Understanding and Managing Leverage    • 175
also fall to $2.50. If, instead, the value of the underlying security increases 
by $2.50, the value of that allocation will rise to $7.50.
In a levered portfolio, each $5 allocation uses some proportion of 
capital that is not yours—borrowed in the case of a margin loan and con-
tingently borrowed in the case of an option. This means that for every 
$1 increase or decrease in the value of the underlying security, the lev-
ered allocation increases or decreases by more than $1. Leverage, in this 
context, represents the rate at which the value of the allocation increases 
or decreases for every one-unit change in the value of the underlying 
security.
When thinking about the risk of leverage, we must treat different types 
of losses differently. A realized loss represents a permanent loss of capital—a 
sunk cost for which future returns can offset but never undo. An unrealized 
loss may affect your psychology but not your wealth (unless you need to 
realize the loss to generate cash flow for something else—I talk about this 
in Chapter 11 when I address hedging). For this reason, when we measure 
how much leverage we have when the underlying security declines, we will 
measure it on the basis of how close we are to suffering a realized loss rather 
than on the basis of the unrealized value of the loss. Leverage on the profit 
side will be handled the same way: we will treat our fair value estimate as the 
price at which we will realize a gain. Because the current market price of a 
security may not sit exactly between our fair value estimate and the point at 
which we suffer a realized loss, our upside and downside leverage may be 
different.
Let’s see how this comes together with an actual example. For this ex-
ample, I looked at the price of Intel’s (INTC) shares and options when the 
former were trading at $22.99. Let’s say that we want to commit 5 percent 
of our portfolio value to an investment in Intel, which we believe is worth 
$30 per share. For every $100,000 in our portfolio, this would mean buying 
217 shares. This purchase would cost us $4,988.83 (neglecting taxes and 
fees, of course) and would leave us with $11.17 of cash in reserve. After we 
made the buy, the stock price would fluctuate, and depending on what its 
price was at the end of 540 days [I’m using as an investment horizon the 
days to expiration of the longest-tenor long-term equity anticipation secu-
rities (LEAPS)], the allocation’s profit and loss profile would be represented 
graphically like this: