If one's view is that NFLX will collapse to the point that puts trading for 10 cents will be deep in the money, then obviously that view incorporates the belief that the stock will reach far greater volatility than is implied by the option price.
That's not buying for leverage. He's buying because he's taken a view on the realized volatility. He can lever it up if he wants based on the strength of his view and his tolerance for risk but that is a different aspect of the trade. There is a guy here who had the view that BIDU would be 165 after earnings and thus bought deep out of the money calls. It didn't work out. He got the direction right, the volatility wrong and what his loss was is based on how much leverage he employed (financial risk vs account size).
opt789 excellent post ! Hardly a 'feeble attempt" This is a post that says it all. Thanks for stating your hard earned wisdom and sharing it.
Maybe I can improve it with a different counterexample to SLE's generalization that you +100d. SLE basically said one shouldn't use options for leverage, one should use futures (and other instruments) instead. Well if it's OK to use futures for leverage then it's OK to use options to construct a synthetic futures position for leverage if there are no futures contracts on the underlying. And if that's OK, then it's OK to construct other positions with options for leverage that might not meet the definition of a synthetic futures position but better serve a particular trade thesis. My point is that generalizations about what NOT to use options for ignore their versatility. Especially when the generalization is to not use them for one of their primary benefits. Of course along with leverage you get the other characteristics (such as limited risk if you're long) which has been pointed out.
Really? Buying puts for 10 cents that you think will be worth 10 dollars is not buying for leverage on what planet? As I said before, obviously that's a view on volatility. But that doesn't mean you can deny the leverage aspect of it. It's simply not accurate to speak of leverage and volatility as though they're independent because the lower the volatility, the more contracts one can buy for the same amount. So I could say I'm looking for leverage but the volatility is too high to buy the number of contracts for x dollars that I need to make the risk/reward favorable given my estimate of the probability of the underlying making a move that large. Of course the impact of holding more contracts is dampened by changes in "the Greeks" when the IV is lower with OTM options like the ones I was referring to, but that lessens as the price of the underlying moves towards the strike and my thesis is that the underlying will move beyond the strike.
Yes, but you're addressing the wrong argument... I don't think I or anyone else ever suggested that you can't use options for leverage. Obviously, you can. That's not the point. The point I am trying to make is that it's suboptimal to use options purely for leverage in the presence of a more liquid (by definition) market in the underlying. So yes, I see your point, but, given your very own replication argument, whatever leveraged trade you want to place w/options, you're likely to be better off doing with the underlying. Obviously, the one big inherent flaw in any replication, no-arbitrage logic is that mkts are complete and one can transact at every infinitesimally small price move. The fact that this isn't even remotely true in reality is what makes options materially different and it's the pricing of this liquidity aspect that matters.
Not sure where you're getting that impression because I used "shouldn't" and "it's OK to" instead of "can't" and "it's possible to." But clearly one shouldn't use options when it's suboptimal and there are more efficient means available. But sometimes they're not available. For example accounts with inherent restrictions like IRAs. In which case one can construct a position with options that will approximate something you can't do directly. Of course sometimes that will work depending on the strikes available and if they're sufficiently liquid, etc., but sometimes that's not the case and the position would be too crude and inefficient to be worthwhile.
I don't know what planet you are on, but on Earth Expected Value and Leverage are very different concepts. And you are mixing them up. Only after you have decided that an option is underpriced can you decide how many you are willing to buy (your leverage factor however you chose to calculate it). just because a 10 cent option can be worth $10 doesn't make it leverage. It just means it is underpriced. Buying options just because you put out less capital for big payouts don't make them leveraged bets. Is the lottery a leveraged bet? $1 can payout $1MM. It's true that as an asset class options can have much larger swings in pnl. But the same is true for stocks vs bonds or Commoodities vs FX. Does that make stocks a leveraged bet vs bonds? Or Commodities a leveraged bet vs FX?
Well I have been to earth and thought earthlings called leverage, leverage but maybe something got lost in the translation so try this with version 63.456.27653.88.1b of my translator: Assume xyz is trading at $100 and you anticipate a collapse to $40 and you're looking at the 50 strike puts which are 10 cents. Buying $10,000 of those puts because you think the underlying will crash making them worth 10 dollars is absolutely using leverage because your $10K gives you the right to sell 100,000 shares of xyz for $50/share and if xyz does collapse to $40 that leverage takes your original $10K to $1 million. You'd make a miniscule fraction of that using $10K to short xyz instead. So how on earth is using $10K to leverage 100,000 shares and make $990,000 instead of a few thousand not leverage? Of course expected return and leverage are different concepts but leverage can influence expected return. And no, you don't have to decide that an option is underpriced first, you missed my point completely. For example: if you define expected return as E(R) = sum of: probability (outcome i) * return (outcome i) and have a trade thesis specific enough to use it, you can plug the formula with inputs into a spreadsheet and use solver to find out how cheap an option must be for a given expected return. Or, given a fixed amount for the trade and an option, is it cheap enough? Etc.