174  •   The Intelligent Option Investor
Understanding Leverage’s Effects on a Portfolio
Looking at leverage from a lambda or notional control perspective gives 
some limited information about leverage, but I believe that the best way 
to think about option-based investment leverage is to think about the ef-
fect of leverage on an actual portfolio allocation basis. This gives a richer, 
more nuanced view of how leverage stands to help or hurt our portfolio 
and allows us more insight into how we can intelligently structure a mixed 
option-stock portfolio.
Let’s start our discussion of leverage in a portfolio context by thinking 
about how to select investments into a portfolio. We will assume that we 
have $100 in cash and want to use some or all of that cash to invest in risky 
securities. Cash is riskless (other than inflation risk, but let’s ignore that 
for a moment), so the risk we take on in the portfolio will be dampened 
by keeping cash, and the returns we will win from the portfolio will be 
similarly dampened.
We have a limited amount of capital and want to allocate that capital 
to risky investments in proportion to two factors:
1. The amount we think we can gain from the investment
2. Our conviction in the investment, which is a measure of our per -
ception of the riskiness of the investment
We might see a potential investment that would allow us to reap a profit 
of $9 for every $1 invested (i.e., we would gain a great deal), but if our 
conviction in that investment is low (i.e., we think the chance of winning 
$9 for every $1 invested is very low), we would likely not allocate much of 
our portfolio to it.
In constructing a portfolio, most people set a limit on the proportion 
of their portfolio they want to allocate to any one investment. I personally 
favor more concentrated positions, but let’s say that you paid better atten-
tion to your finance professor in school than I did and figure that you want 
to limit your risk exposure to any one security to a maximum of $5 of your 
$100 portfolio. 
An unlevered portfolio means that each $5 allocation would be made 
by spending $5 of your own capital. Y ou would know that if the value of 
the underlying security decreases by $2.50, the value of the allocation will