Options Leverage
The Smart Profits Report: Issue #262
Tuesday, November 29, 2005
Options Leverage - How to Use Delta to Maximize Leverage
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
The best weapon in the financial world is leverage. Applying this principle allows you to control a large amount of goods with a very small investment. That’s the smartest way to use your money. While you’re saving dollars on one investment, you can use them to buy more investments. And there’s no better way to apply this method than in the options arena. I’ve said this to many people time and again: If you want to buy stock, make sure you do it by using options, specifically deep-in-the-money options (DITM).
Buying call options in lieu of buying the actual stock is a great way to leverage your money. You pay the small upfront cost of the call option and you get to control the stock until option expiration. The up-front cost of the call option can sometimes be 20 times less than buying the stock. That’s leverage!
But with such fantastic leverage, you also need the stock to make a large move to become profitable. This is where picking the strike price is critical to balancing out your leverage with making a profitable trade.
Let’s take a closer look at how you can increase your leverage (and your profits) using deep-in-the-money calls.
How to Get Dollar-for-Dollar Moves on Your Options
Many investors will settle on buying an out-of-the-money (OTM) call option when they want to use leverage to get in on a bullish expectation for the stock. An OTM call option’s strike price is higher than the current level of the stock. For instance, if Intel (Nasdaq: INTC) is trading at $26.98, an OTM call option would be one whose strike price is $27.50 or higher. (See the option chain below.)
If you bought the July 2006 $30 call for $1.05, you wouldn’t see a profit until INTC gets above $31.05 (if held to option expiration). That’s how you calculate your breakeven point with options - you add the strike price to the cost of the options ($30 + $1.05 = $31.05). You’re certainly using leverage with this trade. Instead of buying the stock and shelling out $2,698 for every 100 shares, you would pay only $105 to control the same 100 shares. The only issue, as we just mentioned, is that you wouldn’t make any money until INTC goes up another $4.05 per share. This is fine for someone who wants to spend a little money on the hopes that INTC goes up that amount in the time allotted.
Now, let’s look at a different way to leverage your money and profit immediately when INTC makes any kind of move - using a deep-in-the-money call option. A DITM call option has a strike price far below the current price of the stock. In the case of Intel, we’d be looking at strike prices of $25 and lower. The key to having a successful trade with DITM call options is the “delta.” Delta shows you the correlation between the movement of the option to the movement of the stock. You want a delta value of at least 90 or higher.
Look at the Delta column in the option chain above. We see the July 2006 $15 call option has a Delta of 100. This tells us that the July 2006 $15 call will move 100% in tandem with any move that INTC makes (up or down). If INTC goes up $1, the $15 call should go up approximately $1. That’s what you want. You want your option to move just as much as the stock. So how much does the $15 call cost? According to the option chain, it costs $12.25 (splitting bid/ask). That’s $1,225 for one option contract. Yes, that’s about $1,100 more than it costs to buy the $30 call, but it’s still about $1,500 less than it costs to buy 100 shares of INTC outright.
Leverage Benefits of Buying Calls
Here are the benefits to buying the $15 call:
- As we mentioned, it will cost you almost $1,500 less than buying INTC shares.
- You’re going to get 100% of the same movement (up or down) as INTC.
- With the $1,500 you saved, you can go out and buy some other DITM options on other stocks you might like.
- The most you have at risk is your $1,225 initial investment. If for some unknown reason INTC tanks to $0 per share, the most you can lose is $1,225. All the holders of the stock can lose all of their investment.
With the $15 call, your break-even point, or cost basis, is $27.25 ($15 strike + $12.25 = $27.25). Contrast this with the $30 call where your break-even is $31.05. A much better deal in my opinion, even though the option costs more.
Weighing Your Cost vs. Your Profits
When you buy options, you need to weigh your cost versus your profitability. If you’re okay with waiting for INTC to get above $31.05 before seeing a profit, then the $30 call might be for you. But, if you want immediate gratification, then you should look to purchase a DITM. Remember, we want to substitute a call option for the stock. In order to do that, you must choose a strike price that has a very high Delta (90 or above). That is the key to giving you all the same movement for a fraction of the cost.
Come expiration time, you have two choices: You can sell the call back to the open market, and the trade will be over and done with. Or you can exercise the call, in which case you will be required to come up with the rest of the payment for the stock. The advantage of the DITM is that you only have to put up a small down payment up front. After you pay for the rest of the stock, you will see the 100 shares deposited into your trading account on the Monday following expiration.
In my opinion, this is a no-brainer. When interested in buying stock, why not buy some DITM call options which will cost you less, give you all the same movement, lower you total risk, and also allow you to put some of that saved money into other investments?
Good Trading,
Lee Lowell
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Today’s Smart Profits Cribsheet
- Lee spent seven years in the options pits of the New York Mercantile Exchange. Check out his Market Maker Series (Smart Profits #241, #243, #247 and #252), which details the action on the floor of the exchange.
- While today’s Smart Profits Report focuses on buying deep-in-the-money calls, Lee’s put together a special electronic report on how to profit when investors buy out-of-the-money options. The report, How to Receive Instant Cash Payments for “Locking In” Lower Prices on Your Favorite Stocks, is a handbook that can be e-mailed right to your inbox… Click here.
- For definitions of words like “expiration”, “leverage” or “excercise price” check out our Smart Profits Glossary, full of over 175 options terms!
Related Articles:
- Sell to Close Options: How “Patient” Trading Turned $8,000 into $192,000
- Credit Spreads With Options: How Option Credit Spreads Give You a Better Chance to Win
- Buying Put Options & Covered Calls: Two Ways To Play A Downside Trend
