In this article, we will deal with the topic of stock options. Here, we have already described how put options can be used to secure the value of your shares. For small investors, this is also the only use of options if you do not want to speculate with them.
So-called CFDs can also be traded with leverage – you can find more on this topic here – Contract for Difference (CFD).
However, we have never talked about leverage in connection with stocks.
What is “leverage”?
Yesterday, our order from Erste Group Bank was executed at a price of 15.50 euros. We have secured 100 shares and therefore invested 1,550 euros (plus order fees of EUR 6.80).
Let us assume that Erste Group’s share prices develop well over the next few months and rise to 20 euros. This would give us a (book) profit of 450 euros or 29 % of our invested capital.
So where was the leverage?
Do not hurry! There has not been leverage so far. This would be a case if there was a possibility to reduce the capital investment (1,550 euros) but still be able to benefit from the share price development to the same extent.
By “to the same extent” we do not mean that we achieve the same profit in percent, but in absolute numbers.
This possibility exists! You need to buy call options.
Repetition: What are options
If you cannot remember the basic terms such as strike price, strike day, American options or European options, we suggest that you take a brief look here again.
Can you remember what options are? If not, we will give you a brief revision:
With an option you acquire the right, but not the obligation, to buy (call option) or sell (put option) a certain amount of a share (underlying) at a predetermined price.
Trade stocks with leverage
Let us assume that you buy 100 call options which will allow you to buy 100 shares of Erste Group at a price of 17 euros by the end of the year.
We assume that you pay 1.55 euros per option. Your investment therefore amounts to 155 euros. The purchase price is now also the value of the option, as you could sell it on the stock exchange at any time.
What is interesting now is the development of the share, as it is almost identical to the development of the option. If the share price of Erste Bank rises, the price of the option also rises by approximately 1 euro.
What is different now, however, is the capital investment. We have paid 15.50 euros for one share and only 1.55 euros for our hypothetical options.
This ratio (15.50: 1.55) results in a leverage of 10. In other words, we operate in a ratio of 1:10.
If the value of the share rises by 10%, our options increase by 100%. However, if the stock only loses 5% in value – which would not be a big loss if quarterly payments were poor – our options will already have lost half of their value.
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Share options and small investors
What should be kept in mind is that call options are high-risk investments. Options themselves belong to the group of derivative financial instruments, the derivatives, and are not recommendable for small investors.
However, if a total loss of your investment would not do you any damage, you may as well consider buying options. The amount of the investment should still be rather small, e.g. less than 1% of your net assets or the money you would otherwise spend at the casino.
This is because with options, you have to expect a total loss at any time. As an illustration: If the share prices in our example rise but do not reach the target of 17 euros, you will still suffer losses.
A summary on the topic of shares can be found here.