Option Investor
Educational Article

The Temptations of Leverage

Printer friendly version

In our last column (last week, in case you have short term memory loss), you learned about calls. Hopefully, you remember that when you purchase a call, you own the right, but not the obligation, to purchase an asset at a predetermined price (strike price) on or before a predetermined date (expiration date).

We used a real estate example in which you bought an option (for $5,000) for the right to buy a house from the owner for $100,000. You paid $5,000 for that right. So, that concept should be pretty clear by now. Now, let's look at the same transaction from the property owner's point of view. While you "purchased" a call option, in effect, he "sold" you a call option.

When he sells you this call option, he puts the $5,000 in his pocket. That is now his money. He never has to give it back. In exchange for that $5,000, he agreed to take his house off the market for a period of three months. He has taken on an obligation to perform. It is a contract with no loopholes. He has contracted to sell you the house - IF you choose to buy it for $100,000. You have a choice. He doesn't.

The only way the homeowner can get out of this obligation to perform is if he buys back the option that he sold to you. The option may vary in price - up or down, depending on what transpires during those three months. The option will increase or decrease in value as the value of the property increases or decreases.

It works the same way in the stock market. Let's say, hypothetically, that:

1. It's the first week of March.
2. Leroy owns 1,000 shares of Intel (INTC) stock trading at $24.25.
3. Leroy believes that INTC isn't going anywhere anytime soon.
4. Enter Abdul. He thinks that Intel's share price is about to move substantially higher. Why does he believe that? Who knows? Maybe he heard Jim Cramer ranting about it the night before. Maybe he read a blog by some stock guru who never trades his own money. Maybe he called the Psychic Friends Network. It doesn't really matter. Coin flipping works just as well.
5. He thinks it will happen within the next six weeks.
6. Abdul is willing to bet $1.50/share (or $1,500 for 1,000 shares) that Intel will be higher in six weeks.
7. Because Abdul is bullish, he wants to buy 10 April call options (remember, there are 100 shares per option contract) from Leroy for the right to buy the 1,000 shares at $25 per share on or before April option expiration (the third Friday in April)

Leroy says, "Hell, yes!" He's glad to take Abdul's $1,500. Leroy is willing, if necessary, to sell his 1,000 shares to Abdul for $25 (the strike price). Leroy is obligated to sell those shares at $25 - even if Intel shares go to $35.

As an option seller (writer), Leroy receives the $1,500 premium from Abdul and it shows up in Leroy's brokerage account the very next business day.

In effect, Leroy has sold what is knows as a "covered call." He sold the option to Abdul and has obligated himself to deliver the Intel stock at $25. It's referred to as a "covered" call because Leroy already owns the stock he may need to satisfy his potential obligation. It he didn't own the stock, it would be referred to as an "uncovered" (or naked) call. Naked calls are very dangerous and a BAD idea.

Looking At Leverage

We learned, in our last column, that an option buyer is trying to take advantage of leverage. He is buying an option for a small amount of money to control a much larger asset for a specific period of time. In the stock market, it's rare that the option buyer really wants to exercise his option and buy the stock.

Let's take a quick look at how leverage works. Let's say:

1. Abdul guessed right and Intel is now trading at $35.00.
2. At option expiration, Abdul can exercise the call option he purchased and buy the 1,000 shares of Intel for $25,000. Then, he can simply sell those same 1,000 shares in the open market for $35 per share, or $35,000. What would his profit be?

Plan A
a) Abdul spent $25,000 to buy the Intel stock
b) Abdul received $35,000 when he sold the Intel stock
c) Don't forget about the $1,500 Abdul originally spent for the April $25 call.
d) Abdul's profit is then: $35,000 - $25,000 = $10,000. Then $10,000 - $1,500 = $8,500.

Not bad, you say? Well, let's look at the percentages. There are other alternatives, and stock purchase may not be the best one. Initially, Abdul risked $1,500 and spent $25,000 for the stock - a total of $26,500. He made a net of $8,500 on the transaction. His percentage return is a little over 32%.

Plan B
During the life of the option, as the price of Intel increases (if it increases), so does the value of the April $25 call. By the time expiration comes around, and Intel is trading at $35, the value of the $25 call will be a minimum of $10 in the option marketplace.

That's right. Abdul can sell his $25 call back to the market any time he likes, prior to expiration. Just because Abdul purchased the option from Leroy, it doesn't mean that Leroy personally has to buy it back from him. Marketmakers are obligated to make a market in these options, so there will always be an opportunity to sell the option, if Abdul chooses. So, here's a second scenario:

a) on expiration Friday, Intel is at $35 and his April $25 call is worth $10.
b) Abdul sells his 10 contracts (equivalent to his 1,000 shares) of the $25 call for $10,000.
c) Abdul now shows a nice profit of $8,500 ($10,000 - the original $1,500). Same as Plan A.

Look at the percentages again. Abdul spent a grand total of $1,500. He made $8,500. Hang on to your shorts, gang, and get the calculator. The percentage return is a whopping 566%. Not too shabby. How often does is happen? Occasionally, but don't hold your breath. (Note: To calculate your percentage of return, simply divide all that you have spent into all that you have profited.)

There's no reason for Abdul to spend the money to buy Leroy's shares of stock and then turn around and sell the stock. That requires Abdul to have a substantially
larger brokerage account. Why bother? Abdul can simply sell the option that has appreciated in value.

That's why is rather unusual for people to actually use Plan A, when Plan B seems so make so much more sense. But that doesn't stop some people. Why? Lack of education. Lack of gray matter.
Thus far, you have learned what it's like to be the buyer of a call - and also to be the seller of a call. It's progress -- and it's a great start.

Sounds like there are some incredible money making opportunities using options, doesn't it? There are. But you have to learn to crawl before you can walk. Friends, we're still on all fours. I know it's tempting. But try and keep your money in your pocket, for now. That's the only way you'll be able to keep it at all.

Mike Parnos - The Good, The Bad, & The Ugly

Who Is This Guy?
The outspoken Mike Parnos has been writing Option Investors very successful Couch Potato Trader column for over four years. Hes been trading and teaching options for over 15 years and knows what you NEED to know to trade options profitably.

Too many traders trade the more advanced option strategies without having a good understanding of options, how they work, and how they are meant to be used. The results? Say goodbye to your money. That is why there such a stigma attached to options. And thats a recipe for disaster. If you have more money than you know what to do with, losing $5,000 or $10,000 is no big deal.

However, if youve worked hard for your money, and you appreciate the value of a dollar, you should make every effort to learn everything you can about options before you put your money at risk.

Mike will tell you like it IS, not how you hope it will be. As you read through the columns, feel free to send him your questions at support@optioninvestor.com, with Options 101 somewhere in the subject line. Who knows? You might end up in next weeks issue.

Options 101 Archives