Leverage – it’s one of the biggest plusses to trading options. I would argue that if you don’t maximize your leverage, you should not be trading options. Not using leverage is like using a Ferrari as a paperweight. Sure, it holds the paper down, but there are a lot less costly ways to get the job done. If you are not using leverage to trade options, you are probably wasting capital to get the job done.
Let’s take a look at a bullish play in Marriott. Our time horizon is February expiration. Using the implied volatility (no technical resistance above all time highs), we are targeting the $85.00 price point. We can do a few things.
We can sell a put spread, but the reward to risk ratio is poor, so we won’t do that. There are better choices. Here are three.
All using February expiration, we can do the 80/85 call spread, the 82.5/85 call spread, or simply buy the 80 call. For simplicity’s sake, let’s say we were right on and at expiration, we were trading $85.00. Great! What would have been the best trade to do?
Let’s say we are going to allocate the same amount of capital to each trade, $1,000. As of the morning of 12/23/14, the 80/85 call spread was trading $1.60, the 82.5/85 was trading $0.60 and the at-the-money 80 calls were trading $2.10.
So, one lot of the 80/85 call spread would cost $160.00, the 82.5/85 call spread would cost $60.00 and the 80 call would cost $210. Using our $1,000 of investment capital, we see that we can buy 6.25 lots of the 80/85 all spread, 16.67 of the 82.5/85 or 4.76 lots of the 80 calls (given we know that you cannot buy fractions of options contracts).
Our max profit for the 80/85 call spread is $2,125. For the 82.5/85 call spread, we can make $3,167.30 and the straight call would make us $1,380.40.
Buy employing leverage and trading the 82.5/50 call spread, we see how to use option leverage to maximize trading profits.
