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Author: spirach2 Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 211757  
Subject: BRK Leaps: Date: 11/8/2012 2:52 PM
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To anyone who's interested, my test-the-market (and try and figure out where the hell the real price is) order for the '14 $70 calls just went through (to my pleasant surprise) at $17.60.

Pretty cheap, with BRK at maybe 3.5% above buyback threshold.

A bit lower and I'll buy a bunch more.
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Author: hclasvegas Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195636 of 211757
Subject: Re: BRK Leaps: Date: 11/8/2012 2:55 PM
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you bought 1 call at 17.60 ? how much do you pay to make that trade ?

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195640 of 211757
Subject: Re: BRK Leaps: Date: 11/8/2012 4:04 PM
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A bit lower and I'll buy a bunch more.

And next week you can get the 2015s.
Another year of snoozing before having to deal with it.

Jim

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Author: spirach2 Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195641 of 211757
Subject: Re: BRK Leaps: Date: 11/8/2012 4:09 PM
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Thanks, Jim.

Care to guess how much additional time-premium might attach?

I just bought a couple more, just before close, at $17.25, with the stock at about $84.75.

What do you suppose the '15's would trade at if they were available at that same moment? (Let's stick with the $70's, for the sake of simplicity.)

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195643 of 211757
Subject: Re: BRK Leaps: Date: 11/8/2012 4:21 PM
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What do you suppose the '15's would trade at if they were available at that same moment?
(Let's stick with the $70's, for the sake of simplicity.)


It will probably work out to an interest rate a little under 3%.
So, for the $70s, I'd guess around $1.75 to $2.10 more.

Compare IBM.
The BRK $70s are 17.5% OTM, so a comparable IBM might be the $160s which are 16.3% OTM.
Midpoint of bid/ask for Jan 2014 $160s is $35.80
Midpoint of bid/ask for Jan 2015 $160s is $40.00
Difference is $4.20, which is 2.63% of the 160 strike which is the "borrow".
The borrow on the BRK 70s is $70, and 2.63% of that is $1.84.
Liquidity and bid/ask gap might push that a quarter either way.

For a sense of perspective on whether $1.75 to $2.10 extra is a reasonable
amount to pay for another year at the same strike, my estimate is that
the B shares are rising in value on trend around 80 cents a month so in
that sense fair value would be to pay $9.60 more for an extra year.
That doesn't say anything about how soon price will hit fair value,
but at today's valuation (1.136x) the book will probably drag the price up.
Book or price might dip for a bit, but probably not that long.
I will be rolling my 2013s to 2015 some time between next week and January expiry.

Jim

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Author: spirach2 Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195644 of 211757
Subject: Re: BRK Leaps: Date: 11/8/2012 4:28 PM
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Thank you, that's great stuff.

Two bucks is slightly less than I would've guessed.

And I agree, that would make the '15's extremely attractive.

It'll be fun to see how close you were.

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195666 of 211757
Subject: Re: BRK Leaps: Date: 11/9/2012 6:18 AM
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It'll be fun to see how close you were.

The tough call: do you buy 2014s today while the price is insane (close 84.58 last night),
or wait till next week to get 2015s when you don't know what the price will be?
Unfortunately the bid/ask is pretty brutal if you're going with
conservative ITM options so you don't want to roll them that one extra time.

Jim

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Author: salsdad One star, 50 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195667 of 211757
Subject: Re: BRK Leaps: Date: 11/9/2012 6:41 AM
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I am currently a seller of very-long-term Berkshire holdings: not due to doubts about the future of the company (quite the opposite!), but because of unrelated financial obligations.

As you can imagine, this has me up at night, cursing Warren for his misguided sense of what is "fair" to his partners. (buyback floor at 1.3 x BV, anyone?)

I am thinking about LEAPS as a strategy to:
Get some cash for short-term needs
Keep the Berkshire "investment" and upside
Take a capital gains hit at KNOWN 2012 rates.

Options have never been of much interest to me, so a primer would be helpful now. Any suggestions for reading/research?

Comments from board members ( who are not on the "ignore" list ;-) are most welcome.

Sal's Dad

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195670 of 211757
Subject: Re: BRK Leaps: Date: 11/9/2012 7:34 AM
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Options have never been of much interest to me, so a primer would be helpful now. Any suggestions for reading/research?

Options can be used in millions of different ways, many of which make
sound economic sense and most of which don't.
General purpose primers are rarely of much use; there are simply
too many ways to use them, so such manuals tend to cover all the how
and none of the why or when or why not.

So, for whatever it's worth, here is one way to use options which is
I think at the sane end of the spectrum, and relatively easy to understand.

To wit:
Buy fairly deep in the money call options on Berkshire as a way of holding
the stock that ties up less cash. This might be for different reasons:
you have other uses for the cash now, or you are simply greedy and
want the leverage so you can have the upside on more shares than you could
otherwise afford. The latter is not a great reason, but it's the one I'm using.
Your reason is about the best I can think of: you want to raise some money,
but aren't very happy selling at Berkshire's current share price.

In this case, all you need to know about a call option is that it's
exactly the same as a rain cheque at the grocery store.
It's a piece of paper that gives you the right, but not the obligation,
to buy a certain thing at a specified price any time you want up until
some known expiration date in the future.
Imagine iPhones are selling for $500. A rain cheque giving you the
right to buy it any time in the next few years for $400 is clearly
worth $100 (you could use the certificate and sell the phone the
next day to somebody else for $500, pocketing a profit of $100).
It's also worth a bit more, because you can postpone the decision
whether to use it, or you can decide later not to use it if iPhones go
out of fashion—having more alternatives is worth a bit.
Also, if you only need the iPhone in a few years' time, you can use the
$400 for something else for a few years, so it has a value to you like
the interest on a loan for $400.
So, this rain cheque might have a value of $105 or $110.

