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Think Option Leverage is Simple? Think Again

Think Option Leverage is Simple? Think Again

My role in the Trade Room is a little different from Andrew’s.AK mans the scanners. He’s watching each signal that comes through, and giving his blessings to only the best.Meanwhile, I play the role of trading coach. I ensure that everyone who joins the room is getting the education they need to manage a portfolio like a professional.For example: we’ve spent numerous sessions in the Trade Room recently covering position management techniques. Specifically, managing multiple options positions at once to hedge your risk.Most traders never bother to learn these concepts. They go on an options buying spree, not really understanding what they’re doing, and wind up blowing up their account.Today, I’m going to share just a taste of how you can manage your positions effectively, so you can avoid that.But before I do, know that if you’re a member of Trade Kings and you missed any of my coaching sessions live, you can find all the recordings here.If you’re not a member, there’s no better place to learn trading education in real time.And if I were you, I’d learn all I can to be positioned correctly once this market starts to rally. Click here to learn more.

Understanding “Effective Leverage”

One key concept to understanding how a position will behave is what I call “effective leverage.” Now, we all should know that an option contract controls 100 shares of the underlying stock. So, on the surface, an option position can be considered levered 100:1 to the price move of the stock. However, in practice — especially over differing times to expiry of option contracts — that leverage will vary significantly. This should be top of mind when choosing positions to add to a portfolio that includes hedges.Let’s Illustrate this by comparing a couple MSFT options with different expirations. First, here’s the 2 DTE (days to expiry) MSFT ATM (at the money) call:

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This option is trading at a $3.20 bid by $3.35 ask. So, we need to calculate the effective leverage of this position by its delta, which is .46.Now, let’s look at MSFT ATM calls that are 9 DTE (we’re using these calls because we’re shooting for as close to the same delta as possible):

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The 9 DTE MSFT ATM calls are trading at $5.60 by $5.70 with a delta of .49.What we need from here is a way to express difference in effective leverage of our capital at work across these two positions. I use a ratio I call “delta per dollar” in order to predict how much my profit and loss will fluctuate as the price of MSFT changes.So, for the first position — and trust me, the math is simple here — let’s divide the delta of the option by the price. That will tell me how much capital exposure I have for each unit of delta at work…2 DTE MSFT Calls with a .46 Delta, at a price of $3.25 = .46/3.25 = .14 delta per dollar on the option.9 DTE MSFT Calls with a .49 Delta, at a price of $5.65 = .49/5.65 = .08 delta per dollar on this option.  This is a substantial difference… almost 50%. So, let’s look at how this affects the bottom line of our trading account. To make it easy, assume a $1 move up in price on MSFT. The 2 DTE option will move up in price by $0.46 (delta is how much the option will move per $1 move in the underlying stock) while the 9 DTE option will move $0.49. So, we’re pretty close on this comparison. However, looking at our delta per dollar ratio, the 2 DTE option requires $0.14 of capital exposure for each unit of delta, while the 9 DTE option only requires $0.08 of capital exposure.In effect, I’m almost twice as levered in terms of my actual capital on the 2 DTE option than I am on the 9 DTE option. This is a huge difference, and key to understanding what I consider the most important skill in option trading: knowing the bottom line consequence of price movement.So, even though options are generally considered levered 100 to 1, we can’t assume all options are created equal when you consider actual capital exposure. This is the first step to determining our choice of positions, critical to accurately placing hedges. So, to sum up with a coaching tip: Keeping delta per dollar similar between an option position and its corresponding hedge means we are properly matching up effective leverage. This is just a preview of the great education available during the 3PM-4PM EST live coaching sessions in the Trade Kings Live Trade Room.Again, if you’re not in there, you’re missing out. Click here to change that today.

Until next time,

Bryan KlindworthSenior Analyst, Kings Corner

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