One of the biggest benefits of all trading options is financial leverage. When you take a leverage, you are actually driving your investments to work harder for you, maximizing the profit. What it means is that you are creating leverage for bigger gains through a smaller amount of capital invested. Let’s expand this concept and explain its mechanics.
Definition of Leverage
Financial leverage is based on investing other people’s money in order to maximize future profits. For example, mortgages can be used to invest in real estate, and businesses may borrow money to expand their production. Leverage draws its benefit from increased property value, or higher company revenue which in return increases the value of stockholder’s shares.
How Leveraging Works
Financial leverage is usually created by using other people’s money in an effort to maximize future profits. Mortgages are used to invest in real estate, and companies borrow money to expand operations. The benefit of the leverage comes from increased property value, or higher company revenue which raises the value of stockholders’ shares. On the investor’s part buying options is an ultimate financial leverage. You as an investor can own a huge number of shares for the same initial investment, then if you bought the shares themselves. And the best thing is that you didn’t have to borrow additional capital.
Example
Let’s take an example where you want to invest $2,000 so you buy 10 shares of a company X, which number $200 per share. On the other hand, the option contracts may be valued at $400 for lots of 200 shares ($2.00 for option). That means that you’re your investment capital of $2,000, you could buy five options contracts that would increase your financial leverage by placing you in control of 1,000 shares instead of 10. Now, if the value of those shares surges during the option contract period, you can buy the shares that you have the right to buy at the agreed price, which will at that time be significantly lower than their market value.
Finalizing the Leverage
At that point, you can resell those shares that at market value, capitalizing on a vastly larger number of shares that if you purchased them originally if you had bought those 10 shares for $2,000. Still, bear in mind that you will need a lot more capital at your disposal if you want to pull the trigger on this trade, so you can buy the shares that you are entitled to by your options. And, of course, there is always the risk that the market place can suddenly plummet before you had a chance to resell the shares. In order to pull smart trading decisions, you are going to need a smart tool. You can sign up here to try out a new EquityFeed trading toolbox.
Risks Involved
There were numerous cases of a devastating effect of financial leverage on solvency, when a company that borrowed too much money was brought to the edge of bankruptcy during a business downturn. On the other hand, a company that has taken less leverage has higher liquidity and is more bankruptcy-proof. Leverage has seen a lot of popular prejudice by the people who borrowed a lot of money for personal needs, like overuse of credit cards. On the other hand, it’s worth remembering that in finance businesses borrow money for purchasing an asset with a higher return than the debt interest. By borrowing, a company in fact creates value, while taking debt for personal use there is no value creating, nor leveraging.
If you decide to trade options, you need a good understanding of financial leverage, its benefits and risks. A sound trading strategy can incorporate leverage as a tool for maximizing your profit, while keeping the risk as low as possible.
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