BAC leverage

[racemize]

I was trying to create a spreadsheet where you could type in the common prices each year and compare the cost of rolls/return to the cost/return of warrants.  Assuming Eric is correct, the leaps should always be better, but I'd like to verify with some numbers.

 

 

It's also not an apples-to-apples comparison.

 

The LEAPS strategy, if I roll to at-the-money strikes is a safer strategy.  At every roll I lock in my gains as the price rises.

 

The Warrants strategy -- the put never moves.  It never gets higher than 13.30.

 

So in this sense, the LEAPS strategy is not only less risky (locking in gains as they come), but potentially lower cost as well.

 

We then are not merely arguing about price here -- it's also about the underlying value of a strategy with a rising put strike versus a static one.

 

Risk adjusted, I'll take the rising put strike strategy even if it works out to have no cost advantage.

 

Sure, but I'm just trying to verify that there isn't a case where the LEAPS strategy, over time/rolls, underperforms the warrants--isn't that what you have been saying?  I'm trying to find the downside, is there really not one?

[ERICOPOLY]

May I know how to calculate this cost of leverage ?

I have some AIG warrants and never calculated this cost of leverage ...

 

Incidentally, JPM warrants only have a 5.66% cost of leverage--this seems quite low (one of the lowest of the warrants in my spreadsheet).

 

Just compute the compounding rate at which a 100% warrants strategy breaks even versus a 100% common strategy (at warrant expiry date).  Think of two separate accounts, each one with a NAV at expiration.  At what compounding rate are the two exactly the same?

 

That would be the cost of leverage rate -- the rate at which the asset appreciates at the same pace as the cost of financing it.

[ERICOPOLY]

I was trying to create a spreadsheet where you could type in the common prices each year and compare the cost of rolls/return to the cost/return of warrants.  Assuming Eric is correct, the leaps should always be better, but I'd like to verify with some numbers.

 

 

It's also not an apples-to-apples comparison.

 

The LEAPS strategy, if I roll to at-the-money strikes is a safer strategy.  At every roll I lock in my gains as the price rises.

 

The Warrants strategy -- the put never moves.  It never gets higher than 13.30.

 

So in this sense, the LEAPS strategy is not only less risky (locking in gains as they come), but potentially lower cost as well.

 

We then are not merely arguing about price here -- it's also about the underlying value of a strategy with a rising put strike versus a static one.

 

Risk adjusted, I'll take the rising put strike strategy even if it works out to have no cost advantage.

 

Sure, but I'm just trying to verify that there isn't a case where the LEAPS strategy, over time/rolls, underperforms the warrants--isn't that what you have been saying?  I'm trying to find the downside, is there really not one?

 

 

I hope you find it if it's there.  I'd like to know about it.  Then I can decide if all of the upside in the scenarios I mentioned far outweigh the downside that you find.

 

[Sunrider]

No, no. I'm not trying to multiply one IV to get another. All I am saying is that for the one option there's one IV and for the other option there's another. Given the assumptions that go into the option pricing model we would expect them to be related by a function of square root of time. This is because in the absence of any other information all these models assume that volatility increase that way over time (seeing it's the standard deviation of returns). The fact that we are seeing this roughly being the case speaks to the market pricing both consistently with respect to volatility - put another way, it is not pricing in more volatility than would be due under the usual assumptions in the longer-dated one.

 

I may be wrong ...

 

Ermm - with respect, but doesn't that come to the same thing. I'm comparing vol and say it must change with sqrt(t). You're saying, keep vol the same and compare across maturity and you should see the relationship in price (i.e. price changing with sqrt(t). So I'd kinda expect that intuitively since you priced in the same volatility you have to see the price move and we don't expect that price move to be linear because the formula assume a non-linear relationship to volatility ... hope I'm making sense here.

 

C.

 

There's one thing that has been bothering me in this cost of leverage debate and this probably comes back to the linearity question.

 

In theory - whether you agree with the model or not - the LEAPS and the warrants likely are priced based on similar assumptions by the market. If so, and one crucial assumption being volatility, then we should be able to compare what you're paying for in the rolls to what you're paying for in the warrants. This is similar to the 'loose on every roll until you win on the last one scenario'.

 

I haven't thought this through properly and wanted to offer it for debate. Maybe Hielko can chime in.

