What is Leverage and What Does it Mean for Options Traders?

Founder and CEO Bernie Schaeffer explains the power of leverage

    facebook twitter linkedin


    To understand leverage in options trading, we need to look at how options contracts work briefly. An option gives the owner the right (but not the obligation) to buy or sell an asset at a specified price on or before a specified date. This right is typically referred to as a call or put, depending on whether they have the right to buy or sell. The price of the option contract is known as the premium. The owner of an option can execute their right by either buying or selling the underlying asset.

    Now that we are refreshed on the general concept, leverage is easily one of the most important concepts to understand as a new options trader. When you are trading options, you can increase your buying power by using leverage. This means that you can effectively control more prominent positions with less capital, and when the trade works in your favor, the returns can be substantial.

    This article takes a look at the concept of leverage in options trading, calculating leverage, and its relationship to risk and returns.

    The Power of Leverage in Options Trading

    Leverage is a powerful tool that investors and traders use to magnify the power of their money. In options trading, leverage refers to the ability of options contracts to multiply the power of your capital. Options have a leverage factor associated with them. This factor is applied to your money when determining how many contracts you can purchase, and it increases as the price of the contract increases. Traders often use the term "multiplier" or "leverage factor." 

    This is the crucial advantage that options offer over other types of financial instruments, and it's why they're often used by investors who don't have large amounts of capital to invest.

    Investors who trade stocks, for example, have to have enough money in their accounts to cover the total cost of buying shares before they can take a position. With options, though, you can pay a relatively small amount of money for an option contract that gives you the right – but not the obligation – to buy or sell shares at a specific price point in the future. With only a fraction of the money required to purchase or sell the actual claims, you can do so.

    If you have $1,000 in your trading account, $100 worth of options contracts bought on a particular stock allows you to control the $10,000 value of stocks. In practical terms, you will earn more from the same gains in price from the underlying stocks you are trading. This leverage can also be used to protect profits and make them.

    Put, using leverage in options trading means using cash to buy options, which in turn gives you the right (but not the obligation) to buy or sell an underlying asset for a given price by a given date. The goal of options traders is to make money on the difference between the price at which they can sell their option and the price they can buy it.

    Understanding How Leverage Is Calculated in Options Trading

    You're generally limited to a 50:1 leverage ratio when you trade stocks. So, for example, if you buy a stock for $50, you can only sell it short for $2.50. On the other hand, options contracts do not have a leverage cap built-in. So it's possible to use the leverage of up to 500:1 with options.

    Call options allow you to leverage the value of the underlying security by 100 times (1:100 leverage). For example, buying one call option contract on a stock trading at $50 will cost you $500. However, if the stock price rises to $60, then your call option will be worth $5,000 - meaning your initial investment of $500 has now become a profit of $4,500 ($5,000 - $500 = $4,500). As you can see, this is effectively giving you a 500% return on your investment for only a 50% increase in price.

    When calculating the amount of leverage, the way it works is if you have $10,000 in your trading account and you want to buy ten calls that are each valued at $100, then the leverage factor is ten because each contract costs $1,000. So if the underlying asset were to move in your favor by $1 per share, then your profit would be 100 x 1 x 10 = $1,000 for just a $10,000 investment. This gives you an effective return of 100% on your initial investment. As you would expect, though, leverage also works in reverse and can amplify losses as well as gains.

    This calculation does not consider any fees associated with trading options or commissions incurred when buying or selling shares of stock regularly. The numbers also ignore the effects of compounding interest or loss overtime on your capital investment. However, it does provide a general sense of the leverage calculation about trading options.

    Leverage and Risk in Options Trading

    Trading is always subject to risks, including the possible loss of the funds you use for such investments. Therefore, before buying or selling an option, investors must decide whether a particular option is suitable for their needs. The decision requires an evaluation of the investor's financial position and risk tolerance. Investors must also consider the investment objectives, risks and charges, and expenses associated with a particular investment product (including any investment product that may be offered as part of a 401(k) plan or other employee benefits) before making an investment decision.

    Options trading is also subject to the risk that stock prices could change dramatically over short periods. This is because the value of stocks and options can rise or fall rapidly based on factors affecting individual companies or industries or based on overall market movements.

    The use of leverage is an aspect of options trading that can increase investment gains if the underlying security moves in a favorable direction. However, leverage can also amplify losses if it moves unfavorably. Options also offer their owners a preset, designated risk. However, if the trader's options expire with zero value, this loss can be the total premium paid for the option. As a result, an uncovered call option writer may face unlimited risk. This can happen if they hold out for a significant profit on a trade that goes wrong.

    Begin the New Year With Schaeffer's 7 FREE 2022 Stock Picks!

    1640638248

     




     
    Special Offers from Schaeffer's Trading Partners