In today’s issue of Talk Wall St. by San Jose Options we are going to discuss the differences between trading stocks and options. First, let’s talk about stocks. As most investors know, stocks are directional vehicles. If the price of our asset goes up, we make money. If the price falls, we lose money. Well, that is true if we are long the stock. If we are short the stock, then we can make money when it drops. Anyway, whatever your position is on a stock, it’s directional. One direction we make a profit and the other direction we lose. With stocks, we don’t focus on time or volatility in the markets, we just worry about the way the price is moving, up or down.
So we all know that stocks are simple, directional investments, but what about options? Well, trading options is actually trading 3 Dimensions…time, volatility and direction. I guess this makes options three times more complex than stocks. Now, let’s look at a trading example to compare the difference. Look at this scenario:
A stock takes a full year to move up 10%. The stock trader who bought and held on to his stock has just made 10% on this particular trade. However, the option trader might have made nothing at all or even lost money if he just bought an option.
So why did the option trader lose money if the stock went up? Well, it’s quite simple really. The option trader lost the time value of his options. Each option has time premium factored into the option price, and if the move doesn’t happen fast, then the option trader will most likely lose money if he is simply buying Calls. Also, the volatility will most likely drop on the asset as the price rises, and this will also cause the price of the option to fall.
So, hopefully you can see that in order to trade options, we really need to be educated. Entry level option traders usually buy Calls and Puts, and they don’t understand why they lose money when the underlying asset goes the direction they are hoping. Remember, when trading options, you are not trading a single dimension; you are really trading a 3 dimensional asset. Finally, the exciting thing about options is that once you understand them, they allow you to be very flexible, creative and can be traded in any type of market.
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