 

Volatility, if I remember correctly, moves withe the sqrt of time so with 2015 12 calls at about 34.5% IV at the moment have 1.9 years to go. Warrants have 5.92 years to go. So the warrants have 5.29/1.99 = 2.66 times more time. Assuming the LEAP's IV is fair, we would expect an option with 2.66x more time to price at IV of 34.5% x sqrt(2.66) = 56%.

 

Hielko or anyone else that remembers their finance classes - is that correct? If so, then without making any assumptions on price path, eventual pay-off, etc. we can say that the warrants are not particularly cheap or expensive vis-a-vis the reference LEAPS, right?

 

Cheers - C.

 

It's option value, not IV that is proportional to the square root of time for the same strike prices when IV's are the same. You can simply compare Jan '14 and '15 and see if this is roughly true. Of course the IVs between options with different expirations are usually different(time skew), but if they were exactly the same, option values ought to be proportional to the square root of time.

 

I simply state the option math and that you can't multiply IV by square root of time to get an estimate of another IV. If an option with one month to expire have a vol of 30%, by your logic, a 6 year vol would be 30%*sqrt(72)=254%, making the BAC A warrant seem like an incredible bargain. Does that make sense?

[Studesy]

 

Personally I'm after 1.5x underlying shares of leverage.

 

 

 

Eric...What is your reasoning behind using 1.5x leverage as opposed to a higher or lower amount. Or is this just pure personal preference based on the cost of that leverage and the upside you believe BAC has.

 

Also, in the case we see a decline in BACs share price before the 2015 LEAPS are rolled into 2016's...would you roll into 2016 $12's or would you use a lower slightly in the money LEAP? Thanks again BTW.

 

 

1.5x leverage is just personal choice.  No formula.  The leverage was higher when the upside was greater. 

 

Not sure what strike I'll roll into if the share price declines significantly.

 

By the same token, I might roll into a $17 strike calls in 2015.

 

The trouble with the warrants is that you're stuck with that deep-in-the-money put the entire time (it ought to be deep-in-the-money in the later years, like when the stock is above $20).

 

What if, as the stock advances, I keep moving up the strikes to at-the-money every single time I roll my calls?  All I need to do is hedge the amount of money that I initially "borrowed".  So I would be purchasing fewer and fewer contracts as the price rises, and as the uncertainty is lifted in the stock (along with the rising price) I'll probably still be paying decreasing financing costs (as IV declines).

 

Okay, so now it's 5 years from today, my strikes have been moved up to $25 as I roll my LEAPS,  and now the stock crashes all the way back to $10 due to a systemic event worse than 2009.

 

What say you now warrant lovers!  ;) Is that worst case scenario something you have planned for?  Perhaps you want to rethink again what a "worst case" scenario looks like, eh?

 

So as the pice of the underlying has increased (more risk) you have decreased your leverage(as well as shopped for the cheapest leverage).  At what point along this risk spectrum do you see it necessary to hedge? Also,how much of the 1.5x leverage position do you hedge out and a what price?

 

Let's say the stock is at $25 and I am rolling my calls.  I figure how much I'm levered at the time, and purchase puts to hedge only the leverage (keeping it non-recourse leverage).

 

The warrant guy can't do this -- he is stuck in that $13.30 straight-jacket.  And that warrant put will be about as comforting as a wet blanket when the stock is at $25.

 

Look at what a "clear sailing" put sells for on a bank -- Wells Fargo puts cost something like 5% annualized for at-the-money.

 

So even though I may be hedging at-the-money when I roll my LEAPS as the stock rises for BAC,  I might very well still be (and likely will be!) benefitting from declining financing costs for my leverage.

 

So not only are people paying a dear price for the put in the warrants, they'll likely come to find that it brings them no comfort when people start worrying about the next crisis as it gets near expiry.

 

Makes sense.  So..using todays prices and assuming a 1.5x leverage position......hedging the leverage would work as follows?

 

BAC Share Price= 12.57

2015 $12 Call = 2.40

2015 $12 Put = 1.85

 

 

1.5x levered position =  1 x 2015 $12 Call        +          0.5 x BAC common

                                = $2.40    +  $6.28

                                = $8.68 cash outlay  (downside is 100%)

 

Now to hedge you are protecting the 0.5x common position by purchasing  0.5x  2015 $12 put for $0.92.

 

So in the worst case scenario BAC goes to 0.  Your $2.40 call is wiped out.  Your $6.28 in common less cost of put $0.92 = $5.35

Therefore your downside is $8.68 - $5.35 = $3.33 or 38% (3.33/8.68).  Is this right Eric.

