Stock Option Leverage
Each option contract is based on 100 shares of stock. So, when a stock option is quoted at $2, buying the option will actually cost the investor $200. If the underlying stock does not move much in price, then the same leverage will apply to any sale and the leverage of the stock option won’t come into play and generate big profits.
However, stock options are priced based on two overall components. The first component is the intrinsic value of the stock option. The intrinsic value is defined as the difference between the market price and the strike price of the option.
For example, a call for XYZ with a strike price of $45 has an intrinsic value of $5 when the stock’s current price per share is $50.
The second component of an option’s price is set based on complex mathematical models and market forces. Though this value can change during an option’s life, this is not where the powerful leverage lies.
Intrinsic Value = Big Money
How stock options can make such huge trading profits lies in that ratio where each option is actually a contract for 100 shares of stock.
If a stock is trading at $44 per share and goes to $50 per share, you would make $6 per share if you just bought the stock without using any options. To buy 100 shares, you would have to originally pay $4400. The $6 per share profit on 100 shares equals a $600 profit. Not a bad day.
But, if you bought a stock option with a strike price of $45 for $2, the same stock price movement will result in a much bigger profit. In the beginning, the investor pays just $200 for the call option. At this point, the option’s intrinsic value is -1. When the stock price moves to $50 per share, the option’s intrinsic value increases to $5. But remember, the call is for 100 shares of stock, so that $5 of intrinsic value is multiplied by 100 resulting in a $500 profit for a $200 investment, or over 200% return!
There is a catch. Stock options come with expiration dates. If they aren’t used by then, the expire worthless. In other words, if the stock price does not rise above $45 per share in our example, the option investor loses all $200 or a 100% loss!
But, with lower up-front investments and the potential for huge rewards, a savvy options trader can make a fortune and retire early. Of course, that is easier said than done, so keep reading and learn all the option trading skills and techniques you need before jumping in.