Leverage is one of the biggest advantages of trading options.
By leverage, I mean that when a stock price goes up or down, options on the stock can change by a larger percentage, thus leveraging or magnifying your return on investment.
For example, say a stock is trading for $100, and a $100 call option on the stock is trading for $5. If the stock closes at $115 at expiration (a 15% move) the option will be worth $15, a 200% change.
You spent $5 for an option that rose to a value of $15. This means that if you sell, you will have netted $10 in profit per option.
The option trader in this example has leveraged the return by a factor of 20.
In other words, for every 100 shares the stock investor buys ($10,000 worth), the option buyer can buy 20 contracts ($10,000 / $500 per option = 20).
If the stock trader invested $10,000, it would grow by 15% to a value of $10,000 * (1.15) = $11,500, or a profit of $1,500. The option trader’s account will be worth $10,000 x 200% increase= $30,000.
If we multiply the profit of the stock trader, $1,500, by 20, we end up with $30,000, which is the value of the option trader’s position.
In this example, the option trader’s total account value will always be worth 20 times the stock trader’s profit, assuming the $100 call option has intrinsic value, i.e. the stock is trading for at least $100 a share.
How to ‘Gear’ up for Bigger Returns
The leverage described above is known as gearing, and is actually just an old British term that means leverage.
The two most common definitions are (1) The stock price divided by the option price or (2) The strike price, divided by the option price.
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Using definition 1, you simply divide the stock price by the option price:
Gearing = Stock price / option price
In our example, the stock was $100 and the option was $5, so $100/$5 = 20.
This is just another way of saying the stock trader needed 20 times as much capital to control the same number of shares.
Using the second definition, gearing would be:
Gearing = Strike price / option price
This gives the same answer of 20. But what if the strike was $110? Now the gearing is $110/$5 = 22.
In this way, the option trader may pay $110 for the stock but is controlling it for $5, so is leveraged by a factor of 22.
Another term you may encounter is omega. Omega measures the relative percentage changes between the stock and the option — called an elasticity measure.
For instance, assume the call in the above example has a delta of 0.5. With the stock at $100 and the call at $5, if the stock moves $1 (a 1% move) the call will move roughly one half-point for a 10% increase.
Because the option moved 10 times faster relative to the stock (10% compared to 1%), the elasticity, or omega, is 10.
Omega = Delta / option price
1 / stock price
This can also be written as (stock price / option price) * delta.
Using the above formula in our example, we have a $100 stock price divided by a $5 call option with delta of 0.5, so:
$100/$5 * 1/2 = 10
Regardless of which measure you use, the higher the leverage, the more speculative the position.
How Much Leverage is Right for You?
Option traders should invest in the equivalent share amount as they would a stock purchase, not the equivalent dollar amount.
For example, the trader above invested $10,000 on 100 shares. If he elected to use the call option instead, it is advisable to purchase one contract representing 100 shares as opposed to buying $10,000 worth of the $5 option or 20 contracts.
The reason is due to the leverage. If a trader is not used to dealing in 2,000-share-lot orders (20 contracts), then the leverage and losses can add up alarmingly fast.
By using share equivalents, the stock and option positions will behave similarly and not leave the trader with unacceptable losses.
Leverage can be a VERY powerful — and also a VERY destructive — tool. Understanding the various ways to measure leverage will make you more comfortable with your option picks and strategies!
Watching Your Chickens,