What’s a lever?
Levers are tools used to accomplish more work using less energy.
This is the basic concept of leverage in physics. The same concept works similarly in the stock market, if you think of work as profit, and energy as capital. Thus, leverage allows you to earn more profit using less capital.
The downside to leverage in the stock market is that it works like a double-edged sword. So in the same way you can realize huge gains using leverage, you can also get hammered by losses.
One way investors use leverage in the market is by trading options, as they’re inherently leveraged positions. But how does leverage work with options? And what sort of factors are important to know when trading with leverage?
We’ll get into all those details here so that you know everything you need to about leverage so that you can use it, before it uses your capital.
What you’ll learn
How Leverage Works When Trading Options
For a quick review of options, options are derivatives of various assets & securities that allow you to either buy or sell 100 shares of the security the option/ contract is associated with at a set price, over a set period of time. There are two categories of option contracts: calls, which give you the right to buy; and puts, which give you the right to sell. The price of an option contract is known as its premium.
To understand leverage in the options world, let’s compare the cost of one call contract to the cost of 100 shares of the underlying security, Alibaba (BABA):
- Call option: An at-the-money BABA call that expires in one month would cost $600.
- Underlying: Current share price is $63.00. So 100 shares would cost $6,285.
You can see in the example above that for almost 10 times less, you could essentially be in control of 100 shares of BABA if you choose to purchase a call. This is how options are so leveraged: the premium for one contract is a fraction of what you’d spend on the open market.
50:1 leverage means, for every $1 you deposit, your buying power equals $50. So in this example, if you invest $200, the value of the investment, and your buying power would equal $10,000.
Calculating Leverage
To understand what goes into calculating leverage, let’s briefly go over something called “delta”, as delta is one of the key components that will go into the equation.
Delta is one of the “Greeks” in options. The Greeks are different variables used to assess risk in the options market. Delta is a measure of how much an options premium (aka price) will move, in theory, based on a $1.00 move in the underlying security’s price. Delta can range from -1.00 to 1.00, and there are numerous strategies that aim to achieve delta neutral.
For example, if a Paypal (PYPL) call has a delta of 0.35, this means that, in theory, if the underlying security (PYPL) moves up by $1.00, then the PYPL call’s premium will go up by $0.35. When delta is negative, the price moves inverse to the underlying; so in this case the premium would go down $0.35.
Here’s the equation for calculating leverage:
(Delta of Option * Price of Underlying Security) / Option’s Premium
An Options Leverage Example
Now that we know the variables that go into calculating leverage, let’s plug and chug. Say you want to calculate leverage of an in-the-money NVIDIA call. Let’s imagine that the delta value is 0.54, the current share price is $130, and the premium is $9.50/ share.
Buying an option that represents 100 shares of a firm is usually less expensive than buying the 100 shares of stock itself – this is how options provide leverage.
The leverage value is 7.34. Great, now what? What does this value represent, and how would you use it?
The calculated leverage value is a representation of how many more times you’d earn (or lose) if you trade options versus if you traded an equal number of shares of the same security. So in this example, your profit/ loss would be 7.34 times higher than it would be if you had purchased 100 shares of NVIDIA.
And, notably, you’d be spending far less on the investment. 100 shares would cost $13,000… As opposed to $950 ($9.50 * 100 shares). This is a clear demonstration of just how potent leverage can be when you trade options. Not only do you have the potential to earn over seven times more, but you are also getting a 90% plus percent discount to control 100 NVIDIA shares.
It’s also important to note that you likely can’t just open an options trading account with a brokerage and start trading with leverage. Rather, brokers allow for different levels of options trading which will come with tiered access to the various types of options contracts. Typically, each trader will need to provide information based on their experience trading options, and their income levels. Brokers will examine this to determine the level of risk the trader can afford – and a corresponding level of options trading with access (or lack thereof) to different types of contracts will be granted.
Costs and Benefits of Leverage
It’s easy to be mystified by the power of leverage, but it’s crucial to remember its shadow. You can make some pretty sizable gains without having to spend a lot of capital, but leverage can also magnify your losses if a security’s price moves in the wrong direction.
