In an earlier post, I mentioned I’ll talk about leverage and how it is a double-edged sword… here it is…

According to investopedia, leverage is

The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.

Well, that definition is more apt when describing the purchase of stock using margin. In options, leverage has a slightly different meaning… options allow leverage to be achieved without the buyer borrowing money explicitly… Because of the very nature of options, a buyer is able to control a large number of shares with a relatively smaller amount of capital, thus increasing the potential return of his investment…

For instance, suppose Jonathan bought a $170 AAPL Call for $0.80 when AAPL is trading at $160. If AAPL shoots to $200, the call option may be worth about $35.2… although the option did not increase as much as the stock itself, its percentage increase easily wins that of the stock’s, hands down… The table below illustrates this point…

As can be seen above, the option percentage increase is 4300%, an amazing feat by any measure…. This is the beauty of leverage… when the stock increases in value, a CALL option will tend to increase by maybe a two-to-one ratio*… (i.e. a $2 increase in the stock leads to a $1 increase in the option)… Although an option price increase is less than that of the stock, it is relatively cheaper than the underlying stock, thus the percentage increase is huge…!!!

But, and this is a BIG but…

leverage is a double-edged sword… it works both way…. If suppose AAPL did not rally to $200, but instead sank to $100…. the stock has lost $60, a percentage loss of 37.5%… that’s any investor’s nightmare… but nowhere near the horror experienced by the options trader…. The $170 CALL that Jonathan bought will now probably be worthless… a loss of $0.80, but a percentage loss of 100%!!!!

Of course, if Jonathan only bought one lot, his loss is minimal… however, suppose he invested $16000 in the option, he would have lost all the $16000… on the other hand, if he had used the money to buy 1 lot of AAPL share, he would still have $10000 left…

Thus, in short, if we compare the same amount of money invested in stocks and options; options, because of the leverage they offer, have the potential to multiply our money many times over but also the potential to cause us to lose 100% of our money….

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*Actually this ratio depends on how close the option strike price is to the current stock price… the deeper ITM the option is, the closer the ratio will approach one-to-one… this ratio is also known as the delta of the option… a topic I’ll explore soon….