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Posted

Yep, but let me ask you something.  Where in the hell are you getting the notion that I don't understand any part of that?

 

Nobody said or implied that  you don't understand any part of this.  That said, you've made my point and my goal isn't to convince you of anything -- I've read almost every post on this board for 12 years and I think nobody's done that before. 

 

The thing is, you've mentioned this idea of obfuscating positions quite a few times recently, like it's some sort of breakthrough and a really good thing.

 

It isn't.  It's a very bad thing, because it increases complexity and introduces cognitive biases that makes you misunderstand what you're doing.  I think there's value in refuting that model for other readers of the thread who might have less experience with options, so that they have a fighting chance of not ending up with a bad mental model.  That's the point of my post.

 

For what it's worth, you're not being misunderstood.  You're just being refuted, but I'm not really expecting you to realize that.  I'm simply expecting some others to.

Posted

Yep, but let me ask you something.  Where in the hell are you getting the notion that I don't understand any part of that?

 

Nobody said or implied that  you don't understand any part of this.  That said, you've made my point and my goal isn't to convince you of anything -- I've read almost every post on this board for 12 years and I think nobody's done that before. 

 

You've read my posts, but you haven't understood what I am saying.  Every time you argue "against" me, you are setting up straw men that you knock down.  Then you arrogantly claim that you have defeated me and that I have not offered you a rebuttal.  The problem is, of course, that you are not arguing with me, but rather with your straw man.

 

The thing is, you've mentioned this idea of obfuscating positions quite a few times recently, like it's some sort of breakthrough and a really good thing.

 

Another quality misrepresentation Richard!  I am used to this from you by now.

 

The truth is that, I present it very humbly, the complete opposite of any sort of "breakthrough".  I claim it to be nothing special at all, nor do I claim it to be "good" in any moral sense,  just using derivatives for what they were originally designed for, the swapping of risk. 

 

In my own words, where I explicitly downplay it as any sort of "breakthrough":

 

That's it!  Nothing fancy, nothing insightful, it just is what it is.

 

 

It isn't.  It's a very bad thing, because it increases complexity and introduces cognitive biases that makes you misunderstand what you're doing.

 

Nice!  I "misunderstand" what I am doing when I use derivatives for swapping risk!  Of course, that's just another of your assertions, claiming that out in the field my use of derivatives is causing me to suffer cognitive biases and therefore I misunderstand what I am doing.  You have absolutely no clue if that's true!  None!  Just another of your assertions you pull out of thin air and then attribute to me.  Yet you arrogantly present it to be the case, with no cause to say so.  That's good timing in fact because you just said the following:

 

Nobody said or implied that  you don't understand any part of this. 

 

For what it's worth, you're not being misunderstood.  You're just being refuted, but I'm not really expecting you to realize that.  I'm simply expecting some others to.

 

There you go.  When somebody misrepresents me, I'm being "refuted".  I am the one who can clearly see when the things you say do not match up with the things I understand and believe.  However, you don't expect me to realize that!  How arrogant is all I can say.

 

Posted

I'm not sure that Ericopoly is presenting a bias. You could say that you have a position in BAC hedged by puts, and that you have written SHLD puts for income. Or you could say that you have secured BAC upside and SHLD risk. They are different ways of phrasing the same thing from a portfolio perspective. It doesn't seem like a bias because it describes the actual economic position of your portfolio.

 

Compare that to someone who owns BAC after it drops from $20 to $10, but says, "It's ok. I bought it at $5." There you have a person who is misinterpreting economic reality due to some emotion driven impulse.

 

 

Posted

It doesn't seem like a bias because it describes the actual economic position of your portfolio.

 

I agree.  It just is what it is. 

 

Perhaps there is a cognitive bias but it's not coming from me?  Richard said a few things above that cast a "very bad thing" characterization about "introducing complexity".

 

Compare that to when Rabbitisrich dispassionately describes it in the terms of the actual economic position of the portfolio.

Posted

If buying a deep value net/net, I think the basket approach is best, but if buying a firm with highly secure operations and or a high probability catalyst then larger position. So in a way, IMHO I think the position size is not reflective of the discount to IV, but rather the probability of that discount being closed.

