Dear Trader, One of the great advantages of trading options relative to stocks is leverage -- namely, the ability to rack up profits far exceeding your initial capital investment. But, as with most "power tools," you can only hope to reap the benefits of leverage once you've learned to wield it properly. While most options buyers typically buy too much leverage within the context of also not buying enough time (the super-aggressive "YOLO" trader), it's also possible -- by going too far out in time, and going too far in the money -- that you might actually obtain a degree of leverage insufficient to justify the trade (the "may as well have bought shares" trader). Today, we're going to help you find the risk/reward sweet spot for your own options trades by sharing one simple, yet potent, math equation -- one that our own Schaeffer's traders use right here, in-house, to drill down on the call and put plays primed for the biggest profit opportunities. Don't overlook the leverage ratio While individual investors have become increasingly savvy in their analysis of options trading opportunities, a crucial (and convenient, and freely available...) tool overlooked by most is the "leverage ratio." This figure is calculated by multiplying the stock price by the option's delta, and then dividing this product by the option's premium. Generally speaking, you'd like to target a leverage ratio of at least 5-to-1 for your options trades. (By the way, an option's delta is a measure of how sensitive an option is to the price of the underlying shares. For example, if an option's delta is 90%, this means the option should move $0.90 for every $1 move in the shares. If an option's delta is 30%, this means the option's value will change $0.30 for every $1 move in the shares, so it's obviously less sensitive than the higher-delta option.) At Schaeffer's, we use the leverage ratio to determine whether the dollars we're risking on any given options trade are worth the potential reward. And while this math certainly comes in handy during earning season, when implied volatilities (IVs) -- and, by extension, option premiums -- are so often pumped up, this formula is an indispensable component of our pre-trade due diligence all year long. Greenlighting a BOX put trade As described above, the leverage ratio is the stock price multiplied by the option's delta, divided by the option price -- so the formula is (stock price x option delta)/option price. The resulting number reflects the degree to which the percentage return on the option trade might exceed that of a comparable stock trade. By way of example, we initiated a bearish put trade on Box (BOX) back in late April 2019, when the stock was trading around $20.50 per share. The shares had just rallied into resistance, and we expected BOX to fall hard over the coming weeks, which drew us to the June options series. At the time, the BOX June 22-strike put option was asked at $2.55, with implied volatility at 47.7% and a delta of -63.0% (indicating a roughly two-thirds chance it would finish in the money at expiration). Our formula to calculate the leverage ratio on the BOX trade looked like this: (20.29 x -0.630) / 2.55 = -5.01 [Note that the leverage ratio will be a positive number for call trades and a negative number for put trades, based on the corresponding delta that's figured into the equation.] So what does the resulting leverage ratio of -5.01 mean? Quite simply, that the BOX June 22 put was poised to deliver 5 times the potential profit, on a percentage basis, as shorting the shares. The option would deliver our target profit of 100% (a double) on a 16.7% decline in BOX shares to $16.90. (Box stock ultimately suffered a post-earnings bear gap and briefly fell below the $15.50 level in intraday action on June 4, yielding an average gain of 161% on the trade in just about seven weeks.) ![Learn More](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_shK3pdE8Ro7_jaaA9T6txJuCHuBbICcOk9fezkt_7kPxosXYarPGiAuLSVaCmBytmaM6rONKi8nWEVcTK9r59nibtH3RynqPCgTEHXYyQ-5ig8G5oWdB89f3yEum1ofELlVY70NY4zaXypkA=s0-d) While we've used 5 as our "benchmark" here, an appealing leverage ratio might range somewhere between 5 and 10, depending upon the time frame of the trade. For options with a very short time frame that are near the money, a leverage ratio of 10 could be reasonably expected. Options with two or more months until expiration -- and/or in-the-money options with higher intrinsic values factored into their premiums -- might provide a leverage ratio closer to the ballpark of 5. When the math says to take a pass... Whatever the exact leverage ratio on a given call or put might be, you should pass on the trade if you aren't being rewarded appropriately for the risk you're taking. For instance, if a 10% move in your favor is only going to produce a 60% gain, whereas a 10% move against you is likely to result in a total loss, it's better to pass, given that the potential leverage doesn't justify the risk. The leverage ratio is a key consideration in our pre-trade analysis because it offers a clear-eyed, objective measure of the reward you can expect in relation to the risk you're taking on. This is especially critical in the realm of pre-earnings plays, when implied volatility levels are so often inflated by the expectation for a sudden or unusual move in the underlying stock. If your days of memorizing formulas ended with graduation, don't worry -- we've got your back. Every week, our expert team filters through dozens of potential trades for our Schaeffer's Weekend Trader Alert options recommendation service. Using the leverage ratio, along with a full complement of other technical and sentiment indicators, we send our subscribers only those trades that offer just the right combination of risk & reward to make the most of that leverage we all love so much. With Weekend Trader Alert, you'll receive a new options recommendation direct to your inbox, every Sunday at 7 p.m. ET. Each pick will be accompanied by a thoroughly researched commentary, where you'll learn which signals drew us to the stock -- and why we think it's primed for a major move over the course of just a few months (or less!). Plus, every trade is based on our proprietary Expectational Analysis® methodology, which targets stocks that are poised for big breakouts. And you'll never have to worry about the details, because we provide everything you need to manage the trade, including a target profit and time-stop date. You're never left wondering what to do -- we'll guide you every step of the way. As a special "thank you" for choosing Schaeffer's, we're offering a special deal on Weekend Trader Alert right now. You can take advantage of our powerful full-service recommendations at a major discount off our usual price! While a month of Weekend Trader Alert recommendations typically retails for $149 - a fair price, considering the volume of trades and the ambitious target profits - as a VIP Schaeffer's member, you can claim a month of these exciting trades for just $10! That's an average of 4 of our subscriber-favorite trades for just $10, but you must claim your place within the next three days, or it will be too late! ![Act Now](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_thkcGKiYMg3i2vWmKb38P135J2MOck_YvHt-Sx3BeJDECg7XLBrKxS3hieechPHuy-F4e97df6Xxf2ZSu6sTXQnbk2MdgGIVt0fddFE32VPwrlQjxeeDvklWtnQUOqDYYbWt40Ql7qB6Bn_KoVoEQYmTQ=s0-d) All my best, Bernie Schaeffer Chairman & CEO Schaeffer's Investment Research service@sir-inc.com http://www.schaeffersresearch.com 1-800-448-2080 1-513-589-3800 International P.S. Looking to lock in big, leveraged wins? My Sunday night trades are the smart-money play -- don't sleep on this deal! |
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