Leap Options Strategy - Opinions

[Gopinath]

Hi Members,

 

I know we have discussed many times on this board about the merits/disadvantages of options strategies. I have a specific one to discuss & hoping to get some of your insights on the validity of this idea. Also this is only for personal accounts only, so we can ignore the clients risk/portfolio management discussions.

 

How about buying in the money leap(about 2 years) call  options on well known undervalued companies with a low dividend for 35% portfolio, keep the rest of the portfolio in cash(65%). Ideally we are committing 35% of the portfolio, to have a notional value of 100%(levering 3 times). The cash will act as a buffer if we needed to exercise those options(convert into stocks when they expire) or increase/decrease positions if the prices move up/down. We would have cash left to seize the opportunity if the market/stock prices went down unlike if we owned the stocks outright.

 

Example:

 

Buy 10 Jan 2016 calls for about ~$4.9. In this case, we have a notional exposure of $15, but only committed 35% capital today(hence leveraging 3 times). We all expect/imagine the BAC prices will get close to the intrinsic value of more than $20 within Jan 2016. At least the prices will move up & down, gives us the opportunity to exit even before if we wanted.

 

I am sure we can come up with the list of companies in any given year to be a potential candidates, possible 13Ds etc. Lets select the companies with low dividend yield, so the cost of carrying the option for more than 2 years is minimal.

 

Potential candidates at this time are,

 

BAC,

SHLD

DTV

CHK

SD

XCO

Bank warrants like BAC, COF, PNC etc

 

The question is what is the obvious/less obvious risks that I am missing in the strategy? Do you know any one tried or incorporating this into their portfolio management? I remember Carl Icahn used some sort of combinations like this when he was young & had less money. I value your opinions highly. Thanks in advance!

 

Disclosure: I am invested in this strategy for about 10% of my portfolio. I have done well this year, may be because of the dumb luck as the prices went higher.

 

Gopi

 

 

 

[stahleyp]

Hi Gopi,

 

Taleb talks a lot about this in his various books. I believe he calls this a barbell strategy. Your strategy is a bit different though. I think he discusses using 90% treasuries/cash and only 10% option. The downsides is that if the market moves against you slight, you lose much more but if disaster hits (2008), you only lose 10%

[thepupil]

http://brooklyninvestor.blogspot.com/2012/10/recapitalizing-berkshire-hathaway.html

http://brooklyninvestor.blogspot.com/2013/02/create-your-own-apple-stub.html

 

Brooklyn Investor has some good thoughts.

 

With this strategy you are essentially paying a small cost for a way OTM put (loss is capped at the strike of the call) and the privilege of non-recourse leverage.

 

I am personally shifting to this strategy  as well and am using is as a way to extract cash from my brokerage account. I plow the cash savings into i savings bonds and maxing out my 403b while my income is temporarily low (i am working for a non-profit asset manager for a few years and don't make enough $ to max out and live off my income)

[thepupil]

to expand a bit, i can buy 100 shares of Berkshire for cash $117 ($11,700) or I can buy the 80 Jan 2015 call for  about $39.00 ($3,900). I am paying $2.00 extra (80+39=119) so the way I look  at it is a I'm paying $2.00 to borrow the bottom $80 of Berkshire's equity value (2.5%). I then put the $8000 in I- Savings bonds that earn inflation which will probably be 2% ish. So over the 1.25 years, before taxes, I will maybe lose 0.5% to the options man for the privilege of capping my downside and building in an inflation hedge.

 

between the max i bonds/year (10,000) and the may 401K (17,000). I have lots of cash to extract from my portfolio and to put into those advantaged vehicles with favorable tax/match/inflation protection characteristics.

[hyten1]

Gopinath,

 

i am fairly new to options so please forgive me if anything i said doesn't make sense

 

with any options strategy one big risk is you lose the entire 30% or 10% depending on what you deploy. in a dramatic downturn the options will drop considerable, if it just happens at the time your option expires you are out of luck. if you had bought the stock directly you can wait it out.

