call options and leveraging?

Question

Can someone explain to me why this statement is true:

"A call option loses some of its financial leverage when the underlying share price rises far above the exercise price"

The way I understand this question is that a buyer already owns a call option. When the underlying share price increases significantly from the strike price, I do not understand why the leverage factor would be decreased.

For example, say I bought an option for $3 6 months ago. The strike price is $26 and now expires in 3 months, and the underlying current market price of the share is $55, why does this effect the leveraging in a bad way?

I can see how it would effect the re-sale value of the call option, but not the leveraging.

Answer 1

The answer is that the amount of leverage should be measured from the current price, not the price you originally paid.

Let me use an extreme example to demonstrate.

Suppose a stock is selling for $4.00 per share and you buy a call with a $5.00 stirke price for $1.00.

If the stock goes from $4.00 per share to $10 per share, the call option will be worth at least $5.00 per share. Thus the stock profit was 150% and the option profit was 400%. (8:3 leverage)

If the stock goes from $10 per share to $20 per share, the call option will be worth at least $15 per share. Thus the stock profit was 100% and the option profit was 200%. (2:1 leverage)

If the stock goes from $20 per share to $40 per share, the call option will be worth at least $35 per share. Thus the stock profit was 100% and the option profit was 133%. (4:3 leverage)

The reason to use the current price instead of the price you paid is that options are a liquid asset. You can convert an in the money option to cash at any time.

Answer 2

The lower the strike price of a call, the more the option costs because you have to pay the difference between the stock price and the option strike price. ex. Say you want to buy an option for microsoft. If microsoft stock was at $30, a call with a 25$ strike price may cost you $600. An call with a $20 strike price would cost around $1100 dollars. The lower strike price means it costs you more to control the same amount of stock.

Just a side note, this does not mean that its always better to buy calls with higher strike prices. A lower strike price usually means a lower premium.

Answer 3

identifying to purchase the bonds skill making an investment extra funds. that would not leverage techniques in any way. you have a concern of matching the adulthood of the bonds with the expiration of the techniques. If the bonds are long term, you have a timing mismatch. If the bonds are short term (T-expenditures), expenditures are so low that the pastime would not help you purchase a significant techniques place. the two you compromise for possibility of loss, or the timing mismatch leaves you long bonds with inflation possibility to buying power. So no loose lunch.