How to get leverage from trading call options or derivatives? Investing made simple and easy!
Call option explained:
Popularity of call option as leverage tool:
If you are an active investor, do you use call options as leverage tool?
How to get leverage from call options?
Call option are financial derivatives that provide good leverage tool to the investors. Call options, technically is the right, but not the obligation to buy an underlying stock, commodity, REIT, index at a defined strike price, within a fixed expiration date.
Significance of the call option lies in the high leverage offered with risk limited to the cost of option. Buyers of the call options are leverage traders who want to use small amount of money to make significant profit using technical or fundamental analysis or both. It gives them a high leverage over the regular stock buyer.
Example of a buyer who uses call option to get good leverage and high return on capital. For instance, AGNC, mortgage REIT, a trader is expecting it to gain in value in 30 days time and wants to buy 500 stocks. If the price of the stock is US$ 34.02, then the trader in traditional way of trading, needs to spend US$ 34.02*500 = US$17010. Thus, the amount of capital invested in significant for small trader. If the stock price moves by 1 dollar, then final profit is US$1*500 = US$500. Total return on capital is (500/17010)*100 = 2.9%. However, if the trader has bought a call option of AGNC, strike price 34 and within one month of expected movement, the total amount invested would be around (based on June-July 2012 option pricing), US$35*5 = US$175. This is very small amount as compared to US$17010. However, the profit would be significant when the stock price moves by one dollar and the buyer chooses to sell the call option. To keep the calculations simple and neglecting the spread of bid and ask, option decay, the profit return will be around US$500. Hence, return on capital is (500/175)*100 = 285%, this is astronomically high as compared to 2.9% using traditional investing.
Second benefit of buying call option is that risk is limited to the call option cost. For instance, in the above example, if the stock price of AGNC, US$ 34.02 falls to 0, then the whole capital US$17010 is burnt. However, using the call option, the amount that is at risk is only US$175, although it gives the same leverage as if the amount invested is US$17010. Hence, in case of sudden market fall, call option buyer tend to have a much better position as compared to traditional investors.
However, the call option buyer, needs to take into account the risk of option decay. The option price decays with time and if there is no movement of underlying stock or commodity, then the call option buyer loses all the money. Even though the initial loss is small amount, however, if it happens repeatedly, the losses can add up and become significant. Hence, it is advised to understand all the risks of investment and take good quality training before starting on the journey of option trading.