by Ian Harvey
Financial leverage is one of the biggest benefits of trading options. Leverage is created by making your investments work harder for you to maximize profit. In other words, leveraging is creating potential for bigger gains using a smaller amount of capital.
Financial leverage is usually created by using other people’s money in an effort to maximize future profits. Mortgages are used to invest in real estate, and companies borrow money to expand operations. The benefit of the leverage comes from increased property value, or higher company revenue which raises the value of stockholders’ shares.
For the investor, however, buying options provides inherent financial leverage. Without needing to use borrowed capital, by investing in options, you can control a larger number of shares for the same initial investment, than if you purchased the shares themselves.
For example, if you wish to invest $1 000 you could purchase 10 shares of IMAX stock (hypothetically) valued at $100 per share. Alternatively, the option contracts may realistically be valued at $200 for lots of 100 shares ($2.00 per option). For your investment of $1 000, you could buy five options contracts, increasing your financial leverage by allowing you to control 500 shares instead of just 10.
If, during the option contract, the value of those shares rises substantially, you may wish to buy the shares that you have the right to buy, at the agreed price (strike price), which at that point is much lower than the market value. You can then resell those shares at market value, generating a profit on a much larger number of shares than the ones you would have purchased originally if you had bought the 10 shares with your $1 000. Obviously though, to execute this trade, you would need to have access to a lot more capital in order to purchase the shares that your options entitle you to buy, and be willing to take the risk of the market price suddenly dropping before you have the opportunity to resell your shares.
The best source of financial leverage in this investment, however, comes from the fact that the percentage increase on the option is proportionately higher than the increase of the underlying share. This leverage also comes without the risk of investing the much greater amounts of capital in order to buy and sell the shares that your options give you the right to buy.
In the hypothetical purchase mentioned previously, let’s say that the value of the shares increases from $100 per share, to $105 per share. If you bought those 10 shares, the profit that this would generate on your investment of $1 000 would be $50, or a 5% increase.
On the other hand, a reasonable estimate is that the value of the options you could have bought is an increase from $2.00 to $2.80 per option. For your 500 options, this generates an increase of $400, or 40%. This much higher potential increase is a way that trading options can effectively create leverage.
It is important to be aware though, that the potential loss is also higher. A loss of 5% value on shares could mean a 40% loss of value on the equivalent options.
Understanding financial leverage, the advantages and risks, is very important in trading options. With good trading strategies, using leverage can allow you to maximize your returns, while minimizing the risk.