Stock Options And Leverage

If you are new to investing you’ve probably heard of stock options and wondered if they are something you should include in your portfolio. The answer is “not until you fully understand them”, and even then only with extreme caution. Options are not for beginners, although no one ever lost any money getting a good stock options explanation.

Options involve leverage, the use of which allows you to control more of an underlying investment using less money than you would if you paid cash. If this sounds like an unusual financial maneuver, it’s really very common: home mortgages are examples of leveraged investments. The difference between buying stock and stock options is that the latter have an expiration date, which means that their value is constantly under pressure from “time decay”. With stocks one can simply buy and hold a company’s shares, and wait for the move one expects to occur. With options you do not have this luxury.

The upside of leverage is that for a given amount of money they put into an investment, an upward move its value will result in a higher percentage return on your money. Getting a 10% move upwards in a stock you own gives you a 10% return; buying an option on the same stock could give you a 100% return for the same move in the stock (depending on the specifics of the option contract that you buy). As you might expect there is a downside to leverage as well: a relatively small percentage decline in the value of the stock could wipe out your entire options investment, and instead of being able to wait for the stock to come back and move in our favor, we are confronted by the expiration date of the option getting closer every day.

My purpose here was to lay out the potential benefits and risks of the leverage that one assumes upon purchasing options contracts, without getting bogged down in details. There are plenty of places to learn about stock options but having a firm grasp on the way leverage increases the risk of the investment, as well as the potential returns, is probably the single most important thing to remember when you try to decide whether options trading is for you, or not. Once you understand the game, do yourself a favor and trade options on paper for a while, before you commit real money to them.