Posted

Eric

 

Your act of taking margin debt to buy BAC common (buying puts to hedge it) is no different than what a bank does, am I right? A bank is short near term and long the deep end of curve and profits when yield curve is upward sloping. You are like a bank that is betting on a bank. This works great as long as fed is accommodative.

 

When yield curve inverts, will you close down the margin debt? your margin debt if tied to fed funds will keep going up and total costs (margin interest+ diminishing put premiums) may not exceed the returns on BAC.

 

Posted

Eric

 

Your act of taking margin debt to buy BAC common (buying puts to hedge it) is no different than what a bank does, am I right? A bank is short near term and long the deep end of curve and profits when yield curve is upward sloping. You are like a bank that is betting on a bank. This works great as long as fed is accommodative.

 

When yield curve inverts, will you close down the margin debt? your margin debt if tied to fed funds will keep going up and total costs (margin interest+ diminishing put premiums) may not exceed the returns on BAC.

 

I don`t think that a bank would be allowed to do what Eric is doing. When you look at the risk profile Eric has just a big LEAP call position in BAC and is long in JPM,C and SHLD. If this risk profile is further levered up or not does he only know himself, but from what i read its further levered up. So when a 100% stock portfolio will suffer a 50% drawdown he is on the edge of losing everything.

I don`t think that is something worth copying, especially with this combination of securities. Let argentina blow up and he is probably in trouble.

But as always thats my understanding of his situation, i can be wrong.  :)

Posted

Eric

 

Your act of taking margin debt to buy BAC common (buying puts to hedge it) is no different than what a bank does, am I right? A bank is short near term and long the deep end of curve and profits when yield curve is upward sloping. You are like a bank that is betting on a bank. This works great as long as fed is accommodative.

 

When yield curve inverts, will you close down the margin debt? your margin debt if tied to fed funds will keep going up and total costs (margin interest+ diminishing put premiums) may not exceed the returns on BAC.

 

 

I'll decide what path to follow when we get there.  I expect to get around a 3% dividend yield, which will take out a nice chunk of the margin costs.  Then there is the potential to write covered calls.

 

Initially the boost from higher short term rates will positively impact the bank earnings, and with it I expect the stock price.  That will have an (at least partially) offsetting positive impact on the cost of rolling puts. 

 

Posted

Eric

 

Your act of taking margin debt to buy BAC common (buying puts to hedge it) is no different than what a bank does, am I right? A bank is short near term and long the deep end of curve and profits when yield curve is upward sloping. You are like a bank that is betting on a bank. This works great as long as fed is accommodative.

 

When yield curve inverts, will you close down the margin debt? your margin debt if tied to fed funds will keep going up and total costs (margin interest+ diminishing put premiums) may not exceed the returns on BAC.

 

I don`t think that a bank would be allowed to do what Eric is doing. When you look at the risk profile Eric has just a big LEAP call position in BAC and is long in JPM,C and SHLD. If this risk profile is further levered up or not does he only know himself, but from what i read its further levered up. So when a 100% stock portfolio will suffer a 50% drawdown he is on the edge of losing everything.

I don`t think that is something worth copying, especially with this combination of securities. Let argentina blow up and he is probably in trouble.

But as always thats my understanding of his situation, i can be wrong.  :)

 

The BAC puts are $15 strike.  As the stock drops below that point, the portfolio is no longer leveraged to the downside.  I no longer feel any additional pain from BAC dropping at that point -- instead, the only further pain I can experience is from the amount of notional exposure I write on the other names.

 

It works like this...

 

First, I figure out how much I have left when BAC drops to $15. 

Second, I restrict the notional amounts of C/JPM/SHLD puts that I write to that "$15 is worst case" BAC scenario.

 

There is no chance of total wipeout from the leverage itself.  A "magnified drop", let's call it. 

 

So let's say I have 2x leveraged BAC common position (notional value is 2x the value of the portfolio).  Okay, so at $15 I've lost approximately 20% of account value instead of 10%.  All I can say to that is "big fucking deal".  I can live with a 10% permanent loss.

 

 

Posted

Ok than you are not really further levered up. Its just like the whole portfolio is leap call BAC+long JPM,C,SHLD. The leverage is in the leap call and you can`t really blow up completly but you have a lot of downside risk. Thats ok, as long as you can live with it. And through your derivative setup you are removing the call premium but pay margin interest instead.

