Financial Leverage in Options Trading
There is much Leverage in Options Trading. Financial leverage is one of the biggest benefits of investing. Leverage is created by making your investments work harder for you to maximize profit.
In simple terms to leverage means to take a smaller amount of money and gain exposure and control over an asset of much larger value.
leverage is creating potential for bigger gains using a smaller amount of capital. You can use your own capital but you may also using other people’s money in an effort to maximize future profits.
People take mortgage to invest in real estate. Companies issues stocks or borrowing money from the bank to expand their business. How do investors benefit? It comes from increased property value, or higher company revenue which raises the value of stockholder shares. You want to invest in good stocks. You enter stocks in watch list to follow them for a certain time.
How does leverage works
For the Trader options provides inherent financial leverage. There is no need to use borrowed capital. With options, you can control a larger number of shares for the same initial investment. It is even cheaper than if you bought stocks themselves.
Let us give an example. When you have $1 000 you could purchase 10 shares of XYZ valued at $100 per share. Alternatively, the option contracts may realistically be valued at $2 per option. You could buy 5 option contracts that is 5x2x100=$1.000. This increased your financial leverage by allowing you to control 500 shares instead of just 10.
If the value of those stocks increases much, you may wish to buy the stocks at the agreed strike price. The strike price is at much lower price than the market value. You can then resell those shares at market value.
With Options You make profit on a much larger number of shares than the ones you would have purchased originally. Needles to say though, you need to have much more capital in order to purchase the shares to make the same trade with options.
And with stock you take the risk of the market price suddenly dropping before you have the opportunity to sell your shares.
Benefit much because of Leverage
The biggest advantage comes from the fact that the percentage increase on the option is proportionately higher than the increase of the underlying share. This leverage also comes without the risk of investing the much greater amounts of capital in order to buy and sell the shares that your options give you the right to buy.
We use the hypothetical purchase mentioned previously again. We assume that the value of the stock increases from $100 per share, to $105 per share. If you bought 10 shares you would make $50 dollar. That is 5% on your investment of $1 000.
On the other hand, a reasonable estimate is that the value of the options you could have bought is an increase from $2.00 to $2.80 per option. For your 500 options, this generates an increase of $400, or 40%. This much higher potential increase is a way that trading options can effectively create leverage.
It is important to be aware though, that the potential loss is also higher. A loss of 5% value on shares could mean a 40% (=$80) loss of value on the equivalent options.
We have shown that there is much leverage in options trading. The ability to use leverage to multiply potential profits is a huge advantage that trading options offers over trading many other financial instruments. However, it’s important to recognize the increased risk that comes with using leverage.
Understanding financial leverage, the advantages and risks, is very important in trading options. With good trading strategies, using leverage can allow you to maximize your returns, while minimizing the risk.