ERICOPOLY

The background on how I came up with that equation... 1) I don't know how to use Excel, so I wasn't going to go there 2) I didn't want to have to plot two lines on a graph and find the point of intersection So I just reasoned that the option premium is a cost that would have to be overcome in order to do just as well as the common. So you subtract the option premium from the strike price to get a number. Then you just have to ask at what rate that number needs to compound to get back to the strike price. That rate will be the precise, exact breakeven point versus the regular common stock. Were it to come up short, you would have not met the option premium hurdle -- so it would certainly have underperformed the common. Were it to come up in excess of the options premium, then you would for certain have outperformed the common stock as you've exceeded the amount paid for the premium. Make sense? I'm not sure if it's in any text books or if it's used elsewhere -- probably, but I just came to this on my own out of avoidance of Excel. So the option premium results in a "hole" in the value versus the common if the stock never appreciates before expiry -- the only way to break even versus the common is to precisely fill in that hole.

The time premium of .68 -- I wonder what the market is expecting for dividend reinstatement? I expect the premium would decay at somewhat of an accelerated pace when a significant dividend is reinstated. So over a short time period that could easily get expensive. Or at least, no longer look like such a bargain. What if it went from .68 to zero in one month? Okay, perhaps an exaggerated example. And ultimately, it's only 68 cents so not that big of a deal -- but the cost of leverage on an annualized basis would be high. Still, it can't exceed 68 cents -- leverage costs can be high for short periods and it's not a big deal in the grand picture of things.

Yes. It sounded good in theory to believe one could just write LEAPs as an arbitrage on the warrant dividend, but it may be hard to find such an idiot to purchase the LEAPs in real-time.

Yes, I was trying to figure that out this morning. I'm not sure I've reached any solid conclusions. Let's say the BAC has a $1 dividend and the leaps start having a cost of leverage of 7% due solely to the missed dividends. Would we expect it to trade at a higher cost of leverage than 7%? Perhaps, but I guess we could ignore it now for now. So if someone is looking at Leaps with a 7% dividend-adjusted cost of leverage, and the warrants are trading at 5% dividend-adjusted cost of leverage, then clearly the buyer would go for the warrants. (Unless they wanted less raw gains and a shorter duration). I guess I was thinking (and I think this is what you are saying) that the warrants should trade at least at the same cost of leverage as the Leaps? How much is there a possibility that the cost is just too high and people stop writing LEAPs? Probably, people would still be writing them in some amounts, but that's a lot of cost, since it is 7% for dividends plus any additional expected gains. People would perhaps still be writing the LEAPS (they could buy the common and write the LEAP -- collecting the dividend on the common and profiting on the harm done to the LEAPS). But why would someone want to purchase the LEAPS? I think that's what you meant?

I could be wrong about how much the arbitrage supports the warrants. Let's say I try to do this arbitrage. I purchase the warrant and write a call. What price will I get for the call? For a high dividend scenario, who is going to do this trade without wanting to buy the call for a slightly negative option premium? Once he's bought it, he exercises it and sells the underlying, thereby locking in his negative premium. But that leaves my warrant unhedged again. Hmm... What if instead the warrant is simply supported by the lowest-cost strategy of hedged leverage? I mean, suppose a trader is using portfolio margin an puts to leverage the common. Further suppose the cost of leverage in his strategy is only 3%. Won't this guy be motivated to short the warrants? His arbitrage would be to earn the spread on cost of leverage between the two strategies. Although he would have a cost of borrow for the warrant that he is shorting. Complicating his trade would be the rising volatility premium in the warrants if the stock pulled back down near warrant strike. But his strike prices on his margined stock puts could be quite high -- providing protection. Like for example, if we're talking about BAC at $30 and he is doing this arbitrage with $20 strike puts.... and if that's only costing him 3%, then it would seem to negate some worry. Of course, he takes on interest rate risk still and of course he is paying cost to borrow the warrants for shorting. Maybe somebody who isn't just rambling could chime in.