In the example, this is a call option (right to purchase something),
with strike price $400. Since $400 is less than the current price
of the thing it's tied to, it's known as an "in the money" option.
The $100 difference between the strike price and the current price
of the underlying thing is known as the "in the money" value, or
sometimes the "intrinsic value" (a totally different meanning of the
phrase intrinsic value which is specific to the options world).
The little bit extra $5-10 that the option is worth because of the time
value and the optionality is called the time premium.
Think of it as the interest on a loan in the amount of the strike price.

Here's where it gets interesting.
Obviously the "in the money" value of an option is easy to calculate:
for strike prices below the current price of the goods, it's the
difference between the two prices. For a strike price above the
current price of the goods (and out of the money option), the
in the money value (sometimes called intrinsic value) is zero.
If the two prices are equal, it's an "at the money " option.
e.g., iPhones are trading at $500 today and you have the right to
buy it for $500 any time in the next two years.
The most important non-obvious thing to know:
The time value of the option is always highest at the money, and
lower for options with strike prices higher or lower than the current price.

The best way to evaluate a call potion is simple: assume you exercise
the option the day before it expires. Calculate how much you will
have spent on the shares, which is the cost of the option, plus
the cost of exercising it. This is your breakeven point.
This will always be more than the cost of buying the stock today because of
the time premium, but in return you don't have to tie up so much cash in the mean time.

Let's take an example.
Last night, Berkshire B shares closed at $84.58.
January 2014 $50 call options had a bid/ask price of 35.25/36.50.
You could probably buy those for about $36.25 using a limit order.
So, alternative 1: you buy 100 Berkshire shares today for $84.58.
You tie up $8558 for the next 1.2 years.
You get a profit/loss based on whatever the stock price does from here.
Alternative 2: you buy one call option contract, strike price $50,
expiry January 2014, for a quote price of $36.25.
Each call contract means $100 shares to it costs you $3625 total.
You tie up only $3625 for the next 1.2 years instead of $8558.
The day before it expires, you exercise the contract.
This will cost you the strike price times $100, or $5000.
Your all-in cost is 5000+3625=$8625.
This is only $67 more than the cost of buying the shares today,
but you had the use of the extra $5000 for 1.2 years.
So, it's like paying $167 interest on a loan of $5000, which is
an interest cost of only 3.3% for over a year.
Clearly this is a pretty cheap way to borrow money.
Your end result is that you get the profit and loss of 100 shares
of Berkshire from today until expiration date, minus $167 extra it cost you.
Very importantly, unlike brokerage margin loans, this is an uncallable
loan for its duration: nobody can ask you for that extra money.

What happens at expiration?
There are several possibilities.
This is a much longer and complete list than most people consider.
(1) You're on vacation in Bali and forgot about the option.
It will almost certainly still be in the money at expiration, so your
brokerage will autmatically exercise it for you and take the $5000 cash
out of your account to do so.
(1)(a) If there is $5000 cash in your account, that's it.
You now have Berkshire shares. If you like you can keep them till the
price is good, or sell them and replace them with another call option.
(1)(b) If there is not $5000 cash in your account an dyou have
a margin account, they will buy the shares on margin for you.
i.e., they will lend you the money for a while.
Again, you now have Berkshire shares. If you like you can keep them till the
price is good, or sell them and replace them with another call option.
(1)(c) If there is not $5000 cash in your account and it's not a
margin account (or you are near your margin limit already) they
will sell something in your account. This might be the Berkshire
shares or something else, you'd have to check with the broker.
My broker lets me tell them long in advance what I want them to
liquidate last if this situation should ever arise.
This is a Bad Thing, a situation to be avoided. There is nothing
wrong with betting that a share price will be higher in future, but
it's not a good idea to wager that it will be higher on a specific date.

(2) You are NOT in Bali and have not forgotten the option.
The price of Berkshire is satisfyingly high.
You sell the option at a very large profit shortly before it expires.

(3) You are not in Bali and have not forgotten the option.
You exercise it because you simply want to skip using options and
go back to holding shares.

(4) You are not in Bali and have not forgotten the option.
You're happy with the current price of Berkshire shares.
You exercise the options and sell the shares.
This is almost the exact same thing as #2 but may have slightly better
or worse tax consequences or commissions.

(5) You are not in Bali and have not forgotten the option.
The price of Berkshire is still annoyingly low and you don't want to sell.
(a) There are options still trading for Berkshire, at appropriately
low strike prices in the money, so you sell your current options
and buy the same thing with an expiration two years further out.
This is called "rolling out" the option. It will cost you a little
bit of money, because in effect you're borrowing the strike price
for another couple of years and you have to pay the time value
for that which can be thought of as the interest on the loan.
(b) For some reason there are no options for Berkshire at the time,
or the options are not available at a sane price.
If you have the cash, you exercise the options.
If you don't have the cash, this is another bad outcome.
It's extraordinarily unlikely, but I mention it for completeness.
Your only choice is to sell the options at a low price, or sell them
and use the proceeds to buy a smaller number of shares, in effect
selling a fraction of your holding.
It's very like the situation that you had a loan from the bank, the
bank said they'd renew it when it came due if you needed them to,
but changed their minds and the loan is due.

