let me thank you and every one else for the knowledge thats distributed here. I think I know a bit more about Skew that you guys are talking about. I have a quick question, Normally to leverage on a stock i just buy ATM leaps, Now it seems due to skew this is probably a bad strategy as you are paying most for it compared to if i buy in the money or a little out of money, In that case for example with BAC if I want to have a little leverage it might make sense for buying 20$ 2017 leaps instead of 15 or 17$ as I might get benefitted if the stock moves closer to 20 because in that case if i sell i will get paid maximum skew. I and most of the board expects it to cross 20$ so does this represent a better strategy then buying ATM option? of course I understand i should take too much of it and be prepared for it to all lose money in case i am wrong

 

Thanks

Mukul

 

[ERICOPOLY]

Normally to leverage on a stock i just buy ATM leaps, Now it seems due to skew this is probably a bad strategy as you are paying most for it compared to if i buy in the money or a little out of money

 

Yes, the straw (the extrinsic put option value) is cheaper further from at-the-money strike but for good reason:  in order for it to become spun into gold, Rumpelstiltskin takes your first born child.

 

Opportunity cost is real.

[Mephistopheles]

The warrants now cost 5.4%, implying that the stock will only be at $22.20 in a little over four years, or a total return of 24%. If the stock is at $30 in January 2019, it would return 67% while the warrants would return 140%.

[kevin4u2]

The warrants now cost 5.4%, implying that the stock will only be at $22.20 in a little over four years, or a total return of 24%. If the stock is at $30 in January 2019, it would return 67% while the warrants would return 140%.

 

What warrant strike price and number of shares per warrants are you using at conversion?

[Mephistopheles]

The warrants now cost 5.4%, implying that the stock will only be at $22.20 in a little over four years, or a total return of 24%. If the stock is at $30 in January 2019, it would return 67% while the warrants would return 140%.

 

What warrant strike price and number of shares per warrants are you using at conversion?

 

Just the current price and shares/warrant, which is $13.27 and 1:1. But also obviously not including dividends over $.04/year in the cost of leverage.

[CleverLongboat]

First of all, apologies for bringing up a buried topic again. I've been spending the past two days going through all the threads and subthreads where this strategy has been discussed, as well as staring down the various spreadsheets posted. It was extremely educating. Nevertheless, as the debate raged on for a couple of years, and people's viewpoints seem to have changed over time, I had trouble following some details of the discussions. Is there any possibility maybe, that someone who has followed this debate from the beginning to the end, and feels he/she understands it could provide a summary of what exactly Eric did at what point in time to gain BAC leverage (i.e. leaps, commons, warrants, in which ratio, at what point in time, why)

 

Another side-question I had was about the cost of leverage. What is the exact definition / formula for this? At some points I found that I had understood the concept, but couldn't calculate it. Again, sorry for bringing this all up again, I realize from reading the logs that a lot of people were very emotionally invested in this, but I think a sort of 'grand summary' would benefit everyone.

 

[Sunrider]

Subtract the option premium from current stock price, then divided strike price by the amount this yields. Annualise the resulting return. That's the cost of leverage as Eirc calls it.

[TwoCitiesCapital]

Subtract the option premium from current stock price, then divided strike price by the amount this yields. Annualise the resulting return. That's the cost of leverage as Eirc calls it.

 

Also, important distinction to note, this is only the case you're buying an at-the-money option. You would need to make adjustments for in-the-money and out-of-the money options which can further complicate it.

 

For in the money options, you would use the time value of the option instead of the whole premium in the calculation, but this ignores the opportunity cost of the money that is tied up in the "fundamental value" portion of the option premium so you would need to bump up your total cost by some weighted amount of a given, fixed return expectation for your capital to adjust for this. Obviously, this is a "softer" calculation and will be different for every individual who does the calculation on the same option. It's probably best to think of the result as a rough-average cost as opposed to a number with decimal point precision.

 

Out of the money options require to consider the price appreciation required to get you to the option strike as a "cost" too, even though this isn't money you're paying. It's upside you're foregoing in the name of getting a cheaper option so it still has to be calculated into the cost, but it's also not sucking up your capital that requires the fixed return expectation from above. Again, hard to make exact adjustments for all of these inputs, but if you think of the result as a rough average, or as a range, it probably gets you close enough to compare general forms of leveraged exposure to determine which one comes cheapest.