Options leverage is a core concept of options trading. For a given capital outlay, investing in options will increase your potential returns compared with investing in the underlying stock. However, options leverage works both ways by also increasing the potential losses.
Options leverage is inherent to options trading and allows you to use call or put options to earn the returns on a specific amount of stock (usually 100 shares per contract) with less money than purchasing the stock outright.
What Is Leverage?
Leverage applies to a variety of different financial products. The leverage example most familiar to people is the purchase of a home.
If you’re looking to buy a new home valued at $400,000, one approach would be to pay $400,000 upfront in cash. A more common approach would be to put 20% down ($80,000) and get a mortgage for the $320,000 balance.
Continuing with our house example, let’s say your house appreciates in value to $500,000. If you paid all cash, you get a return of $100,000 or 25% of your initial investment of $400,000. But through the use of a mortgage, you get the same return of $100,000 but on a lower initial investment of $80,000, a return of 125%.
Using a mortgage leverages your cash to potentially get higher returns.
How Leverage Works in Options Trading
Using options leverage works much the same way. No matter which strategies for trading options you use, you may increase the leverage of your investment by using options.
Recommended: How to Trade Options
Example of Leverage in Options
For example; an investor wants to invest in stock ABC currently trading at $50 per share. There is also an at-the-money option with a strike price of $50 trading at $5. They can choose to buy 100 shares at $50 each for a capital outlay of $5,000. Or, using options leverage, they can purchase an options contract at $500 ($5 times 100 shares per option contract).
Some time later the ABC stock trades at $60 per share. If you purchased 100 shares, your shares would now be worth $6,000, an increase of $1,000 and a 20% return on your initial outlay of $5,000.
An investor in the options strategy could see their options triple in price to $15. The options contract would now be worth $1,500, also an increase of $1,000 but on the much smaller initial outlay of $500 for a return of 200%.
In addition, the options investor would still have the opportunity to invest the $4,500 from the original capital as they saw fit. That includes investing the additional capital in ABC stock, buying more ABC options, or pursuing other investments entirely.
Pros and Cons of Leverage in Options
Here are a few of the pros and cons of using leverage in options trading:
The options leverage example above presents the options price movement from $5 to $15 without explaining what drove the price change. Generally, the price of an option is driven by asset volatility, time to expiration, and asset price. Those factors drive the delta Greek of an option which tells an investor how much the option price will change relative to a change in the underlying stock price.
One way to calculate the amount of leverage that you get with a particular option is to take the option’s delta value, multiply it by the stock’s price and divide it by the price of the option. This calculation is usually represented by the Greek letter lambda.
Options can be a way to increase your returns, but with those higher potential returns comes higher potential risk. Before trading options, make sure you understand the risks and rewards of your position, and set up an exit plan.
How much leverage can you get with options?
In theory you can have nearly unlimited leverage with options, if you buy an option with a very low cost. However, the cheaper the option contract that you purchase, the higher the risk that it will expire worthless.
How is option leverage calculated?
To calculate the amount of leverage that you will get with a particular option contract, first determine the option’s delta value. Then multiply that by the stock’s price and divide it by the price of the option to get the leverage or lambda of the option.
Do call options use leverage?
Yes, using call options is one way to use leverage to invest in the stock market. When you buy a call option, you can control 100 shares of stock for a much lower price than purchasing those 100 shares outright.
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