From our birth to our final day we use leverage to sustain our physical body. Our heart rate and breathing are autonomous systems which are controlled by our mind however we are rarely aware of it. Something to be grateful for. Sometimes we use leverage without knowing it. Sweeping the floor we take for granted but we know how to use the broom (leverage) watching others.
The double edged sword
The wealthy understand the principals of leverage and apply it to all areas of their lives. The world of derivatives (options) is no more than a highly leveraged instrument to create wealth. One options contract gives the buyer control over 100 shares of the stock.
Should the stock rise the call option will always produce a greater return than purchasing the stock. This being the leveraged effect.
100 BHP shares @ 35 = $3,500 1 BHP option @ 35 strike = $160
100 BHP shares @ 36 = $3,600 1 BHP option @ 36 strike = $230
% increase = 2.86% % increase = 43.75%
These type of returns as outlined in diagram 1 above attract many option traders. However it can also produce what is known as the double edged sword. This occurs where the stock goes in the opposite direction to your view thereby declining in value. This to can be managed.
100 BHP shares @ $35 costs $3,500
1 BHP option @ 35 strike cost $160
Now in the above diagram 2. Which would you prefer to have at risk? $3,500 or $160. You see here how leverage can reduce exposure and up front costs.
Should the stock drop in value by 10% this will reduce your capital in trade by $350 while the most that is lost using leverage is the value of the options.
It should be noted options are a depreciating asset meaning they have a limited shelf (time) life.
Risking less to make more.
The leverage in options is built into the product. Looking at diagram 2 we see the ratio approximately 4.5% of share price value.
This can vary during the life of each option as they rise and fall with the price of the underlying share.
This is one way to use less of your funds and make larger returns.
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