The Power of Leverage

[ForexArticles]

Why would anyone want to risk capital trading derivatives in lieu of the actual physical underlying vehicle they are based on? The advantages are based on the potential to leverage available capital and better position one’s self for greater profit with greatly reduced risk.

Buying one standardized option affords the owner a veritable safety net on the price of the underlying. The strike price coupled with the cost of the options sets the floor for breakeven. In a sense it creates a predetermined stop loss in itself. Let us look briefly at this in theory.

Consider this scenario:

Trader A buys 100 shares of BRUN @ $34.68 for a total cost of $3,468.00 not including commissions.
Trader B buys 1 BRUN Apr 35 with BRUN trading at $34.68 call option for 0.69.
The call is based on 100 shares of stock so the cost would be $69.00 not including commissions.

As we see the risk is $3,468.00 in owning the actual underlying due to the fact that in theory shares of BRUN could go to zero.* There are ways to attempt to limit the risk via a stop loss order in which a predetermined price set below the stock price triggers a sell order and sells those shares at market; i.e. stop loss set at 5% or $32.95 has your risk set at $1.73 or $173.00 provided the shares trade at the actual stop loss price once triggered.

With regards to risk of owning the BRUN Apr 35 call; the risk is set by the purchase price of the option itself $69.00. Even if the shares drop to 30, if the risk stays the same; $69.00 is the maximum loss on the trade.

On the upside, a 10% rise in the price of BRUN to $38.15 provides a profit for the owner of the actual shares of $348.00. With a risk of $173 and a potential reward of $348.00, a trader would have roughly a 2 to 1 risk/reward ratio.

Under that same scenario for owner of the option, if the shares of BRUN moved up 10%, the intrinsic value of the BRUN Apr 35 call option would be $3.15.** The buyer of the call option would reap a potential gain of $246.00. With the risk predetermined by the purchase price of $69 setting the maximum risk, the option trader would have 3.5 to 1 risk/reward ratio.

The differences in owning shares verses owning the option are that the purchaser of the call option foregoes participating in profiting on his purchase until the shares of BRUN trade to the breakeven point of $35.69;*** whereas the owner of the underlying participates immediately in any minimal up move.

Let us look at the scenario where the purchaser buys 2 Apr 35 call options which increases the risk to $138.00 which is still approximately 20% less risk then the owner of the shares based on the same risk tolerance of a 5% loss. The benefit is in the leverage that the purchaser of the option reaps. If the breakeven is still set at $35.69 per share but the owner is long 200 shares, then a 10% up appreciation on the shares would double the gain from $246.00 to $492.00. The advantage is in favor of the owner of the options. Risk is still less and predetermined at $138 as opposed to the owner of 100 shares of BRUN which is arbitrarily set at $183.00. Reward is increased for the option holder to $492.00 whereas the owner of the actual shares stays fixed at $348.00.

The tradeoff is in the ability to take risk and spread it across a number of different underlying vehicles. No matter how we look at it the potential risk of owning shares will always be greater than purchasing options. Capital requirements alone have the owner of the shares posting 50% in margin. In contrast the purchaser of an option is required only to pay for the actual price of the option at the time of purchase and maintains the right to exercise.**** In taking these the facts in to account and comparing the margin requirements, potential risk and rates of return based on margin verses cost of purchasing options, there is no comparison on the potential rate of return on owning shares verses owning options. The rate of return on the margin for owning the shares, provided the 10% upside target is met is 9.94% whereas the rate of return on the purchase of the option, again provided the 10% upside target is met within the life of that option, is 356%.