Understanding Leverage in Options Trading

What is Leverage in Options Trading?

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 [tooltip tip=”The asset subject to being purchased or sold upon exercise of the option contract.”]underlying asset[/tooltip].

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.

Why Leverage is Attractive to Traders

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. The total cost is £20,250 before brokerage fees. If XYZ rises to 455p you will make £2,500 before net of fees. (£22,750-£20,250), a return of just over 12%.

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.

The Mechanics of Leverage

Options are leveraged instruments because they enable traders to amplify their exposure to a financial asset’s price movements. For example, purchasing a call option gives you the right to buy the underlying asset at a fixed price. If the asset’s price rises, the option’s value can increase many times over, providing substantial returns compared to the initial investment.

Profit Amplification

Leverage can significantly amplify profits. A trader can control large amounts of stock for a relatively small cost, and if the stock price moves favourably, the profit percentage can be significant.

Risk Magnification

Conversely, leverage also magnifies potential losses. The leverage ratio in options trading can lead to substantial losses if the stock price moves against the trader’s expectations.

Effect on Investment Strategy

The strategic implications of leverage cannot be overstated. Understanding leverage allows traders to structure their investment strategies optimally. The ability to control large positions with a smaller investment can lead to diversified and robust portfolios.

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, less than the outright purchase of the 5,000 shares considered above, but having an economic interest in 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 × 1,000 x (0.45-0.24) = £5,250 before costs. So roughly double the profit for roughly a third of the initial outlay, or a return of over 87%. Of course, the downside of buying call options is they can expire worthless and you lose all of 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.