So with great power comes great responsibility. Seasoned traders are good at using options to hedge other investments, creating a balanced strategy. Or they take it a step further and create a delta-neutral strategy. These strategies oftentimes will try to cap loss, while opening the door wide open for gains.
Costs: If you don’t protect your position, you could find yourself in a lot of trouble. Having an unprotected call, for example, is called a naked call, and can expose you to unlimited risk. One bad trade could shed all of the gains you may have made, and all of the capital you have.
Benefits: Now, the plus side of this coin is that the reverse works for gains. Options are often used to make short-term trades that aim to make large profits. Another way to look at the benefit of leverage, outside of just making large gains, leverage can lower the barrier of entry for traders to start making decent gains without having a lot of starting capital.
There are copious numbers of people who might be interested in investing, but might be reluctant to jump in because they don’t think they have enough money to make it worth it. Options can provide an opportunity for those that might not have, or want to spend a lot on a trade, but still want to realize some gains.
This is not the only case where investors use leverage. Maybe you do have the capital but you lack the time to trade & research. In this case, following options trade alerts works well for those that want to invest, but have other time commitments such as a career or a family, ultimately preventing a trader from constantly monitoring the markets.
Conclusion
Leverage is an incredibly powerful tool – and with great power comes great responsibility. The profit potential when using leverage can be tremendous. But much like the sirens in Greek mythology, leverage can be a dangerous temptation trying to lure you in, so be warned: all that glitters is not gold.
We have to remember that risk doesn’t just equal reward. It can equal reward, but it can just as easily equal loss. Using leverage is not a recommended strategy for new options traders.
This risk inherent in leverage is something many investors ignore because they’re wearing rose-colored glasses, thinking they’re going to show off their gains and be the next big WallStreetBets post. This is why it is important to be careful with how your emotions get tied into your trades. That thought of “if I hold the position for just a little longer I know it will go back up!”, or something similar, can be very dangerous when trading leveraged positions…
It’s common for investors to use leverage when perhaps because they don’t have as much capital as they’d like, but still want to realize some decent gains. Or maybe an investor has the capital to spend, and they want to make some prodigious gains. Either way, leverage opens doors to some exciting potential in the market, but also some scary possibilities.
Leverage in Options Trading: FAQs
What Does 20x Leverage Mean?
20x leverage means that for every $1 you invest into a position that is 20x leveraged, the investment would equal $20. This means that when a trader invests their capital, they borrow 20x what they put into the investment. This can be beneficial for different types of traders. Perhaps someone wants to build their capital quicker but doesn’t have a lot of capital, or someone who does have the capital and wants to magnify their gains, leverage can solve these problems.
Why Do Options Give Leverage?
Options give leverage because while they represent 100 shares of the security they’re tied to, they cost a fraction of what you’d spend if you long 100 shares of the same underlying security. So essentially, an investor can be in control of 100 shares of a security, but not have to spend nearly as much as they would if they just purchased shares.
That means that capital you spend on options holds a lot more weight, or value, than the capital you spend on ‘regular’ shares. The value that this capital holds can be thought of like the value different currencies have. While you might have 1 of one currency and 1 of another, the values could be very different.
How Do You Use Leverage When Trading Options?
Leverage can be used in many different ways with options, but at the core of it, you use leverage to have control of more shares using less money. This creates opportunities for people who want to capitalize on their capital, take the risk and hope to reap the rewards. There are also those who might not have as much capital as they want, so they choose to enter leveraged positions hoping to make as much as they would with an “un-leveraged” position.
How Do You Leverage a Call Option?
Call options, as well as put options, are already leveraged positions, so you do not need to do anything to leverage an option. The current delta of the option, current underlying price, and the premium of the option all play a significant role in how much an option was leveraged. You can calculate the leverage value by dividing the delta with the current share price, and then dividing that value by the option’s premium. That value is how many ‘times’ the option is leveraged, so if it is 4, for example, you’d earn 4 times as much profit (or loss) as you would if you long 100 shares of the same security.