Yes, a floor gets established for the value of the premium in the call with no dividend protection. Only, the floor will be $0. The premium won't fall below $0, because of the arbitrage. Once the dividend is large enough, there will be negative utility to own the call. At that point, the best strategy would be to exercise the call and grab the dividend (or sell it back to the market for someone else to do this arbitrage). So the floor in the calls for the option premium is $0 if there is no dividend protection. The premium also can't go negative due to arbitrage. You can think of a 100% dividend to imagine this clearly -- even though it's not a realistic example for an ordinary dividend. So yes, you are right. At a certain point the floor for cost of leverage (after premium goes to $0) will be just the cost of not getting the dividend.

actually, i need to think more about my last post. i believe it may be that the cost of lost dividend is actually a cost on what is actually borrowed after taking into consideration all that prepaid warrant premium. incidentally, i also worked out wahat madonnas "like a prayer" is about. hot damn that's funny. think of tarantino in reservoir dogs when he explains the meaning of "like a virgin" and this is my first post using my big TESLA computer screen -- i'm charging at the tesla supercharger at SpaceX

Previously I put forth my method of computing cost of leverage -- the first part of the calculation was calculating how much is actually being borrowed (it's convoluted because you are prepaying interest to the very person you are borrowing from). But that of course wasn't the full cost of leverage, it was just the cost of the option premium component. Missing is the cost of the excluded dividend (if any). Because this portion of the cost isn't payable upfront, it's cost can just be added to the result of the prior calculation. So a $1 dividend declared in a given year will cost 5% at $20 strike, it will cost 10% at $10 strike, and it will cost 100% at $1 strike. Pretty funny isn't it. Dividends make the leverage costs soar when the strike is lower. So there is a point where the low strike options start to cost more than the at-the-money strike options. Even though the at-the-money strike options are lower risk in a sizable common stock price decline (due to the higher put strike).

ordinary dividend: COMMON STOCK: Stock trades at $36. $1.08 ordinary dividend is declared. Stock now trades at $34.92 on dividend-EX date. $1.08 + $34.92 = $36 WARRANT/CALL: Option trades at $18 $1.08 ordinary dividend is declared Option now trades at $16.92 on dividend-EX date (because the stock dropped by $1.08 on div-EX dates) Better example? Value of common stock portfolio didn't change one bit. Value of option/warrant portfolio DECLINED by 6% That 6% decline happens to be TWICE the dividend yield.

Yes you are comparing that vehicle. Because it's 2x in the case of the special dividend, as well it should be 2x for the ordinary dividend as well -- were it not for the cost that also is 2x in size.

The condensed version is this: The warrant holder enjoys TWICE the yield of a special dividend (compared to the unleveraged common stock investor) The warrant holder similarly should enjoy TWICE the yield of an ordinary dividend (compared to the unleveraged common). But he instead gets ZERO yield -- therefore, there must be an offsetting cost eating it completely up. Thus, this cost must be equivalent to TWICE the yield of the ordinary common shares. Let X = cost 6% - X = 0

It is a cost. But, in my comparison, the total return of the common is what defines that cost. The math of the common total return indicates a loss of only the dividend yield. If I compared a vehicle that did get the dividend yield, then it would get 2x the dividend, as you say, but I am not comparing that vehicle. Why don't you run the calculation again, but this time do it for the special dividend? You will wind up with twice the return for the warrant versus the common. Agreed?

Is not being entitled to a regular dividend a cost or a benefit? It can be written in a contract like you say, or it can be on a cave wall, or on a golden tablet, or it can be written on the Rosetta Stone. Regardless, it's either a cost or a benefit.

How come the expected return from a $20 increase in stock price is higher in one vehicle versus the other, if you only have $18 invested in each one? I'm sure you will agree that it's because you are leveraged to twice as many underlying shares. Then why don't you agree that you are also leveraged to twice as many dividend payments? Only, you are getting none of them :( You seem to believe that you are entitled to twice as much upside in stock price (even though you only have the cash for half that much), but not twice as much dividend. Why the distinction?

Oh yeah, and forgot this really obvious one... The call options only miss out on regular dividends. Special dividends result in an option strike adjustment. And that option strike adjustment on the special dividend amounts to TWICE the economic value that you would enjoy if you just had your $18 invested in the vanilla common stock. So if call options can have TWICE the profit of earning a special dividend, why can't they have twice the COST of missing a regular dividend? What do you say?

You are unable to borrow money to leverage your equity? I don't see why. What would it cost to purchase an out-of-the-money $18 strike protective put (to protect your loan) that expires the next day? So this can't be confused into a put/call parity discussion again (the very reason why I framed it as 1 day before expiry). And 1 day of margin interest isn't even worth discussing.

Or take two $18 strike call option owners (two different people). Person K owns 1 call option Person F owns 1 call option The company is going to pay a $1.08 regular dividend the day before the call options expire. Person K exercises the option and collects the dividend (using borrowed money). His dividend is 6% return on his equity. Person F does not exercise and misses out on the dividend. Who has 6% more money? :D

Let's say person A has $18 to his name, and person B has $18 to his name. Person A buys 1/2 of a share for $18 and earns 3% yield (assuming it were allowable to own 1/2 share) Person B buys 1 call option for $18 and earns no yield at all, even though he has an entire share of upside (twice the dividend loss) So if the economic loss is twice as much, what are you getting hung up on?

fyi: IB doesn't offer "Dollar for lot" if the options have an expiration date. So that program can't be used to close out the typical puts and calls that we are accustomed to dealing with. Here is the relevant snippet from my chat session with them today: Stan M: Sorry this won't work. IB does not extend the Special Position Liquidation program to options that have a definitive expiration date. Stan M: Additionally, IB does not offer cabinet trades.

