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LEAPS, Portfolio Cash and Leverage


vinod1
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I have recently moved towards using LEAPS (primarily in the money Jan 2013 Calls) in my portfolio. Where as in the past I have primarily invested directly in stocks. At this time I am long nominally about 80% of my portfolio size. This uses up about 30% of cash - 15% directly in stocks and 15% in LEAPS. I have the rest of about 70% in cash.

 

I am using LEAP's for four reasons

(1) To get around the fact that I have about 30% in a retirement account where my only options are index funds and cash equivalents.

(2)  Use what seems to be not too expensive non-callable leverage at this time.

(3) As an alternative to buying put options to hedge some of the portfolio. Buying LEAP's seemed to me to be better than using up the cash to buy stock + buy put options to hedge some of that exposure.

(4) As a way of locking in an attractive price in the future for stocks that I would be happy to own at that price.

 

Board members have commented on their cash levels in a recent thread and it got me thinking on how they are measuring the cash levels and how I should view my own cash exposure. I would really appreciate if you could comment on a few items

 

1. How do you measure your cash levels? In the above do I really have 70% cash or should I really be thinking of my cash level as only 20% (100% - my nominal 80% long exposure)?

 

2. How net long as a percentage of portfolio would you be willing to go if the specific stocks in your circle of competence get to once in a generation level of cheapness? I have a roughly 150% net long as my own maximum and wanted to clearly think through the risks in this approach.

 

3. A 15% of portfolio in LEAP's is giving me about 65% of portfolio net long exposure. I am not sure if this is incredibly conservative or incredibly reckless.

 

Looks like good times (sharp market declines) are coming our way and I realize it would be easy to lever up very easily and get wiped out. In the Great Depression, it is said the really smart people waited for the stocks to get down 50% and loaded up only to then see the stocks fall a further 80%. I am hoping to learn from the experience of fellow board members and any recommendations you have on using LEAP's.

 

Thanks

 

Vinod 

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Smart idea.

 

You are essentially betting this will be resolved (this downturn) in 12 months. Also I have learned a painful lesson, leaps work both ways. With that said I would be doing what you are doing if I had cash......

 

I am rotating holdings, and improving the mix / pushing out my leaps today.

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I have recently moved towards using LEAPS (primarily in the money Jan 2013 Calls) in my portfolio. Where as in the past I have primarily invested directly in stocks. At this time I am long nominally about 80% of my portfolio size. This uses up about 30% of cash - 15% directly in stocks and 15% in LEAPS. I have the rest of about 70% in cash.

 

I am using LEAP's for four reasons

(1) To get around the fact that I have about 30% in a retirement account where my only options are index funds and cash equivalents.

(2)  Use what seems to be not too expensive non-callable leverage at this time.

(3) As an alternative to buying put options to hedge some of the portfolio. Buying LEAP's seemed to me to be better than using up the cash to buy stock + buy put options to hedge some of that exposure.

(4) As a way of locking in an attractive price in the future for stocks that I would be happy to own at that price.

 

Board members have commented on their cash levels in a recent thread and it got me thinking on how they are measuring the cash levels and how I should view my own cash exposure. I would really appreciate if you could comment on a few items

 

1. How do you measure your cash levels? In the above do I really have 70% cash or should I really be thinking of my cash level as only 20% (100% - my nominal 80% long exposure)?

 

2. How net long as a percentage of portfolio would you be willing to go if the specific stocks in your circle of competence get to once in a generation level of cheapness? I have a roughly 150% net long as my own maximum and wanted to clearly think through the risks in this approach.

 

3. A 15% of portfolio in LEAP's is giving me about 65% of portfolio net long exposure. I am not sure if this is incredibly conservative or incredibly reckless.

 

Looks like good times (sharp market declines) are coming our way and I realize it would be easy to lever up very easily and get wiped out. In the Great Depression, it is said the really smart people waited for the stocks to get down 50% and loaded up only to then see the stocks fall a further 80%. I am hoping to learn from the experience of fellow board members and any recommendations you have on using LEAP's.

 

Thanks

 

Vinod  

 

Very thoughtful post, Vinod.

 

Some thoughts:

 

Leaps are a good way to lower the risk of permanent loss of capital, but there are good leaps (bargain priced, favorable terms) and not so good leaps (pricey).

 

Cash levels are what they are.  If you had $100 available and used $20 to buy leaps, your cash would be 80% of your portfolio, although your exposure to the market would be levered.  If the leaps lost half their market value, the portfolio would lose only 10% of it's value, and cash would represent 89% of the reduced portfolio value.

 

The cash represents most of your margin of safety.  It doesn't matter a great deal how much you are levered up in notional exposure with whatever percentage of portfolio assets you are comfortable having in leaps, assuming the leaps aren't way out of the money.  What matters most are how long are the leaps.  One year?  Five years?  The longer the leap, the more time you have for cream to rise to the top.  It also helps if leaps are on companies that generate lots of cash and are willing to use most of it to buy back stock if the market price drops way below IV.