Bottom line, in your shoes, if you're not happy selling Berkshire
shares at current prices (who would be?) then a very viable alternative
is to sell some shares, use some of the proceeds to buy call options
which equate to the same number of shares, and wait for a better price
before you close the position that you would have had to sell today.
e.g., say you need to raise $25k this month.
Instead of selling about 300 shares, do this combination:
Sell 500 shares at $84.58 for a total of $42290.
Buy 5 call options at $36.25 for a total of $18125.
You have the difference ($24165) to spend for now, but your options will continue to
track the price of Berkshire stock so your total Berkshire position size is unchanged.
If the price is good some time before expiry, sell the options at a profit.
If not, roll them out just before expiry and wait longer for Mr Market to be rational.
Note, the January 2015 options will be trading next week, so use those,
not the January 2014 ones that I mention in the example above.
It's much more likely that Mr Market will be rational within 2.2 years
than that he will be rational within 1.2 years.
For budgeting purposes I'd plan on rolling them out at least once.
i.e., buy Jan 2015 next week, plan that around Dec 2014 sell those and buy Jan 2017 ones.
By January 2017 it's likely there will have been a much better exit price than today's.

I this example I rather arbitrarily used a strike price of $50.
A lower strike price will tie up more money at a very very slightly
lower implied interest rate. A higher strike price will tie up
less money (will have higher leverage) for a rising interest rate.
As the strike price approaches and passes the current stock price
the implied interest rate gets quite steep.
The way to calculate this is easy: your all-in cost is strike price plus
what you pay for the option. The "interest" is the amount by which
this sum exceeds the current stock price, and the amount you're
"borrowing" is the lower of the strike price or the current stock price.
Thus, the interest rate is "extra cost" / "effective borrow amount".
Then you annualize the number: obviously if it's a two year option,
this implied fixed interest cost is spread over more than one year.
Armed with this simple arithmetic, you can compare the pros and cons
of different strike prices: what's the interest rate for different size loans?
While the market is open you can see the bid/ask for call options in the upper table at this link
http://finance.yahoo.com/q/op?s=BRK-B&m=2014-01

Jim

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Author: salsdad One star, 50 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195673 of 211757
Subject: Re: BRK Leaps: Date: 11/9/2012 9:17 AM
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"Any suggestions for reading/research" I asked, hopefully - and in response, an entire strategy is laid out for me - in some detail, from a source that I have grown to respect over the years.

"So, for whatever it's worth, . . . "

Worth? A great deal, I am sure!

This board, and one or two contributors in particular, provides a remarkable resource. It is appreciated.

This lurker may have little to contribute (and tries not to bring down the "signal-to-noise-ratio" with extraneous comments); but regular posters should know that their wisdom IS being heard.

Thank you

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195674 of 211757
Subject: Re: BRK Leaps: Date: 11/9/2012 9:29 AM
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but regular posters should know that their wisdom IS being heard.

Just remember that half of what I say is totally wrong.
If only I knew which half.

Jim

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Author: DrtThrwingMonkey Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195682 of 211757
Subject: Re: BRK Leaps: Date: 11/9/2012 10:25 AM
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The best way to evaluate a call potion is simple: assume you exercise
the option the day before it expires.


This certainly reinforces the idea that this is some kind of magic...


The way to calculate this is easy: your all-in cost is strike price plus
what you pay for the option. The "interest" is the amount by which
this sum exceeds the current stock price, and the amount you're
"borrowing" is the lower of the strike price or the current stock price.
Thus, the interest rate is "extra cost" / "effective borrow amount".



I'm trying to understand how the borrowed amount would not just be the strike price. For instance, for a $50 call, purchased at $36.25, you are effectively laying out $36.25 of the final price (which is $86.25), and borrowing the $50, no? Ok, I think I see what you mean. If BRK.B shares dropped to $40, towards expiration, I would not exercise (repaying the 'borrowed' $50), but rather purchase the shares outright (with a 'borrowed' $40), is that what you mean?

Regards DTM
(Purchaser of some $80 call potions this morning, and looking forward to the 2015 brew)

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195683 of 211757
Subject: Re: BRK Leaps: Date: 11/9/2012 10:54 AM
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I'm trying to understand how the borrowed amount would not just be the strike price...

Generally, yes, for in the money calls.
But consider an out of the money call.

In effect, to me the "loan" is the amount of cash you don't have to put
up today (the benefit), not the amount that you do have to put up later.
That's the benefit for which you're willing to pay a fee which resembles interest.

If the stock price is $85 and you buy a $90 call, the amount of money you're not having
to put up now is $85 because for that amount you could simply have bought the shares today.

I suppose it might be more accurate to say that the "benefit borrow"
is exactly what you don't have to put up today, which is always the
current stock price minus the total option premium whether ITM or OTM.
Since I'm normally looking fairly deep in the money, that's similar to
the strike so I'm in the habit of using the strike.

Jim

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Author: Wotdabny Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195702 of 211757
Subject: Re: BRK Leaps: Date: 11/9/2012 6:15 PM
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I find it useful to think of options as a means to trade risk. I might have a large stock position, the value of which I want to protect, but I don't want to (or cannot) sell. Buying a put option means I have protected my stock holdings' value, because if the stock goes down, I can always sell my puts at a profit that makes up for that paper loss -- for a time, anyway. In this scenario, I'd rather keep my stock and let the puts expire worthless; I'd rather keep the car than collect the collision insurance.