 

Thanks Again

[nkp007]

I appreciate Eric and everyone else's input and questions. This has been a very educational thread for me.

 

I'm going to stick to my warrants because I can't wrap my head fully around the options strategy. I feel much better making a concentrated investment in something that expires in 2019.

 

What makes me happy is that if Eric's strategy works out, that means the underlying Bank of America shares should be doing well.

 

[Studesy]

I appreciate Eric and everyone else's input and questions. This has been a very educational thread for me.

 

 

+1 Great stuff!!

[ERICOPOLY]

 

Personally I'm after 1.5x underlying shares of leverage.

 

 

 

Eric...What is your reasoning behind using 1.5x leverage as opposed to a higher or lower amount. Or is this just pure personal preference based on the cost of that leverage and the upside you believe BAC has.

 

Also, in the case we see a decline in BACs share price before the 2015 LEAPS are rolled into 2016's...would you roll into 2016 $12's or would you use a lower slightly in the money LEAP? Thanks again BTW.

 

 

1.5x leverage is just personal choice.  No formula.  The leverage was higher when the upside was greater. 

 

Not sure what strike I'll roll into if the share price declines significantly.

 

By the same token, I might roll into a $17 strike calls in 2015.

 

The trouble with the warrants is that you're stuck with that deep-in-the-money put the entire time (it ought to be deep-in-the-money in the later years, like when the stock is above $20).

 

What if, as the stock advances, I keep moving up the strikes to at-the-money every single time I roll my calls?  All I need to do is hedge the amount of money that I initially "borrowed".  So I would be purchasing fewer and fewer contracts as the price rises, and as the uncertainty is lifted in the stock (along with the rising price) I'll probably still be paying decreasing financing costs (as IV declines).

 

Okay, so now it's 5 years from today, my strikes have been moved up to $25 as I roll my LEAPS,  and now the stock crashes all the way back to $10 due to a systemic event worse than 2009.

 

What say you now warrant lovers!  ;) Is that worst case scenario something you have planned for?  Perhaps you want to rethink again what a "worst case" scenario looks like, eh?

 

So as the pice of the underlying has increased (more risk) you have decreased your leverage(as well as shopped for the cheapest leverage).  At what point along this risk spectrum do you see it necessary to hedge? Also,how much of the 1.5x leverage position do you hedge out and a what price?

 

Let's say the stock is at $25 and I am rolling my calls.  I figure how much I'm levered at the time, and purchase puts to hedge only the leverage (keeping it non-recourse leverage).

 

The warrant guy can't do this -- he is stuck in that $13.30 straight-jacket.  And that warrant put will be about as comforting as a wet blanket when the stock is at $25.

 

Look at what a "clear sailing" put sells for on a bank -- Wells Fargo puts cost something like 5% annualized for at-the-money.

 

So even though I may be hedging at-the-money when I roll my LEAPS as the stock rises for BAC,  I might very well still be (and likely will be!) benefitting from declining financing costs for my leverage.

 

So not only are people paying a dear price for the put in the warrants, they'll likely come to find that it brings them no comfort when people start worrying about the next crisis as it gets near expiry.

 

Makes sense.  So..using todays prices and assuming a 1.5x leverage position......hedging the leverage would work as follows?

 

BAC Share Price= 12.57

2015 $12 Call = 2.40

2015 $12 Put = 1.85

 

 

1.5x levered position =  1 x 2015 $12 Call        +          0.5 x BAC common

                                = $2.40    +  $6.28

                                = $8.68 cash outlay  (downside is 100%)

 

Now to hedge you are protecting the 0.5x common position by purchasing  0.5x  2015 $12 put for $0.92.

 

So in the worst case scenario BAC goes to 0.  Your $2.40 call is wiped out.  Your $6.28 in common less cost of put $0.92 = $5.35

Therefore your downside is $8.68 - $5.35 = $3.33 or 38% (3.33/8.68).  Is this right Eric.

 

Thanks Again

 

That's not quite what I'm doing.

 

Think of it like I'm putting first 100% into the common, then backing out just enough common to purchase $12 calls so that the leverage is 1.5x.  So I will have a fractional ownership of 1 call mixed with a fractional ownership of 1 share common.

 

I'm hedging only what I'm borrowing.  I wouldn't be hedging at all if it were 100% common.

 

And when this whole discussion began, the stock was at $12.03 so there was no intrinsic value in the LEAPS calls -- that made it easier to think about.

 

 

[ERICOPOLY]

Look, if you guys want to hear my magic bullet theory on where the bulk of the problem lies with the warrants, it's this.

