Trader Q&A: Get More Bang For Your Buck With Leverage Ratios

Leverage ratios help option traders get the most for their money, according to Schaeffer's Senior V.P. of Research Todd Salamone

Jan 20, 2017 at 2:38 PM
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Leverage ratios can help option traders make the most out of every dollar invested, and determine how much of a profit a trade could potentially yield. The leverage ratio -- the leverage a trader gets on an option compared to a stock -- is essentially a quantified measure of "bang for the buck." Today, we turn to Schaeffer's Senior V.P. of Research Todd Salamone for more information on this valuable trading tool.

What is a leverage ratio?

TS: The leverage ratio is calculated by multiplying the stock price by the option's delta, and then dividing by the option price. It measures the percentage return you might expect from an option purchase, relative to the move in the underlying asset.

For example, if stock XYZ is currently trading at $100, and our XYZ option is priced at $10 with a delta of 0.8, the leverage ratio on the option will be 8.0 ([100/10] * 0.80). This tells investors that an investment on that XYZ option can yield eight times the profit as investing in the XYZ stock outright. Put more simply, investing $10,000 in XYZ will yield a $100 profit if the stock gains $1, while investing $10,000 in XYZ options will yield an $800 profit, if the stock gains $1.

Leverage Ratio Jan 20

How useful are leverage ratios in option trading? When is using a leverage ratio most or least useful?

TS: One purchases options in order to reduce their initial dollar outlay (exposure), relative to buying shares of a stock or exchange-traded fund (ETF). This is done while simultaneously putting the trader in a position for being able to reap a nice dollar reward for being correct about the underlying's movement. Therefore, a leverage ratio can be used to determine the multiple of the expected return on the option purchase, relative to the percentage move of the underlying.

Looking at the leverage ratio may be least useful when buying short-term, deep in-the-money or far-out-of-the-money options, since these options give you little leverage to begin with, given the high cost of the option relative to the underlying stock, or the delta of the options is so small that the option is insensitive to the movement of the stock.

Describe an "ideal" leverage ratio trade.

TS: The ideal leverage ratio trade will depend on the options that you typically play. If you're buying options that expire in a short time period, and are near the money, you might expect a return on the option that is 10 times or more the percentage move on the underlying. In other words, a 15% move on the underlying could produce a 150% profit on the option.

If you're buying more than a couple of months ahead of expiration, or are buying in-the-money options that tend to carry higher premiums, a leverage ratio of 5.0 might suffice. In the former scenario, you are more likely to experience total losses if you're wrong, versus in the latter scenario, you're more than likely able to capture at least some of the option's premium if you sell the option at expiration, or earlier.

Are there any recent successful examples that highlight why using a leverage ratio can work to a trader's advantage?

TS: In our Weekend Trader service, we recently closed a trade on General Motors Company (NYSE:GM) with a 100% gain. Going into the trade, GM had a leverage ratio of 8.4, and would need a stock move of just 11% in the underlying for the trade to double in value. By targeting a trade with such a high leverage ratio, we were able to double investment with minimal effort.

Are there any recent examples of when a leverage ratio prevented you from putting on a trade? 

TS: Yes, particularly in a situation where there is a known event, such as earnings. Often times, the option prices will be jacked up in anticipation that the underlying equity could make a sudden or unusual move. Such a move could work for you, or against you. If you aren't being rewarded appropriately for the risk you are taking, then you should pass on the trade. For instance, if a 10% move in your favor is only going to produce a 60% gain, and a 10% move against you is likely to result in a total loss, it is better to pass, given that the potential leverage doesn't justify the risk.

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