 

sure you can row it over, but that increase your cost, also when do you row it over that is a question? when it  has drop 10%, 20%, 30%, 50% ... etc.

 

so what that means you obviously need to keep track of it more closely.

 

also base on what you said you have the 70% as a wait a see thing, that obviously tie up your money, and if you are not discipline that 70% might start to dwindle as you start nibbling at other opportunities.

 

not saying this is not good strategy, i use it to some extend for non recourse leverage.

 

jmho

 

 

hy

 

[Packer16]

I would be careful with this type of strategy.  I tried to replicate this overtime with some of Berkshire holdings  and the option premiums seriously reduced the value of the portfolio over time.  The one thing that may not be obvious with options is you need to be right with both the valuation and the timing, a very difficult thing to do.

 

Packer

[thepupil]

Packer,

Which Berkshire holdings? Dividend payers like KO, WFC? Or do you mean your holdings of Berkshire Hathaway? In my example, what other costs are there than the premium over spot that you pay? In my example, it is 2.5% over 1.25 years before factoring in any return on cash holdings. Let's ignore whether or not Berkshire is a good buy right now (it looks fairly valued to me).

 

I understand that cost would compound over time, but if it helps you allocate to opportunities that can return more than the annualized premium that have very little risk (i.e. i-bonds, 401K/403B contributions where the match is low risk, debt paydown like mortgage, student loan, auto loan, margin etc) I don't see how you lose.

 

Deep ITM Leap financing is incredibly cheap right now on big blue chips because of ZIRP and low levels of volatility.

[ERICOPOLY]

Deep ITM Leap financing is incredibly cheap right now on big blue chips because of ZIRP and low levels of volatility.

 

Not quite as good as it first looks though. 

 

The $18 strike 2015 Wells Fargo looks cheaper before one contemplates the cost of missing the dividend.  I mean, you are missing a $1.20 dividend and you are only effectively borrowing $18.  So that's like 6.7% cost just from the missed dividend.

 

Borrowing $18 means you miss the entire $1.20.

 

[thepupil]

Agreed, which is why I used Berkshire since a dividend is unlikely for the foreseeable future.

[ItsAValueTrap]

In my opinion you should buy options only when they're underpriced.

 

Taleb's book on options is worth reading.

 

http://glennchan.wordpress.com/2012/12/18/valuing-stock-options/

[value-is-what-you-get]

Agreed, which is why I used Berkshire since a dividend is unlikely for the foreseeable future.

 

I looked at this one as well.  There are a few specifics that make the Berkshire LEAP strategy more compelling.  The stock is low volatility, there is the Buffett put at 120% of stated book and there is no lost dividend.  Also, you can always sell a few puts on dips to make up the implied cost of borrowing.  Main concern is that it can go sideways for years at a time and has risen steadily since 2011.  Will it continue?

[thepupil]

If there ever was a time to rethink my opinion, it would be when Ericopoly, Packer, and ItsAValueTrap disagree with me!

[ERICOPOLY]

Agreed, which is why I used Berkshire since a dividend is unlikely for the foreseeable future.

 

 

I just wanted to point out that the WFC $18 put is only 11 cents, costing only 60 bps.

 

60 bps for the put versus 670 bps for the call.  A difference of 610 bps.

 

I know, I know, we're ignoring the cost of margin -- the put strategy assumes you've borrowed on portfolio margin to purchase the common stock.  Okay, so IB charges anywhere from 50 bps to 140 bps for margin interest.

 

610 bps difference is far greater than the worst-case IB margin rate of 140 bps.  Well, not "worst case" -- the Fed might aggressively raise the base rate over the next 12 months, and pigs might fly backwards.

 

But, using best case margin pricing, the put strategy costs only 110 bps.  Versus 670 bps for the call strategy. 

 

So sometimes the put+margin strategy is much, much, much better (cost wise) than buying deep-in-the-money calls.

