What Does Leverage Mean for Options Trading?

Leveraged Options Trading Ticker Sign

In the mechanical world, a lever is a tool that allows you to amplify the amount of force you exert without expending extra effort. In the same manner, options afford traders the benefit of leverage -- that is, options allow you to amplify your potential investing returns by minimizing the amount of capital you commit to the trade upfront.

A call or put option is a derivative asset, typically based on 100 shares of the underlying stock. So, when you buy a call option, you're not buying 100 shares directly; you're simply buying a contract that affords you control of 100 shares of that stock. As such, option contracts are cheaper to buy than the same number of shares from which they derive their value.

As it pertains to options, leverage is probably best explained through an example:

With XYZ trading at $25 per share, it would cost $2,500 to buy 100 shares.

Meanwhile, a 25-strike call option on XYZ expiring in one month is asked at 0.75, which means a trader would pay $75 (0.75 x 100 shares) to buy one contract.

If XYZ rises to $30 per share by options expiration, 100 shares of stock would be worth $3,000. A trader who bought in at $25 could sell all 100 shares, and net a profit of $500 in the process ($3,000 - $2,500).

On a move up to $30, that 25-strike call option would carry 5 points of intrinsic value at expiration. After multiplying the ask price of 5.00 by 100 shares per contract, the option could be sold for $500. Since the contract was initially purchased for $75, that's a gain of $425.

In this example, the call-buying strategy actually put $75 less profit in the trader's pocket.

However, consider the return on investment: The stock trader netted $500, which is a gain of just 20% on the $2,500 he shelled out in the first place. On the other hand, the option buyer raked in $425, which represents a profit of 567% on his initial investment of $75.

In other words, options allow you the ability to capitalize on the same directional moves that benefit stock holders, but they require a proportionally smaller investment on the front end. Since option players are able to collect profits many times greater than the amount dedicated to the trade, it's safe to say the benefit of leverage is a major draw for veteran and aspiring options traders alike.

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