Obtaining a margin account with your broker can be difficult. Credit checks, minimum balances and paperwork can make obtaining a moderate leverage of 2:1 nearly impossible for most investors. Brokerage firms are a tough sell for leverage, especially in today’s volatile markets and restrictions on day traders.
Deep in the money options
Luckily, deep in the money options provide a way to leverage equity positions. By purchasing deep in the money options, an investor can avoid the hefty premium of options not yet in the money and lower the amount necessary to make an investment.
A deep in the money option is like any ordinary option, but the price of the stock is already well above the strike price, or the price at which you are able to exercise your options.
Stock Options are usually considered very speculative investments, and generally they are, but through proper money management techniques, the use of options can increase your market exposure and put less money on the line.
Less at stake
With deep in the money options, only the amount of what you pay for the option is at stake – which might just be a small portion of what the actual stock price happens to be.
For equities, it is possible to watch your stock fall to $0 per share. With options, you can never lose more than your premium because you have the choice to exercise the option or just let them expire. You do not have to exercise your options when the stock price is lower than your option price. And for that matter, you do not have to exercise them when the stock price is higher than the option price, but why wouldn’t you?
As of this writing, Exxon Mobil trades for $86.81 per share. To purchase 100 shares of Exxon, you would need $8,681. However, for the same exposure to Exxon Mobil, you would only put up $3,710 for 100 Exxon options with a strike price of $50 per share set to expire in January 2009.
If the price of Exxon Mobil’s stock moves to $100 per share…
…the value of your stock would now be $10,000 from an investment of $8,681. Your options, on the other hand, would be worth $5000, up from an investment of $3710. You would earn a profit of 15% on your stock purchase, while your options would rise by 34%. A total profit of $1,319 would be generated on your stock investment and $1,290 on the option purchase.
This calculation is lacking one minor detail – the difference of $4,971 between buying stock and buying stock options. If you were instead to deposit the $4,971 in a money market account, you earn an extra $200 in interest. The interest added to your option returns leaves you with a $1,490 total gain, with less money at risk.
Less capital at risk
Deep in the money options allow investors to make much safer investments. Stock Options are only riskier if the full amount is invested in options. As we can see from this scenario, it would have been possible to buy twice as many calls as shares. Deep in the money options are a great way to pay a little bit extra for a much better return. Remember, options are not inherently risky – it’s what you do with the option that makes it risky.
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