This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
Options are one of the most efficient ways to get leveraged exposure to a stock. The buyer pays a premium for the option, and the premium is a fraction of the cost of buying the stock outright. A small move in the stock in the right direction can produce a large percentage return on the option premium, and the leverage is the source of both the magnified returns and the risk of total loss.
The difference between options leverage and margin leverage is that the option's loss is capped at the premium. The option buyer cannot lose more than the premium paid, regardless of how far the stock moves against the position. The margin trader can lose more than the initial margin, because the broker's loan is secured against the account's entire balance.
How options produce leverage
A call option on a €100 stock with a €110 strike and a 30-day expiry may cost €3 per share. The cost of buying 100 shares of the stock is €10,000. The cost of buying one call option contract (covering 100 shares) is €300. The option gives the buyer the right to buy 100 shares at €110 per share at expiry.
If the stock rises to €120 at expiry, the option is worth €10 per share (€120 minus €110), and the buyer's return is €1,000 on a €300 investment, a 233% return. The stock itself has risen by 20%, a 20% return on a €10,000 investment. The option's leverage has produced a 233% return on a 20% stock move.
If the stock falls to €90 at expiry, the option expires worthless, and the buyer loses 100% of the €300 investment. The stock has fallen by 10%, and the stockholder has a 10% loss on the €10,000 investment. The option's leverage has produced a 100% loss on a 10% stock move.
The leverage is not constant
The option's leverage is not constant over the option's life. The leverage is highest when the option is at the money (the strike is close to the stock price), because the premium is small relative to the stock's notional. The leverage decreases as the option goes deeper in the money (the premium increases, and the option behaves more like the stock) or deeper out of the money (the premium is small, but the probability of the stock reaching the strike is low).
The leverage also decreases as the expiry approaches, because the time value of the option decreases, and the option's premium becomes more sensitive to the stock's move. The option's leverage is highest with 30-60 days to expiry, and the leverage declines as the expiry approaches.
The risk of total loss
The risk of total loss is the main risk of options leverage. The option buyer can lose the entire premium, and the loss is 100% of the investment on every trade that expires out of the money. The trader who buys options as a default, without a defined exit and a defined risk budget, is buying lottery tickets, not trading.
The trader who buys options for leverage should treat the premium as the maximum loss on the trade, and the premium should be sized to the trader's risk budget. A trader with a €10,000 account and a 1% risk budget should spend at most €100 on the option premium for a single trade, regardless of the option's leverage or the trader's conviction.
The strategies for using options leverage
The simplest strategy is the outright call or put purchase. The trader buys a near-the-money option with 30-60 days to expiry, and the position is a leveraged directional bet. The strategy is binary: the trader is right and the option returns a multiple of the premium, or the trader is wrong and the option expires worthless.
The more advanced strategy is the spread (a call debit spread, a put debit spread). The trader buys one option and sells another option at a different strike, and the spread reduces the premium cost and the potential return. The spread is a lower-risk approach to options leverage, because the premium is smaller and the maximum loss is capped.
The most advanced strategy is the calendar spread (buying a longer-dated option and selling a shorter-dated option on the same strike). The leverage comes from the difference in the time decay between the two options, and the leverage is more consistent than the outright purchase.
Common questions about options leverage
Is options leverage better than margin leverage? Options leverage caps the loss at the premium, while margin leverage exposes the trader to a potential loss beyond the initial margin. The options leverage is safer for a single trade, and the margin leverage is safer for a trader who needs to hold the position for more than a few weeks.
Can I lose more than the premium on an option? No, the option buyer's loss is capped at the premium. The option seller's loss is not capped (for a naked call) or large (for a naked put). The buyer and the seller have different risk profiles.
What is the best option strategy for leverage? The outright call or put purchase is the simplest option strategy for leverage. The spread strategy is a lower-risk approach with a lower leverage.
Related resources
Where to start
If you are evaluating options for leverage, the most useful features to compare are the option premium, the leverage ratio, the time to expiry, and the implied volatility. Our broker comparison lists the option trading platforms and the available features, which together tell you what the leverage looks like before you buy.