FINANCIAL GENUIS IS LEVERAGE IN A RISING MARKET

“FINANCIAL GENUIS IS LEVERAGE IN A RISING MARKET”, John Kenneth Galbraith

Who can argue with that statement? But how can we make leverage work?

There are many ways to leverage investments. Margin trading accounts, Rydex index leveraged funds, and options, for example. Some readers have seen examples of how options can leverage an investment and provide a greater return than ownership of the underlying stock. Let’s review how options can make leverage work:

We have $8,000 to invest. Our research shows that DUK stock is likely to rise in price after its good earnings report is released in next week. DUK is currently selling for $80 per share and we predict it will rise to $84 after the earnings report comes out. To profit from this increase in price, we have a couple of choices:

Buy 100 shares of DUK at $80 per share. If DUC rises to $84 next week, we will do well, making a $400 gain, or a 5% return in a week. ($84 per share-$80 per share = $4 per share * 100 shares = 400. 4/80 = 5% return.)

Buy 40 option call contracts at $200 per 100 share contract. These call options on DUC have a strike price[i] of $80. Our research into this DUC call option tells us that with each increase of $1.00 in the price of DUC stock, the call option will also rise $1.00, or $100 per 100 share contract.[ii]

So when DUC stock rises to $84 per share, each call option contract will rise from $200 per contract to $600 per contact. ($4 per share call * 100 share per contract = $400.) But it gets better, much better. Since we bought 40 contracts with our $8,000, our contracts are worth $16,000, for a return of 100%.

This is an extreme example, to be sure. Over the next few weeks the Author will examine uses of options and option strategies. They have many uses in a portfolio and we will explore some ways that you can make options work for you.

YOUR CHOICES ARE YOUR OWN IN THE DESERT OF THE REAL!


[i] There are three major features to an options contract. The underlying stock, the strike price and the expiration date. DUC is the underlying stock. The strike price is the exercise price of the option. In this case, the call gives us the right to buy $ DUC at $80, regardless of the market price. Finally, all option contracts are limited in time. They expire on a fixed date.
[ii] Because this call rises $1.00 per call as the underlying stock rises $1.00 per share, the stock is said to have a delta of 1.00. Delta is a measure of the rate of change. In the option universe, delta compares movement in an option to movement of the underlying stock. If the call moved $.75 for each $1.00 movement of the underlying DUC stock, then the delta would be .75. .75/1.00 = .75. If the call moved 2.00 for each $1.00 movement of the DUC stock, then the option would have a delta of 2.00.