Selling puts to open a position is lovely way of accepting risk in panicky markets: Worst case scenario, you get great companies for a very low price; best case scenario, you are paid handsomely to take risk off the table for people who cannot stomach more risk, then lather, rinse, repeat. Great for crashing markets, but it takes a lot of cash you might wish you had not tied up, as you can no longer use it to move on even more attractive opportunities if the crash continues -- that's the risk.

Buying calls has a risk I am not sure is clear thus far in this thread: Berkshire's stock price could be cut in half, along with the rest of the market, and stay there past your expiration date, only to recover fully and a whole lot more at some point down the line. Your call options: Worthless. You don't sell right after the crash because they are only 90% worthless, but as time goes on, they lose all value. Stock holders get all their value back, but you do not.

Options give you leverage, which can surprise and astonish, and over time, certainly does -- even to the most seasoned investor. There are smart guys on the AAPL board right now discussing how they haven't made anything in AAPL this year, even though they've been long the whole time, even though the stock is up enormously even after the recent 20% haircut, thanks to their options choices. If they had simply bought the stock and held, they'd be much, much better off. For reasons like these, many perfectly sensible people talk about options as though they are necessarily toxic. This need not be the case, but you must appreciate the risks, or else they definitely will be, and even then, they can be tricky.

I use options, and the ways I use them tend to be safer than the simple risk of going on margin. Maybe Jim can back this up -- I have never read it anywhere, but I did the math once: Margin -- in common and popular use in the 1920s -- would devastate an investor trying to hold through the 1930s. Not 30%, not 20%, not 15%: No margin, not even 1%, would have allowed an investor's account characterized by a basket of Dow Industrials to survive the margin call at the close of certain trading days. Leverage in this sense cannot be used over long holding periods without causing greater loss, sometimes catastrophic loss, that otherwise would not be sustained.

So, the trick is, if one is to use options or other leverage or additional risk-taking at all, to sort out when it is a good idea, and how to limit losses. Unless you have developed an account management model that limits your losses but enables you to recover from them, as well as make that extra money the leverage promises in the first place, I would not recommend using call options at all. I have played with many models, with various objectives, and I am still working it out; I know generally for which accounts how much risk to take and how much is enough, but there is simply no specific set of rules I have discovered that always works that also does not also require an escape hatch, one which takes me to a different model in which no leverage is used at all for a period of time. In other words, even if I park only 5% of my portfolio in call options, to be replenished when it declines in value (or goes to zero) every x months, there is no solving for x that satisfies what actual volatility will do: Destroy the value of my account to the point that, in spite of many years of outperformance, I would have been better served not buying options at all. What I have arrived at over a long period of time is a sophisticated model that at its core rests on my own perceptions, guided by the insights of others and their mechanical models, of the market generally and my investments specifically, which simply is not quantifiable, but has outperformed satisfactorily -- thus far, and in spite of conspicuous learning-curve volatility, and only because I chose to change gears radically or sit out certain periods entirely. If I had stayed constantly in any long-only or long-plus-options model I know of, I would be far behind where I am now.

Sorry for such long-winded thoughts, but this stuff is complicated, to the point that I have managed to do little more than point and grunt at a small subset of important considerations. If they weren't important, I wouldn't have bothered, but I am not so sure how much light I have shed. Please, if anybody else has anything they would like to add, corrections or attempts to verify or disconfirm my assertions or positions, or just have a different way of looking at things, jump in.

Wot

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Author: karensie Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195703 of 211757
Subject: Re: BRK Leaps: Date: 11/9/2012 6:41 PM
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With you Wot,

"How NOT To Make Money: Trading Stock Options"
"13 Unlucky Reasons Not To Trade Stock Options"

http://25yearsofprogramming.com/blog/20070411.htm

Tim (burned very badly by a Berkshire margin call 15 years ago and still not fully recovered financially or emotionally)

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Author: DrtThrwingMonkey Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195704 of 211757
Subject: Re: BRK Leaps: Date: 11/9/2012 6:51 PM
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I know generally for which accounts how much risk to take and how much is enough, but there is simply no specific set of rules I have discovered that always works that also does not also require an escape hatch, one which takes me to a different model in which no leverage is used at all for a period of time. In other words, even if I park only 5% of my portfolio in call options, to be replenished when it declines in value (or goes to zero) every x months, there is no solving for x that satisfies what actual volatility will do: Destroy the value of my account to the point that, in spite of many years of outperformance, I would have been better served not buying options at all. What I have arrived at over a long period of time is a sophisticated model that at its core rests on my own perceptions, guided by the insights of others and their mechanical models, of the market generally and my investments specifically, which simply is not quantifiable, but has outperformed satisfactorily -- thus far, ...

Sorry for such long-winded thoughts, but this stuff is complicated, to the point that I have managed to do little more than point and grunt at a small subset of important considerations. If they weren't important, I wouldn't have bothered, but I am not so sure how much light I have shed. Please, if anybody else has anything they would like to add, ...



Let me add my encouragement to wotdabny's, for anyone who can shed light on this issue of quantifying leverage. I have a small opportunistic option part of my portfolio, mostly short index futures, with a few short puts (Sears, Berkshire, Seagate) and long calls (currently only Berkshire), including some I bought first thing this morning.