 

1.  They trade at a cost-of-leverage premium due to the dividend protection (in essence, you are paying for the dividend when you buy the warrant).  Except you are putting the cash down upfront when the stock is at $12.

 

2.  Later the company will pay you the bulk of those dividends when the stock is trading north of $20.  Perhaps north of $24.  So you might be paying 1 dollar of value today to get 50 cents of value paid back to you later.

 

3.  Let's say banks normally trade at a 3% dividend yield based on payouts of 1/3 earnings and P/E 10 multiple.  Later on, when I roll my calls at-the-money and the stock is at $30, a 3% dividend yield would be 90 cents. 

 

So it looks like you might be getting a bargain price for all the dividends you are collecting in the future from the warrants if you are expecting $3 of dividends to be paid over the life of the warrant, but keep in mind that if you invested that "dividend protection" warrant premium today when the stock is $12, it too would grow to a large amount over time (simulating a large future dividend).

 

So I'd rather pay a 10% cost of money and invest that excess money into the stock at $12.  Others would rather pay a 13% cost of money and get that dividend back in the future (and get taxed in the process if US taxpayers).

 

Besides, I don't believe I will be always be paying 10% -- I feel it will fall to 7% or perhaps 5% annualized cost of the at-the-money calls when the stock normalizes in price (uncertainty is lifted).

 

And for US taxpayers the guys with the warrants will have to clip a bit of their warrants every year to pay that dividend tax.  So that raises the breakeven point of the warrants vs common because they'll have fewer warrants at expiry.

 

 

[Studesy]

 

Personally I'm after 1.5x underlying shares of leverage.

 

 

 

Eric...What is your reasoning behind using 1.5x leverage as opposed to a higher or lower amount. Or is this just pure personal preference based on the cost of that leverage and the upside you believe BAC has.

 

Also, in the case we see a decline in BACs share price before the 2015 LEAPS are rolled into 2016's...would you roll into 2016 $12's or would you use a lower slightly in the money LEAP? Thanks again BTW.

 

 

1.5x leverage is just personal choice.  No formula.  The leverage was higher when the upside was greater. 

 

Not sure what strike I'll roll into if the share price declines significantly.

 

By the same token, I might roll into a $17 strike calls in 2015.

 

The trouble with the warrants is that you're stuck with that deep-in-the-money put the entire time (it ought to be deep-in-the-money in the later years, like when the stock is above $20).

 

What if, as the stock advances, I keep moving up the strikes to at-the-money every single time I roll my calls?  All I need to do is hedge the amount of money that I initially "borrowed".  So I would be purchasing fewer and fewer contracts as the price rises, and as the uncertainty is lifted in the stock (along with the rising price) I'll probably still be paying decreasing financing costs (as IV declines).

 

Okay, so now it's 5 years from today, my strikes have been moved up to $25 as I roll my LEAPS,  and now the stock crashes all the way back to $10 due to a systemic event worse than 2009.

 

What say you now warrant lovers!  ;) Is that worst case scenario something you have planned for?  Perhaps you want to rethink again what a "worst case" scenario looks like, eh?

 

So as the pice of the underlying has increased (more risk) you have decreased your leverage(as well as shopped for the cheapest leverage).  At what point along this risk spectrum do you see it necessary to hedge? Also,how much of the 1.5x leverage position do you hedge out and a what price?

 

Let's say the stock is at $25 and I am rolling my calls.  I figure how much I'm levered at the time, and purchase puts to hedge only the leverage (keeping it non-recourse leverage).

 

The warrant guy can't do this -- he is stuck in that $13.30 straight-jacket.  And that warrant put will be about as comforting as a wet blanket when the stock is at $25.

 

Look at what a "clear sailing" put sells for on a bank -- Wells Fargo puts cost something like 5% annualized for at-the-money.

 

So even though I may be hedging at-the-money when I roll my LEAPS as the stock rises for BAC,  I might very well still be (and likely will be!) benefitting from declining financing costs for my leverage.

 

So not only are people paying a dear price for the put in the warrants, they'll likely come to find that it brings them no comfort when people start worrying about the next crisis as it gets near expiry.

 

Makes sense.  So..using todays prices and assuming a 1.5x leverage position......hedging the leverage would work as follows?

