Understanding Options Leverage
The Smart Profits Report: Issue #103
Monday, April 19, 2004
Understanding Options Leverage - The Power of Leverage Is Bigger than You Think
By Karim Rahemtulla
Chairman, Mt. Vernon Research
At my last seminar in New Orleans, I talked at length about understanding options leverage - and afterwards fielded a good number of questions from the audience.
It was clear that a lot of investors didn’t really understand the concept, or how they even use it in their own investing.
More importantly, almost none of them understood how options offer a leverage tool with phenomenal strength to bring dramatic returns. After all, options are leverage. That’s their power. If you can control 1,000 shares of a stock for a dollar a share, why pay $50 a share? Leverage is how a lot of people have made a ton of money.
Leverage - Knowing More Than You Realize
Leverage is something you use every day - very likely without even knowing it. And I’m not just talking about prying the lids off paint cans with a screwdriver. Each time you buy something on credit, make a house payment or a car payment you are using financial leverage. You are giving yourself the ability to control something big, or own something very expensive, for a relatively small amount of money.
While a home may be worth $1 million, with today’s interest-only loans, you could actually live in it for just a few thousand dollars a month. That is leverage.
The same type of thinking applies to the options market. I hate to say that because most people use options just like they use their credit cards - with reckless abandon.
When you buy a put or a call, your goal is to make money, lots of it. But instead of buying the shares outright, you want to employ leverage by using an option. Let’s see what the allure actually is…
Now Enter The Options Player
Say you are bullish on Microsoft. You can buy 1,000 shares of Mr. Softie for $25,000 ($25 per share). Your target is $35 in 10 months. So, you stand to make $10K.
He takes the same $25,000 (humor me for this example) and buys 100 contracts of MSFT options (each contract is 100 shares, at, let’s say, $2.50 a share) with a 10-month expiration and a $25 strike price. When MSFT hits $35 in 10 months, his position will be worth $35 minus $25 minus $2.50… which comes to $7.50 per share.
So, at 7.50 per share he has tripled his investment, or made $50,000 in net profit from the $25,000 option investment. That is five times the $10,000 the stock trader made with the same money. That’s the good news.
The bad news is that this type of win only happens once every 10 or 20 times… unless you employ a strategy that can boost your odds.
So, now you know the lure of options, you might be considering calling your broker to begin to speculate using this powerful tool. Don’t do it… not yet anyway. There is much more good and bad to know about options, the options market and options brokers - all of which I’ll be covering in upcoming letters.
One last thought… if you are really insane, you could actually increase your leverage even more by buying options on margin. If that strategy interests you, make sure the gun under your mattress is not loaded…
Good trading,
Karim Rahemtulla
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Today’s Smart Profits Crib Sheet
- Visit our handy Smart Profits Glossary for detailed definitions of “options leverage,” “bid and ask,” or any other concept of options trading.
- Check out Smart Profits #262, by Lee Lowell, Options Leverage - How to Use Delta to Maximize Leverage.
Related Articles:
- Strike Prices - Increase Your Odds by 99%
- Options On ETFs - Increased Safety and Profit Potential
- Meet Bob… And a New Take on Leverage
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