Understanding Leverage in Trading Options
For many years, trading options has been regarded as risky investment due to its complexity and speculative nature. While this statement is true to a certain extent, true risk is largely due to the ignorance of a trader. With that being said, the concept of risk is always closely tied to leverage. In this chapter, you will come to understand what exactly leverage is and how leverage can be used in trading options.
In a nutshell, using leverage in trading is a means of acquiring a position size in an asset without paying the full actual amount of money the asset is worth up front. Here is an example:
Let’s start with an initial capital of $2,000. When you are trading stocks without leverage, you can use it to buy 100 units of a stock worth $20 per share. In other words, in the very unlikely scenario of the stock plummeting to $0, you will lose 100% of your initial $2,000 investment. In this case, there is no leverage involved. What you invest is what you get.
However, when dealing with options, you can potentially use $2,000 to buy 5 contracts worth $4 each. Since each contract contains 100 shares, you effectively have the rights to own 5 x 100 = 500 shares. For the same amount of investment that you are putting into options, you can own 5 times the number of shares. This is leverage.
But there is always the flip side to be considered. As much as using leverage in trading can amplify your profits, it can just as easily amplify your losses.
In stock trading without leverage, it takes a lot to lose 100% of your initial investment. However, in options trading, it doesn’t take as much to lose a lot. Imagine if your option has a strike price of $18. By the time of expiration of your contracts, if the stock price trades below $18, your entire investment is lost, because you cannot exercise the contract. But remain positive, because it also doesn’t take a lot for your profits to rise significantly if the share price moves in a direction that favors you.
So why trade on leverage if you can lose so easily?
The key lies in your trading strategies. While this mini-course is an introductory to options trading, we will avoid complex strategies and scratch the surface on the most basic rule of all – cutting loses. A disciplined trader really only needs one big winner from ten trades to recoup all the losses they made from the other 9 and then some. To do that, a trader will usually make use of the stop loss function offered by most trading platforms. This means that if an underlying asset falls below a certain price that is against the intent of the trader, the option is immediately exercised to prevent further losses. This effectively cuts potential losses before they snowball into huge mistakes. This way, a trader can effectively use leverage to great effect by simply weeding out the losers and letting winners go higher.
It might seem really simple when explained in words but the truth is, option trading is much more multi-dimensioned than just looking at numbers. At this point of time, you just need to have a firm understanding of the fundamental factors.