 

BAC Share Price= 12.57

2015 $12 Call = 2.40

2015 $12 Put = 1.85

 

 

1.5x levered position =  1 x 2015 $12 Call        +          0.5 x BAC common

                                = $2.40    +  $6.28

                                = $8.68 cash outlay  (downside is 100%)

 

Now to hedge you are protecting the 0.5x common position by purchasing  0.5x  2015 $12 put for $0.92.

 

So in the worst case scenario BAC goes to 0.  Your $2.40 call is wiped out.  Your $6.28 in common less cost of put $0.92 = $5.35

Therefore your downside is $8.68 - $5.35 = $3.33 or 38% (3.33/8.68).  Is this right Eric.

 

Thanks Again

 

That's not quite what I'm doing.

 

Think of it like I'm putting first 100% into the common, then backing out just enough common to purchase $12 calls so that the leverage is 1.5x.  So I will have a fractional ownership of 1 call mixed with a fractional ownership of 1 share common.

 

I'm hedging only what I'm borrowing.  I wouldn't be hedging at all if it were 100% common.

 

And when this whole discussion began, the stock was at $12.03 so there was no intrinsic value in the LEAPS calls -- that made it easier to think about.

 

How do you determine this ratio though.  I mean to have 1.5x leverage you could go;

 

            1 Common to 0.5 Leap on one end of the spectrum  (cash outlay= 17.77)

            or

            1 Leap to 0.5 common on the other end of the spectrum (cash outlay= 9.88)

            or

            you could go with something in between....but how do you determine which ratio is optimal

 

[wisdom]

Eric - one additional thing to consider (if my understanding is correct)

 

There might be some value in the warrants as they allow for cashless exercise of the warrants. Whereas with the options - you could loose 100% of your investment. So all the value in the warrants is not just because of the dividend feature.

 

The warrants will atleast leave you with some value unless BAC is 0 - that is an extremely low probability.

[bobp]

"get that dividend back in the future (and get taxed in the process if US taxpayers)."

 

Eric - I could be wrong, but I think you're incorrect on the idea that warrant holders will owe taxes on dividends as they're paid out. If they adjust, you'll eventually pay tax in cap gains tax when you sell the warrant at a higher price or exercise with a lower strike. If you paid a dividend tax you'd be paying twice.

 

Other warrants have already adjusted for dividends- Hartford, Lincoln, Ford. There are probably holders of those here who'd know.

 

 

[ERICOPOLY]

"get that dividend back in the future (and get taxed in the process if US taxpayers)."

 

Eric - I could be wrong, but I think you're incorrect on the idea that warrant holders will owe taxes on dividends as they're paid out. If they adjust, you'll eventually pay tax in cap gains tax when you sell the warrant at a higher price or exercise with a lower strike. If you paid a dividend tax you'd be paying twice.

 

Other warrants have already adjusted for dividends- Hartford, Lincoln, Ford. There are probably holders of those here who'd know.

 

They account for the double taxation threat by adding the adjustment to your cost basis.

 

But you lose because you have to clip the warrant and miss out on future appreciation.

[ERICOPOLY]

Eric - one additional thing to consider (if my understanding is correct)

 

There might be some value in the warrants as they allow for cashless exercise of the warrants. Whereas with the options - you could loose 100% of your investment. So all the value in the warrants is not just because of the dividend feature.

 

The warrants will atleast leave you with some value unless BAC is 0 - that is an extremely low probability.

 

Cashless or not, the warrant will have no value if it's trading below the strike at expiration.

 

Same with the LEAPS.

 

But if I roll the LEAPS every year to an at-the-money strike price (locking in my gains along the way), then that price might be $25.  Thus I've locked in all my gains and it would then be impossible to lose any of them if the stock went back down below $25 (assuming it's a temporary decline only).

 

But with the warrant you risk losing 100% when the stock goes back down.  That's not a risk with the "2019 LEAPS" strategy if you go the route of rolling to at-the-money strikes.

 

 

 

[ERICOPOLY]

Wells Fargo dropped from $30 to $8 over just 3 months in early 2009 during the financial crisis, and that was a strong well-led bank!

 

It's therefore possible for the warrants to lose 100% of their value in the final minutes before expiration -- even if the stock has been trading up near $30 before the crisis hits.

 

But that's impossible with the LEAPS strategy if the gains are continually locked in every year by rolling to at-the-money strikes.

 

[Studesy]

Disregard my last question Eric. I was confusing notional leverage with the debt leverage. With this leap play as a businessman ...you have 0.5 debt to equity and have 1.5x notional upside.

[ERICOPOLY]

 

Personally I'm after 1.5x underlying shares of leverage.

