Superleverage: Limiting Your Risk While Boosting Your Returns

Some marketers, promoters, and touts like to say the greatest misconception about options is they are full of risk. I say the greatest misconception about options is they are low risk. If anyone ever tries to tell you that you can earn a high return with low risk, zip your wallet!

But if you understand options, and it’s easier than you may think, you’ll quickly realize just how powerful a means to making profits they can be for you.

What is Superleverage?
You grasp that speculators make their fortunes from changing prices. Chances are, you are also familiar with the benefits of leverage. Leverage is an important tool for speculators.

Leverage involves using OPM (Other People’s Money) to try to make more money than you can with your own. Using OPM may augment rewards when you are right, but it may also greatly accelerate the risk of additional losses when you are wrong.

If leverage can be applied with an always known and strictly limited risk, it takes on a more sensible aspect. It becomes…

…Superleverage, the art of profiting from changing prices, with limited risk AT ALL TIMES, without ever getting a margin call, asked to put up additional funds, or forced to liquidate your position.

The instruments of Superleverage are exchange traded put and call options.

Buyers of puts and calls are the ONLY ONES who possess the full profit power of Superleverage.

Option buyers have several advantages: You don’t need to be a financial wizard or have large sums of money to participate. Only as an option buyer do you have all the benefit of using OPM when right, without the concomitant costs and risks when wrong. Total risk is ALWAYS known and limited to your cost of taking a position (making your bet).

While the option buyer has an always known and strictly limited risk, you will be well-served to remember that the risk is still extremely high, as it should be for the opportunity to earn unlimited gains…it’s the full amount of your bet, but not one cent more.

Here are a couple examples…

Let’s say you’re looking at two different stocks, Chili Co. and PepperTec. (I’m making up these names…as far as I know, there are no companies called Chili Co. or PepperTec…my first dogs were named Chili and Pepper).

First, Chili Co. In October, the stock is trading at $38. You’re thinking the stock will rise to $50 by the end of the year. In volatile market conditions, the stock could also collapse or it could settle down and move quietly sideways.

There are many things you could do, because there are many options to choose from. They come with a variety of strike prices and monthly expirations, and each of those options cost a different price—and therefore offer different opportunity to profit.

Let’s say you buy a Chili Co. January $40 call option for $200 (or $2 a share, since each option represents 100 shares). The price you pay for the option—in this example, $200—is called a premium. The premium depends on a wide range of factors, including the actual price of the stock, time until expiration, and volatility.
“Chili Co.”, in this example, is the underlying instrument, the specific security the option gives you the right, but not the obligation, to buy or sell. “January” is the expiration month for the option. Equity options last trade on the third Friday of the expiration month, with the Saturday immediately following being the official expiration date. “$40” represents the strike price, the price per share you have the right to buy Chili Co. at. And buying the call option means that anytime before the third Friday in January, you can buy 100 shares of Chili Co. stock for $40 a share…no matter what the market price of Chili Co. If Chili Co. is trading at or below $40 on the third Friday in January, your option will expire worthless. That is your risk.

Meanwhile, PepperTec is selling for $117 in October, but you think the stock is headed for a big fall come the new year. The stock could also continue higher or drift sideways. Rather than go through the expensive hassle of shorting the stock, you decide to buy put options instead. Again, options are available with a variety of strike prices and a wide range of expiration months, but you decide on the PepperTec January $115 put option, for $300. Any time between now and January you can, but you are not obligated to, sell (receive money for) 100 shares of PepperTec for $115 a share. If PepperTec. is trading at or above $115 on the third Friday in January, your option will expire worthless. That is your risk.

You, or your broker, are monitoring your positions daily. Chili Co. has just made a major announcement, and its shares have moved up sharply…to $50 a share. Back when Chili was trading at $38 per share, your option had no real value. The $200 premium you paid was for time and volatility only. But, with Chili Co. trading at $50, your call option, your right to buy 100 shares for $40 has a real, intrinsic value of $1,000 (the right to exercise your option and buy 100 shares at $40 and immediately offset by selling them for $50). But you don’t have to exercise options to make big profits. Most of the time, you simply resell the option to close your position. You’re looking at a 400% return, minus commissions and taxes.

Congratulations! You just used Superleverage to turn $200 into $1,000. Throughout the transaction, your risk was completely known and strictly limited.
By the way, if you had bought the 100 shares outright at $38 (for $3,800) and sold at $50 (for $5000) your gain would be just under 32%. Still nice, but paltry compared to the return on the option. That’s the power of Superleverage.

Now, it’s mid-January. You check PepperTec, and it turns out I was wrong (that happens occasionally). PepperTec stock is climbing towards $130. Because your option is to sell the stock at $115, it has no real value…and is headed toward a worthless expiration. At the end of the day, you have a 100% loss of the $300 premium you paid.
You may have lost $300, but that’s far better than if you had shorted the stock. If you had sold short 100 shares at $117 and the stock went up 11%, covering the short would have cost you $1,300 ($13,000 – $11,700). Technically speaking, buying the option saved you $1,000.

Options offer their owners the power of Superleverage—the potential to make spectacular profits in a short amount of time, on relatively small moves in the underlying shares, with an always known and strictly limited risk.

Combining the tools of Superleverage with a disciplined method, sound money management principles, and a good understanding of your personal tolerance for risk gives you the cornerstones of a complete game plan for trading success.

Sincerely,

Steve Sarnoff
Editor, Options Hotline