leverageRatio – option should be a *low-cost* insurance

If you think in terms of “controlling” 100 IBM shares, then option gives you leverage over outright ownership. My CFA book explained that risk-management tools like options (and futures, swaps[3]) are like insurance products and therefore should be low-cost. Cheaper than …. than trading the underlier.

That means spot/premium (P/S) should be a high multiple, and the inverse a low percentage. See other posts on that percentage.

First derivative of premium against underlier is the #1 greek– delta. Note d_P/d_S != P/S. ATM delta is about 50, but leverage is much higher than 2 !

For a stock trading at $77, it takes $77,000 to own 1000 stocks. If an ITM call option sells for $6.50, then 10 contracts cost $6.50 * 100 * 10 = $6500, and give us a comparable exposure or control. Comparable (not “similar”) because for delta hedge, the 10 call contracts amount to 60% * 1000 = 600 stocks.

The ratio of $77/$6.50 is known as option “leverage ratio” or “leverage” for short. See http://www.tradingblock.com/Learn/public/ShowLearnContent.aspx?PageID=28 What determines leverage ratio? Volatility.

[3] I feel futures is also “low-cost” insurance because all futures contracts are traded by margin, so you use a small amount of cash to “control” a large “insurance” amount.


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