Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Options leverage is a core concept of options trading. For a given capital outlay, investing in options may offer the possibility of greater returns compared to investing in the underlying stock. However, options leverage works both ways — it can amplify gains, but it can also magnify losses.
Options leverage is inherent to options trading and allows you to use call or put options to seek returns on a specific amount of stock (usually 100 shares per contract) with less money than purchasing the stock outright.
Key Points
• Leverage in options trading allows investors to control a larger position in a stock with less capital, potentially increasing returns.
• High leverage can lead to significant losses, potentially exceeding the initial investment in certain cases.
• Timing and direction of stock movement can significantly affect option pricing and potential returns, though all options strategies carry inherent risk.
• Options trading may offer less liquidity compared to trading stocks directly.
• Options leverage allows for greater flexibility in constructing investment strategies, offering opportunities for hedging and speculating.
What Is Leverage?
Leverage applies to a variety of financial products. The leverage example perhaps most familiar to people is the purchase of a home.
For example, when purchasing a $400,000 home, you may decide to put down 20% ($80,000) and finance the rest through a $320,000 mortgage, rather than paying $400,000 upfront in cash.
Let’s say the house appreciates in value to $500,000. If you paid all cash, you would get a return of $100,000 or 25% of your initial investment of $400,000 (before any fees or taxes). But through the use of the mortgage, you would get the same return of $100,000 but on a lower initial investment of $80,000, for a return of 125%.
Using a mortgage leverages your cash to potentially get higher returns.
How Leverage Works in Options Trading
Using leverage in options trading works much the same way. No matter which strategies for trading options you use, you may increase the leverage of your investment by using options.
Recommended: How to Trade Options
Example of Leverage in Options
For example, an investor wants to invest in a stock that’s currently trading at $50 per share. There is also an at-the-money option with a strike price of $50 trading at $5. They can choose to buy 100 shares at $50 each for a capital outlay of $5,000. Or, using options leverage, they can purchase an options contract at $500 ($5 times 100 shares per option contract).
Sometime later, the stock trades at $60 per share. If the investor purchased 100 shares, their shares would now be worth $6,000, an increase of $1,000 and a 20% return on your initial outlay of $5,000.
An investor in the options strategy might see the price of their options increase to $15 depending on factors like stock price movement, volatility, and time remaining until expiration. The options contract would now be worth $1,500, also an increase of $1,000 but on the much smaller initial outlay of $500 for a return of 200%.
In addition, by choosing the options route, the investor only needs to invest $500 initially, leaving the $4,500 from their original $5,000 capital available for other investments, such as purchasing more options or buying the stock outright, assuming the stock moves favorably for the options position.
Although this example illustrates the potential for higher returns, it’s worth noting that the entire $500 investment in the options contract could be lost if the stock price doesn’t move favorably before the contract expires.
💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.
Pros and Cons of Leverage in Options
Here are a few of the pros and cons of using leverage in options trading:
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Pros:
• Potentially higher percentage of returns compared to stock investment
• Can allow you to hedge an existing position against unfavorable movement
• Flexibility to make money with a variety of strategies
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Cons:
• Risk of losing your entire investment (or more with certain strategies)
• Given their limited lifespan, being wrong about key factors, such as stock direction, timing, or volatility can lead to significant losses
• Has less liquidity than stocks
Calculating Leverage
The options leverage example above presents the options price movement from $5 to $15 without explaining what drove the price change. Generally, the price of an option is driven by asset volatility, time to expiration, and asset price. These factors influence the delta Greek, which approximates how much the option price will change relative to every $1 change in the underlying stock price. Delta can shift as these factors evolve, however.
One way to calculate the amount of leverage that you get with a particular option is to take the option’s delta value, multiply it by the stock’s price and divide it by the price of the option. This calculation is represented by the Greek letter lambda, which measures leverage specifically but tends to be discussed less often than delta.
The Takeaway
Options offer the potential to enhance returns, but they come with a higher risk of amplified losses compared to direct stock investments. Before trading options, make sure you understand the risks (such as time decay and volatility impact) and set up an exit plan that aligns with your investment goals.
Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.
FAQ
How much leverage can you get with options?
In theory, you can have nearly unlimited leverage with options if you buy one at a low cost. However, the cheaper the option contract that you purchase, the higher the risk that it will expire worthless.
How is option leverage calculated?
To calculate the amount of leverage that you will get with a particular option contract, first determine the option’s delta value. Then multiply that by the stock’s price and divide it by the price of the option to get the leverage, or lambda, of the option.
Do call options use leverage?
Yes, using call options is one way to use leverage to invest in the stock market. When you buy a call option, you can control 100 shares of stock for a much lower price than purchasing those 100 shares outright.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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