Options 101. "Unbalanced Leverage"
Options for Civilians (Harley Bassman, aka The Convexity Maven)
Options are clearly something I need to be MORE well-versed in given the direction of flows in FI markets I watched closely and which were a much bigger part of my previous life.
There’s simply none better than the man who calls himself The Convexity Maven. He gets a pass because he did come up with the bond markets VIX index — The MOVE — which is clearly on the move
AND in some bigger picture context
With his claim to fame in mind, HERE is his latest attempt to educate the masses
… Unbalanced Leverage simply means that the gains can be larger than the losses for equally opposite outcomes; mathematically this is positive Convexity.
With SPY (S&P 500 Index ETF) at 470 (4700 on the S&P 500), an at-the-money (ATM) call option that expires in two-year costs $52.50. This is the most one can lose, while the gains are unlimited. Well, not exactly unlimited, but the gains can certainly be much greater than the losses – as such, they are “unbalanced”.
Moreover, this unbalanced leverage can occur well before expiry. Assuming an instantaneous 10% shift in the price of SPY, the call option will rise by 54% to $81 versus declining by 43% to $30, holding all else equal.
This leverage compounds as the price changes become more extreme; so, for a 20% shift, the option rises by 119% to $115, or declines by 72% to $15. This is probably not news to investors with even a cursory familiarity with options. But it is likely unappreciated that in buying a call option versus purchasing the underlying asset, one is implicitly borrowing the funds saved.
The entire 10pg note worth a point and click. I’m leaving it here more for ME than you…