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BAC leverage

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oddballstocks:

--- Quote from: meiroy on March 15, 2013, 07:18:29 PM ---
--- Quote from: oddballstocks on March 15, 2013, 07:03:10 PM ---
--- Quote from: meiroy on March 15, 2013, 06:31:42 PM ---
--- Quote from: Kraven on March 15, 2013, 07:09:37 AM ---Time to start a dead pool for some of the posters on this thread.

--- End quote ---

Look who's talking, the guy who bet his entire life savings against the BAC buyback/dividend outcome.

The way that ERICOPOLY thinks and explains cost seems fascinating to me and worth thinking about.  I have not bought any options and probably will not, at the same time this area is worth understanding, it can be applied to other investments as well.  Cost of leverage and how to compare the different possibilities. It's beautiful. Every choice has a cost. It might seem simple to the pros but not to those who are starting out.

On the other hand, you have all these people who invest in the warrants, thinking that because they have 6 or 8 more years they are magically not really options and do not have a certain leverage cost. So maybe you should invite them to your pool first.

Having said that, I would love to know (seriously) the Kraven Strategy as you have mentioned you invest in about 20 companies and get great results. So can we start an Ask Kraven/grumpy old man thread (sorry)?

--- End quote ---

I thought the Kraven strategy (as posted in the annual results thread) was to invest in 100+ companies using Graham/Schloss methods and get 20%+ returns.  To do that Kraven's strategy needs to be just as disciplined as Eric's except there's no sexy factor in buying net-nets, low book value stocks and companies with no brand value.  A muffler companies selling for net cash generates returns but no one is willing to admit they own it..

Somehow as the bull market has taken hold this board has come to worship guys who bet the farm on a handful of stocks with can't lose prospects.  I've honestly believed if something was a no lose then bet everything one owns, Eric has done that successfully.  Of any person on this board who touts concentration he is the only one really walking the walk.  If it's a sure thing bet and bet big, and go levered as well, why wimp out?

Maybe I'm the sap at the table, I'm still looking for "safe" companies and I'm worried about losses.  I've even sold down positions for cash.  Maybe the market will fall and my strategy will pay off, or maybe I'll look back and say I was an idiot for not following everyone along into the hot investments here….time will tell.

--- End quote ---

What are you talking about?   Eric himself wrote more than once that it is not a sure thing and that it is a gamble.  If I am not mistaken even when he was "all in" he was still hedged with some puts so in fact it was not all in at all, but maybe I'm wrong.  Using options does not mean you have to go 100% all in, but it can be used to increase leverage for small investors.

Below you mention a book by Joel Greenblatt, well this risk:reward guy, wrote about LEAPS in his You Can Be.. and also discusses the weight of the options as part of the whole position.

And lets not mention Buffett in his younger days...


You are right about Kraven:

"Dozens of positions.  No position started at larger than ~1% of portfolio.  I invest like my investing idols, Graham and Schloss.  I buy when things are very cheap and sell when they reach IV.  Cash never less than ~30%.  No leverage."

--- End quote ---

I'm not against options at all, I've used them myself.  I'm not sure if that's what you're getting at, I'm saying if you have a portfolio that's 100% options you run the risk of a complete loss.  An option has an expiration date, once it's past there's no value, a common stock is an ownership interest in something.  If that something has value or not is a separate debate.

In past threads I strongly had the impression that Eric felt that at the prices he was buying BAC it was a no-fail proposition.  If you go back through the BAC thread I think a lot of people on the board felt that way.  I have no idea if they still do, but at much lower prices they did.  I believe most established their positions there as well.

I was under the impression that Eric bet most of the farm, maybe 80% of his portfolio and kept the rest in cash.  I remember reading one post where he said if he lost it all on BAC his family would still do fine on what he saved.  Not sure if he was hedged or not.

A lot of people use leverage their whole life and never have a problem with it.  Let's face it, most entrepreneurs are both levered and 100% concentrated in their single best idea.  Actually most Americans are as well through their mortgages on their homes.

ERICOPOLY:

--- Quote from: Hielko on March 15, 2013, 04:58:40 PM ---
--- Quote from: ERICOPOLY on March 15, 2013, 04:11:19 PM ---
--- Quote from: Hielko on March 15, 2013, 04:09:52 PM ---But you don't know how much the cost of leverage is for a two year period if you use the warrants, because the costs depends on what happens with the share price, implied volatility, theta decay and all those 'academic things'. So how can you claim the X is cheaper than Y if you don't know the cost of X?