Posted

But in this portfolio, your upside and downside exposure is spread between BAC, JPM, C, and SHLD. In Eric's scenario, his upside exposure is pure BAC but downside exposure still diversified. The downside risk doesn't seem any worse than any other 4 stock portfolio's downside risk, with the exception of a small exposure to levered BAC downside. I hope I'm understanding this correctly.

 

When you sell a put option you still have an upside exposure to the stock. When you sell a put option with a delta of 0.5 (which is exactly an ATM put) you have an upside exposure of 50%. Of course the delta gets smaller the more out of the money the option gets, so its not exactly as i posted but roughly the same in both directions. The closer this construction gets to expiry the more it gets like you described.

Posted

I think weightings is more complicated than it looks on the surface.

You could have a 10% weighting in Sears, or a 26% weighting in BAC.  For the same amount of capital at risk.

Reason?  The at-the-money $35 strike SHLD put trades at 26% of strike, and the $17 strike at-the-money BAC put trades at roughly 10% of strike.

I think without looking at the options, it can be a bit misleading to announce what your limitations are for weightings.  It is much more nuanced than it looks.

Saying you have a 10% weighting limitation doesn't take into account reality.  It doesn't really make sense.

I don't understand fund managers who claim they have this limit of 5% to holdings, or 10% to holdings.  You can see that 10% in one holding equates to 26% in another.  Get it?

 

 

I  don't get why weightings is complicated. Out of 100% of your portfolio how much are you allocating for each security?

What has weighting of security in a portfolio got to do with capital at risk?

From your example. I can have 10% in SHLD and 10% in BAC and that's my weighting.

You can have 10% in SHLD/BAC + Puts at 26% or 10% of strike so your weighting is 12.6% for SHLD and 11% for BAC.

My risk for both is I can lose 100% and your risk is you lose 26% and 11% so what.

 

The question asked by the person who started this thread was "How you weight your holdings" ?

1. Equal weight like Mohnish Pabrai

2. Weight by relative Value or upside like Bruce Berkowitz

3. Weight by sector

 

 

Posted

I  don't get why weightings is complicated. Out of 100% of your portfolio how much are you allocating for each security?

 

You're right, it is that simple.  It becomes complex when you start mixing together positions in your head, and fool yourself into believing it's more difficult than it is.

 

It is a nice illustrative thread.

Posted

I think weightings is more complicated than it looks on the surface.

You could have a 10% weighting in Sears, or a 26% weighting in BAC.  For the same amount of capital at risk.

Reason?  The at-the-money $35 strike SHLD put trades at 26% of strike, and the $17 strike at-the-money BAC put trades at roughly 10% of strike.

I think without looking at the options, it can be a bit misleading to announce what your limitations are for weightings.  It is much more nuanced than it looks.

Saying you have a 10% weighting limitation doesn't take into account reality.  It doesn't really make sense.

I don't understand fund managers who claim they have this limit of 5% to holdings, or 10% to holdings.  You can see that 10% in one holding equates to 26% in another.  Get it?

 

 

I  don't get why weightings is complicated. Out of 100% of your portfolio how much are you allocating for each security?

What has weighting of security in a portfolio got to do with capital at risk?

From your example. I can have 10% in SHLD and 10% in BAC and that's my weighting.

You can have 10% in SHLD/BAC + Puts at 26% or 10% of strike so your weighting is 12.6% for SHLD and 11% for BAC.

My risk for both is I can lose 100% and your risk is you lose 26% and 11% so what.

 

The question asked by the person who started this thread was "How you weight your holdings" ?

1. Equal weight like Mohnish Pabrai

2. Weight by relative Value or upside like Bruce Berkowitz

3. Weight by sector

 

 

The first option is "equal weight like Mohnish Pabrai".

 

I think you'll find that he doesn't purchase short-term call options in his funds (including LEAPS, although he was able to purchase GM warrants in one of his funds).

 

He has this 10% weighting in order to be able to limit single issue risk.

 

So you are cheating the system if you hike up the single-issue risk by purchasing calls.  You still have 10% max exposure, but a much higher amount of risk on that 10%.  It's not really the same thing at all as what Mohnish is practicing.

 

You may think you are playing within his framework of rules on position sizing, but not really.