 

Plus, Wells Fargo will probably hike the dividend again -- costing even more for the calls.

[ERICOPOLY]

In fact (at IB margin rates), you can go long WFC common with 2015 $37 strike put for the same "cost of leverage" as the 2015 $18 WFC deep-in-the-money call.

 

Leveraging up with no downside below $37 at the same cost as taking on downside all the way down to $18.

 

It looks convincing to me which strategy to follow.

[rkbabang]

Of course this changes if you are talking about an IRA where margin isn't an option.

[Gopinath]

Looks like we are steering off talking about cost of the leverage in high dividend paying stocks. That's not one of the criteria's that I have mentioned specifically for the same reason. You can also add IBM to this list of potential candidates.

 

Low valuation/under valued stocks

Low Dividend

Stable business

Less cost to carry the leverage(3% per year)

Activists involvement(catalyst)

 

I would be inclined to hear more to add to this criteria.

 

Thanks!

 

[ERICOPOLY]

Looks like we are steering off talking about cost of the leverage in high dividend paying stocks. That's not one of the criteria's that I have mentioned specifically for the same reason.

 

That's why I brought it up actually.  You've built a criteria that it needs to be low dividend paying.  But that's just for calls.  I had to point out that the dividend is irrelevant if you instead go the puts+"portfolio margin" route.

 

Your criteria was less than 3% total cost for the leverage.  Under that criteria, I pointed out that WFC qualifies under the puts approach but not under the calls approach.

 

"Leap options strategy" -- puts are LEAPS too.

 

[Gopinath]

Ok, Do you think the IB margin rates are going to stay within 50-140 basis point for the whole 2 years?

[ERICOPOLY]

Ok, Do you think the IB margin rates are going to stay within 50-140 basis point for the whole 2 years?

 

The Fed hasn't even unwound QE yet.

 

Listen, if it only costs 60 basis points for the $18 put by Jan 2015, and another 50 bps for the margin at current Fed base rates, what are the odds that the Fed is going to move the base rate up by 190 bps soon... and the later they raise the rate, the less likely the blended average Fed base rate increase over the two year period will be 190 bps.

[ERICOPOLY]

In my opinion you should buy options only when they're underpriced.

 

Taleb's book on options is worth reading.

 

http://glennchan.wordpress.com/2012/12/18/valuing-stock-options/

 

I haven't read the book.  What does he consider to be an underpriced option?  Does he give an explanation about how to arrive at what he deems the "fair" price in order to determine what "overpriced" is? 

 

So far I've observed that when WFC or BAC options are trading at their peak premium it has been the best time to purchase them.  These moments have happened when the market is scared about something and the common stock is depressed.  As investor worries are eased, the stock jumps.

 

BAC for example had a $2 premium for at-the-money $5 strike January 2014 call options in December 2011.  That was 40% of strike, which seems expensive.  But this happened at a time when the stock was soon going to rise by quite a bit.  As the stock rose, the premiums for at-the-money options didn't go down on an absolute basis.  Take for example today's $15 strike 2016 call.  It's been almost two years since December 2013, but nearly-at-the-money call options are still $2.  Okay, $2 is not 40% of $15, but neither is it a reasonably high probability for the stock to triple from here over the next two years.  You get what you pay for.

 

So you could have got in at $5 for the $2 premium, then today you could be exercising them (near expiration) and writing the at-the-money call to recover the premium.

 

So you recover your lost premium and lose the next two years of further appreciation.  But remember you were able to only put a 40% initial down-payment for shares that have now tripled to $15.  So you had a lot less risk on the table to begin with.

 

So is that an overvalued option?  I guess I wonder what his criteria is.

 

 

 

[ERICOPOLY]

Or alternatively (instead of writing a $15 call) you just take delivery and buy puts to replace your $5 strike embedded put.  A  2016 $5 strike put costs only 8 cents.  It's practically free.

