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Calculating Portfolio Leverage

Best Practices

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

We believe in selling option premium for numerous reasons including that Implied Volatility (IV) overstates the expected move. We also believe in trading small and trading often so that your number of occurrences will be large enough for that statistics to work in your favor. The problem that may arise is that it’s easy to end up taking on more risk than intended. So how can we measure notional leverage to better understand a portfolio’s tail risk?

The notional value can be thought of as the maximum Delta for an option multiplied by the underlying price. That means 100 multiplied by the share price for Standard Options and for Futures, the multiplier times the underlying price. When using a Delta Neutral strategy that has both a short Put and a short Call such as a Strangle we only count one leg since only one side can expire in-the-money (ITM). An example was used of stock XYZ trading at $100. A position of being short a 1 Standard Deviation Strangle would have a notional value of $10,000 ($100 x 100 shares) because even though the Delta is low it’s possible the option could go deep in-the-money (ITM). Tom credited his longevity in the markets to using a form of notional equivalency to determine how much capital he would place at risk.

To place in context the risk of a portfolio, a sample portfolio of $50,000 net liq at 3x leverage was displayed. The portfolio included the underlying price, portfolio positions such as a Strangle, a Straddle, a Naked Put and Futures Contract, plus the notional value for each strategy and the total notional value. A table of different levels of leverage and their risk level was displayed. The table showed that IRA accounts only have a 1x leverage since they are cash secured. At 3x-4x leverage the tail risk starts to build but is manageable. Leverage of 7x plus is very risky. Tom and Tony mentioned that they live in between 2x-4x leverage range most of the time. “We don't lose our discipline with respect to the amount of risk level that we take.” Potential profit is tied to risk. The higher the leverage, the greater the expected profit. A trader, though, has to stay in the game to make a profit. Defined-risk spreads were not included in this discussion because the max loss is defined and there is no tail risk.

Watch this segment of Best practices with Tom Sosnoff and Tony Battista for the important takeaways and a better understanding of how leverage equates to risk and what type of leverage will likely keep you in the trading game.

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