Forums  > Pricing & Modelling  > Which is more Appropriate way to calculate Leverage with Options Contracts ?  
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Joined: Aug 2022
Posted: 2022-08-15 16:09
Below are 2 Methods for calculating the Leverage of a Option Contract with examples. The first method is the standard method i have seen. the second method is what intuitively i would use in calcuating leverage.

Method 1

It seems like the more referred way online to calculate Leverage for a Option Contract is to use the formula below,

Leverage = (Delta x Underlying Stock Price) / Option Premium Price

Example : Stock Price = $ 10 per share

Strike Price = $ 10 per share

Delta = 0.6

Now the following is using standard leverage formula,

Assuming the same details, lets add that the Delta = 0.6,

Leverage = (Delta x Underlying Stock Price) / Option Premium Price

Leverage = ( 0.6 x 10pershare)/ 1 option premium price

Leverage = 6 Leverage = 6 to 1

The conlusion is that this option contract provides a 6 to 1 Leverage.

Method 2

The way I would intuitively calculate the leverage of the option contract is like the formula below,

Leverage = (Notional Value of Option Contract - Premium Price Cost) / Option Premium Price Cost Paid

For the same scenario,

Notional Value = 5000WorthofUnderlyingStockShares( 10 per share x 500 Shares)

Option Premium Cost Paid = 500( 1 per option contract x 500 Shares )

Leverage = ( 5,000− 500) / 500 Leverage = 9 Leverage = 9 to 1

In this method of calculating the leverage, it is actually showing you the amount that you are being leveraged, because it places the Notional Value of the Option Contract($ 5,000) in the numerator in the formula. The Notional Value of the Option Contract, is the value of the Stocks Shares you control with the option with the option contract. This Notional Value of Stock shares is much more Bigger in value than the premium you paid. In other words, just for easy words sake, i will pu tit like htis, The Notional Value is the amount your being lent or how much your borrowing, so to speak. This is the total value your being leveraged. to get the exact leverage, the premium cost is subtracted from the Notional Value.

Now my questions :

1.) As explained in Method 1, i do not see the reason of using the theoritical underyling potential profit gain from underlying stock that does not control same amount of shares as an option contract. refer to method 1 for my reasoning. Why is it being used, when it underestimates levereage by great amounts ?

2.) Delta can change during the option contract timeframe, so when you enter in the contract, if you used the Leverage formula that uses Delta, could your Leverage Value that you calculated when you entered the contract be inaccurate because your detla value could be totally different at later time frame in the Option Contract ?

3.) For Method 2, the method i used with Notional Value to calculate leverage, is this way of calcuating leverage only approriate if youre assuming you will hold option contract until expiration ?

4.) Which method is more accurate, Method 1 calcualting Leverage with Delta, or Method 2 Calculating Leverage with Notional Value and Premium Cost ?

5.) I plan on creating and using synthetic option strategies that would hold the option contracts near or at expiration dates. Which Method is more accurate for Calcualting Leverage before entering and buying an Option Contract ?
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