Using Options To Leverage Stock Trades | High Risk High Rewards
While stock options can be used for many purposes, from protecting stock positions to reducing the cost of controlling a block of stock, many stock traders prefer using options to leverage stock trades in an effort to maximize stock trading profits. While using options to leverage stock trades is not terribly complicated, this strategy is quite risky due to the nature of how options derive their value and their potential to expire worthless, causing a total loss of trading capital committed to the options trade. However, with high risk comes the potential for high rewards, which makes using options to leverage stock trades a tempting trading strategy when traders feel strongly about an imminent stock price move.
Using Options To Leverage Stock Trades | How It Is Done
The strategy of using options to leverage stock trades simply involves buying either call (long) options or put (short) options for a stock at a price level and expiration date that covers the time period in which an anticipated price move in a stock, either up or down, is expected to occur. What makes using options to leverage stock trades instead of buying or selling short stocks outright risky is that if the options trades do not work out as intended, the options can expire worthless, whereas buying or shorting a stock would maintain a position in the stock that still has value (although reduced due to the unexpected price movement) that could potentially recover.
The advantage to using options to leverage stock trades is that it allows a stock trader to control a much larger amount of shares than they could control for the same amount of money if the stock was purchased or shorted. With more shares comes more profits, if the stock trade turns out as expected. Also, stock options often make much larger percentage moves than the underlying stocks that they are written for, and therefore not only do stock options allow a stock trader to control more shares, but they also often make far greater percentage price moves, thus increasing profits tremendously.
The following is an example of using options to leverage stock trades. To buy 1,000 Facebook’s FB shares at $30 per share would cost $30,000. However, using call stock options to leverage a long stock trade in Facebook could cost about $50 to control the same 1,000 shares of FB stock for a few months out (which could include a quarterly earnings report or another big Facebook event). This is because each Facebook option call option controls 100 shares of Facebook, and if hypothetically a trader paid $2 each for ten Facebook call options with a strike price of $30 and an expiration date three or four months out, the 1,000 shares worth of Facebook call options trade would only cost $30 to establish ($20 for the ten call options, plus a $10 commission). That leaves the stock trader $29,970 dollars to trade elsewhere, while they control 1,000 shares of FB. Not a lot of money to risk to trade 1,000 shares of Facebook stock.
If Facebook shot higher to $35 before the $30 call options expire, the percentage increase of the $30 call options could be approximately 150% (from $2 per option to $5 per option), rather than the nominal percentage increase of Facebook’s stock, which would be approximately 18% for a price move from $30 to $35 per share. Given the low cost and tremendous profit potential, it is easy to understand why stock traders like using options to leverage stock trades.