 

Regarding how much if any to increase your exposure when the market melts down: no more than you can afford to lose.  One way to limit risk when tempted to double down in a market meltdown is to buy the stock instead of buying more leaps which would be very pricey in a high volatility regime.  Then, you can hold the double down position for many years if necessary without attritional losses from time decay until the intrinsic value is reflected in the market price.

 

 

 

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I find that when the options settle I sometimes want to hold onto the shares.  So if (instead of getting the calls) I buy puts to hedge vanilla shares, I can take a tax loss on the puts at expiry.

 

Earlier this year I did buy some IWM $120 strike puts and then wrote the covered $80 strike put when it was at-the-money.  Today I bought back that covered put for a tax loss and bought some shares in a few different companies.  Hopefully the shares I bought today wind up beating the IWM $120 strike puts that I continue to hold.  The gain thus far on the $120 strike puts far exceeds the loss I took purchasing the covered calls, and the tax loss is valuable given the gains I took on SSW earlier in the year.  So I'm happy with how this worked out.

 

Best thing to happen now is a huge sustained rally so that I can take a tax loss on the IWM puts I still hold.

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  • 2 years later...

Vinod, how do you think about the borrowing cost of these leaps?

 

I used to calculate it the following way:

 

(LEAP cost + strike price - stock price) / (strike price x term of LEAP in years)

 

This gets you the rough annual borrowing cost but it is not accurate as you are prepaying the interest upfront.

 

Eric has recently pointed this flaw and although the above calculation would still get you the cost for 1-2 year LEAPS roughly right, it would be better to calculate it the way he mentioned it.

 

I am copying what he wrote in another post (I do not have the thread link but I did make a copy):

 

You are prepaying all of this interest, long before it is due, which is effectively an interest-free loan to the very person you are borrowing it from.

 

Thus, you aren't really borrowing as much as you think.

 

Therefore, you have to figure out how much you are really borrowing first, before then calculating what interest rate you are really paying.

 

And that is an easy calculation.

 

Given:

BAC stock price $15.60

BAC "A" warrant price $6.54

Strike price $13.30

x= cost of leverage interest rate

 

$15.60 - $6.54 = $9.06

 

Now you need merely solve the following equation for 'x':

$9.06 * 1.x^5 = $13.30.

 

I'm using 5 years in the calculation to keep it simple, even though we're not exactly 5 years from expiry.

 

Viinod

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To use an example take BRK $100 strike call 2016 LEAP that is selling at about $23.6 while BRK is trading at $115.6. Since the term is roughly 2 years on the LEAP (from now until Jan 2016) I rounded it to 2.

 

Old way would be (23.6 + 100 - 115.6) / (100 x 2)

 

This gets you 4% annual costs.

 

The more accurate way

 

(115.6 - 23.6) * 1.x ^2.0 = 100

 

This gives you 4.25% annual interest. Not that significant since LEAP is only 2 years out and interest cost is relatively low, but as interest cost or term increases, the difference would be significant.

 

Vinod

 

 

 

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I typically don't consider options, but LEAPS seem interesting if someone actually wants to make a long-term bet, and doesn't have a problem with their investment potentially going unexercised and hence losing their initial investment.

 

Has anyone combined a valuation metric, say EV/EBITDA or Value Factor One, with a LEAP strategy? I don't know how it would perform in a typical investment climate, but in the 2008/2009 upset, couldn't you just buy a basket of LEAPS based on whatever value investing metric you want to work with?

 

It doesn't seem like there are too many LEAPS available and mainly the largest companies are represented, but that means it'd be fairly easy to rank them based on relative cheapness. Buy the cheapest 5-10% of the universe, so 25-50 LEAPS, and then hold for a period of time. That seems to be a better way to take advantage of a similar 08/09 situation versus holding a leveraged large cap ETF, using margin, or going long alone.

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  • 3 weeks later...

Question on how to calculate the cost of leverage or similar metric for puts:

 

I know for calls the cost of leverage is solved using:

Strike = (common stock price - premium)*(1+leverage %)^(term)

 

For puts, would an equivalent equation be:

Strike = (common stock price + premium)*(1+leverage %)^(term)

 

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I don`think its a good idea. You should perhaps think about the other side of the trade to understand my point. You can be relative sure that you buy the call option from a professional options trader. And what does the options trader do? He buys stock or other options to hedge his trade. So what you are doing is paying someone else to buy stock for you, because you want to be protected on a large downswing. When you are not sure if the market rises further and your holdings are fair or overvalued then either sell covered calls on your holdings or sell and buy undervalued stocks.

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