How leverage works in purchasing call options? Leverage is a means of enhancing return or value without increasing investments. You use leverage when you invest in real estate or buy securities on margin, i.e. you borrow money to increase your potential for income or capital gains. For example, when you buy a house you typically put down 20% and finance the other 80% of the purchase price. If the price of the house goes up 20% you double your equity.
Rights, warrants and option contracts provide leverage, not involving borrowings but offering the prospect of high return for little or no investment. A good leverage allows you to double your money when the underlying financial investment goes up 10% in price. A poor leverage requires a 30% advance. Options, rights and futures as short term financial instruments carry additional risk because not only their prices have to move up, but they have to do it before their expiration.
Let’s assume that at a time when the market price of IBM stock is $75 a share, an IBM Call costs $5. If the price of IBM stock subsequently rises to $85 a share, the option will rise to $10 so you’ll double your money, Please note that you never have to buy IBM shares to realize profits. Instead you can simply sell your option to another investor.
Table below compares profits and losses of an investor who invested in IBM stock and IBM options. For example, if you would purchase IBM shares outright you would have to invest $7,500 and after selling them at $83 a share you’d make 14% on your investment. By buying an IBM Call option you had to invest only $500. The option would become worthless if IBM shares would be selling at $75 or below. Your loss would be total but it would be limited to $500.
How Leverage works?
Option selling strategies cover the greatest probability of success. These strategies rely on statistics which indicate that four out of five option buyers lose money. We can therefore conclude that the sellers of options have an 80% probability of a winning trade. You have to remember however that these strategies carry unlimited risk, and at the same time carry a limited profit potential.
Selling Call Options
The seller of a Call option obligates himself to sell the underlying stock at a specific price for a specific period of time. He gets the premium from a buyer of his option. An investor can sell covered or uncovered (naked) Calls.
Selling covered Calls
The strategy of selling covered Calls is used by investors whose market views are mildly bullish. This strategy carries a limited profit potential with an unlimited risk. If an investor owns at least the amount of the underlying stock that is deliverable upon exercise of the Call he has sold (written) he is said to be a covered Call writer.
An investor that buys Call options hopes that the stock price will rise. An investor who sells Call options is more cautious. He believes that the price will go up, (otherwise he wouldn’t bean owner of the shares), but that they will rise moderately. If he’s forced to sell his shares, he’ll sell them with a profit.
Let’s assume that IBM stock sells for 570 a share and an investor buys 100 shares of IBM. At the same time he sells an IBM 75 Call for $5. If the price of IBM stock rises above $75, the investor will have to sell his IBM stock at $75 a share. He’ll make $10 per share (or 14%); $5 from the stock appreciation and $5 from the option premium he received.
How leverage works in buying Call Options? If the price of IBM stock is below $75 a share he would not have to sell his shares and his profit will be $5 from an option premium he received from the option buyer. After the option has expired he can repeat this transaction by selling another Call option. Should one he forced to sell one would make a profit.