Leverage or No Leverage

Is leverage trading risky, or can leverage be our best friend?

The inspiration for this article came from a recent conversation with a potential investor in our fund. We discussed the fund’s strategy, which is part of the investment agreement and was presented in the same form to the Czech National Bank (ČNB) during the fund’s registration. The strategy includes a discussion of leverage usage. So, let’s dive deeper into one leveraged instrument used in stock market trading.

The threat of accelerated losses when using leverage in financial instruments is often overestimated. However, a thorough understanding of each instrument is essential.

How Classic Financial Leverage Works?

In leveraged trading, an investor borrows money from a broker to trade with a larger capital than what they have available.

For example:

• If an investor has $10,000 and the broker allows leverage of 1:5, they can control a position worth up to $50,000.

• If the asset value increases by 10%, the investor achieves a 50% profit on their own capital (a 10% movement on $50,000 results in a $5,000 profit, which is 50% of their original $10,000).

• However, if the asset value decreases by 10%, the investor loses their entire 50% capital.

Advantages of Classic Leverage:

✅ Allows investors to trade larger volumes without needing to invest their entire own capital.

✅ Potential for high returns when risk is managed properly.

✅ Enables speculation on small price movements, making it attractive for short-term traders.

Disadvantages of Classic Leverage:

⚠️ Significantly increases risk – even a small decrease in asset value can result in the loss of the entire capital.

⚠️ Margin requirements – if the market moves against the investor, the broker may require additional funds (margin call).

⚠️ Psychological pressure – traders often underestimate risks and can easily get carried away by the potential for higher profits using borrowed funds.

⚠️ Higher demands on margin management – traders frequently make the mistake of utilizing their entire or too high a percentage of available capital for new positions, leading to forced liquidations when the market moves against them.

What is leverage, and how does it work?

Most of us have at least a basic idea of what leverage means, but let’s explain it in more detail. Leverage in a financial instrument means that a change in the price of the underlying asset causes a proportionally larger change in the value of our investment.

Example:

Let’s take the stock of Apple (AAPL). If the price of AAPL moves by $2 in a single day and we hold a leveraged product with a ratio of 1:20, the value of our investment will change by approximately $40 (for simplicity, we’ll ignore fees, time decay, etc.). This works in both directions – if AAPL rises, we gain $40; if it falls, we lose $40.

How to handle leverage?

Using leverage is appealing when it amplifies profits, but it can be unpleasant when it magnifies losses. Does this mean we should avoid leverage entirely? Or should we stick to conservative, passive stock investments? The answer depends on each investor’s approach, risk tolerance, and desired returns.

Since I trade options – an inherently leveraged instrument using the leverage effect – let’s compare stock trading without leverage to options trading with the leverage effect and focus on the risks associated with both approaches.

Comparing stocks and options in terms of risk

Let’s use AAPL as an example again. A single share of AAPL is currently priced at around $150. Suppose we:

• Hold 20 shares of AAPL.

• Purchase one option with a delta of 0.2 (approximately equivalent to 1:20 leverage effect) and a one-month expiration.

Note: In the current market, which is moving sideways or downwards, I wouldn’t buy a long option and would instead prefer holding stocks or writing an option. However, we need this example to illustrate the concept.

Example:

• Stocks: Cost $3,000.

• Option: Costs approximately $200.

If AAPL’s price rises by $2:

• Stocks: Gain $40 in value.

• Option: Gains $40 as well.

If the price continues to rise to $170:

• Stocks: Generate a linear profit of $400.

• Option: Generate a profit of approximately $850 (due to the change in delta and the impact of time decay).

Investment efficiency:

• Stocks: $400 profit on a $3,000 investment.

• Options: $850 profit on a $200 investment.

What happens in the opposite direction?

If AAPL’s price falls to $130:

• Stocks: Result in a $400 loss.

• Option: Ends with a loss of $200 unless we exited the trade earlier (which is also possible with stocks).

The worst-case scenario for the option is losing the entire premium paid ($200 in this case). With a purchased option, you cannot lose more than the amount paid for the option.

On the other hand, stocks are unprotected against further losses, and our loss could deepen as the price continues to fall. Unlike options, which have a predefined expiration date, stocks can be held indefinitely. However, there is still a theoretical risk of a total loss if the stock price falls to zero.

Protecting against losses with options

I’ve already mentioned that holding 20 shares isn’t effectively protected against losses. Stocks are often purchased in multiples of 100 because one option represents 100 shares, providing a great tool for protection.

Let’s revisit our example:

We own 100 AAPL shares with a total value of $15,000 (approximately 367,000 CZK). This is our market exposure and risk. Since we hold 100 shares, we can say our position has a linear relationship to the stock price: a $1 move in AAPL results in a $100 change in the value of our investment (equivalent to a 1:100 leverage effect).

If the stock price falls to $130, our loss will amount to $2,000. Without using an options hedge, we’d be exposed to further losses if the price continued to decline. An options hedge (e.g., a protective put) involves leverage, but its primary function here is not amplification but limiting the maximum potential loss.

It’s crucial to understand that even when simply holding stocks, there is an “intrinsic leverage effect” determined by the number of shares held. This multiplier dictates how significantly our gains or losses fluctuate with the underlying asset’s price, and without protection, the risk remains unlimited in both directions.

Comparing options and stocks

Let’s compare a long stock position to a long option position:

If AAPL’s price rises to $170, our stocks will yield a $2,000 profit. To achieve the same profit with an option, we’d need one with a strike price of $125 and a one-month expiration, costing approximately $2,650. This example highlights the significant leverage effect provided by options compared to a direct $15,000 investment in stocks.

However, it’s important to note that such an aggressive approach with options would only be suitable in a strong uptrend. The main advantage of a long option is that losses are capped at the premium paid ($2,650 in this case), whereas stock losses could be significantly higher if the price falls.

Stocks vs. Options

• Long options: Offer unlimited profit potential and limited losses (equal to the option’s premium).

• Stocks: Offer unlimited profit potential but also carry high theoretical loss potential if the stock price drops significantly.

From this perspective, conservative, seemingly safer investing solely in stocks cannot be considered risk-free or less risky than leveraged products. Stocks inherently carry risk due to their linear relationship with price movements and the size of the position held.

The above is not investment advice. For detailed strategies, see my article Why and How I Trade Options.

While buying long options may seem attractive, long-term statistical probability favors option sellers over buyers. The edge is on the side of those who write options rather than purchase them.

If you want to learn more about options trading strategies, risk management, and how to use the leverage effect effectively, check out our materials and online courses designed for traders.