Of all the advantages provided by options trading perhaps none is as coveted by the little guy as the ability to use leverage. When used properly leverage can allow traders to grow their portfolios quicker. However – and this is extremely important to note – its misuse has driven many reckless traders to the poorhouse.
Leverage is perhaps best illustrated with an example. Suppose you and I are both bullish on Microsoft. You buy 100 shares of stock at $41 while I buy a three-month 41 strike call option for $135. Over the next week, the stock rallies to $43 causing the call option to rise in value to $203. While the stock has climbed 5%, the option has surged in value by 50%. That is leverage. A small move in the stock resulted in a large move in the option contract.
The relative cheapness of options coupled with their ability to deliver higher percentage returns explains their mass appeal to individuals boasting smaller trading accounts.
Leverage isn’t all sunshine and lollipops, however. Often unseen by rookie traders is leverage’s ability to magnify losses. It’s a double-edged sword, you see. Just as a 5% rise in Microsoft stock generated a 50% gain in the call option, a 5% drop in the stock could have delivered a 50% loss in the call option.
One way to think of leverage is that it accentuates your skill level. If you’re a stock-picking rock star and your transition to using a more leveraged instrument like call options, you may see an acceleration in your accumulation of profits. On the other hand, if your stock-picking skills are lacking, using leverage will simply speed up your destruction.
Perhaps the riskiest thing you can do is place the same amount of money in a leveraged option trade (like buying call options) that you would have placed in a long stock trade. Using the aforementioned Microsoft example it would cost $4100 to purchase 100 shares of the stock. You do not want to take the entire $4100 and buy-up call options instead. Your risk of loss in the long call is much higher than the risk of loss in the long stock purchase. To lose 100% of your investment with the stock position requires the stock to fall all the way to zero. Had you plowed $4100 into the three-month 41 strike call, the stock would simply need to reside below $41 at expiration for you to lose ALL your money.
Keep these principles of leverage in mind as you embark on your option trading adventure.
- Jonas Taylor is a financial expert and experienced writer with a focus on finance news, accounting software, and related topics. He has a talent for explaining complex financial concepts in an accessible way and has published high-quality content in various publications. He is dedicated to delivering valuable information to readers, staying up-to-date with financial news and trends, and sharing his expertise with others.