Options Leverage Calculation
Options Leverage - Definition
Options Leverage is the cash equivalent multiple of one's options position relative to the actual cash price of the underlying asset.
Options Leverage - Introduction
The power of leverage is one which we have all learnt early in our school days.
The concept of leverage dates back to the days of Archimedes
who claimed to be able to move
the world if given a long enough lever. In a nutshell, leverage allows a less advantaged element to par in effect to a more advantaged element.
In investment terms, financial leverage allows a smaller amount of money to participate in and own profits usually assessible only to a larger amount
of money. Derivatives such as stock options epitomizes this concept
of financial leverage.
Options leverage has given rise to popular urban myths such as making hundreds of thousands
using only a thousand within just a few days through option trading. Indeed, the explosive profit potential of option trading due to options
leverage has attracted a huge following of speculative option traders into the option trading arena and opened the door to more profitable and safer short term trading such as
Options Leverage - Illustration
How exactly does options leverage work?
Stock options produces options leverage as every contract represents 100 shares of the underlying stock while costing only a fraction of the price.
This allows option traders to control the profits on the same number of shares at a much lower cost.
Here's an Options Leverage illustration: Assuming you have $1000 and wish to invest in shares of XYZ company. XYZ company is trading at $50 while it's $50 strike price call options are
asking for $2.00. In this case, you could simply buy shares of XYZ company with all your money and own 20 shares or you can buy 5 contracts of $50 strike
call options on XYZ company shares which controls 500 shares! With the same amount of money, you can control 25 times more shares of XYZ company
than you normally can by buying shares. That's options leverage in option trading.
Each stock options contract controls 100 shares
of the underlying stock.
Options Leverage - Calculation
The problem with the above illustration of options leverage is that even though 5 contracts of the $50 strike price call options represents 500
shares of XYZ company, it does not move in exactly the same magnitude as the shares of XYZ company. Stock Options move only a fraction of the
price move on its underlying stock, governed by its delta value.
An At The Money Option, typically has a delta value of
0.5. This means that each contract of $50 strike call options moves only $0.50 for every $1 move in the underlying stock.
Options Leverage Calculation Example
Assuming XYZ company rallies to $55 the very next day,
the $50 strike call options will rise from $2 to $4.50, up $2.50 ($5 x 0.5 = $2.50).
Therefore, the actual options leverage of an option position can be arrived at using the following formula :
Options Leverage =
(delta equivalent stock price - option price) / option price
Following up from our above example: XYZ shares is trading at $50 and its $50 strike price call options has a delta value of 0.5:
Options Leverage = ([$50 x 0.5] - $2) / $2 = 11.5 times
The above options leverage calculation reveals that the $50 strike call options of XYZ company carries an options leverage of 11.5 times,
which means that it allows you to make 11.5 times the profit on the same amount of money, which also means that it allows you to control
11.5 times the number of share equivalent with the same amount of money. In layman terms, 11.5 times options leverage balloons your money
by 11.5 times, allowing your $1000 to be worth $11,500 in share control power.
Options Leverage - Interpretation
Understanding options leverage multiple is essential in option trading as the higher the options leverage multiple, the higher the risk of
loss! All leverage are double edged swords and Risk/Reward is proportionate to one another in option trading. Because of this, the options leverage
of In The Money options will always
be lower than the options leverage of At The Money Options, which is in turn lower than Out Of The Money Options.
Here's a comparison:
Following up from our above example:
XYZ shares is trading at $50 and its
1) $50 strike price call options is asking for $2 and has a delta value of 0.5
2) $45 strike price call options is asking for $6 and has a delta value of 0.8
3) $55 strike price call options is asking for $0.10 and has a delta value of 0.01
Options Leverage (1) = ([$50 x 0.5] - $2) / $2 = 11.5 times
Options Leverage (2) = ([$50 x 0.8] - $6) / $6 = 5.7 times
Options Leverage (3) = ([$50 x 0.01] - $0.01 / $0.01 = 49 times
As you can see above, the options leverage on the out of the money $55 strike price call options is dramatically higher than the options leverage on
the in the money $45 strike price call options, which further supports the teaching that out of the money options are more dangerous than in the money options.
Even though the out of the money options offers 49 times more profit, it can also inflict 49 times the losses to the extend of wiping out all the
money invested should XYZ company fails to move beyond it's strike price by expiration!
A quick rule of thumb gauge of how dangerous your option plays are in accordance to options leverage on directional call and put option trading,
developed by Masters 'O' Equity, is represented in the diagram below:
The above is ony an unempirical, rule of thumb gauge, allowing option traders to see if they are threading in the proverbial red zone.
Options Leverage - Applications
Options Leverage multiple is essential in option trading for:
1. Portfolio construction
2. Risk Management
3. Trading System Development
Important Disclaimer :
Options involve risk and are not suitable for all investors.
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