Option Leverage – How It Works and Why You Should Know About It

Option leverage lets traders amplify potential gains while using less capital. By paying a small premium, you can control 100 shares—something that isn’t possible with stocks alone. This article breaks down how option leverage works, why leveraged options are so powerful, and what makes them a game-changer for market exposure.

Key takeaways

• The option leverage is the typical built-in feature that allows traders to amplify gains by paying a small premium for significant market exposure.
• When you compare buying stocks vs. options, you’ll find that the latter offer substantial leverage since they typically require only a small upfront payment for control of 100 shares.

What Is the Option Leverage? The Option Multiplier Factor

Option leverage allows traders to take bigger positions in the market without investing a lot of capital upfront. By paying a small premium, you can control a much larger number of shares—usually 100 per option contract—offering significant market exposure at a fraction of the cost of buying the stock directly.

This aspect is known as the built-in multiplier of an option. We’ll tell you more below.

How Option Leverage Amplifies Gains (and Losses)

One of the most attractive aspects of option leverage is its ability to deliver large percentage gains when the stock price moves in your favor. For example, say you buy an option with a premium cost of $2 per share (or $200 for the contract), and the stock price rises sharply.

That rise could multiply the value of your option several times over. Essentially, you’re paying a small amount for the opportunity to benefit from much larger price movements.

Of course, this works for the other side of the coin as well. If the stock price moves against you, your potential losses can also be magnified by option leverage. That’s why it’s important to have a solid understanding of not only how option leverage works but also how to manage risk effectively.

The Risks of Leveraged Options

Leverage, while powerful, is not without its risks. It’s worth understanding how unfavorable price movements can create potential pitfalls:

• For Option Buyers: Your loss is capped at the premium you’ve paid. If the stock doesn’t move as expected by the expiration date, you lose the premium—but nothing more.
• For Option Writers (especially uncovered writers): The risk can be far greater. Writing uncovered call options exposes you to unlimited losses because if the stock price skyrockets, you’ll have to fulfill your contract at a much lower price, buying shares at market rates to sell to the holder.

With option leverage, smart risk management is essential. While the rewards can be significant, the risks could offset those potential gains if not carefully considered. Knowing the limits and potential consequences of both buying and writing options helps ensure a more balanced and informed trading approach.

Pros and Cons of Option Leverage

From the previous section, it is clear that there are several pros and cons to using option leverage. Here’s a table summarizing the main advantages and disadvantages of relying on option leverage for your trading activity:

Pros of Option Leverage

• Amplifies returns: With a small premium, traders can achieve larger market exposure, maximizing returns on favorable stock movements. 
• Predetermined risk: Losses for buyers are capped at the initial premium paid, reducing the chance of unexpected disasters. 
• Opportunities for diversification: Less capital is tied up, allowing traders to spread investments across different options or assets. 

Cons of Option Leverage

• Magnifies losses: Leverage works both ways, amplifying losses if the stock price moves in the wrong direction. 
• Options can expire worthless: If the stock doesn’t move as expected by expiration, traders lose their entire premium. 
• Complexity: Options require a thorough understanding to avoid costly mistakes, making them challenging for beginners. 

Balancing these pros and cons is key to using leveraged options wisely and effectively.

What Kind of Leverage Do Options Offer?

Let’s now be a little bit more practical and look at the leverage options provide. Option leverage lets you control a large position in an underlying asset with a relatively small upfront cost. The options multiplier, typically set at 100 for equity options, plays a critical role in determining the leverage.

Example of Option Leverage

• If a stock is trading at $200 per share, buying 100 shares costs $20,000 (100 x $200). 
• Alternatively, if a call option costs $5 per share, the total cost for one options contract controlling 100 shares is only $500 (100 x $5). 

This means you’re controlling $20,000 worth of stock with just a $500 investment, creating a leverage ratio of 40:1 ($20,000 / $500). This substantial leverage can amplify returns if the stock price moves favorably.

Profits and Risks

• Buying Options: The maximum loss is capped at the premium paid (e.g., $500 in the example above), making it more predictable. 
• Selling Options: Writing uncovered options carries significantly higher risk. If the stock price skyrockets, losses are potentially unlimited as you might have to deliver shares at below market value.

Option leverage offers exciting opportunities, but the magnified risks demand thoughtful trading and risk management.

Calculate Leverage in Options

You should know that, unlike some other derivatives, options leverage is not fixed—it varies depending on the position and options pricing. This dynamic nature is what makes leveraged options so versatile. Leverage in options trading is determined by comparing the total value of the underlying stock position to the capital required for the option.

Example of Calculating Leverage

• If 100 shares of a stock cost $12,000 ($120 per share), buying those shares requires the full $12,000. 
• Alternatively, purchasing a call option for $3 per share only costs $300 (100 shares x $3). 
• This gives a leverage ratio of 40:1, meaning you control $12,000 worth of stock for a $300 investment.
• Notice that this leverage ratio is not constant. If you come from futures trading, you’ll be used to fixed leverage. However, options provide a more dynamic approach that may adapt to your risk management strategy (but it may also make risk calculation a bit harder).

Key Points to Know

• Long Options: Traders find long options appealing because the maximum loss is limited to the premium paid. This keeps risks predictable while offering the potential for magnified returns. 
• Short Options: Selling options works differently. While the premium received offers upfront profit, risks can escalate quickly. Uncovered call options, for example, carry unlimited loss potential if the stock price surges unexpectedly. 

For short options, leverage is often calculated using the buying power requirement in a margin account. This allows traders to initiate positions without needing the full risk amount upfront. However, this convenience can lead to large losses without proper risk management.

Mastering option leverage requires understanding these calculations and being prepared for both the rewards and risks it brings.

A Practical Option Leverage Example – Buying Stocks vs Buying LEAP Options

Finally, we want to tell you that we have actually run a backtest analysis through our options screener to assess how option leverage works in real-world scenarios (you’ll find the link to the full article at the bottom of this text). This study compares two investment strategies—buying 100 shares of stock versus purchasing long LEAP call options that are at least 10% in the money and expire in one year.

Our test began with stocks recommended as a “Buy” by analysts. For each stock, we evaluated its performance from January 2023 through the end of the year, applying the two strategies. The results highlighted both the opportunities and risks offered by leveraged options when compared to outright stock purchases.

Key Findings from the Study 

1. Higher Returns: LEAP options could deliver much higher profits compared to owning the stock if the price rose significantly. For example, Alphabet (GOOGL) saw a stock gain of 55.04%, but its LEAP option posted a 188.86% return—a clear demonstration of the power of leveraged options. 
2. High Risk: On the downside, stocks with large declines led to massive losses for options. For instance, Estée Lauder (EL) experienced a 42.72% stock drop, resulting in a 99.83% loss for its LEAP option. 
3. Underperformance Risk: Even small stock gains might result in option losses due to value erosion. Disney (DIS) is the perfect example here, as the stock showed a modest 1.96% price gain, but its option lost 44.36%. 

Nvidia as a Standout Example 

Nvidia (NVDA) showcased the ideal scenario for options trading. Its exceptional performance in 2023 demonstrated how LEAP call options can amplify gains for investors who correctly predict substantial stock appreciation. 

This analysis emphasizes the value of option leverage in maximizing market exposure. However, the risks, such as substantial losses or underperformance, make it essential for traders to approach leveraged options with clear goals and proper risk management.

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