Options trading offers a myriad of benefits, one of which is leverage. One contract gives you the opportunity to control 100 shares of a stock at a fraction of the stock price. However, too many traders shy away from options trading, thinking they are “dangerous”. Today, let’s talk about how options trading leverage works – and how to take advantage of it to grow your wealth.
Options trading requires a strategy
Trading options is very difficult if you don’t have a strategy. If you’ve heard stories about investors getting wiped out quickly trading options, they likely didn’t have a strategy in place. Instead, they probably attacked an options trade like they are at a craps table in a casino. You can certainly gamble on options, but much like in a casino, you will fall victim to the law of diminishing returns.
I have been trading options successfully for income for many, many years. I have a strict strategy in place so as to achieve a better result than the market – and it works. As of today, our swing trading portfolio is up nearly 37% on the year.
So yes, the leverage from options is indeed very powerful and can really enhance your overall portfolio returns. While there are several ways to do this (using covered calls, selling naked puts, buying straight calls, and using put protection), you need to have some goals in place.
How options trading leverage works
Like I said above, options give you the opportunity to control 100 shares of any given stock with one contract. Options trade in the money, at the money, or out of the money at any point in time. They are rated by a “point” system called delta, and they decay at a rate called theta.
What is decay? Basically an option loses value each day it remains under a strike price. For example, a Meta Platforms November 2024 580 call (expiring November 15) carries a premium of $28. The current price of Meta (on September 27) is $566, so there is ZERO intrinsic value for this option.
Hence, theta – time decay – is in control here. The more days the stock is under the strike price ($580), the more value the option loses. The longer you own the call, the more money you can potentially lose. However, since you only own one contract, $2,800, is our maximum loss (100 share x $28).
If you owned 100 shares at $565, your cost would be $56,500. A 5% loss in the value of the stock is the equivalent of losing your one option purchase.
There is plenty of leverage to the upside!
Say Meta soars to $700 after a very strong earnings report in late October. The stock would have risen 24%, a stellar move higher.
But how about the option? That call would be worth north of $120 ($700 less $580), and our gain on paper would be $9,200, or a 228% gain. ($12,000 less the $2,800 cost). The leverage ratio of 228/24 is 9.5, an outstanding level.
You are only risking $2,800 to make a profit of $9,200 versus risking $56,500 to make a profit of $13,500. Though the dollars are less for the option win, the percentage gain is much higher – and with much lower risk. (Of course, the option has a time consideration and this move would need to be completed before the November 15 expiration.)
So yes, options trading leverage can significantly enhance returns for your portfolio.
Next week, I will talk about writing calls against your stock, an easy way to employ an options trading strategy.
