Option Leverage and the Risk of Going to Zero
One call costs a fraction of the stock price yet shares in the gains on 100 shares. But if the stock doesn't rise enough, it goes to zero. Compare the returns of buying stock vs. buying a call.
Risk warning: forex, CFDs, options, futures and crypto assets usually involve leverage or high volatility, and you can lose more than you put in. This lesson only teaches the concepts; all numbers are for illustration and are not investment advice.
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Text version · Options Basics, lesson 9: “Option Leverage and the Risk of Going to Zero”
One call costs a fraction of the stock price yet shares in the gains on 100 shares. But if the stock doesn't rise enough, it goes to zero. Compare the returns of buying stock vs. buying a call.
A little money controls 100 shares
Buying 100 shares costs $10,000; buying 1 30-day at-the-money Call costs only about $360, yet you share in the rise of those 100 shares. If the stock rises 10%, the Call might more than double. That's the leverage of options.
The other side of leverage: going to zero
If the stock hasn't risen above the strike price by expiration, the Call is worthless: a 100% loss. Someone who bought the stock loses nothing in a flat market, but a Call buyer can lose everything.
The further out of the money, the more like a lottery ticket
Out-of-the-money Calls are cheaper with more leverage, but the stock has to rise further to break even; in-the-money Calls cost more with less leverage and behave more like the stock. The higher the leverage, the bigger the chance of going to zero.
Key takeaways
- An option controls 100 shares for a small premium, so for the same price rise its return can be several times the stock's.
- If the stock doesn't rise above the strike by expiration (for a call), the option loses 100%, while a stock buyer might only be slightly down or even flat.
- The further out of the money, the cheaper and more leveraged the option, but it needs a bigger rise to break even and is more likely to expire worthless.
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- Pick “At the money $100” and leave the stock at $110: the stock makes 10%, so what's the Call's return? How many dollars did 1 Call make?
- Drag the stock back to $100 (flat): the stock breaks even, so what's the Call's return?
- Switch to “Out of the money $110” with the stock still at $110: you got the direction right, so why is the Call still −100%?
- Switch to “In the money $90” and look at “Leverage at opening”: is it higher or lower than the roughly 14.8× of at the money? When the stock falls to $95, how much does it lose (compared with at the money)?
Quiz and explanations
- 1. The stock is $100 and a 30-day at-the-money call costs $3.60. At expiration the stock is $110. Roughly what's the call's return?
- Answer: +178%.It's worth $10 at expiration, a gain of $10 − $3.60 = $6.40, and $6.40 ÷ $3.60 ≈ +178%. The stock only rose 10% over the same period.
- 2. Same call, but at expiration the stock is still $100. What's the call's return?
- Answer: −100%.An at-the-money call has no intrinsic value at expiration, so the whole $3.60 is lost. The stock is simply flat.
- 3. Which statement is correct?
- Answer: Out-of-the-money calls have more leverage and a higher chance of going to zero.Each premium dollar on an out-of-the-money call controls more stock, but it has to rise past a more distant breakeven, so it usually expires worthless.
Terms in this lesson
- breakeven (Breakeven): The underlying price at expiration where you neither make nor lose money.
- in the money (ITM) (ITM): An option with intrinsic value, such as a call whose strike is below the stock price.
- leverage (Leverage): Controlling a large position with a small amount of margin; 1:100 means $1 controls a $100 position.
- out of the money (OTM) (OTM): An option with no intrinsic value, such as a call whose strike is above the stock price.
- premium (Premium): The price of an option, paid by the buyer to the seller; it's the most the buyer can lose.
- strike price (Strike): The price written into an option contract at which you can buy or sell.