Sunday, December 8th, 2019

Options Trading Leverage

 

Options trading leverage is what attracts many to options trading. In the various kinds of options trading, the ratio of change of the price of the option to the change in the underlying equity price is the delta. For example, a delta of 0.8 means that for every dollar the equity changes the option price changes 80 cents. The delta is also called a hedge ratio. Options trading leverage is demonstrated in the example of buying stock versus buying call options on a stock with a delta of .8. If the stock sells for $10 a share the trader could buy 100 shares of the stock for $1,000. If the trader buys an out-of-the-money call option for $1.50 a share that will cost $150. Providing that the trader has done his or her homework the equity in question will rise in price before the expiration date. The options trading leverage in this situation is that with a delta of 0.8 the option value will rise 8 cents for every 10 cents that the equity price rises. However, the initial option investment is 3/20th of that of buying the stock. If the stock goes up a dollar the investor will gain $100 on an investment of $1,000. The trader will gain $80 on an investment of $150.

Many traders favor out-of-the-money options with distant expiration dates. These options are usually quite cheap, sometimes cents a share. Out-of-the-money call options are call options on stocks that are trading below the strike price of the options contract. The strike price is the price at which the option will sell if the purchaser chooses to execute the options contract. If a call option is out-of-the-money its only value is its “time value.” The longer the time until the option expires the more time there is for the price of the underlying equity to move. This is the option’s speculative value and will gradually decrease as the time until contract expiration decreases. So, what is an option worth? It is worth its intrinsic value plus its time value. It will be worth a lot more if the underlying equity goes up in price. Options trading leverage makes the investment in a call option potentially more valuable, dollar for dollar, than the purchase of the same stock.

If the trader is buying puts instead of calls, movement in the option price versus the equity price is expressed as a negative delta. If the buyer buys a put on a similar and out-of-the-money option it will be a situation where the equity is selling above the strike price. If the price of the equity goes up it counts as a potential loss for the options trader as is expressed as a negative number. However, the underlying ratio will be the same. When selling puts the options trade is compared to selling the stock short. The trader will incur a larger potential expense in selling short than in selling the put. This situation has a similar degree of options trading leverage although it involves selling with a short options strategy versus selling a put. As with all investments in options the trader needs to study the fundamentals of the underlying equity and the technical aspects of market movement. Deciding to buy calls or puts on an equity depends on where the trader thinks the equity price will go and it depends upon doing the math involved to know where the profit can be.

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