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What is Leverage?

Leverage can be a very powerful tool when it comes to trading. If you ask a majority of traders out there, they will agree that leverage is one of the biggest benefits to speculating with options because it gives them more bang for their buck.

Why? 

Because leverage gives a trader the ability to turn relatively small amounts of capital into significant profits. Since options are derivatives and equal to 100 shares of the underlying asset, they’re cheaper to buy — effectively freeing up trading capital to be used elsewhere. 

Let’s take a closer look at how leverage works.

Leverage Using Options

When a trader buys options, it allows them to control a greater amount of the stock than they otherwise could by purchasing the underlying directly.  

Simply, if you had a certain amount of capital to invest, then you could create the opportunity for far higher returns through buying options than you could buying stocks.

Assuming that you had $20,000 to trade, and you wanted to buy Apple (AAPL) shares because you thought they were going to increase in price.  If AAPL was trading at $200, then you could purchase 100 shares for your investment of $20,000.  Now, say the stock increased in value to $225.  You would generate a $25/share profit, or 225-200/200 = 0.125 * 100 = 12.5% return on investment.

Now, let’s assume that you decided to purchase the 200-strike call option on AAPL, and these were being asked at $2.00 each. This means you could pay $200 to buy one contract, which effectively gives you control of 100 shares of Apple — a much smaller upfront investment than if you chose to buy 100 shares of the stock outright. 

Now… This is where it gets even better with the use of leverage.  

Let’s say Apple rises to $225, and that 200-strike call option you purchased at $2.00 per contract is now worth $3.00. This would result in a $1.00 per contract, or $100, gain — or a 50% profit on your initial investment! 

Here is a breakdown of the two trades for your comparison:

 

Stock:

Capital spent: $20,000

Number of shares: 100

Stock bought: $200

Stock sold: $225

Profit: $25

% profit: 12.50%

 

Options:

Capital spent: $200

Options bought: 1 contract

Number of shares: 100 share buying power

Options bought: $2.00 / contract x 100 shares = $200 / contract

Options sold: $3.00 / contract x 100 shares = $300 / contract

Profit: $100 / option x 1 contract = $100

% Profit: 50% 

 

As you can see from the outline above, a trader is able to return 50% of their capital using less money upgront — much larger than the return on investment from just buying the stock outright.  Plus, the stock trader generated a $25 profit compared to the option trader’s $100 gain.  

 

Wrapping up

The ability to use leverage to multiply your returns is one of most rewarding aspects to trading options over stocks.  And because options are derivatives — effectively controlling 100 shares of the underlying asset — leverage allows traders to reduce their upfront cost, and free up their trading capital to be used elsewhere. 

Author:
Options Academy

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