 

So your total cost becomes something like $2.08 for a 4 year call.  The leverage for the first two years was expensive, but the average cost is roughly 1/2 as much after considering how cheap it is for rolling the position to the 2016 put.

 

So was the $2 premium for a $5 strike call expensive after all?  It's a little muddy.

[ItsAValueTrap]

I haven't read the book.  What does he consider to be an underpriced option?  Does he give an explanation about how to arrive at what he deems the "fair" price in order to determine what "overpriced" is? 

He considers options pricing to be an art.  It doesn't break down into mathematics perfectly.  The book covers various factors that affect what an option is worth:

skew

expected volatility

expected interest rates

expected borrow costs (the book doesn't talk about equity options much, but this is something you would extrapolate from the book)

expected dividends

whether the stock will continually move in one direction or not

insider trading (those with inside information tend to buy puts and to buy volatility)

counterparty risk

stuff specific to barrier options (doesn't apply in this case)

etc. etc.

 

Now here's an insight: if you delta hedge, you don't really need to care about the direction that a stock moves.  This is very different than value investing.  Options traders don't need to know much about a company's fundamentals.  They just have to be good at predicting future volatility (how much the stock will move up and down).  They'll absolutely pay attention to earnings because volatility spikes after earnings are announced, and then everything goes back to normal.  And they'll pay attention to mergers and spinoffs.  But what I'm trying to say is that valuing an option is very different than valuing a stock.  You mostly care about volatility, not fundamentals.

 

2- Taleb's book is about options in general.  I believe most of his experience is in options other than equity options.

 

3a- You can look at how Buffett handles options.  When volatility was crazy high in 08/09 (and presumably trading volumes in options was much higher), he messed around with selling options on BNI / Burlington.  In hindsight, obviously volatility was too high.  When volatility is super high, you probably want to be selling options.  It's unlikely that the super high volatility will continue (it could happen but it's unlikely).

 

*He also ended up with warrants in GS and BAC, though those came along with the preferred shares.

 

3b- Doug Dachille has an excellent presentation on Buffett's derivatives (the equity put options).

http://video.mit.edu/watch/doug-dachille-analysis-of-buffetts-love-hate-relationship-with-derivatives-3802/

[ItsAValueTrap]

Does he give an explanation about how to arrive at what he deems the "fair" price in order to determine what "overpriced" is? 

I understand that I haven't given you a very good answer to your question.  So I'm going to try again.

 

You have to understand that you're asking a very difficult question!!!  It's not quite as simply as plugging everything into Black-Scholes and calling it a day.  There are a number of things that can affect what an option is worth.  There is a lot of art involved in pricing an option.

 

2- Recall some of Buffett's lessons:

 

a- Stick to your circle of competence.

 

b- QUOTE: Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game.  As they say in poker, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.”

 

Most equity options out there are priced close to their correct value (in my opinion).  I can't spot any one-foot hurdles myself.  The frictional costs are higher than for stocks so you need a slightly bigger margin of safety.

[ERICOPOLY]

I use options for mostly two different reasons.  Depends on the scenario.

 

1)  Swapping risk

I went 100% long BAC using $5 strike calls when it was in the mid-$5 range.  I paid for those calls by writing puts on other names.  So I had 100% notional downside in other names, 100% notional upside in BAC.  That was what I called a Frankenfund.  I had all the upside of being "all in" BAC, but absolute zero downside risk from BAC.  I wanted to understand that the European banks weren't going to collapse like dominoes -- the news at the time was tense and I was susceptible to some of the rumors of what could happen to BAC in that scenario. 

 

2)  Still talking about the BAC situation, later after LTRO and other signs that the crisis was easing, I bought back some of those puts and used the money to add BAC warrants.  Then I was 2x notional levered. 

 

 

So basically, when I use options it typically has absolutely nothing to do with the reasons you mentioned. 

[ageofsocrates]

Hi Eric,

 

Just a quick question. What kind of companies do you normally sell puts on?