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Primer on options?


Bart
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Not me.

 

I just learned about options by thinking about them mainly.

 

For example, the $2 strike BAC 2014 call option has an "ask" of $6.3.  I can buy it in my Roth IRA where margin loans aren't permissible.  I can get about 1.33x leverage by purchasing that option.  $6.30+$2=$8.30, which is a 17 cent premium above the market price of BAC.  17 cents is 8.5% of $2, so 4.25% (plus foregone dividend yield) is roughly the interest rate on the loan, except you have the disadvantage of having to put up the interest costs upfront.  You also have the huge advantage that there are no margin calls and there is an embedded put -- if the stock price declines considerably, the rising value of the put will soften the blow of your losses.

 

Second example is that if you fear high consumer price inflaiton is you can put 100% of your margin account in TIPS, and then write deep-in-the-money puts on something like BRK class B shares, or perhaps your other favorite company.  As the CPI rises, so does the value of your TIPS, and hopefully the underlying stock value of whatever you wrote puts on (maybe just an index ETF). 

 

Etc... etc... 

 

I find thinking about options in these practical terms to be more productive than studying academic theory on volatility pricing, etc...

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I second Eric's comments.  What you want to find is an undervalued asset and use the option to get cheap non recourse financing to lever up the returns.  I have never used the more complex option strategies as I don't understand how you can use them to make a bet on an undervalued asset.  The one caution is that options appear to be easier than they are on the surface because when you buy options you are making both a timing and valuation bet.  LEAPs and long-term warrants can reduce the amount of timing bet you are making and thus are what hear most on this board.  The implied interest framework Eric mentioned is what I have found to be the most useful.

 

Packer 

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I agree with the feedback above. I learned the academic theory of options as part of the CFA program but I did not find it of any practical use. Reading Ericopoly comments and then spending time to think through helped me immensely in understanding options in practice. I remember copying some of Ericopoly's comments into an email so I can revisit them and think through in more detail later on.

 

Vinod

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Couple of other practical add ons:

 

1) The Greeks are usefull but not the way they are taught. Treat volatilty as a proxy for RSI. Write at the high end, cover at the low end. 2) Liquidate as soon as premium approaches 30% of share cost, where the long/margin alternate takes over. Or suddenly see your market go no-bid. 3) Favour convertibles for their debt/equity arbitrage ability. Either you or someone else.

 

Seldom mentioned, & often more valuable, is the tax application. Sell a long dated low volatility at the money call from a tax deferred RRSP, & buy in a tax exempt TFSA account. Unwind on a high volatility event. The RRSP loss becomes the TFSA gain, & wealth transfers from the RRSP with no witholding tax. RRSP -> Market loss & Market ->TFSA gain structure nixes challenges.

 

         

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Couple of other practical add ons:

Seldom mentioned, & often more valuable, is the tax application. Sell a long dated low volatility at the money call from a tax deferred RRSP, & buy in a tax exempt TFSA account. Unwind on a high volatility event. The RRSP loss becomes the TFSA gain, & wealth transfers from the RRSP with no witholding tax. RRSP -> Market loss & Market ->TFSA gain structure nixes challenges.

 

Problem is u can only sell covered call on RRSP or TFSA. So hard to transfer large amount of money.

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Seldom mentioned, & often more valuable, is the tax application. Sell a long dated low volatility at the money call from a tax deferred RRSP, & buy in a tax exempt TFSA account. Unwind on a high volatility event. The RRSP loss becomes the TFSA gain, & wealth transfers from the RRSP with no witholding tax. RRSP -> Market loss & Market ->TFSA gain structure nixes challenges.     

 

So if I understand properly you are counting that in say a 1 year timeframe there will be some shock to the system that will add volatility?

Would the CRA allow us to be long RRSP and short in TFSA of the same security?

 

BeerBaron

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So, using this logic- what's the right price for WFC warrants? strike 34 current price 31 expire in 6.5 years.

 

Or maybe not the right price but how should I think about the warrant. I can figure out that if the price was 43 now and the warrant was say still 9, then from now on I will have a X4.5 leverage on WFC's results, but what can you tell me about my leverage now, when Im not yet in the money.

 

Even if I were right on the money- 34$, what is my leverage from now on? you can't just divide the mkt price by the warrant price because that's the leverage that very moment, but after a rise of 1% in price which will cause a 3% rise in the warrant the leverage is different.

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Beerbaron: CRA is silent. Both transactions are directly with the market. It is also no different from todays process of swapping securities between the accounts - both accounts have to sell/buy from the market. Execution is via a series of transactions over a period of time.

 

Shlom: Determine at what price long/margin takes over (warrant price[PV]/max margin). Subtract from todays price to determine the max remaining warrant increase. Add to warrant price [FV]. Use remaining time to expiry & calculate YTM. Multiply by prob that WFC may never get that high by expiry date. What remains is maximum risk adjusted return. Walk if it is not good enough.