 

 

 

Eric...What is your reasoning behind using 1.5x leverage as opposed to a higher or lower amount. Or is this just pure personal preference based on the cost of that leverage and the upside you believe BAC has.

 

Also, in the case we see a decline in BACs share price before the 2015 LEAPS are rolled into 2016's...would you roll into 2016 $12's or would you use a lower slightly in the money LEAP? Thanks again BTW.

 

 

1.5x leverage is just personal choice.  No formula.  The leverage was higher when the upside was greater. 

 

Not sure what strike I'll roll into if the share price declines significantly.

 

By the same token, I might roll into a $17 strike calls in 2015.

 

The trouble with the warrants is that you're stuck with that deep-in-the-money put the entire time (it ought to be deep-in-the-money in the later years, like when the stock is above $20).

 

What if, as the stock advances, I keep moving up the strikes to at-the-money every single time I roll my calls?  All I need to do is hedge the amount of money that I initially "borrowed".  So I would be purchasing fewer and fewer contracts as the price rises, and as the uncertainty is lifted in the stock (along with the rising price) I'll probably still be paying decreasing financing costs (as IV declines).

 

Okay, so now it's 5 years from today, my strikes have been moved up to $25 as I roll my LEAPS,  and now the stock crashes all the way back to $10 due to a systemic event worse than 2009.

 

What say you now warrant lovers!  ;) Is that worst case scenario something you have planned for?  Perhaps you want to rethink again what a "worst case" scenario looks like, eh?

 

So as the pice of the underlying has increased (more risk) you have decreased your leverage(as well as shopped for the cheapest leverage).  At what point along this risk spectrum do you see it necessary to hedge? Also,how much of the 1.5x leverage position do you hedge out and a what price?

 

Let's say the stock is at $25 and I am rolling my calls.  I figure how much I'm levered at the time, and purchase puts to hedge only the leverage (keeping it non-recourse leverage).

 

The warrant guy can't do this -- he is stuck in that $13.30 straight-jacket.  And that warrant put will be about as comforting as a wet blanket when the stock is at $25.

 

Look at what a "clear sailing" put sells for on a bank -- Wells Fargo puts cost something like 5% annualized for at-the-money.

 

So even though I may be hedging at-the-money when I roll my LEAPS as the stock rises for BAC,  I might very well still be (and likely will be!) benefitting from declining financing costs for my leverage.

 

So not only are people paying a dear price for the put in the warrants, they'll likely come to find that it brings them no comfort when people start worrying about the next crisis as it gets near expiry.

 

Makes sense.  So..using todays prices and assuming a 1.5x leverage position......hedging the leverage would work as follows?

 

BAC Share Price= 12.57

2015 $12 Call = 2.40

2015 $12 Put = 1.85

 

 

1.5x levered position =  1 x 2015 $12 Call        +          0.5 x BAC common

                                = $2.40    +  $6.28

                                = $8.68 cash outlay  (downside is 100%)

 

Now to hedge you are protecting the 0.5x common position by purchasing  0.5x  2015 $12 put for $0.92.

 

So in the worst case scenario BAC goes to 0.  Your $2.40 call is wiped out.  Your $6.28 in common less cost of put $0.92 = $5.35

Therefore your downside is $8.68 - $5.35 = $3.33 or 38% (3.33/8.68).  Is this right Eric.

 

Thanks Again

 

That's not quite what I'm doing.

 

Think of it like I'm putting first 100% into the common, then backing out just enough common to purchase $12 calls so that the leverage is 1.5x.  So I will have a fractional ownership of 1 call mixed with a fractional ownership of 1 share common.

 

I'm hedging only what I'm borrowing.  I wouldn't be hedging at all if it were 100% common.

 

And when this whole discussion began, the stock was at $12.03 so there was no intrinsic value in the LEAPS calls -- that made it easier to think about.

 

How do you determine this ratio though.  I mean to have 1.5x leverage you could go;

 

            1 Common to 0.5 Leap on one end of the spectrum  (cash outlay= 17.77)

            or

            1 Leap to 0.5 common on the other end of the spectrum (cash outlay= 9.88)

            or

            you could go with something in between....but how do you determine which ratio is optimal

 

 

It was pretty confusing the way I said it.  Today the LEAPS have some intrinsic value to them but they didn't when I put on the trade -- they were truly at-the-money.  That's the trouble of having the stock price move while this discussion has been going on.  The prices and examples keep changing and I'm getting tired of running the math twice.

