The Power Of Leverage

The dictionary defines leverage as the power to act effectively.  In the world of investing, options can give you that power to act effectively (otherwise known as financial leverage).  By controlling shares of stock at a fraction of the cost of an outright stock purchase, options give you the power to supercharge your returns.

Now that you are familiar with the mechanics of Call and Put options, let’s compare them to buying and selling stock to see just how powerful leverage can be.

The following table shows that when we are bullish on a stock we can either buy call options, sell put options, or purchase the stock.  Recall from the Options Building Blocks key, however, that we do not typically want to be a naked put seller.

Let’s consider then, an example showing the differences between buying call options and buying stock.

Example - Long Calls vs. Long Stock

Stock

Say you purchase 100 shares of XYZ stock at $50 per share.

Initial Investment: $5000

Breakeven: $50 (the purchase price of the stock)

Max Risk: $5000

Max Reward: Unlimited

Options

Say you purchase 2 XYZ Call 50 options at $2.50 (remember 1 contract controls 100 shares of stock).

Initial Investment (Option Premium): $500 (2 contracts @ $250 each)

Breakeven: $52.50 (Strike Price + Option Premium)

Max Risk: $500 (equal to your initial investment)

Max Reward: Unlimited

Stock Risk/Reward Profile

With the stock at $55, profit is $500 ($5 per share * 100 shares)

Return = 10% ($500 profit / $5000 investment)

Long Call Risk/Reward Profile

With the stock at $55, profit is $500 ($2.50 per share * 200 shares)

Return = 100% ($500 profit / $500 investment)

The Advantage of Options

Leverage your investment capital

•          In this example, with a 10% increase in XYZ’s stock we saw a 100% return on our call options.

Minimize Risk

•          With 1/10 of the investment capital at risk ($500 vs. $5000) our options made the same profit as an outright stock purchase.

Diversification

•          By only spending $500 of your $5000 capital to control XYZ stock, you can invest the remaining $4,500 in a diverse basket of stocks.

See how leveraging helps preserve your capital in Why Options are Not Risky.