 

You need to go back and think about why position sizing exists in the first place.  It could be a system of risk management (for the downside).  Right?  So doesn't the position sizing change when you use derivatives to hike the risk through the roof?

 

This is why I'm encouraging you to think of position sizing in terms of upside/downside exposure.  Look through the derivative and see what it represents on the underlying side.  I'm talking about unleveraged downside, so that it's apples-to-apples comparison with the type of unleveraged downside that Mohnish it talking about.

 

You have to ignore another person on this thread who is pleading with you to treat a derivative like it were common stock when you choose position size.  You can't just refuse to think about the look-through leverage (and the premiums/costs you pay for it) under the banner of avoiding complexity.  The complexity is already there unless you have a rule not to own derivatives -- once the derivative is owned, you don't reduce it's complexity through refusing to think about it.  It takes a bias to believe that ignoring something makes it go away -- a false sense of absence of complexity (out of mind, out of reality?).

 

So let's say you have at-the-money position size of 10% in call options.  You can lose the entire 10% from time-decay alone!  Now, are there other places in the portfolio where you'll have an offsetting profit from time-decay?  That's what I'm doing -- I'm netting out my future time-decay risk (I purchased premiums, and I sold premiums), and then asking myself on a net basis, how much time decay exposure do I have?

 

 

 

Posted

You could have 10 positions (BAC calls, GM calls, KO calls)... etc... where each is at-the-money calls.  You actually have a 100% loss potential from the passage of time alone (until expiry).

 

So you need some sort of framework to think about option position sizes if you hold options.  I don't think you can use the same rules as you use with common stock.  My framework is to think about how much net time decay exposure I have (netting out premiums on options I've purchased against premiums on options I've written).  Then I further think about (if I'm dealing with in-the-money calls) how much leverage I have to the downside price movement in the underlying stock. 

 

Suppose I have 2x leverage in deep-in-the-money calls -- I think of that more in terms of a 20% position sizing rather than a 10% position sizing.  Otherwise, I'd fool myself into believing the position is smaller than it really is (you quickly realize the mistake if the stock drops and your losses look and feel like they are twice as deep compared to the unleveraged common).  Now, if you want to grin a bit from the irony of it all, somebody else on this thread urgently wants you to think about it as only 10% exposure (so that you don't suffer unknown/unexpected risk from a complexity-induced bias! LOL, his approach leads to a "simplicity-induced" cognitive bias for the reason mentioned in the second sentence of this paragraph  ;)).

 

 

You don't blindly take rules designed for uncomplicated things (unleveraged strategies) and apply them to complicated things (leveraged strategies).

 

 

Posted

You don't blindly take rules designed for uncomplicated things (unleveraged strategies) and apply them to complicated things (leveraged strategies).

 

Isnt that obvious? Like what happened in Volkswagen. A margin call could turn a 5% exposure shorting Volkswagen into a 100% loss on the whole account.

Personally I never use leverage/margin so its simple for me. I also don't think the person who started the thread was thinking about weighting using leverage.

 

 

Posted

You don't blindly take rules designed for uncomplicated things (unleveraged strategies) and apply them to complicated things (leveraged strategies).

 

Isnt that obvious? Like what happened in Volkswagen. A margin call could turn a 5% exposure shorting Volkswagen into a 100% loss on the whole account.

Personally I never use leverage/margin so its simple for me. I also don't think the person who started the thread was thinking about weighting using leverage.

 

 

Damn right it's obvious that portfolio weightings need to be expressed while taking notional leverage into account.  You either have notional leverage, or you don't.  The Mohnish system is for unleveraged -- add some leverage through derivatives, and it changes things.

 

 

 

Posted

Ok than you are not really further levered up. Its just like the whole portfolio is leap call BAC+long JPM,C,SHLD. The leverage is in the leap call and you can`t really blow up completly but you have a lot of downside risk. Thats ok, as long as you can live with it. And through your derivative setup you are removing the call premium but pay margin interest instead.

 

 

The original inspiration for the construction of this BAC portfolio was when I held the class "A" warrants a year ago.  The warrants have this feature where they give you credit for the dividend, but it is a non-cash dividend.  However, the IRS taxes it the same way as it taxes cash dividends.

 

So you have this decaying put premium embedded within the warrant, but you can only implicitly deduct it from your capital gain when you go to sell the warrant.

