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Accepting Exposure 229
×= ≈$19,500
$5,000 13 .9 4: 1leverage
Selling the $195/$220 call spread will generate $651 worth of pre-
mium income and put at risk $2,500 worth of capital. Nothing can change
these two numbers—in this sense, the short-call spread has no leverage.
The 4:1 leverage figure merely means that the percentage return will ap-
pear nearly four times as large on a given allocation as a 1:1 allocation
would appear. The following table—assuming the sale of one contract of
the $195/$220 call spread—shows this in detail:
Winning Case Losing Case
Premium
Received
($)
Target
Allocation
($) Leverage
Stock
Move ($)
Percent
Return on
Allocation
Stock
Move
($)
Dollar
Return
Percent
Return on
Allocation
651 20,000 1:1 2 3.3 +25 1,849 9.2
651 10,000 2:1 2 6.5 +25 1,849 18.5
651 5,000 4:1 2 13.0 +25 1,849 37.0
Note: The dollar return in the losing case is calculated as the loss of the $2,500 of margin
per contract less than the premium received of $651.
Notice that the premium received never changes, nor does the worst-
case return. Only the perception of the loss changes with the size of our
target allocation.
Now that we have a sense of how to calculate what strategic leverage
we are using, lets think about how to size the position and about how much
risk we are willing to take. When we are selling a call or call spread, we are
committing to sell a stock at the strike price. If we were actually selling the
stock at that price rather than committing to do so, where would we put
our stop loss—in other words, when would we close the position, assuming
that our valuation or our timing was not correct?
Lets say that for this stock, if the price rose to $250, you would be
willing to admit that you were wrong and would realize a loss of $55 per share,
or $5,500 per hundred shares. This figure—the $5,500 per hundred shares
you would be willing to lose in an unlevered short stock position—can be
used as a guide to select the size of your levered short-call spread.