how to calculate options leverage
TRANSCRIPT
Leverage is one of the reasons
that people trade options instead
of buying and selling stocks
directly.
How does options trading
leverage work?
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First of all you can control a
larger number of shares for less
money on a call option than by
purchasing the stock in question.
And second, when the stock goes
up in price you have also
leveraged you profits by having
purchased the call options.
Here is how to calculate options
leverage.
Leverage When You
Execute the Trade
How to calculate options
leverage is fairly simple if you
execute profitable trades.
As an example, you
purchase calls on XYX Corp. for
$200 for 100 shares.
The stock sells for $100 and the
strike price is $102.
In our example the share price
goes up to $112 a share and you
execute the contract allowing
you to buy 100 shares at $102
and then turn around and sell at
$112 a share making a profit of
$10 x 100 shares = $1,000 minus
$200 for the premium.
To make the numbers simple we
ignore fees and commissions and
we get a 400% return on invested
capital.
If we had purchased the stock for
100 shares x $100 = $10,000 we
would have made a profit of
$1,200 or 12%.
Adjust these numbers for fees
and commissions and the point is
still made that you can
significantly leverage your
trading capital with a successful
options trade.
And if that stock had gone down
$100 in price you would have
only lost $200 on your options
trade instead of $1,000 on the
value of the stock that you
purchased.
But what if you simply exited
your options contract because
you did not have a margin
account with sufficient capital to
buy and sell shares?
Figuring Delta Values
When the share price of a stock
moves up or down, the price of
the call option moves by about
half as much.
The governing factor is called the
delta value.
When an option is at the money
the delta is typically $0.50 for
every dollar move in the
underlying stock.
A stock goes up $5 and its at the
money call option goes up by
$2.50 when the delta is 0.5.
In the money call options
commonly have lower deltas so
when stock goes up again by $5
the call option may only go up by
$2 because the delta is 0.4.
However, when an option is out
of the money its delta is
commonly higher.
So, when a stock trades for $90
with a strike price of $100 it is
out of the money.
When it rallies to $110 its delta is
significantly higher during that
move at perhaps 0.8.
Thus the price of the options
contract will go up in this
example by $20 x 0.8 = $16.
When you learn how to calculate
options leverage you can see how
it is that well-chosen out of the
money call options can be very
profitable.
One of the best ways
of succeeding in option
trading is in fact to find out of
the money call options that the
market has ignored and whose
underlying stock holds promise.