I'm happy with a small amount of leverage, but I would be even happier if I could quantify it. For instance, a deep in-the-money option will have a lot less leverage than one that is at-the-money. My $80 BRK.B calls (bought for $9.30 per share) will expire worthless if Berkshire just drops 10%, and if Berkshire goes up 20% in the next 14 months, my calls will go up by more than 100%. But if I had bought the $70 calls instead, for about $10 more, they would lose less if Berkshire drops, and make less is it goes up. So the amount of leverage must depend in some way according to the distance between the strike price and the share price.

Does anyone know of any way of assessing this leverage and quantifying it, and how leveraged a portfolio is overall?

Regards, DTM

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Author: Wotdabny Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195707 of 211757
Subject: Re: BRK Leaps: Date: 11/9/2012 8:59 PM
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As far as quantifying the leverage on options:

It will tend toward a maximum, particularly as expiration nears, of this simple formula from the time of purchase: Stock price divided by option price. Whenever I price options to see which offer more potential/value, I look at this simple ratio. If I am not mistaken, this is what is meant in options speak by "leverage," or "delta." So if the stock is trading at $50 and I buy a $5 call option, my maximum leverage is 10, meaning that if the stock moves up 3% one day, the option could move up by as much as 10 times that, or 30%. This works both ways: The options can lose 30% just as quickly. Options that offer 10 times leverage do not often pay off; only big, unexpected up moves make that happen -- but 4 times leverage or a little better happens all the time, particularly when the market and the stock is not very volatile, and where those options have some activity/liquidity. Oh, and provided you are shopping for OTM options, but that's my preference. ITM may have different characteristics, but I'm not as familiar with them -- someone help clarify here, if you would, please.

This leverage might start out more modestly, and build toward its maximum. The rate at which it does so is called, if memory serves, "gamma." Whatever it's called, it is essential to have a feel for how it works to craft an options strategy that works for you. I spent a lot of time watching hypothetical portfolios, with a given stock and various options, to develop a sense for this. This was important for me. Note that this can be remarkably different in character in different market conditions, and I'm not just talking about fast markets, which are not merely different, but quite treacherous. Let's just say this: Limit orders only. Seriously.

When things go well, you will notice that as the stock (and gamma) goes up, the gain of the call accelerates. Just remember that works both up and down: The asymmetry of returns. It's what makes options worth learning about. Along the way you'll wish you had done things differently. A lot. You'll wish you had bought a lot more. You'll wish you had bought a lot less. Every move in the market that ever got your attention now has leverage -- discipline is core.

I have owned various LEAPS calls over various holding periods. Often, both gains and losses are around 3-5 times or so the percentage move in the underlying stock. I began, and sometimes still use, a strategy I learned from the legendary Sparfarkle of buying calls 18 months out, around 10% OTM, held for 12 months, sold with six months remaining. Here, a 20% gain in the underlying stock will often be something like an 80% gain in the call; turn those numbers to negatives when the stock declines. To me it is a little weird how well long calls pay; I have never seen less than about 3 times the percentage gain on a rising stock, but I have seen much more, including over 7 times this year, because the underlying stock was soaring, and that pushed leverage up toward its maximum potential quickly. What you don't want when buying calls is a stock that goes nowhere -- but that too can be tolerated if the options are rolled with months to go, keeping most of their value, over and over, until one day it climbs up quite quickly, making a killing. This is more tolerable with ITM options, naturally, but again, not my area of expertise.

That's one way to do it, anyway. But as always, it can all go to zero. Don't forget that.

Wot

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195719 of 211757
Subject: Re: BRK Leaps: Date: 11/10/2012 8:16 AM
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Buying calls has a risk I am not sure is clear thus far in this thread:
Berkshire's stock price could be cut in half, along with the rest of
the market, and stay there past your expiration date, only to recover
fully and a whole lot more at some point down the line. Your call options: Worthless.


Nice post. But I wouldn't consider this specific point a big risk.
My $45 BRK call options will expire worthless? It could happen, but it seems unlikely in the extreme.
Even an ending price under $75 seems rather unlikely, though it's in the realm of possibility.

I buy call options with the intent of having the money (if need be) to exercise
them at expiry or another viable strategy to stay in the position till the price is acceptable.

Berkshire's price is below strike when the calls expire?
Then it's cheaper to buy the stock then it would have been to exercise, so do that.
You're better off having done this than buying the stock to begin with.

The price is so low that you still want the position, but not so
low that your calls are worthless? Exercise them, or roll them out
to approximately the same options expiring much later.
I'd generally roll out, but you can't know 100% for sure that appropriate
low-strike long dated options will still be listed when the time comes.
It's also possible that interest rates will be 20% and it will be unfeasible.
It's only because of these two rather rare risks that one has to have a
plan for coming up with the money to exercise them, just in case.
My central planning expectation for any call I buy is a four year hold:
LEAPS with two years to run, rolled forward once.

e.g., you might look at IBM Jan 2015 $140 calls at $61. Just before
expiration, you'll probably be able to roll them to Jan 2017 for a
premium of under $15 extra, so total cost probably under $76.
Breakeven is with IBM trading at $216 or better, not far from its price last month.
Barring another global financial crisis I think a central estimate of
the share price in 2017 would be $275 or more, a doubling of the cash
committed and at risk during the option-holding period.

The situation you mention is a serious concern for "gambling" out of the money or
at the money options, but not so much for "investment grade" deep in the money options
where the bulk of the cost is in-the-money value and the time value erosion is negligible.
They don't offer much leverage, but you don't want or need much—a tiny bit goes a long way.
I normally lean towards the deepest in the money, longest-dated call options I can find.

