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Leverage is a major benefit of options investing, and when used wisely it is a significant advantage. Initial leverage has everything to do with whether the option is in, at, or out of the money.

Options that are "out of the money" have more leverage than those that are deep "in the money." Knowing how this works will help you design and find the right trade when evaluating an investment opportunity.

There is more than one way to look at option’s leverage. The method we will use is a function of the underlying stock’s value and the initial premium or price paid for the option itself. This is convenient because it illustrates the relationship that leverage has with risk. More leverage typically equal more risk as well as more potential profitability. Let’s look at three options and the leverage each one has.

  1. Consider a standard option chain for a month worth of options on Microsoft (MSFT). The stock is currently priced at $27.39 per share. Because a single option contract controls 100 shares of stock the total underlying stock value of an option contract is $2,739. The at the money call with a strike price of 27.50 has an ask price of $1.23 a share or $123 per contract, which is a leverage ratio of 22 to 1 (2,739 / 123 = 22)
  2. The deeper you go, in the money, the lower the leverage drops. For example, the in the money strike price of 20 has an ask price of $760 per contract or a leverage ratio of 3.6 to 1. This lower leverage amount reflects the higher probability that this option will retain some value or remain in the money until expiration.
  3. An out of the money option like the 31 strike price, with an ask price of $22 per contract, has a much higher leverage ratio of 125 to 1.

To really understand what leverage means we need to take this one step further and translate it into profits. Assume that all went well and the stock moved from $27.39 per share to $32 per share by expiration. We will use expiration prices so that we don’t need to account for time value.

  1. The in the money 20 strike price is now worth $1,100 of intrinsic value for a return of 44%. We can calculate that by dividing the $760 investment into the profits of $340 (1,100 – 760 = 340) per contract.
  2. The 27.50 strike price is now worth $350 of intrinsic value for a return of 184%
  3. The 31 strike price is now worth $100 of intrinsic value for a return of 354%
The return is higher with more leverage but the probability of the market rising enough to create profits in an option with more leverage is much less than one that has less leverage. This means that more leverage equals more risk.

In the video we will look at this example and discuss why you may consider options that are further out of the money when you expect much larger stock price movements in the near term versus an at the money or in the money option when you expect a smaller price movement in the short term.

Leverage is a powerful tool – make sure you are using it to your advantage and know what to expect.

Watch the video below then proceed to Covered Calls.