Financial Leverage Using Options
What if I told you that you could get the benefit of owning $10,000 worth of stock using only $1,000 of your money?
Sounds like a good arrangement, right?
When you buy an options contract, you can use less of your capital while potentially locking in more profit than if you bought the same dollar amount of shares.
This is an example of financial leverage, which allows you to generate higher percentage returns with less money.
And when used correctly, financial leverage can help you accumulate profits quickly and accelerate your freedom journey!
Financial leverage also comes with extra risk
NB: You should always make sure you understand the risks involved with any leveraged strategy before putting in money you can’t afford to lose – and this applies to options trading.
This article continues the three-part mini series on options by explaining how option prices move and showing you the potential rewards (and risks) associated with these investment tools. You can access Part 1 here.
What Is an Options Contract Really Worth?
As we covered in Part 1, options contracts are agreements that give you the right to buy or sell shares of stock.
- A call contract gives you the right to buy 100 shares of stock at a price set within the option contract (the strike price).
- A put contract gives you the right to sell 100 shares of stock at a price set within the contract (the strike price).
These contracts trade on exchanges just like shares of stock.
And the price you’ll pay for these contracts depends on the perceived future value – what investors expect the value of the contracts to be down the line.
What then determines the price of these contracts?
There are a few different components that determine the price of an options contract.
And when you understand these components, you’ll be able to make better decisions about which options contracts to use for your personal wealth strategy.
Let’s start by thinking about how much an options contract would be worth if you were to exercise your right to buy or sell shares right now.
Using our example of Apple Inc. (AAPL) $150 call contracts from Part 1, think about how much that right to buy shares of AAPL would be worth if the stock were trading at $175.
If you could buy shares at $150 and immediately turn around and sell them in the market at $175, that value would be worth $25 per share. Or better still – since we are wealth builders not traders – you would instantly have $25 profit in your portfolio.
This is called the intrinsic value of an options contract. But it’s only part of the story.
If AAPL was trading at $175 and you were buying an AAPL $150 call contract that was valid for another three months, you would probably expect to pay more than just $25 per share option.
After all, you’d be getting the right to buy shares of AAPL for $150 at any time over the next three months, and the stock could trade higher than $175. If the AAPL price goes higher than $175 anytime before expiry of the option, you can exercise the option and make more than the $25 current intrinsic value.
So with three months left to go – and if you believe AAPL will trade higher than $175 – you would be willing to pay a bit more for the option.
So maybe instead of paying $25 per share option, you would be willing to pay something closer to, say, $35. That extra $10 on top of the intrinsic value is known as the extrinsic value – or time value – of an options contract.
Tracking the Price of Your Call or Put Contracts
When you own a call contract and the price of the underlying stock trades higher, the market price for your contracts will usually also trade higher.
That’s because the intrinsic value will increase.
Let’s go back to the example of the AAPL $150 call contract.
If shares of AAPL are trading at $175, the intrinsic value of the $150 3-month call is $25. And if AAPL trades even higher, up to $185, the intrinsic value would be $35.
As you can see, a small percentage increase for a stock price can lead to much bigger percentage gains for your option contract.
In the example above, a 5.7% increase in the price of AAPL shares would lead to a 40% increase in the intrinsic value of the option.
➤ This is the power of leverage.
Put contracts work the opposite way.
If you own a put contract, it gives you the right to sell 100 shares of stock at a specific price.
Let’s imagine you own a put contract that lets you sell 100 shares of Netflix Inc. (NFLX) for $500.
If shares of NFLX are trading at $450, the put contract has an intrinsic value of $50.
After all, if you could buy shares in the market right now at $450 and use your put contract to sell these same shares at $500, that contract would be worth at least $50 to you!
As shares of the stock move lower, your put contract becomes more valuable.
For example, if shares of NFLX were to trade at $400, your $500 put contract would be worth at least $100 per share.
Having the ability to sell shares at $500 when the stock is trading at $400 gives you the ability to immediately turn a profit of $100 profit.
Since investors can buy an options contract and then sell it in the market (rather than exercising the right the contract represents), many short-term traders use options to speculate on movements in stock prices.
These traders buy call contracts when they expect stocks to trade higher.
They buy put contracts when they expect stocks to trade lower.
Always Be Aware of Time Decay
One of the most challenging things about buying options contracts to speculate on stocks is the fact that every contract has an expiration date.
When the expiration date passes, the contract is no longer valid. After expiration it has zero value. So there’s a clock ticking every time you purchase one of these options contracts.
This is the time value part of the option’s price we talked about above. When there’s no time left, the option is worthless.
(Incidentally, this is why the price of an option is called a “premium” – you’re buying a right, not a direct asset. With some options you have to specify that you want to exercise; if you don’t , even an option with intrinsic value is valueless after expiry.)
The time value of every options contract diminishes slowly as time passes – and it drops more quickly the closer we get to the options contract’s expiration date.
Traders call this erosion time decay because over time, the price of your options contracts will decline.
You’ll notice that when you look at different options contracts for the same stock, contracts with a lot more time left are almost always more expensive than short-term contracts.
Always keep time decay in mind when buying put or call contracts – and in deciding how long to hold them.
Limited Risk, But Don’t Bet the Farm
The final thing you need to remember when buying options contracts is that every dollar you invest in an options contract could be at risk.
Think about the example of our AAPL $150 call contracts.
If AAPL trades lower before the options contract expires and eventually moves below $150, the call contracts would eventually be worthless.
After all, there’s no reason to pay for the right to buy AAPL at $150 if you can buy the shares in the open market for, say, $130.
So while it’s very rare to lose all of the money you invest in the stock of a legitimate company, losing the full amount paid for an options contract is pretty common.
➤ There’s a trade-off in this situation.
An AAPL call contract could allow you to spend less of your capital to leverage a larger dollar amount of AAPL shares.
But at the same time, you could potentially lose all of the money you paid for the call contract.
You have the potential for a much higher percentage return on the money you use for your call contract. But you also have the potential to lose 100% of the money you put into this play.
For this reason, if you’re going to buy options contracts to profit from stock movements, it’s wise to use a much smaller percentage of your investable net worth for each position that you take.
That way, if your trade works out the way you expect, you’ll be able to lock in some very attractive profits.
But if the position doesn’t turn out as you hoped, you won’t be risking too much on any one play.
If you haven’t yet signed up, remember that my
Options Trading Masterclass is available online.
In the Masterclass I turn the tables and show you how to take less risk with options and generate reliable income with these cool tools.
There is also some info on this strategy in Part 3 of this mini series.
Live your life to the fullest, it’s beautiful and precious and it’s here NOW.
PS You can continue the conversation on our Facebook Community Page (it’s free to join) and see what others are saying. Have you successfully leveraged your investments using options? We’d love to hear how they work for you. Do you have questions about the specifics of trading options? The Facebook Community Page is a great place to reach out for answers.