 

So if you were purchasing a $100,000 BAC position that you wanted to be levered at 1.5x, you'd find the math equation that brings it to 1.5x if you mixed cash and at-the-money LEAPS with no cash left over.  I would give the equation to you if I had one, but I don't -- just need to figure it out.

 

I see another mistake in your scenario that doesn't reflect what I'm doing:

 

You wrote:

Now to hedge you are protecting the 0.5x common position by purchasing  0.5x  2015 $12 put for $0.92.

 

I don't own any $12 puts in my "2019 LEAPS" strategy.  The puts are implicitly embedded in the $12 calls -- that implicit put protects the "borrowed" money that gives me my leverage.  That implicit put adds the non in the word non-recourse.

 

[Studesy]

Great explanation Eric! I get what your saying...makes sense. 

[Cardboard]

"Besides, I don't believe I will be always be paying 10% -- I feel it will fall to 7% or perhaps 5% annualized cost of the at-the-money calls when the stock normalizes in price (uncertainty is lifted)."

 

That is a near certainty Ericopoly, but not just because uncertainty on the company will have dropped and implied volatility (that is a tougher call actually since volatility is based on latest movement and a rapid spike up would count to keep it up), but on larger dividends likely being paid. Dividends reduce call values. See that WFC puts trade at a higher price than calls and BAC ones are not. Calls and puts at the money, of same strike, same expiration will be equal if dividend yield equals interest rate.

 

"It's therefore possible for the warrants to lose 100% of their value in the final minutes before expiration -- even if the stock has been trading up near $30 before the crisis hits."

 

That is true for any deep in the money call. If you take this further, the stock is the ultimate deep in the money call. Therefore, you would not want to own any stock once it is priced high enough since the upside or return vs capital employed is too low. That is why I buy sometimes at the money calls on cheap large caps vs the stock: high certainty of return, but low payout. The calls fix the capital employed problem.

 

Regarding the cost of leverage of the warrants vs the LEAPS... While I agree with your points or relative benefits of the LEAPS, I cannot comprehend why the "A" warrants are so expensive and that is not seen in other TARP warrants. The risk of being "locked in" as you mentioned should be factored in as a discount on the warrants. Also, for long term options, they essentially act as a loan or like you calculated. That is why a BAC Jan 2015 call is cheaper than a BAC Jan 2014 when you discount your premium paid, hence a BAC Jan 2019 should be even cheaper in yearly percentage. The more you think about it, the more it is logical since a stock longer term should display a lot less fluctuation than in the short term: less risk to absorb for the writer of them.

 

While I have read the prospectus quickly before (I was simply considering these strike and conversion adjustments to be icing on the cake), I may have missed something big here. I even saw a calculation on the net where the strike could drop to as low as $8 and change based on what looked to me reasonable dividend expectations. So is there anyone who knows how they really adjust? There is a discrepancy of monumental proportions here and we should try to explain it.

 

Cardboard

[ERICOPOLY]

Dividends reduce call values.

 

You are right.  The LEAPS have tax-free dividend protection built into them.  Not absolute dividend protection, as you can never get it exactly right, but it's an "approximately right" protection.  That's a good way of looking at them.

 

And I can take that certain dividend and buy stock with it.  Rather than hoping for the company to not cut it's payout (or do what they did this week... not pay a dividend at all).

 

 

 

[ERICOPOLY]

That is true for any deep in the money call.

 

Yes, it should be practically common sense.

 

But I had to mention it because a lot of posters have been accusing me of risking 100% wipeout by going with LEAPS vs warrants because I hadn't considered a 2009 style crisis or whatever.

 

I can accept that perhaps they just don't understand LEAPS strategies and thus didn't know what they were talking about, but never did they seem to acknowledge the risk in the warrant strategy of that exact same event wiping the warrant out 100%.

 

So I used Wells Fargo as an example where a highly respected bank that Warren Buffett loves can go from $30 to $8 in a 3 month period of time.  That should completely obliterate the warrant's value.

 

 

 

[Rabbitisrich]

Look, if you guys want to hear my magic bullet theory on where the bulk of the problem lies with the warrants, it's this.

 

1.  They trade at a cost-of-leverage premium due to the dividend protection (in essence, you are paying for the dividend when you buy the warrant).  Except you are putting the cash down upfront when the stock is at $12.

 

2.  Later the company will pay you the bulk of those dividends when the stock is trading north of $20.  Perhaps north of $24.  So you might be paying 1 dollar of value today to get 50 cents of value paid back to you later.