Leverage in investing is a good thing if and only if you meet five criteria:
- the underlying asset is sufficiently safe and sufficiently reliably not falling in value
- the price/value ratio is attractive enough at the time of entering the position to offer a good margin of safety
- the cost of the leverage is very low and will remain so
- the loan can't be called
- the loan is long term or guaranteed to be renewable in some way.

IMO buying deep in the money long dated call options on Berkshire now meets four and a
half of those five points, so it's almost a good enough idea to count as prudent investing.
The "renewability" is probable but not guaranteed, so either you have to
class it as speculation, or have a contingency plan for coming up with the money to exercise,
or be willing to sell at a low market price if that should happen.
Since the latter was the beginning assumption at the start of the thread,
it's quite likely an improvement over a willy-nilly regular liquidation plan
which is guaranteed to be selling during any period of very low market prices.

Jim

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Author: hclasvegas Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195720 of 211757
Subject: Re: BRK Leaps: Date: 11/10/2012 8:54 AM
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thanks, but WHO is selling those calls so cheap and why ? Anyone have any idea ? I'm long the stock but i wouldnt sell calls out that far so cheap, no way.

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Author: spirach2 Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195725 of 211757
Subject: Re: BRK Leaps: Date: 11/10/2012 6:29 PM
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Yep, that's definitely a tricky call.

Personally, I thought they were cheap enough the other day (in low $17's) to merit buying a few more, and apparently got cheap enough yesterday morning (stock dropped into $83's, and I'm assuming the LEAPS could be had for low $16's at that point) that I would gladly have bought a bunch more, and foregone next week's potential... except that the Nor'Easter knocked out all my communications (for the third time in the last two weeks), and made it impossible for me to monitor and take advantage yesterday.

I hope they get even cheaper in the near future, or I'm gonna feel like that storm --and the Medieval communications infrastructure around here-- may have cost me a lot of money (and it's already cost me a lot of money as it is).

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Author: Wotdabny Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195726 of 211757
Subject: Re: BRK Leaps: Date: 11/10/2012 9:38 PM
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Nice post. But I wouldn't consider this specific point a big risk.
My $45 BRK call options will expire worthless? It could happen, but it seems unlikely in the extreme.
Even an ending price under $75 seems rather unlikely, though it's in the realm of possibility.


Risk: This is one of the crucial definitions, isn't it? I mentioned the importance of keeping one's portfolio balanced, specifically to keep risk to acceptable levels. Why? Well, what happens if one doesn't?

The fact is that $45 BRK calls will almost certainly not expire worthless. And they offer some leverage advantages, at least potentially, over the stock, with mostly minimal risk of loss. It's a nice way to make more money, over the long term, than holding the stock. What could go wrong?

Well, "almost certainly" does not equal "certainly"; sooner or later, the nearly impossible will happen. If I had a portfolio made entirely of just such BRK calls, inevitably the value of that portfolio would one day become zero. Almost but not quite zero probability events happen every so often, and more to the point, with greater frequency than they are expected. Nassim Taleb famously made his fortune by betting on almost impossible outcomes, as he details in his books. He was only right three times, wrong countless other times, for years. He could not predict (by his definition, no one can) black swan events, but he knew they would happen, sooner or later. So he, quite uniquely, decided he would set things up to profit from them.

What I have learned, a bit, is how to profit from investing while also protecting my portfolio from destruction. Buying long, deep ITM as opposed to 10% OTM changes the risk of losing that entire investment quite favorably, and enormously so -- but it does not reduce that risk to zero. Having most of one's portfolio in ITM options will one day cause that portfolio to lose most of its value. This may be acceptable -- if the extra returns are worth it. Are they? I haven't played with that question, but it seems worth looking into, using daily closing stock prices over long periods. And how does that improve with timing mechanisms, such as Jim's 99-day rule? What sort of rolling and rebalancing mechanisms are best? What sort of proportions of the portfolio? And how does all of this compare with a smaller proportion of the portfolio in OTM options? Could that be even less risky? These are questions worth considering before buying any option position, otherwise, how does one decide what to buy, when and what price, when to sell, when to buy more? If you don't know, you are opening yourself to unknown risks, a particularly poor sort of gambling, I would say.

This is one of the defining things about options that makes them endlessly fascinating and intimidating: You can do just about anything with them. And we're still just talking about the simplest possible options strategy: Buying calls. Yet, the strike, the date, the portion of the portfolio, the rebalancing method, the underlying stock you've picked: There's a lot going on, and many, many ways of winning and losing.

Any thoughts regarding the questions raised thus far? Or should this discussion move to another board?

Wot

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Author: Umm Big gold star, 5000 posts Top Recommended Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195736 of 211757
Subject: Re: BRK Leaps: Date: 11/11/2012 3:48 PM
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"Nice post. But I wouldn't consider this specific point a big risk.
My $45 BRK call options will expire worthless? It could happen, but it seems unlikely in the extreme.
Even an ending price under $75 seems rather unlikely, though it's in the realm of possibility."


What happens to options when the company declares some sort of special dividend that drastically changes the composition of the company underlying the option?

As an extreme example, for whatever reason, BRK decided to declare a special dividend to shareholders. This special dividend will be a new ticker that holds all of the insurance and operating companies, as well as all of the investments. The only assets remaining under the old BRK ticker is the $40 billion in cash. What happens to the outstanding BRK option prices?

