35 lines
2.4 KiB
Plaintext
35 lines
2.4 KiB
Plaintext
Understanding and Managing Leverage • 173
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matter if a significant chunk of your portfolio is exposed to those returns!
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Lambda is a good measure to show how sensitive percentage returns are to
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a move in the stock price, but it is useless when trying to understand what
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the portfolio effects of those returns will be on an absolute basis.
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Notional Exposure
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Look back at the preceding table. Let’s say that we wanted to make
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lambda more useful in understanding portfolio effects by seeing how
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many contracts we would need to buy to match the absolute return of
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the underlying stock. Because our expected dollar return of one of the
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$39-strike calls only makes up about a third of the absolute return of the
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straight stock investment ($3.82 / $11.75 = 32.5% ≈ 1/3), it follows that if
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we wanted to make the same dollar return by investing in these call options
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that we expect to make by buying the shares, we would have to buy three
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of the call options for every share we wanted to buy. Recalling that op-
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tions are transacted in contract sizes of 100 shares, we know that if we were
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willing to buy 100 shares of Oracle’s stock, we would have to buy options
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implying control over 300 shares to generate the same absolute profit for
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our portfolio.
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I call this implied control figure notional exposure. Continuing with
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the $39-strike example, we can see that the measure of our leverage on the
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basis of notional exposure is 3:1. The value of the notional exposure is cal-
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culated by multiplying it by the strike; in this case, the notional exposure
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of 300 shares multiplied by the strike price of $39 gives a notional value
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for the contracts of $11,700. This value is called the notional amount of the
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option position.
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Some people calculate a leverage figure by dividing the notional amount
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by the total cost of the options. In our example, we would pay $18 per con-
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tract for three contracts, so leverage measured in this way would work out to
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be 217 (= $11,700 ÷ $54). I actually do not believe this last measure of lever-
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age to be very helpful, but notional control will become important when we
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talk about the leverage of short-call spreads later in this chapter.
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These simple methods of measuring leverage have their place in ana-
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lyzing option investment strategies, but in order to really master leverage,
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you must understand leverage in the context of portfolio management. |