Leverage in options trading: Boost returns & manage risks

Imagine you’re buying a small plot of land with the hope that its value will skyrocket in the near future, and you only pay a fraction of the total price upfront. If the value goes up, your profit is immense relative to your initial investment. This is akin to using leverage in options trading—a powerful tool that can either greatly multiply your gains or expose you to significant losses.

What is leverage in trading?

Leverage is a financial concept that involves using borrowed funds or financial instruments to increase the potential return of an investment.

In the world of options trading, leverage allows traders to control a larger position in the underlying asset with a smaller amount of capital. Essentially, leverage magnifies the potential returns (or losses) on an investment.

Example: Suppose you want to purchase a piece of real estate worth ₹50 lakh. Instead of paying the full amount upfront, you make a down payment of ₹5 lakh and take out a loan for the rest.

If the property’s value rises to ₹60 lakh, your return on investment would be ₹10 lakh on your ₹5 lakh investment, effectively doubling your money. However, if the value drops, you could face significant losses, far greater than your initial investment.

What is leverage in options trading?

Options are financial derivatives that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before or at the expiry date.

There are two types of options: call options, which give the right to buy, and put options, which give the right to sell.

Leverage in options trading comes into play because options contracts allow traders to control a large amount of the underlying asset with a relatively small investment. This is due to the fact that options are priced significantly lower than the actual asset, yet they can offer similar profit potential.

Advantages of leverage in options trading

Leverage in options trading offers several benefits for options traders, including:

Amplified Returns

Leverage allows traders to amplify their returns by controlling larger positions with smaller capital outlays. This can lead to significant profits if the trade goes in the desired direction.

Capital Efficiency

By using leverage, traders can free up capital to invest in other opportunities, thereby increasing their overall potential returns across a diversified portfolio.

Flexibility

Options provide traders with the flexibility to implement various strategies, including hedging, speculating, and generating income, all while using a smaller amount of capital than would be required for direct investment in the underlying asset.

Risk Management

While leverage increases potential risk, it also allows traders to use options as a risk management tool. For example, buying put options can act as insurance against a decline in the value of an underlying asset.

Limitations of leverage in options trading

Despite its benefits, leverage in options trading carries significant risks:

Magnified Losses

Just as leverage can amplify gains, it can also magnify losses. A small adverse movement in the price of the underlying asset can lead to substantial losses, potentially exceeding the initial investment.

Time Decay

Options are time-sensitive instruments, meaning their value decreases as the expiration date approaches. This time decay can erode potential profits, particularly if the market does not move as expected.

Market Volatility

Leverage can make options trading highly sensitive to market volatility. Even small price fluctuations can have a large impact on leveraged positions, leading to increased risk and uncertainty.

Complexity

Options trading, especially when using leverage, requires a deep understanding of the markets, the underlying assets, and the specific options strategies being employed. Without this knowledge, traders can easily make costly mistakes.

How leverage in options trading works?

Leverage operates differently in call and put options:

Call Options

When you purchase a call option, you’re betting that the price of the underlying asset will rise. The leverage comes from the fact that you’re only paying a fraction of the asset’s current price to control the full value.

If the asset’s price increases, the value of the call option can rise significantly, providing a leveraged return on your investment.

Put Options

Conversely, when you buy a put option, you’re speculating that the price of the underlying asset will fall. Leverage allows you to control a large amount of the asset with a small initial investment.

If the asset’s price drops, the value of the put option increases, again offering leveraged returns.

Example of call option: Suppose you buy a call option on a stock trading at ₹500 per share, with an option price (premium) of ₹20 per share. The total cost to purchase one contract (which typically represents 100 shares) would be ₹2,000 (₹20 x 100).

If the stock price rises to ₹550 per share, the option might increase in value to ₹50 per share. You could then sell the option for ₹5,000 (₹50 x 100), realizing a profit of ₹3,000 on your initial ₹2,000 investment—a 150% return.

Example of put option: Consider you buy a put option on a stock trading at ₹800 per share, with a premium of ₹30 per share. The total cost for one contract would be ₹3,000 (₹30 x 100).

If the stock price drops to ₹700 per share, the option might increase in value to ₹100 per share. Selling the option at this point would yield ₹10,000 (₹100 x 100), giving you a profit of ₹7,000 on your ₹3,000 investment—a 233% return.

Examples of leverage in options trading

Let’s explore a few real-life scenarios that demonstrate the power and risk of leverage in options trading:

Example 1: The power of leverage in a bullish market

Ajay, an investor, believes that Reliance Industries’ stock, currently trading at ₹2,000 per share, will rise in the next few months due to an upcoming earnings announcement.

Instead of buying the stock directly, he purchases call options with a strike price of ₹2,100, expiring in three months, for a premium of ₹50 per share. Each option contract controls 100 shares, so Ajay spends ₹5,000 per contract.

Two months later, Reliance Industries’ stock price jumps to ₹2,300 following a strong earnings report. The value of Ajay’s options rises to ₹250 per share.

He sells the options for ₹25,000 per contract (₹250 x 100), realizing a profit of ₹20,000 on each ₹5,000 investment—a 400% return. This example highlights how leverage can lead to substantial profits when the market moves favorably.

Example 2: The risk of leverage in a bearish market

Simran, a trader, anticipates that Infosys’ stock, trading at ₹1,400 per share, will decline due to expected weak quarterly results.

She buys put options with a strike price of ₹1,350, expiring in two months, for a premium of ₹40 per share. She spends ₹4,000 for each contract controlling 100 shares.

Unfortunately for Simran, Infosys reports better-than-expected results, and the stock price increases to ₹1,500.

The value of her put options plummets to ₹10 per share, and she decides to sell them for ₹1,000 per contract (₹10 x 100), incurring a loss of ₹3,000 on her initial ₹4,000 investment—a 75% loss.

This example illustrates how leverage in options trading can quickly turn against a trader when the market moves in the opposite direction.

Key considerations for traders

Before engaging in leverage in options trading, it’s crucial to consider the following:

Risk Tolerance

Understand your risk tolerance and only invest capital that you can afford to lose. Leverage can lead to significant losses, especially in volatile markets.

Market Analysis

Conduct thorough research and analysis of the underlying asset, market conditions, and relevant news that could impact the asset’s price. Knowledge and timing are critical in leveraged trading.

Diversification

Avoid putting all your capital into a single leveraged trade. Diversifying your options portfolio can help mitigate risk.

Strategy and Discipline

Develop a clear trading strategy and stick to it. Avoid making impulsive decisions based on emotions or market noise.

Exit Plan

Have a predetermined exit plan, including stop-loss orders and profit targets. This helps in managing risk and locking in profits.

Conclusion

Leverage in options trading is a double-edged sword—it can magnify your gains, but it can also expose you to significant losses.