A more realistic, real world example would be when COP did a special dividend of their PSX unit.

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Author: spirach2 Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195742 of 211757
Subject: Re: BRK Leaps: Date: 11/11/2012 11:58 PM
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Read this discussion:

http://boards.fool.com/leaps-question-29951763.aspx

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195774 of 211757
Subject: Re: BRK Leaps: Date: 11/12/2012 3:21 PM
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The fact is that $45 BRK calls will almost certainly not expire worthless.
...
"almost certainly" does not equal "certainly"; sooner or later, the nearly impossible will happen.


No argument with what you say, just to re-emphasize that calls make sense
only if you have a strategy for lengthening the holding period as necessary.
Roll 'em, or exercise 'em, or sell 'em and buy stock instead.
Making a bet that the price will hit intrinsic value is fine, but making
a bet that it will be rational within a shortish fixed time frame is not prudent.
Provided you have a way to extend the time frame, the "worthless" calls
aren't a problem...just keep the position till the price recovers,
either with the stock or calls or whatever.
With this proviso (and only with this proviso), there isn't any risk of
wipe-out provided the firm is viable and the financial system survives.
Not merely a remote risk, but a zero risk.

Besides, it's nice to note out that in the even that Berkshire's price falls below
a deep ITM strike by expiry, you're better off than if you had bought the shares.
This is an extremely unlikely outcome, we both agree, but it's not a bad one.
If you buy $50 calls for $38 and the price goes to $40, take your loss of $38
and buy the shares at $40, net cost per share and breakeven is $78.
Conversely if you buy the shares today at $85 and the price goes to $40,
you have the same number of shares but your net cost per share and breakeven is $85: worse.
Again, this makes sense only if you have a strategy to lengthen investment horizon
beyond the expiration date: money to switch to a long stock position, in this case.

For any long stock or long-equivalent option position, you should be
prepared for the investment horizon to be at least 5 years.
A single call with a single term isn't an investment, it's a pure gamble.
But I view my investment in Berkshire as a multi-year thing, and it may
be any combination of methods at various times along the way.
I've had A shares, old B shares, new B shares, single stock futures,
short puts (ITM and OTM), and long calls (ITM and OTM).
If I've missed anything, somebody drop me a line!

Jim

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Author: Umm Big gold star, 5000 posts Top Recommended Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195782 of 211757
Subject: Re: BRK Leaps: Date: 11/12/2012 10:59 PM
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"Read this discussion:

http://boards.fool.com/leaps-question-29951763.aspx"


That discussion was informative and partially answered the question when the special dividend is cash. What about when the special dividend in something that is not cash (such as spinning a division or subsidiary off to it's shareholders)? Non-cash transactions are much harder to value and come up with a concrete amount to lower the value of options contracts by.

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195815 of 211757
Subject: Re: BRK Leaps: Date: 11/13/2012 4:27 PM
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What about when the special dividend in something that is not cash (such as spinning a division or subsidiary off to it's shareholders)?
Non-cash transactions are much harder to value...


Spinoffs are subject to an adjustment as well.
For example, the spinoff from Sears last year of Orchard Supply caused all outstanding options to be adjusted.
If there isn't any obvious cash value, they make the contract deliverable "XXX in cash plus YYY shares of the spinoff company's shares".
All in all, the system is pretty fair.

The distinction is generally what's "mostly predictable" (regular dividends = no adjustment) versus what's out of the blue.
The main variance is between what the current run-rate of regular dividends is,
what the market consensus is of future regular dividends, and how reality turns out.
These are all generally very close, but the risk is generally limited to guessing
that the firm won't have regular dividends and it introduces them or vice versa.

Jim

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195831 of 211757
Subject: Re: BRK Leaps: Date: 11/14/2012 10:20 AM
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What do you suppose the '15's would trade at if they were available at that same moment?
(Let's stick with the $70's, for the sake of simplicity.)
...
It will probably work out to an interest rate a little under 3%.
So, for the $70s, I'd guess around $1.75 to $2.10 more.
...
It'll be fun to see how close you were.


At the moment the bid/ask on the Jan 214 $75s is a very wide $13.3/16
The bid/ask on the new Jan 2015 $75s is also quite wide at $15.25/18.35
Taking the difference of the bid/ask midpoints for the charge for the extra year, it's $2.15 more.
Paying $2.15 extra to borrow $75 for an extra year is like an interest rate of 2.87%.

Note that this "extra" is smaller than the bid/ask gap.
It's important to make sure you don't roll these things too often!
Better to do it once every two years than once a year.

Jim

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Author: Umm Big gold star, 5000 posts Top Recommended Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195842 of 211757
Subject: Re: BRK Leaps: Date: 11/14/2012 1:16 PM
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"If there isn't any obvious cash value, they make the contract deliverable "XXX in cash plus YYY shares of the spinoff company's shares".
All in all, the system is pretty fair."


Thank you. This makes sense and does seem pretty fair.

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195918 of 211757
Subject: Re: BRK Leaps: Date: 11/17/2012 12:40 PM
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FWIW
I bought some Jan 2015 $65 calls for $24.39.
Net entry price $89.39 = $134085 in about 2.2 years.
The stock price was in the 85.14-85.19 range at the time, let's say $85.16.
So, I'm paying $4.23 more per share htan I would have simply bying the shares today.
In return, I don't have to cough up the other $65 for 2.167 years.
So that's like an uncallable loan for 2.95%/year interest. I can live with that.