I just know that his house sitter isn't famous for sitting houses, but that's what he says she does for him. Glad he is providing her with honest work.

Correct, based on that 3% dividend assumption on today's market price. People are expecting the stock to go up 40% (or at least Kyle Bass is). That would put the dividend at $1.72 (at 3% dividend payout yield level), which is 9.55%cost from the lost dividend. So the total cost of leverage would be greater than 10% a year. So it depends on the dividend. I'd personally prefer the portfolio margin approach here, because I see the rising interest rate to be a lesser risk than the rising dividend. I think you're probably right about the potential downside risk (how ironic) to a really nice dividend being reinstated for the GM warrants. Most likely, I'll be switching to the common. Thank you for your posts on this subject of leverage. You can always wait until that dividend actually arrives -- the warrant decay isn't that big of a deal since you didn't pay much premium for the warrant. EDIT: But there again, why the $18 strike? Why not a short-term higher strike call? That way, if the price of GM does in fact fall hard, one could get in cheaper (below the strike). My favorite would still be the common+put.

There is actually a $3 strike BAC 2016 call option. Imagine how expensive the leverage would turn out to be if they were to pull out a 40-60 cent annual dividend. That call would turn out to be more expensive leverage than today's at-the-money strikes! Yet without all the downside protection.

Correct, based on that 3% dividend assumption on today's market price. People are expecting the stock to go up 40% (or at least Kyle Bass is). That would put the dividend at $1.72 (at 3% dividend payout yield level), which is 9.55%cost from the lost dividend. So the total cost of leverage would be greater than 10% a year. So it depends on the dividend. I'd personally prefer the portfolio margin approach here, because I see the rising interest rate to be a lesser risk than the rising dividend.

You can only buy mutual funds in 529 plans. Did you know that Fairholme Funds offers Coverdell ESA (Education Savings Accounts)? My kids each have some of their college savings funds managed by Bruce Berkowitz via those accounts.

We are thinking the same way, I just wasn't careful in how I described my example. yes, two shares of upside. two dividends missed. twice we "borrowed" $18. Thus, 1 missed dividend per $18 borrowed. Therefore, the missed dividend of 1.08 (per call) is 6% of the "borrowed" amount of $18 per call. I get that 1.08 / 18 is 6%. I just don't understand why we would think we should get the 1.08 in the first place. If we had bought $18 of shares, we would have got a 3% yield, or .54. If my choice was to buy the common unlevered or to buy the call, or some combination, nothing was going to give me a 6% yield, so why would I be missing that unattainable 6%? Example 1: Using portfolio margin Let's say I only have $18 to my name and I buy 1 share of common stock for $36 using $18 of money borrowed on margin. I get dividend yield both on $18 of my own capital tied up and on $18 of the borrowed money Example 2: Using calls I don't get a damn bit of dividend on my own $18 of equity, neither do I get a dividend on the $18 worth of synthetically "borrowed" money. In Example 2, I not only miss out on dividend yield from the $18 borrowed, but I also miss out on the dividend yield from the $18 of my own equity that I contributed. So that's why it's 6% cost and not 3% cost. Because you synthetically borrowed only 1/2 the price of the stock, but you gave up the dividend on the entire thing! Your own money got no yield. Normally, if you invest your own $18 into the stock you get a 3% yield. But that vanishes when you add $18 of "borrowed" money to the deal. So you multiply it by 2, and thus it becomes a 6% cost of having added $18 of leverage. Yup. But if the writer of the call borrowed money as in example #1 and used it to write a covered call, that double dividend would influence him to charge less for writing that call, especially compared to writing a put where posting a compensating balance would earn almost nothing --- thus leading to demanding a higher price for writing an equivalent put. I think it's likely just the wording but I don't understand what you are getting at. So if I repeat what you are trying to say using different phrasing, it's an accident. I think normally if somebody is trying to earn a leveraged dividend yield (buying extra shares on margin) they would want to hedge with a put and pay for the put by writing a call. That way they would get the leveraged dividend with no price risk to the common. This would be such a good trade that it would be chased by traders until it skewed the put/call out of parity to the point where the trade no longer had any leveraged benefit for the given interest rate. Is that what you are effectively saying?