Leverage in Options
What is Leverage?
Leverage, also known as gearing, can be very powerful when it comes to investing in your portfolio because by using this method it’s possible to use relatively small amounts of capital to control a much larger amount of the underlying asset.
Leverage is a way of amplifying the power of your investment.
With instruments such as stocks, you have to commit a large amount of capital in order to gain exposure, as stocks are fully paid instruments. Consider an investment of 5,000 shares in XYZ Plc at 405p.Total cost £20,250 before costs. If XYZ rises to 455p you will make £2,500 before costs. (£22,750-£20,250)
Options offer a way of using leverage to your advantage. This is because the cost of options contracts is typically much lower than the cost of their underlying asset, allowing you to multiply the power of your starting capital and yet still benefit from price movements in the underlying asset in the same way.
Example of Leverage in Options
Now think of an option on XYZ Plc (1,000 shares per contract).
If you buy 25 XYZ Plc 410 call options at 24p the total cost will be 25×1,000×0.24 = £6,000 before costs, so less than the outright purchase of 5,000 shares but having control of (an interest in/exposure to?) 25,000 shares.
If XYZ rises to 455p the 410 call options will be worth at least 45p as this is the intrinsic value. Your profit would be 25×1,000x(0.45-0.24) = £5,250 before costs. So roughly double the profit for roughly a third of the initial outlay. Of course, the downside of buying call options is they can expire worthless and you lose the premium you paid.
Leverage can also be very risky when dealing with short options as initial and variation margins as well as potential losses can escalate very rapidly causing severe margin calls. Always understand the ultimate risk when considering selling or shorting options and fully understand the effects that leverage (gearing) can have on your positions. It is possible to lose more than your initial account deposit when using short options. Always seek financial advice.