How to estimate option leverage

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by rwhit9

I though I would share a quick tip. Estimating option leverage is a helpful way to help understand the risk/reward of an option position. The calculation is simple: current leverage = (delta/option price)*current stock price.

Recap: Delta is an estimate of how the value of an option changes for each $1 move in the underlying stock.

Example: SPY 295c 5/15 Delta: 0.3858, Price: 2.22, SPY current price: 293.74

Current Leverage: (0.3858/2.22)*293.74 = 51.04

This option has over 51x leverage. compare buying this option to buying SPY shares at with an account 51x times the option price. Pretend your account is $11332 (51 times as much as 1 option contract at $222 per contract). Assume you place 100% of your account value in SPY shares. you would have 11332/293.74 = 38.54 SPY shares.

If SPY increases $1 from 293.74 to 294.74 SPY will increase (294.74-293.74)/293.74 = +0.34% increase. your 38.54 shares has increased 0.34% to $11360.54. if you close the position the profit is +$38.54. this is the same estimated gain as buying the 295c 5/15 (0.3858 delta*100=38.58)

If you place 2% of your portfolio in this option, it is similar buy SPY shares with 100% of your portfolio.

Now calculate the leverage as you go further OTM. SPY 305 5/15 Delta:0.0558, Price: 0.175, SPY current price: 293.74

Leverage:=0.0558/0.175*293.74 = 93.6x

Now calculate for a longer expiration option SPY 295 7/17 Delta:0.4889, Price:11.09.

Leverage = 0.4889/11.09*293.74 = 12.9x

To summarize, Further OTM options provide greater leverage. Shorter expiration options provide more leverage.

Remember leverage is constantly changing due to changes in IV, theta decay, and gamma changing delta as the price moves.

If you understand how fast a 3x levered ETF can go against you. This will help frame up the risk at 10-93x option leverage. So before your next option buy convert the delta to a leverage ratio.

 

Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence.

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