Understanding Notional Leverage and Risk in Options Trading

In the world of options trading, understanding the concept of notional leverage and risk is crucial for making informed decisions and managing your portfolio effectively.

In a recent episode of You've Got Options for Income Navigator, the focus was on Hedged Income Trades (HIT), specifically a tiered options strategy involving the E-mini S&P 500 (/ES) contracts.

This post breaks down the key concept of Notional Risk and its implications for traders, drawing from the insights shared in the episode.

What is Notional Risk?

Notional risk refers to the theoretical or potential risk exposure based on the notional value of the underlying asset in an options contract.

The notional value is calculated as the price of the underlying asset multiplied by the contract’s multiplier.

For instance, in equity options, the multiplier is typically 100, meaning a call option on a stock trading at $100 per share has a notional value of $10,000 (100 shares × $100).

This represents the total value of the underlying asset controlled by the contract.

For buyers of options, the actual loss is limited to the premium paid. However, for sellers, particularly those selling naked options, the notional risk can be substantial, as it reflects the maximum potential loss if the option moves unfavorably or expires worthless.

In the case of selling a put option, the notional value remains the same, but brokers often require significantly less capital upfront, leading to high leverage.

Example: Notional Risk in /ES Options

Let's talk about trading ES options, where the multiplier is 50.

With the S&P 500 at 6,000 , an at-the-money put option controls $300,000 worth of the underlying asset (6,000 × 50).

Let's assume we're selling 2 OTM puts at 5100 strike.

Each put has a notional value of $255,000 (5,100 × 50), so two puts represent a total notional value of $510,000.

However, brokers like Tasty Trade might only require $15,000 in buying power to initiate this trade, creating significant leverage.

If the /ES were to drop to zero (an extreme and unlikely scenario), the trader would be liable for the full $510,000, offset partially by a put debit spread worth up to $15,000, resulting in a potential loss of $495,000.

Dividing the notional risk ($495,000) by the buying power requirement ($15,000) yields a leverage ratio of approximately 33:1.

The Leverage Trap

This high leverage can be deceptive.

In a $300,000 account, a trader might aim to use 30% of their buying power ($90,000) for such trades. Since each 112 trade requires $15,000, they could put on six positions, totaling $90,000 in buying power.

However, these six positions would carry a notional risk of $2.97 million (6 × $495,000), nearly 10x the account’s net liquidating value ($300,000).

This level of leverage is aggressive and can lead to significant losses if the market moves unfavorably or volatility spikes, as brokers may increase buying power requirements rapidly.

If the broker required $50,000 per trade instead of $15,000, the trader could only afford two positions, reducing the notional risk to $1 million and the leverage to 3.3x.

While this limits potential income, it significantly reduces exposure and the risk of margin calls during market downturns.

Managing Notional Risk

To mitigate the risks associated with high notional leverage, consider the following strategies:

1. Opt for Defined Risk Trades: Structures like 1122 or 1133 ratios allow traders to know their maximum risk upfront, unlike naked options where losses can be substantial.

2. Self-Impose Higher Buying Power Requirements: Even if a broker requires $15,000, treat the trade as requiring $30,000 or $50,000 to limit the number of positions and reduce leverage.

3. Diversify Across Underlyings: Instead of concentrating risk in ES or similar instruments like SPX or SPY, explore uncorrelated assets like gold, bonds, or oil to spread notional risk.

4. Monitor Notional Leverage: Aim for a notional leverage ratio of 3x to 5x relative to your account size, as 10x is considered highly aggressive.

Key Takeaways

Notional risk and leverage are critical yet often overlooked aspects of options trading.

While brokers may allow traders to control large notional values with minimal capital, this can lead to over-leveraging, especially in volatile markets.

By understanding the notional value of your positions and their relation to your account size, you can make more informed decisions, balancing potential income with risk exposure.

As highlighted in the episode, protecting yourself from excessive concentration in a single underlying or strategy is key to long-term success in options trading.

I hope you found this post educational. If you have any questions please reach out: [email protected]