Leverage is the ability to use a little bit of money to potentially make a large amount of money. For the past six years leverage has been used in the real estate market as lenders introduced new lending products such as zero down loans and Adjustable Rate Mortgages(ARMs) as well as through the use of option contracts. Leverage is also used to great effect in the stock market options market for about 25 years and in the commodities market for hundreds of years. In fact, leverage is what makes these markets liquid. That is to say these markets would be much less efficient without the use of leverage to bring hedgers, speculators, and manufacturers together and allow them to trade quickly. Options are only contracts that people form to use leverage in a very simple form. Options are used in real estate and the stock market primarily, but may be used for any commodity or futures contract. An option is a simple contract that must be purchased from the option writer, or the person who owns the underlying asset for a price called a premium. This allows the options buyer to purchase the asset at a predetermined price no matter what the value of the asset may be when the contract/option is actually exercised, if it is exercised at all. This premium may only be 3% to 20% of the total value of the asset. This is leverage. Controlling a large valuable asset for a small price, even if for only a limited time period. Leverage also allows the stock option holder to buy the stock for the predetermined price once the strike price is reached. If this happens the option holder may exercise the contract to purchase the stock at the predetermined price, no matter what the market price actually is at the time. Leverage exists because the price of the premium is usually between 3% to 10% of the total value of the shares that are being controlled. Stock options are standardized to control 100 shares of stock for the time period agreed upon. So if a stock that is trading at $100 can be controlled for 5% of the total value to the shares there is a huge amount of leverage for the option holder. $100 X 100 shares = $10,000 of total value of the shares. Five percent of $10,000 = $500. So for a mere $500 an options holder can control $10,000 worth of shares for a limited time. This is leverage that any legal adult can use in either real estate, commodities contracts or in the options market to use resources (the asset) owned by someone else, for a limited time, for a very small price based on the total value of the asset. By using leverage properly any investor has the opportunity to build a large amount of wealth for a very low cost. Because options in real estate, commodities contracts and the stock market are considered very risky to the risk adverse, everyone must determine for themselves just how much risk they are willing to assume before using leverage as a tool for wealth building through investments. |
