Using Option Leverage to Increase Your Gains
An attractive quality of options is that they offer leverage. Compared to buying a stock, buying a call option on that same stock gives you the opportunity to earn a much higher percentage return on your investment.
Of course, if you are wrong and the stock falls, you will probably lose a bigger percentage of your investment.
Leverage can work for or against you. However, losing a bigger percentage doesn’t mean losing more money. This is because when you buy an option, you usually invest a much smaller amount.
Let’s See How It Works
Let’s say you really like Cisco (NSDQ: CSCO). You think it will rise in the next year and you want to buy 200 shares. As of this writing, CSCO is trading for about $53, so you would need about $10,600 to purchase 200 shares.
Note that no matter what happens, you won’t lose more than $930. On the other hand, the upside is theoretically limitless.
Percentage Gain vs. Dollar Gain
Because the original starting amount is so much bigger when you buy the stock, even if you lost 10% of the original $10,600, you would lose more ($1,060) than if you lost 100% of your $930 investment in the CSCO call.
Now, the opposite also holds true. If CSCO moves in your favor, even though your percentage gain may be much greater, your dollar gain may not be as big.
Let’s say CSCO ends up at $65 on September 18, 2020. If you bought 200 shares of CSCO at $53, your percentage gain would be 18.9% and your dollar gain would be $2,000 ($10×200).
If you held the September 2020 calls and sold them right before expiration, each contract would be priced at about $8. Since each contract is equivalent to 100 shares of the stock, that means the position is worth about $1,600. Your gain would be about $670 ($1,600-$930).
In percentage terms, that’s a 72% gain, but clearly in dollar terms, it’s a smaller profit. However, the beauty is that with an option you only risked $930 to make the $670 profit.
Beware of the Passage of Time
A major downside to options is that they have finite life and time works against the buyer. As expiration approaches, time decay accelerates and the value of the option goes down faster.
A way to mitigate this problem is to buy an option that doesn’t expire for a long time, such as the Cisco example I gave above. Because the expiration date is way down the road, the long-dated option suffers less from time decay. The flip side is that in return for the extra time, you will have to pay a higher premium.
Still, buying a long-dated call would cost less than buying shares of the stock outright.
Consider a LEAP
If you are interested in the maximum long-dated option available, you can seek out LEAP (long term equity anticipation) options. These are available for up to three years in the future and they always expire in January. For example, CSCO has a January 2021 LEAP available. (To clarify, the September CSCO call discussed above is technically not a LEAP, but it serves the same purpose.)
By buying an option, you won’t have normal shareholder rights such as dividends or voting rights, but chances are, if you are trading options you are most interested in capital gains, not dividends. When used properly, long-dated options can be an excellent way to boost returns.
If you’re interested in discovering additional ways of boosting returns, turn to my colleague Jim Fink.
Jim is chief investment strategist of the elite trading services Options For Income, Velocity Trader, and Jim Fink’s Inner Circle. He has agreed to grant access to his “paragon” trading system, which can help investors earn 2,500% in just one year, guaranteed.
We’ve put together a presentation to explain how paragon works. But time is running out; spaces are going fast. Click here to join the action.