Illustrating Leverage Via Stock Options and Real Estate
By Tom Mullaly
Leverage is one of the concepts that is crucial to understand if you want to take an active role in managing your investments. A simple definition of leverage might be to gain control of an assert with less money than it would take to buy it outright. This can be accomplished by borrowing the funds to pay the seller, as with real estate, or it might be done through the basic structure of an investment like stock options.
Probably the most common example of leverage is a mortgage on your home. For usually no more than 20% of the purchase price of a house you can acquire ownership from the bank that lends you the money to buy it. For most people this makes the difference between being able to buy a house and not be able to do so.
Stock options investing also fits our definition of needing far less cash to control an asset than would normally be necessary, in this case by owning the right to buy 100 shares of a stock at a given price by a given date in the future. However, the motivation for investing in options is completely different from that of home ownership, as are the mechanics and timeframes involved. One enters into an options trade solely for the purpose of profiting from a price move that he expects in an underlying stock, within a relatively short timeframe. Normally the funds one uses to purchase stock options are not borrowed on margin from a stock brokerage, as the investment is already leveraged, often extremely so.
Recently we have seen how even an investment as relatively safe as residential real estate is subject to severe price fluctuations. Declines in the value of the underlying investment (one's home) might even become greater than the amount that we have invested in the first place. However as a house is a functional asset that one 'uses', in addition to being a long-term investment, people might still be comfortable waiting until the housing market reverses and a they actually have positive equity again. While these fluctuations might be psychologically uncomfortable for the homeowner, it will probably be less relevant as long as he is able to keep up with his mortgage payments.
With stock options, one doesn't have the luxury of waiting indefinitely for a price reversal in a trade that goes against him, because of the time decay that is constantly occurring with options. As they have an explicit expiration date just days, weeks or months in the future, investing in them makes it impossible to simply wait until the price moves in your favor again. Having achieved your leveraged position with options, you are engaged in a different, much riskier game than taking out a mortgage, as a long options position often carries with it the real risk of the contract(s) expiring worthless. This is virtually impossible with a leveraged real estate investment.
When it comes to timeframe, mechanics, as well as overall safety, stock options are a very different investment than real estate. In having a basic understanding of each however, the concept of leverage can be clearly understood. This certainly does not mean that you should attempt to trade stock options by the way, as they are extremely risky. However, education is a good first step to determining if they should have a role in your investment portfolio.
About the Author:
Leverage is a big part of options investing and if you need options explained to you, it's one of the concepts you have to understand. Do remember that stock options are very risky. Trading options should only be attempted when you really understand them, and even then only with a small percentage of your investment capital.
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