--- End quote ---

Let's stop pretending that we all aren't in this for a rising stock price.

Raise of hands, can anyone tell me what happens to a put option price as the common stock skyrockets?

--- End quote ---
I'm not the one who started a huge thread on how X is better than Y... The stock price going up is obviously good news for both leaps and warrants, but doesn't change the fact that this whole thread is mostly nonsense.

--- End quote ---


Why don't you just plug in the value of a 6 year out-of-the-money put using Black Scholes and compare it to an at the money put?

The cost of leverage in the at-the-money put is sky high compared to the out-of-the-money put.

So despite the fact that almost everyone here is expecting a big repricing in the common when the underlying earnings shine through this fog of expenses, in about two years time, I can't seem to hammer it into your head that there will still be a 4 year put here at that time.  And the cost of leverage for me to buy it at that time will be far less.

Go back to your academics -- they'll tell you that a stock isn't undervalued in the first place because the market is efficient.  Why are you even here if you believe that stuff?  They brought you Black Scholes too by the way.

ERICOPOLY:

--- Quote from: Hielko on March 15, 2013, 04:09:52 PM ---So how can you claim the X is cheaper than Y if you don't know the cost of X?

--- End quote ---

I do know the worst case cost of X over two years but I don't know the worst case cost of Y (and I'm going to be defensively minded and not take that risk!).  I've calculated "X" already in this thread.

Let X be the LEAPS -- over a two year period the leverage will cost me 10% annualized
Let Y be the Warrantss -- over a 6 year period the leverage will cost me 13% annualized

I know I can't do worse than 10% annualized if I go with the LEAPS.

I could take a gamble and hope that somehow the Warrants will decay at less than 13% annualized rate, but that's getting pretty damned hopeful.  Because if it decays at LESS than 13% rate, it only means the next 4 years will be a higher than 13% rate.  So operating on the greater fool theory, then yes go right ahead and hope you can sell those warrants for a higher cost of leverage in two years time.  Best of luck, because warrant holders are expecting the stock to rise (why else are they in this game?). 

Once the stock rises, it's going to crush the value of the leverage embedded in the put.

It's a terrible strategy for somebody who is expecting the stock to swing high to the upside (they have a strong opinion of present common stock undervaluation).

Black Scholes only understands that the market is efficient.

ericd1:
I've been following this leverage discussion and I believe I understand Eric's strategy. This may be a little simplistic, but I think what he's saying is that the warrants are "ahead" of the common in appreciation and at today's prices the common represents a better value than the warrants.  And if you want to "juice" (leverage) the returns then add some in/near the money leaps because the cost of their leverage is lower than the warrants. He's also suggesting his strategy of adding options is less risky than owning the warrants. 

His logic is sound and he's crystallized this thoughts. Nice job!

My approach probably won't garner the same gains, but I was comfortable investing across the common, warrants, short ITM options (april/may) and long ITM leaps (jan 14 n 15) - more of a basket approach. So far so good.

ERICOPOLY:

--- Quote from: ericd1 on March 15, 2013, 08:16:59 PM ---but I think what he's saying is that the warrants are "ahead" of the common in appreciation and at today's prices the common represents a better value than the warrants.

--- End quote ---

I'm not saying that exactly. 

I'm just shopping for cheaper leverage if I can find it.

Downside first should be the mantra.  Even when you use leverage, you should first think about the downside.

And the downside I'm thinking about with the cost of leverage in those warrants is that Black Scholes will kill off the value of their embedded puts when the stock reprices to "normalized earnings" once the expenses at BAC runoff over the next two years.

Ironically people keep thinking I'm missing something with regards to Black Scholes.

I fully understand the market relies on Black Scholes and that's why I'm staying the hell away from the warrants for now.  Once the market reprices the BAC common (in two years) I will look again at the warrants after Black Scholes reprices their leverage.

I don't see how it can be any more obvious -- Black Scholes relies on an efficient market... that reliance gets exposed by undervalued securities that reprice long before warrants expire.  So it's a bizarre case that value investors who don't believe in efficient markets would consider wading into the warrants for a stock they strongly believe to be undervalued. It's like a suicide mission of opportunity cost in the amount they are overpaying for their leverage in the years after the repricing of the common.




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