 

3.  Let's say banks normally trade at a 3% dividend yield based on payouts of 1/3 earnings and P/E 10 multiple.  Later on, when I roll my calls at-the-money and the stock is at $30, a 3% dividend yield would be 90 cents. 

 

So it looks like you might be getting a bargain price for all the dividends you are collecting in the future from the warrants if you are expecting $3 of dividends to be paid over the life of the warrant, but keep in mind that if you invested that "dividend protection" warrant premium today when the stock is $12, it too would grow to a large amount over time (simulating a large future dividend).

 

 

I'm not a fan of that feature as well. Particularly if you are sanguine enough about the banking industry to require something close to a market return, you may appreciate the dollar value of dividends. The warrants will not only return a lower dollar value, but they will return lower lower dollar values as the strike adjusts. This is mitigated by the reinvestment of your lower lower dollars at the adjusted strike, and by the fact that your whole inventory, not just the marginal shares "purchased", will adjust downwards. But you pay tax on that as well, because you have to report the fair value benefit to the IRS. I guess by that logic, warrant holders would have received a tax BENEFIT had we received larger dividends while the strike is above the current stock price.

 

 

By the way, has anyone heard from holders of other warrants about whether these are qualified dividends? I have received a trustworthy opinion to the affirmative, but people should have received broker guidance by now.

[racemize]

Ok, question on the concept/model of "cost of leverage" as we have been discussing in this thread.  We've been defining it as the break even point versus the common, or the bond rate of the money left over from: (current stock price-premium paid) to reach the strike price, per annum.  This makes a fair amount of sense for most warrants, but it is confusing me a bit for the BAC-B's.

 

These have a strike price of 30.79, so even if you paid nothing for the warrants, there would still be a "cost of leverage" of 18% per year.  The fact that it is completely decoupled from the price you pay, in this particular instance, is setting of alarm bells in my head.  What am I missing?

[ERICOPOLY]

Ok, question on the concept/model of "cost of leverage" as we have been discussing in this thread.  We've been defining it as the break even point versus the common, or the bond rate of the money left over from: (current stock price-premium paid) to reach the strike price, per annum.  This makes a fair amount of sense for most warrants, but it is confusing me a bit for the BAC-B's.

 

These have a strike price of 30.79, so even if you paid nothing for the warrants, there would still be a "cost of leverage" of 18% per year.  The fact that it is completely decoupled from the price you pay, in this particular instance, is setting of alarm bells in my head.  What am I missing?

 

When you say decoupled from the price you pay, do you think the rate of interest is cheap or expensive?  Are you realizing it's an extortionist interest rate, or do you think they are underpricing the "loan"?

 

You have 1 warrant priced at 80 cents and an $11.77 cent "loan" that you pay 18% annualized interest on.  You don't pay much of the interest upfront, rather you pay it in opportunity cost should the stock trade above $30.

 

I suppose you could put the entire $11.77 into more warrants -- think of this as having a very high loan-to-value ratio and thus you are a high risk borrower.  So you pay a high rate.

 

I'm not sure what you think -- is this high or low?

 

 

 

[racemize]

Ok, question on the concept/model of "cost of leverage" as we have been discussing in this thread.  We've been defining it as the break even point versus the common, or the bond rate of the money left over from: (current stock price-premium paid) to reach the strike price, per annum.  This makes a fair amount of sense for most warrants, but it is confusing me a bit for the BAC-B's.

 

These have a strike price of 30.79, so even if you paid nothing for the warrants, there would still be a "cost of leverage" of 18% per year.  The fact that it is completely decoupled from the price you pay, in this particular instance, is setting of alarm bells in my head.  What am I missing?

 

When you say decoupled from the price you pay, do you think the rate of interest is cheap or expensive?  Are you realizing it's an extortionist interest rate, or do you think they are underpricing the "loan"?

 

You have 1 warrant priced at 80 cents and an $11.77 cent "loan" that you pay 18% annualized interest on.  You don't pay much of the interest upfront, rather you pay it in opportunity cost should the stock trade above $30.

 

On the other hand, the lender might not expect the stock to trade anywhere near $30 and thus isn't really demanding that high of a rate after all.

 

Well, I mean you could say the price was 0.00000000000000000001, and it would still show an 18% "cost of leverage", so that seems odd. 

 

Said another way, it could be a 0 cost, so you don't have any "leverage"--it seems pretty costless at that point, even though the calculation shows 18%.