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Options Trading - Benefits of Leverage

Aug 17, 2007
Options are riskier to trade than stocks. That's fairly well known. And we'll get into why.

Since options have an expiry date the investor has to make a choice within a relatively short time frame. This adds risk and complexity to the trading scenario.

Also, since options are derivatives, they have no inherent worth. Their value is determined by the value of the underlying security. They can move in sharply different directions from the underlying asset. One can short a stock or go long, but once bought the value of the shares is known. Even after you purchase options, their value is often solely 'time value', they're worth money only because some event may occur in the future, such as a rise in the price of the asset.

But they also offer significant advantages over stocks! And that's why they're so exciting to trade.

And one of the characteristics that make them so interesting to many investors is that a trader can make use of the power of leverage.

And the word "Leverage" is no accident. It comes from the word "Lever" . Think back to your Physics classes. You probably learnt how levers can help a small person lift a very large weight. By placing the pivot point at the right spot (close to the heavy object and far away from the person) the small person can lift up a much heavier object! The force the person exerts is "multiplied" by the lever.

Well this "multiplying" effect is exactly what leverage does in trading as well.

The basic idea is that an investor can control a very high valued asset for a much lower investment amount. e.g. An investor could control $2000 worth of a security with an investment of only $200.

Suppose INTC (Intel) is trading at $24 on a given day. A trader who anticipates that the price will rise can purchase one options call contract which confers the right to buy 100 shares.

That call option, with say an expiration date in three months time with a strike price of $26, will cost somewhere around $3. (The 'strike price' is the pre-set price at which the shares have to be bought if the option is exercised.)

If the shares were purchased outright, even at the lower $24 price, the investment would cost $24 x 100 shares = $2,400 (plus commission). But by buying the call option instead you invest $3 x 100 shares = $300 (plus commission) and control the same number of shares. That ratio, $2400/$300 = 8 is the "leverage". You have control of an asset that is worth 8 times more than what you've invested.

Why is leverage such an advantage?

The answer is that, though the investor takes on the risk of losing the premium (the cost of the contract), that multiplier effect operates on profits in just the same way as it did for the costs. A smaller movement in value of the overall assets controlled becomes a much larger movement in the smaller amount invested.

Suppose INTC rises above the strike price ($26) to $31. If you purchased the shares directly at $24 per share, with $300 to invest, you could only purchase 12 shares. (12.5 if you have a plan that allows fractional share investing, but part of that will go for a commission.)

Your profit on the trade would be (ignoring commissions) 12 x ($31 - $24) = $84. If instead you had purchased an option on 100 shares, your profit would be (($31 - $26) - $3) x 100) = $200.

You had to pay more per share, and the premium reduced your profits, but you controlled many more shares. The net is still considerably higher.

It's important to remember, though, that leverage also works on losses in the same way. If INTC had fallen in price, but you were obligated to a strike price of $26. So exercising the option would cost you by that same factor. Under those circumstances, traders simply let the option 'expire worthless', limiting the loss to the amount of the premium or 100% of your investment...

So treat leverage with respect. But when you have it working for you it can be a huge ally in helping you make tremendous profits trading!
About the Author
Richard Cochrane is an investor, trader and educator on stock and options trading, with a focus on day trading and swing trading strategies for investors. For more information on successful stocks and options trading techniques visit http://www.hotoptiontrades.com
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