Page 277

refers to a part of an option’s price known as the time value premium. This is not the same as the actual option price but depending on the strike price of the option, its time to expiration, and the current underlying stock price, it may be the equal to the option price. More on this later.

Leverage

One of the greatest features of derivatives is the leverage they offer to the investors. In our discussion of futures we covered leverage quite a bit. As a reminder, while derivatives do not equate ownership, they give their owners the ability to control a relatively large amount of the underlying products. For example, we learned how a gold futures contract holder controls large amounts of gold. Options also give the same kind of benefit to their holders. A stock option contract thus represents a large number of the underlying shares. Remember that each option contract in standard options market is based on 100 shares of the underlying stock. For example, one call option contract for IBM gives the contract holder the right (but remember, not the obligation) to buy 100 shares of IBM at the specified price prior to the option’s expiration date. Five contracts correspond to 500 shares and 20 contracts correspond to 2,000 shares, and so on. Therefore leverage gives the investor who cannot otherwise afford buying many shares of a stock the vehicle to participate (in an alternative manner) in the stock price movements at a lower cost, given some risks of course. With leverage, price movements of the underlying shares are also reflected in their options but a lot more magnified. As an example, a 10% upward move in a stock could give a corresponding call option a 100% or 200% boost depending on the option. The profit potential is high but again it comes at a high risk. …