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The Benefits of Options - Leverage

One of largest benefits of using options is leverage. We know that options give the buyer the right, but not the obligation to buy a stock at a fixed price for specified length of time. The ability to "fix" a stock price entry level for a specified length of time has tremendous leverage implications. Using just a fraction of the capital required to buy the underlying security outright, the option buyer is able to participate in price movement.

Consider this example. IBM Corp. (IBM) stock is trading at $100. An investor believes IBM common stock will soon advance to $120 and decides to buy one contract of the IBM November 100 calls for a premium of $2. The cost of this transaction is just $200 plus commissions versus buying the stock outright at a cost of $10,000 plus commissions.

If the investor is correct and IBM does rally to $120 the IBM November 100 calls would advance to $20, that is a gain of 900 percent or $1,800! If the investor had bought the common stock for a capital outlay of $10,000 the gain would have been a handsome $2,000 but the return on investment would have been just 20 percent. In this case buying an option was the correct course of action.

Of course leverage is a double-edged sword. If IBM common stock had remained at $100 through the life of the contract or worse, declined below the $100 strike level by the expiration date the option would have declined to zero and the loss would have been 100 percent.

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