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Assume

5 yr warrant, strike of $11.00

Share price today is $10.50. Max margin of 70%

Warrant price today of $4.00

P(margin equivalency achieved <  warrant ½ life): 60%

 

Margin equivalency: Today’s $4.00 warrant price could be pledged as long & margin equity. ie: if the share price was $13.33 & you used 70% margin to buy it, you would need to make a $4.00 equity investment 13.33x(1-.7)=4.00

 

At margin equivalency, the warrant will be $2.33 in the money. 13.33-11.00=2.33

Assuming no other change, the warrant price will be $6.33 (4.00+2.33)

Assume a warrant 1/2 life of 2.5 yrs (5yr life/2)

PV=4.00, FV=6.33, N=2.5, PMT=0, IRR=20.15%

Risk adjusted IRR = 12.09% (20.15x0.6)

Reject if you want a return > 12.09%

 

Quick & simple, & one of many methods. Because of the risk most would not consider it unless there was current low share volatility, & the risk adjusted return was > 25-30%   

 

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I have learned from board members here and practice, practice, practice.

 

As per Packer's comments I only use Leap calls, these days.  Basically a levered bet based on a pre-assessed stock. 

 

Al's rules (apply only to me):

1) leap calls only

2) must have high liquidity and only in US optioms markets.

3) only for use with stocks that have already been determined to be undervalued by a significant margin - WEB's approximately right.

4) No writing puts

5) no buying puts any more (may break this one if another crisis is looking inevitable but that is a few years out).

 

As to the WFC warrants any method of valuing them is useless.  They are near the strike price these days.  They are trading at 9.30.  Basically its a 3:1 leveraged bet.  You get exposure to 3 x as much stock holding the warrants.  From my perspective the odds of Wells being below $43 dollars in 6 years is pretty low providing they dont do something colossaly stupid.  So the downside is limited, and the upside is probably good.  Will it be better than holding the common: anyones guess. 

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Guest valueInv

I have learned from board members here and practice, practice, practice.

 

As per Packer's comments I only use Leap calls, these days.  Basically a levered bet based on a pre-assessed stock. 

 

Al's rules (apply only to me):

1) leap calls only

2) must have high liquidity and only in US optioms markets.

3) only for use with stocks that have already been determined to be undervalued by a significant margin - WEB's approximately right.

4) No writing puts

5) no buying puts any more (may break this one if another crisis is looking inevitable but that is a few years out).

 

As to the WFC warrants any method of valuing them is useless.  They are near the strike price these days.  They are trading at 9.30.  Basically its a 3:1 leveraged bet.  You get exposure to 3 x as much stock holding the warrants.  From my perspective the odds of Wells being below $43 dollars in 6 years is pretty low providing they dont do something colossaly stupid.  So the downside is limited, and the upside is probably good.  Will it be better than holding the common: anyones guess.

 

Could you expand on why you avoid puts?

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Write "just-out-of-the-money" puts on a company you wish to own. Once assigned, write OTM calls at a strike you doubt can be achieved within a certain time frame.

 

-------------------------------------------

 

If possible buy "deep-in-the-money" LEAPS (calls). Hedge by buying ITM puts in an associated industry ETF.

 

Downsides?

 

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Assume

5 yr warrant, strike of $11.00

Share price today is $10.50. Max margin of 70%

Warrant price today of $4.00

P(margin equivalency achieved <  warrant ½ life): 60%

 

Margin equivalency: Today’s $4.00 warrant price could be pledged as long & margin equity. ie: if the share price was $13.33 & you used 70% margin to buy it, you would need to make a $4.00 equity investment 13.33x(1-.7)=4.00

 

 

Thanks for the reply Sharper, I  don't understand the meaning of margin equivilancy ,warrant 1/2 life and  max margin (marked above)

 

It's only recently that I've begun to think about options, and that's only because of the bank warrants, So thanks for helping out.

 

BTW, who is this forum's admin? I tried registering 4-5 times until I was approved, and I'd really like to change my nick :)

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shlo, dont blame you: Sanjeev Parsad - i think his call sign is Parsad.

 

valuinv - Nearly every time I have sold (wrote) puts I have had to buy out of them at inopportune times - They are my single largest money losing strategy.  I prefer my downside to be capped.  When these move against you they really move.  It is just not worth it to get an extra few percent.  Easier and safer to buy something with a big fat dividend using leverage.

 

Buying puts as protection has cost me some money but generally it has been useless and created drag on a rising position.  Economically better to just reduce a position.  That being said, If BAC goes to $20 by the end of the year, I might buy low strike puts to protect my 2014s.  They have their uses. 

 

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margin equivilancy: The share price at which the $4.00 investment in the warrant could alternatively be used to buy the stock itself with the maximum possible 70% margin financing.

 

max margin financing: The maximum amount a broker will permit an investor to borrow, using the stock itself as the loan collateral.

 

warrant 1/2 life: Proxy for your intended holding period. Market convention is to average; hence divide remaining time to expiry by 2.

 

You might also want to review the value of a warrant at expiry, & the practical margin elibibilty of a warrant.

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