By: Wayne Duggan
One of the most appealing things about options for many stock traders is the ability to ramp up leverage to supercharge potential gains. Of course, leverage is a 2-way street and can put traders at risk of huge losses if they don’t fully understand the risks involved.
How Option Leverage Works
Essentially, an option contract allows traders to get more bang for their buck. Each option contract typically represents 100 shares of the underlying stock. The cost of options contracts is usually much lower than the price of the underlying stock, but option buyers still gain or lose based on the price changes of those underlying shares.
For example, an investor with $500 could only afford to buy 50 shares of a stock trading at $10 per share. If the stock gained 25% and climbed to $12.50, the investor would only generate $125 in profit.
That same trader could instead choose to purchase 500 call options for the same stock priced at $1 each with a strike price of $10. In that case, if the underlying stock gained 25%, the value of those call options would jump to $2.50, a 150% gain. By using the power of leverage, that call buyer turned a $125 stock trade profit into a $750 option trade profit.
Calculating an option contract’s leverage is fairly straightforward once you understand a variable called delta. The delta value of an option contract is the ratio of how much the price of the contract moves compared to the price of the underlying stock. For example, the price of an option contract that has a delta of 0.5 would move 50 cents for each $1 move in the price of the underlying stock.
If you know the delta of a contract, you can easily calculate the leverage of that contract using the following equation:
(delta value x price of underlying stock) / price of option contract = leverage
In the previous example of the $500 trade, assume the contracts had a delta value of 0.6. Here’s what the leverage calculation would look like:
Delta (0.6) x underlying stock price ($10) = 6
Divided by option price ($1) = 6
Therefore, these contracts have a leverage factor of 6, meaning you make 6 times as much of a profit buying the option contract than you would buying the underlying stock. That math checks out because the option trader earned $750 in profits, exactly 6 times as much as the $125 the stock trader earned.
Word Of Warning
Leverage can ramp up profits, but it can also ramp up losses just as quickly. In the example above, the option trader made an extra $625 in profits because the stock gained 25% by the option expiration date. However, if the $10 stock had gained 0% and stayed at exactly $10, the stock trader would still hold stock worth $500. The option trader, however, would be sitting on 500 call contracts that were completely worthless. In that scenario, leverage turned a break-even stock trade into a $500 option trade loss.
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