Understanding Leverage

Through the decades, leverage has made it possible for millions of people to own homes that they could not have afforded without securing a loan from a bank. This is the most common example of leverage in the investment world, even though most people probably wouldn’t think of their mortgage as an investment. But since it is employing a relatively small amount of money to control an asset that is worth much, much more than this amount, your home mortgage certainly does qualify as a leveraged investment. Stock options are also leveraged investments, though they have a couple of differences that distinguish them from mortgage loans. Once you understand both of these investments you should have a good handle on leverage per se.

The first difference is that options have an expiration date. A stock option contract gives you the right to buy 100 shares of stock at a given price by a specific date in the future. This means that if by that date, the underlying stock for which you purchase the right to buy is not above that so-called “strike price”, the right to purchase it at that price would expire worthless, since we never pay more for something than we must. Much of the basic challenge of making money with stock options, and part of what makes them leveraged bets, comes from this basic condition: it’s not enough to be correct about the direction in which the stock might move. You must be correct as soon as possible, as the ‘time value’ that the market gives to an option based on how much time there is before its expiration, is always decaying.

The second big difference between the leverage you’ll find in stock options versus that of a home loan, is obviously the motivation for entering into each of these investments. Whereas the loan is taken out in order to control an investment that has utility as well as the possibility for appreciation in the long run, stock options are bought to participate aggressively in a change one expects in the price of a stock, often in an effort to achieve triple-digit gains rather than maybe 10 to 30%, usually over a much shorter time frame than one has when buying a stock, (or certainly a mortgage).

If leverage is something you are trying to understand, comparing and contrasting this important financial concept as it exists in both stock options and home mortgages might be helpful. Just be clear that when you are investing in stock options you understand that the investment strategy of “buy and hold” does not apply to options.

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