How does option trading differ from stock trading? This is a great question to ponder as you start to look at the options world. There are many differences due to the makeup of options and there are similarities as well. So let’s take a look at the similarities first.
When you buy a stock you want to sell it at a higher price than you bought it for. It is as simple as that. When you “short” a stock (for those who are familiar with playing the short side of trades) you want the stock or underlying to fall in price as you are selling first, then buying the stock back, hopefully at a lower price to close the trade.
Call options are similar to buying a stock in that you pay for the call option and you want to sell it at a higher price than you purchased it for. With the purchase of put options we in essence take the side of the seller and try to make money when the stock/underlying goes down. However, instead of selling the put, you are buying the put and hopefully selling it at a higher price as the stock or underlying goes lower, just like an equity short sale would make money on a down move.
Now let’s take a look at some of the differences between the two asset classes. The biggest difference is that option pricing is based on something else (like IBM, $SPX, AAPL, the price of oil, the yen, or many other things). That is why options are referred to as “derivatives” because the price is derived party based from the price of the underlying symbol that you are tracking.
Options also have a timing component or time value and expire on a given date, whereas stocks do not. This time value is an additional fee, if you will, associated with the time to expiration for the option. The longer the time the option has before expiration the greater the “fee” is. Think of it as the difference between a one month insurance policy versus a twelve-month policy. You pay much more for the twelve-month policy.
The time component adds an additional element to your directional trading because not only do you have to be correct in your thoughts about direction, you also have to be correct as to the timing of the move. This is one of the biggest adjustments that stock traders have to make when moving to options. It is not unusual to hear a stock trader new to options say that he or she was right with respect to direction but lost money due to being incorrect on the timing of the expected move.
This is also one area where new option traders make the biggest mistake in not allowing enough time for the trade to work out (by purchasing an option that expires too quickly) and so they fight “time decay” or the loss of value of the option as it gets closer to expiration. As mentioned in the previous article, they may also be fighting volatility if a stock grinds upward and implied volatility falls out of the option’s price. We will address volatility further in future articles.
Seth Freudberg and Michael Schwartz
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