Asymmetric Leverage, or Asymmetrical Leverage, is an attempt to apply asymmetry to leverage in an attempt to capture the potential upside of leverage with limited downside.
Leverage can be in the form of debt, or using other people’s money, toward an investment opportunity.
Asymmetric Leverage Example:
An example of asymmetric leverage is trading a Call option instead of buying a stock with a Stop Loss.
If we buy a $100 stock, and we have predetermined if the stock dropped to $90 the trend directional reason we initially bought the stock is no longer present, then we would risk $10 per share, or a -10% price decline in the stock before selling to cut the loss short.
Instead of buying the stock at $100 and placing a Stop Loss at $90, the portfolio manager could consider instead structuring the Long exposure with listed options.
The process we use to determine which method to construct the exposure is much more analytical than this example affords, so the detail is beyond the scope of this explainer, but let’s assume a simple scenario for educational purposes.
If the portfolio manager looks at listed Call options and focuses on the options with an expiration date that fits the expected time for for the uptrend to move, let’s say the Call option expiring 3 months from now is $5 ATM (At The Money) meaning the strike price is $100, so the Delta is 0.50.
Delta is the amount an option price is expected to move based on a $1 change in the underlying stock. Calls have a positive delta, between 0 and 1. So, if the stock price trends up and no other pricing variables change, the price for the call will go up. The delta for a stock at the money is 0.50, which means for every $1 the price trends up, the call option is expected to rise 50 cents. Once the price does trend up the delta for the option also trends up, so there is some dynamic management necessary, but for simplicity, let’s go with what is today.
Since Delta estimates the mount the call option is expected to move in response to the underlying stock price moving $1, and delta is only $0.50 for an ATM $100 call, then the portfolio manager will need to buy 200% of contracts to achieve a $1 for $1 expected move.
Looking for Asymmetric Leverage, the portfolio manager now has a second choice to consider to gain exposure to this $100 stock.
For every 100 shares we would buy at $100, we could instead buy 2 call options that would give us the right, but not the obligation, to buy the stock at $100 until expiration. In this simplified idealized example, we could spend $5 per 100 shares for the right to buy the stock but if we want the 1:1 price correlation we’d need to pay $10 for 2 calls which controls 200 shares for a delta of 1.
We use an idealized example to illustrate the point, and to gain this edge in Asymmetric Leverage requires options analytics, but here is the alternative.
We could buy 100 shares at $100 with a Stop Loss of $90 for a risk of $10 per share or 10%. This exposure would cost $10,000 per 100 shares and we’d be risking $1,000, or 10% of the investment to discover if the price will trend up as expected. An advantage is there is no time limit, so we can hold the stock and long as we want to allow the capital gain to unfold, but most active portfolio managers don’t want to tie up hard earned capital for too long if the stock doesn’t move, so we may consider the expiration of the call option like a time stop. A time stop, which we could also put on our calendar for the shares, would serve to remind us we’ve given the exposure X time frame to make a move and if it doesn’t we shall evaluate our position.
We could buy 2 call options giving us to right buy the stock for the next 3 months (in this example, but it could be shorter or longer) and those 2 calls cost $10 for the 1:1 delta exposure to the price trend.
If the call option strategy is used instead of the stock, the money required for the exposure is significantly less, and results in the potential for asymmetrical leverage, all other things remaining the same.
While 100 shares of a $100 stock requires a cash investment of $10,000.
However, buying 2 call options at $5 is $1,000 since each options contract represents 100 shares.
If the position is maintained with a delta of 1 such as how it started, the upside of the two positions is the same, but the downside cost is 90% less for the call option resulting in asymmetric leverage.
PLEASE NOTE: Options trading is not for everyone and it is important to understand the risks involved – especially since options are a decaying asset. There are varying degrees of risks involved with options that are dependent upon the strategy. For example, the purchaser may buy 1 ABC 100 Call at a premium of $8.00. This call contract gives the purchaser the right to buy 100 shares of ABC at $100.00 per share at any time before expiration at a total cost of $800.00. Because the purchaser owns the call, the purchaser also owns the right to exercise their right to buy at 100 shares of ABC at $100 per share at any time – the choice to exercise is at the buyer’s discretion. Therefore, the purchaser’s loss is limited to $800.00 regardless of how far up or down ABC moves.
On the other hand, the seller who sold 1 ABC 100 Call at a premium of $8.00 has much greater loss potential. If ABC increases to $125.00 and the purchaser decides to execute the terms of the contract, the seller has the obligation to sell the purchaser 100 shares of ABC at a price of $100.00 when the buyer decides. The seller needs to purchase 100 shares from the market at $125.00 in order to meet the obligation. This strategy has unlimited loss potential from the seller’s point of view as ABC can theoretically increase infinitely.
OIC education can be accessed at the OIC web.
You must be logged in to post a comment.