 

All the years along the way, you have to pay this dividend tax -- and the tax rate on that goes up to about 33% in California.

 

So I decided to reconstruct the warrant using the common stock with portfolio margin and puts.  Then, I can deduct the puts every year and not get the dividend tax.

 

I can play games, like take a tax loss on the last day of this year on my expiring BAC puts, and defer the gains on my JPM,C,SHLD puts until the very next trading day (the next tax year).  So by doing this I can move a tax bill out to a future year.

 

Plus I can move the strike price up on the puts, as I recently did (moving from $12 up to $15 strike).  That's something you can't do with the warrants.

 

So anyways, it's very very very very helpful I have found to really deconstruct all of this stuff.  You really get intimate with the risk so you don't wind up with that head-in-the-sand cognitive bias I mentioned (where you treat highly leveraged positions the same as if they weren't, and where you make the second mistake of not counting up all the time decay you expose yourself to on a net basis).  IMO, I benefit from keeping my eyes open to exposures -- the risks.

Posted

Similar to argonaut I weight both by upside and downside.  I have a few positions which could be multi-baggers but could also be 0's, if the odds on it being a multi-bagger seem asymmetric I have to take the bet but those are usually 4% or so.  Then there are others which aren't going to double/triple anytime soon but appear to have a very high chance of appreciating and relatively low chance of going to 0 (BRK, LUK, LMCA), those are more like 10% positions as they are hard to find.

Posted

eric, if the purpose is to diversify the downside risk, why hold two of the three in the same industry?  i imagine that movement in both c and jpm is highly correlated with movement in bac.

Posted

eric, if the purpose is to diversify the downside risk, why hold two of the three in the same industry?  i imagine that movement in both c and jpm is highly correlated with movement in bac.

 

Single-issue downside risk is what I'm trying to limit.

 

An example:

 

Fairfax restatement of financials in July 2006 due to mistakes they made in currency translations (who would have expected that???). 

 

I like concentration in the banks right now.  Some don't, I do.

Posted

With options, I think the standard means to calculate weight of holdings is with net position delta.

 

Of course the delta is volatile and will vary depending on price movement relative to strike price and other factors. But even if you sold a way out of the money put, you're still long some small position delta. It won't be zero.

 

Technically you could have a net delta of zero and only exposed to volatility but you'd have to spend a fortune on transaction costs and be in front of a screen daily.

 

Posted

The original inspiration for the construction of this BAC portfolio was when I held the class "A" warrants a year ago.  The warrants have this feature where they give you credit for the dividend, but it is a non-cash dividend.  However, the IRS taxes it the same way as it taxes cash dividends.

 

So you have this decaying put premium embedded within the warrant, but you can only implicitly deduct it from your capital gain when you go to sell the warrant.

 

All the years along the way, you have to pay this dividend tax -- and the tax rate on that goes up to about 33% in California.

 

So I decided to reconstruct the warrant using the common stock with portfolio margin and puts.  Then, I can deduct the puts every year and not get the dividend tax.

 

I can play games, like take a tax loss on the last day of this year on my expiring BAC puts, and defer the gains on my JPM,C,SHLD puts until the very next trading day (the next tax year).  So by doing this I can move a tax bill out to a future year.

 

Plus I can move the strike price up on the puts, as I recently did (moving from $12 up to $15 strike).  That's something you can't do with the warrants.

 

So anyways, it's very very very very helpful I have found to really deconstruct all of this stuff.  You really get intimate with the risk so you don't wind up with that head-in-the-sand cognitive bias I mentioned (where you treat highly leveraged positions the same as if they weren't, and where you make the second mistake of not counting up all the time decay you expose yourself to on a net basis).  IMO, I benefit from keeping my eyes open to exposures -- the risks.

 

+1 - This is totally the right way to do things.

Posted

Single-issue downside risk is what I'm trying to limit.

 

An example:

 

Fairfax restatement of financials in July 2006 due to mistakes they made in currency translations (who would have expected that???). 

 

I like concentration in the banks right now.  Some don't, I do.

 

thanks.

Posted

I focus more on the downside than upside when weighting the portfolio. If the upside isn't large then I probably wont buy it in the first place.

 

I also think about the likelihood of the business deteriorating, how what position would I be comfortable with if I had to hold it for 5 years.

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