Back of the envelope:
Book value was $111718 at end Q3 this year.
Up to end 2014 that's 9 quarters.
Let's say 2.25 years at 6%/year book value growth or book ~$127368 around the time the calls expire.
Let's say price/book is still low, at its "squishy floor" of 1.13x book or ~$143926.
That would give a 27% profit on the calls = 11.5%/year compounded.
As a wild guess, I'd say that there is only a <=20% chance of an outcome worse than that.
If the price is still crummy, I kick the can down the road: exercise
the calls, roll them, or buy the stock, whichever is cheapest.

To the optimistic side, let's say the stock is trading at a fairly full valuation level of 1.55x book = $197421.
I estimate maybe a 20% chance of that happening.
That would give a profit of 273% on the calls = 58%/year compounded.

As mentioned, this makes sense only if you have a strategy for
lengthening the time horizon beyond the expiry date if needed.
That basically means having a way to cough up the money to exercise them, just in case.
Plus, of course, you have to have something else safe and useful
to do with the $65 you're not plunking down right away.

Jim

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Author: LONGREITS Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195920 of 211757
Subject: Re: BRK Leaps: Date: 11/17/2012 1:11 PM
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Perhaps 50% ITM BRK calls, 50% LUK common would pay off nicely. One, or both, highly likely to at least double from this level. The highly diversified two security portfolio is likely to pay off well - unless it doesn't. I dream about the potential returns but don't have the guts - or intelligence or lack thereof - to actually go through with it. So, 2/3 BRK, 1/3 LUK I sit.

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Author: GanznSchmuck One star, 50 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195921 of 211757
Subject: Re: BRK Leaps: Date: 11/17/2012 3:21 PM
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Plus, of course, you have to have something else safe and useful
to do with the $65 you're not plunking down right away.


Well... what about buying some BRK!

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195937 of 211757
Subject: Re: BRK Leaps: Date: 11/18/2012 8:07 AM
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Plus, of course, you have to have something else safe and useful
to do with the $65 you're not plunking down right away.
...
Well... what about buying some BRK!


Tempting, so tempting, and it would probably come out OK, but probably not good idea.
There is no good reason to believe that a two year holding in Berkshire
or any other stock will be a profitable proposition.
For equities you have to have an investment horizon longer than that.

Jim

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 201711 of 211757
Subject: Re: BRK Leaps: Date: 5/14/2013 12:25 PM
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Date: 11/17/2012
FWIW
I bought some Jan 2015 $65 calls for $24.39.
Net entry price $89.39 = $134085 in about 2.2 years....


This has been a very nice little trade.
The price has now doubled in six months.
I bought, err, rather a lot of these.

I'm shopping for a new car.

Jim

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Author: physdude One star, 50 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 201714 of 211757
Subject: Re: BRK Leaps: Date: 5/14/2013 2:26 PM
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Indeed. Thanks for another great suggestion from you, Jim!

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Author: calguy489 One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 201715 of 211757
Subject: Re: BRK Leaps: Date: 5/14/2013 3:45 PM
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Great trade!

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Author: knighttof3 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 201720 of 211757
Subject: Re: BRK Leaps: Date: 5/14/2013 7:20 PM
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I'm shopping for a new car.

Jim


Buy a Tesla :-)

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 201724 of 211757
Subject: Re: BRK Leaps: Date: 5/14/2013 8:47 PM
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I'm shopping for a new car.
Jim
Buy a Tesla :-)


I've looked at 'em quite seriously!
Sadly, since they discontinued the Roadster* production the prices haven't weakened.

I've been looking lustfully at the pretty pictures of a gently used Alfa 8C Competizione Spider.
http://upload.wikimedia.org/wikipedia/commons/thumb/a/a2/Alf...
Hey, a guy can dream.

Jim

* as far as I can tell the Model S has no relevance outside the US--it's a foot too wide.

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 201725 of 211757
Subject: Re: BRK Leaps: Date: 5/14/2013 8:50 PM
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Great trade!

Yeah, but here's my deep dark secret: it's not a trade.
I'm planning on keeping them, or at least almost all of them.
I'll roll the options as long as I can.
If I have a windfall I'll probably switch back to stock.

Jim

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Author: spirach2 Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 201730 of 211757
Subject: Re: BRK Leaps: Date: 5/15/2013 12:30 AM
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I'm sure my investment was much smaller than Jim's, but I acquired a nice-sized pile of Jan '14 70s in the spring of '12, at prices between 16 and 18 bucks.
Also added a little in November, in the post-Sandy slide, in the $17's.

They're now up about 150%.

(Was ready to buy a lot more if they dropped back into the $16's, and they did... but a second round of post-Sandy power failures put the kibosh on my opportunity. That storm --and PSEG's incompetence-- cost me a lot of money.)

Anyway, that trade has worked out extremely well.

Thanks to Longreits, whose post alerted me that the '14s were about to be issued.

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Author: spirach2 Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 201731 of 211757
Subject: Re: BRK Leaps: Date: 5/15/2013 12:38 AM
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Oh, and additional, indirect, thanks to the Loudmouth from Las Vegas, who helped cement my decision to go with that trade by ridiculing it, suggesting that those of us discussing it were 'odd-lot pikers' too dumb to realize that the 'big boys on the other side of the trade' undoubtedly knew all kinds of stuff we weren't privy to.

I guess maybe the 'big boys' aren't as smart as he thinks they are.

That guy makes one hell of a contrary indicator.

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