Previously we have discussed borrowing funds as a tool for leverage in order to amplify gains or take advantage of opportunities that would otherwise be missed. For this article, we’ll cover the use of options both for leverage and a risk management tool.
Option strategies can be complex when used in combinations, so we will focus on just using the call option to supplement your investment strategy.
What are call options?
Options are a popular form of leverage used by retail investors who want to give their portfolio a boost, but don’t want to carry the risks involved with borrowing money. Call options utilize risk-adjusted leverage that enables you to greatly magnify the return (or loss) on money invested.
Buying a Call option on a stock gives you the right, but not the obligation, to purchase that security at a given price. Options are bought in round lots, or 100 share blocks. So buying one call of XYZ at $10 is the same as controlling $1000 worth of XYZ stock.
Calls can best be explained with an example. Let’s say in September you buy a Call for $300 on XYZ company, which currently trades at $30, that expires in December with a strike price of $40.
If you were to instead buy the stock outright, you would have to come up with $3,000 upfront. Now if the stock rises to $50, you would profit $2,000 or 67 percent. However, even though you bought the Call at $40 instead of $30, you only paid $300. That means you profited $700 from just $300, an astounding 233 percent gain!
Your risk is lessened with options as well. Using the same example, let’s say the stock dropped to $20 instead. If you bought the stock at $30, you’ll oversee a $1,000, or 33 percent loss. Because you are not obligated to buy the stock at $40 with the Call option, you would only lose your initial investment of $300. A 100 percent loss, but a mere fraction of the total of what it would’ve otherwise been.
Uses for call options
If you already own a stock, you can use call options to boost leverage in the stock, or as a fail-safe device. If you bought XYZ at $20 and it’s now at $40, you’re probably thinking of selling and locking in those gains; unfortunately, you believe the stock is going to continue to go up. No problem. Sell your stock and buy a call option at $40. You’ve locked in your gains, minus the cost of purchasing the call, and you can still take advantage of any upside movement.
Using options as a tool for leverage is probably the least risky way to spice up your portfolio. Unlike borrowing money, calls will only cost you the amount you paid for them – never more than that. It allows you to control more stock with less money and doesn’t lock you into action. Remember that they are called options — you get to choose whether or not to exercise them.
What about you? Do you use options in your portfolio? Why or why not?