Options Trading - Say hello to my good friend Leverage

Why do options offer any advantage over trading stocks? They’re riskier, since they expire within a certain amount of time and their values are more complicated to assess.

Because they expire on a given date, the investor has to make a choice within a relatively short time frame.  In my earlier post, I think this expiration can be viewed in a positive light as it forces one to get out of trades without relying on their emotions but, for the sake of this article, lets consider it a disadvantage as it forces you to make accurate price predictions over a given time and, we all know, that is difficult and sometimes impossible. All options expire and even the longest term options, called LEAPs (Long Term Equity AnticiPation Securities) generally expire within two years.

Because options, as derivatives, have no inherent worth,  they can move in sharply different directions from the underlying asset. One can short a stock or purchase a long position 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 on a playground.  A small child can lift an adult into the air, provided the pivot point is placed appropriately. That multiplying 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 allows the right to buy 100 shares of the underlying stock.

That call option, lets say with 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 ~$10 commission). Buying a call instead costs $3 x 100 shares = $300 (plus ~ $10 commission). That ratio, $2800/$300 = 9.33 is the effect known as leverage.

In another scenario, 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.

“Okay, I understand what you’re saying, but what is your point?” you say. 

How is this leverage 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 exponentially 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.

The stock’s price increased by $7 and your profit on the trade would be 10 x $7 = $70. If instead you had purchased an option on 100 shares, your profit would be (($35 - $30) - $3) x 100) = $200.  Remember, the option had a strike price of $30, so you only captured $5 of the gain, not the full $7 as you would have if you had bought the underlying stock.  The point is to look at the percentages of your return.  Making $70 on your $300 is, an impressive, 23% return, but making $200 on your $300 options purchase would have netted you a 67% return.

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.  You put your $300 completely on the line with options with a very real possibility of losing it all, but if you want to make a big play on a given stock and believe it will move dramatically in a given time period, options allow you to skyrocket your returns by giving you leverage. 

Trading on margin lets you leverage as well, but margin requires borrowing money which requires you to pay back the borrowed portion whether the stock went up or not (leading to the dreaded ‘margin call’), but with options, the amount you put in is the maximum amount you can lose.  If Microsoft went to zero, you’d still lose only your $300, but if Microsoft went to $40, you’d stand to gain $1000 on the $300 investment, more than tripling your investment.

Leverage can be your best ally in skyrocketing your returns, but it requires accuracy in predicting stock movements over a fixed time table and a much higher tolerance for risk (unless you use options for hedging techniques which I’ll address in a future article).  Definitely do your research before getting involved in options trading, but I encourage you to investigate as they can be an exciting and rewarding way to boost your returns.

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