The notional value of a position is the real amount at risk, excluding margin relief. If we own 100 shares of stock at $50.00 per share, we have $5000 of notional value at risk. If the stock price drops to $0.00, we stand to lose $5000. In a margin account, we are offered 2:1 leverage on stock purchases. What does this mean? Basically, that same 100 shares of stock would only require $2500 of capital to purchase. What we have to remember is that we still have that same $5000 of notional value. In other words, we only have to put up $2500 at first, but if the stock price goes to $0.00 we still lose $5000. Understanding the difference between leverage & notional value is one of the most important concepts to learn:
When it comes to options, leverage works a little differently. Unlike stock, available buying power doesn’t change. If we deposit $10,000 into my account, our option buying power will be $10,000. If we are in a margin account, the stock buying power will be $20,000. That is how the stock leverage works.
If we’re in a margin account and have full margin for options, the difference lies in the buying power reduction (BPR).
Let’s say we sell a put at the $50 strike, when the stock price is trading at $55.00. In an IRA account, which is cash secured and has no leverage, we would be required to put up $5000, less the credit we receive for selling the put. Each put contract has the theoretical equivalent of 100 shares of long stock, which is why the shares are already accounted for when selling the put.
In a margin account, however, we would only be required to put up a fraction of the total value. In a lot of cases, it may be around 20% of the strike (around $1000 in this case). There are a few different calculations the brokerage works through, and they choose the highest value of those calculations for BPR. This is where leverage plays a role. We are only required to put up $1000 initially, but we still stand to lose $5000 less the credit received if the stock price goes to $0.00. This is why we always keep a lot of cash available in our portfolio, as these margin requirements can change by the minute.
Leverage is generally highest in futures products. Take /CL for example, which is the light sweet crude oil futures contract. This product trades for $1000 a point. That’s right, $1000 a point! If we own a futures contract, and /CL is up $1.00, we would see a gain of $1000. That means that in order to find the notional value, we’d have to multiply the current price by 1000. If /CL is trading at $47, the notional value of one contract is $47,000.
In a margin account, the cost to purchase one contract is only about $3,500 at that price! That means the investor is getting over 10:1 leverage on that contract, when you look at notional value vs buying power required to purchase the contract. All futures products are different, so it’s extremely important to understand the notional value & point value for futures contracts that you’re trading.
Leverage comes in all shapes and sizes. More leverage can give us a higher return on capital, as we’re not required to put up as much, but it can also magnify losses quickly. Understanding leverage and how we can use it is imperative for futures, options, and stock traders alike.
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