Leverage - article by High Quality Articles

Options - Leverage

Since they expire the investor has to make a choice within a relatively short time frame. (Even LEAPs - Long-term Equity AnticiPation Securities - are generally written for no more than two years.)

Since, as derivatives, they have no inherent worth they can move in sharply different directions from the underlying asset. One can short a stock or go long, but once bought the value of the shares is known. Even after you purchase options, their value is often solely 'time value', they're worth money only because some event may occur in the future, such as a rise in the price of the asset.

Nevertheless, options are actively traded in large volumes. What do options traders know that many investors have yet to learn? One thing they know is the value of leverage.

Imagine a teeter-totter in a children's playground. A small child can lift an adult into the air, provided the pivot point under the horizontal plank is placed appropriately. That force 'multiplier effect' has an analogy in financial markets.

For generally around 5% of the price of the underlying asset an investor can control - even though they do not own - 100% of a quantity of stock.

Suppose MSFT (Microsoft) is trading at $28 on a given day. A trader who anticipates that the price will rise can purchase one options call contract which confers the right to buy 100 shares.

That call option, with say an expiration date in three months time with a strike price of $30, will cost somewhere around $3. (The 'strike price' is the pre-set price at which the shares have to be bought if the option is exercised.)

If the shares were purchased outright, even at the lower $28 price, the investment would cost $28 x 100 shares = $2,800 (plus commission). Buying a call instead costs $3 x 100 shares = $300 (plus commission). That ratio, $2800/$300 = 9.33 is the 'multiplier effect' known as leverage.

Conversely, you could invest the same $2,800 dollars by simply buying more contracts to control more shares. That's another form of leverage. Controlling more shares for the same money is equivalent to controlling the same shares for less money.

How is this an advantage?

The answer is that, though the investor takes on the risk of losing the premium (the cost of the contract), that multiplier effect operates on profits as it does on costs. Since the investor controls more shares, profits are potentially higher.

Suppose MSFT rises above the strike price ($30) to $35. If you purchased the shares directly at $28 per share, with $300 to invest, you could only purchase 10 shares. (10.7 if you have a plan that allows fractional share investing, but part of that will go for a commission.)

Your profit on the trade would be (ignoring commissions) 10 x ($35 - $28) = $70. If instead you had purchased an option on 100 shares, your profit would be (($35 - $30) - $3) x 100) = $200.

You had to pay more per share, and the premium reduced your profits, but you controlled many more shares. The net is still considerably higher.

Keep in mind, though, that it works on losses the same way. If MSFT had fallen in price, but you were obligated to a strike price of $30, exercising the option would cost you by that same factor. Under those circumstances, traders simply let the option 'expire worthless', limiting the loss to the amount of the premium.

The multiplier effect - leverage - is one major factor in the value of options.

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