Stock Leverage: This Is How It Works

As a rule, equities can generate annual returns of 7 to 8% . But it gets even better: options can leverage stocks, which can lead to even higher returns. There are a few fundamental aspects to consider, because leveraging stocks not only has benefits, but also involves risks. It is important to understand the principles of stock leverage.

Stock Leverage – what is it?

Many private investors do not know exactly what leverage is in stocks and how it works. On the stock exchange, investors have the opportunity not only to invest directly in a commodity, in a currency or in a share (underlying), but also to secure the purchase of an underlying at a fixed price via so-called derivatives .

The advantage: when buying a derivative, such as an option, investors have to take much less capital into their hands than with a direct investment.

Stock Leverage – an example

Here is a simple example: A company quoted at $15. An investor not only buys 100 shares (15 x 100 = $1,500), but also invests in 100 purchase options ( Call options ), with which the investor acquires the right to acquire 100 shares of the company within one year at the price of $17.

For the corresponding call options the investor pays $1.50, which adds up the capital investment to $150. The call options are even traded on the stock exchange and have a leverage of 10, whereby the investor benefits de facto in the ratio of 1:10 from the rising stock price of the underlying (company shares).

If the stock rises by 10% to $16.50 in the corresponding year, the investor can not only realize a book profit of $150. The value of the option also increases by 100% from $1.50 to $3.0

Thus, the 100 purchase options on the stock exchange worth $300, and the investor can in this fictitious example, a total profit of $300 (150 + 150).

It should be noted, however, that the leverage also applies in the opposite direction. If the underlying loses 5% in our example, the option loses 50% of its value. In practice, this can even lead to a total loss of the capital invested in call options if the underlying does not develop in the desired direction.

The lever and influencing factors

In practice, further key figures such as residual maturity, omega and delta influence the leverage effect and thus, have a tremendous impact on the price development of the option or the warrant.

An important factor in the selection of options is the omega lever, which indicates the actual leverage of the option. The Omega Leverage indicates to the investor the percentage by which the option or warrant will increase if the value of the underlying changes by 1%.

In general, low-leverage options are less volatile than high-leverage options and, therefore, are better suited to investors who are new to derivatives.

Investors should also be aware of the difference between an option and a warrant . There is no issuer for the option (call or put). Therefore, in this case, the risk of price manipulation and the bankruptcy risk of the issuer is eliminated.

Conclusion

Leveraging stocks opens up additional yield opportunities, but is also highly risky

Overall, it should be noted that, leverage products are highly risky and, investors must expect a total loss if the underlying does not move in the desired direction. Therefore, the leverage of stocks is only interesting for speculative investors or for professionals, who want to hedge existing positions .