What Is Leverage?
Leverage has two basic definitions applicable to options trading. The first defines leverage as the use of the same amount of money to capture a larger position. This is the definition that gets investors into the most trouble. A dollar invested in a stock and the same dollar invested in an option do not equate to the same risk.
The second definition characterizes leverage as maintaining the same sized position, but spending less money doing so. This is the definition of leverage that a consistently successful trader or investor incorporates into his or her frame of reference.
Interpreting the Numbers
Consider the following example. You're planning to invest $10,000 in a $50 stock but are tempted to buy $10 options contracts as an alternative. After all, investing $10,000 in a $10 option allows you to buy 10 contracts (one contract is worth one hundred shares of stock) and control 1,000 shares. Meanwhile, $10,000 in a $50 stock will only buy 200 shares.
In this example, the options trade has more risk than the stock trade. With the stock trade, your entire investment can be lost but only with an improbable price movement from $50 to $0. However, you stand to lose your entire investment in the options trade if the stock simply drops to the strike price. So, if the option strike price is $40 (an in-the-money option), the stock only needs to drop below $40 by expiration for the investment to be lost, even though its just a 20% decline.
Clearly, there is a huge risk disparity between owning the same dollar amount of stocks and options. This risk disparity exists because the proper definition of leverage was applied incorrectly. To correct this misunderstanding, let's examine two ways to balance risk disparity while keeping the positions equally profitable.
Conventional Risk Calculation
The first method to balance risk disparity is the standard and most popular way. Let's go back to our example to see how this works:
If you were going to invest $10,000 in a $50 stock, you would receive 200 shares. Instead of purchasing the 200 shares, you could also buy two call option contracts. By purchasing the options, you spend less money but still control the same number of shares. In other words, the number of options is determined by the number of shares that could have been bought with the investment capital.
Say you decide to buy 1,000 shares of XYZ at $41.75 for a cost of $41,750. However, instead of purchasing the stock at $41.75, you can buy 10 call option contracts whose strike price is $30 (in-the-money) for $1,630 per contract. The options purchase will incur a total capital outlay of $16,300 for the 10 calls. This represents a total savings of $25,450, or about a 60% of what you would have paid buying the shares.
This $25,450 savings can be used in several ways. First, it can take advantage of other opportunities, providing you with greater diversification. Second, it can simply sit in a trading account and earn money market rates. The collection of interest can create what is known as a synthetic dividend. For example, if the $25,450 savings gains 2% interest annually in a money market account.during the option's life span, the account will gain $509 interest per year, equivalent to about $42 a month.
You are now, in a sense, collecting a dividend on a stock that may not pay one while also benefiting from the options position. Best of all, this can be accomplished using about one-third of the funds needed to purchase the stock outright.
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