Options Are Not Stocks: Key Differences

This post was first published at StockTradingToGo.com on Apr 1, 2009

If you are an experienced stock trader who is anxious to get
involved with trading options, I must issue one stern warning: Options
are not stocks.

Some consider themselves to be pure traders and believe they can
trade anything. It doesn’t matter whether it’s stock, options, futures,
currencies etc. I don’t believe that. Options are easy to understand, but are more complicated to trade because many factors influence the price of options in the marketplace.

It’s reasonable to assume that everyone has access to all
information concerning a stock. Given that information, some are
buyers, some are sellers, and some avoid taking a position. Supply and demand
determines whether the stock moves higher or lower. Some may buy or
sell, taking advantage (it’s against the law) of inside information,
but in general, no one has any special advantage over anyone else. What
separates one trader/investor from another is better judgment.

Fundamental analysts know what’s going on with earnings, sales etc. Technical analysts
have the same data, but may be using different software to evaluate
future prospects for the stock. Either of these analysts may ‘discover’
an edge that encourages the purchase or sale of stock.

But option prices depend on far more than supply and demand. When
markets are generally calm, option prices tend to decrease. When
markets are volatile, option prices tend to increase. And that’s true
for puts and calls because option owners benefit from significant price changes in the underlying stock, and volatile markets provide an environment that makes it more likely that a stock price will change dramatically.

3 Major Differences between Stocks and Options:

1. Options expire. Stocks last forever (unless the company goes bankrupt).

2. Options are derivative products. Their value is derived from the
value of another asset. Stocks are assets, and have an intrinsic value.

3. Option owners have rights, but do not own anything tangible.
Stock owners are entitled to dividends and own a share of the company.

Trading Differences

1. Stock prices depend on supply and demand, and move accordingly.

2. Option prices depend on many factors, each of which affects the price of an option in the marketplace.

  • The price of the underlying asset. As the asset moves higher, calls move higher, puts move lower

  • The type of option.
    Calls move in the same direction as the underlying asset (they have
    positive delta) and puts move in the opposite direction (they have
    negative delta).

  • The time to expiration. All options lose value as time passes.

  • The prevailing interest rates.
    As interest rates increase, calls increase in value (but only by a
    small amount, unless there is a lot of time before the option expires).
    Puts decrease in value as interest rates rise.

  • The strike price. The lower an option’s strike price, the more a call option is worth. The higher the strike price, the more a put option is worth.

  • The dividend paid by the underlying asset. A high dividend reduces the value of a call and increases the value of a put.

  • Volatility.

    This
    is the crucial factor in determining the price of an option. Each of
    the other factors involved in an option’s price is known with
    certainty. But the volatility estimate used to calculate the value of
    an option refers to the future volatility. Specifically: how volatile
    is the stock going to be between the time the option is purchased and
    the time it expires? Because the future is unknown, the volatility
    component of an option’s price can only be estimated. Different people
    make different estimates, and thus, each has a different idea as to the
    value of an option. If you notice options changing price when the stock
    doesn’t move (or vice versa) it’s likely due to a change in the
    volatility estimate.

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15 Responses to Options Are Not Stocks: Key Differences

  1. slait73 04/08/2009 at 5:38 AM #

    Hi Mark,
    Should be possible an article about adjustin the IC related to the greeks (delta) or about Sheridan´s methods?.
    THKS

  2. Mike S. 04/08/2009 at 7:23 AM #

    Hi Mark, a simple question:
    WHY IS THERE MORE THAN 1 STRIKE PRICE OF SAME AMOUNT ON CERTAIN STOCKS?
    Thanks, I’m a beginner.

  3. Mark Wolfinger 04/08/2009 at 7:52 AM #

    Good idea.
    Look for it within a few days

  4. Mark Wolfinger 04/08/2009 at 8:09 AM #

    It’s the result of a stock split or merger.
    The options appear to be the same, but they are very different because the underlying asset is different.
    You must look at the option symbol to determine which is the ‘regular’ option and which is ‘special.’
    The safest thing for you to do is to avoid trading any options with unusual symbols. For example, if most of the options for stock XYX have a symbol such as XYXAE (Jan 25 call) or XYXWF (Nov 30 put), don’t get involved with XYQAE (also Jan 25 call) – but the underlying asset will NOT be 100 shares of XYX stock.
    If you want more detail, the CBOE website will tell you reasons for the new option symbol as well as the details for each option. (Enter the symbol you want to know about into the search box in the upper right hand corner of the CBOE page (cboe.com) But, it’s much easier to avoid trading those options.

  5. Mike S. 04/08/2009 at 8:30 AM #

    Excellent! One last question:
    How do you calculate profits?
    CALLS:
    Last price of stock-target strike price+premium?)
    PUTS: (Last price of stock-target strike price-premium?)
    Let me know if I have it right.
    Thanks again for your help.

  6. Mark Wolfinger 04/08/2009 at 9:03 AM #

    Mike,
    When you buy an option, it’s not a good idea to hold it until the option expires. When you do that, you sacrifice all the time premium you paid for the option. It’s usually best to sell it prior to expiration.
    This sounds simplistic because it is. Very.
    a) Your profit is the cash you collected when selling minus the cash you paid when buying.
    b) If you do hold it until expiration, losing ALL time premium, then:
    The break-even point for calls = strike price (K) + premium (P). If the stock (S) is higher than that, you have a profit.
    Thus, you are correct: Profit = S – (K + P)
    For puts, the break-even point is strike minus premium (K-P).
    Profit = (K – P) – S
    Unsolicited opinion: You are concerned with the wrong things. Your goal should be to understand what an option is, how an option works, and why you would want to buy or sell them. Worrying about profits if an option is held to expiration is the least of the education process.

  7. Blue cat 04/09/2009 at 5:39 PM #

    Hi Mark,
    A question for you (and your readers). Do you (or does anyone else) know of stocks or indices for which the options usually have low bid-asked spreads?
    For example here is a table (from http://quote.morningstar.com/Option/Options.aspx?ticker=FCX&sLevel=A) of prices for the FCX April Calls. (FCX closed at 44.07 today.)
    Strike Symbol Bid Asked
    42.00 FCXDX 2.81 2.85
    43.00 FCXDY 2.13 2.17
    44.00 FCXDZ 1.55 1.58
    —————————-
    45.00 FCXDI 1.09 1.11
    46.00 FCXDC 0.73 0.75
    47.00 FCXDD 0.47 0.49
    These seem to me to be fairly tight spreads.
    Here are some similar Apr Calls but from RUT. (These are from http://delayedquotes.cboe.com/options/options_chain.html?ASSET_CLASS=IND&ID_OSI=9824287&ID_NOTATION=8941836.) (RUT closed at 468.20.)
    440.00 RUWDO 28.80 30.10
    450.00 RUWDY 20.90 21.80
    460.00 RUWDK 14.20 14.80
    —————————–
    470.00 RUWDM 8.90 9.40
    480.00 RUWDC 5.20 5.50
    490.00 RUWDA 2.60 2.90
    The FCX spreads for the two options around the strike price are 0.03 and 0.02. The comparable spreads for RUT are 0.6 and 0.5. You would expect the RUT prices and spreads to be about 10 times greater than the RCX spreads. But these are more like 20 times greater.
    Where else can one find tight spreads?

  8. Blue cat 04/09/2009 at 9:36 PM #

    One more question. Every once in a while I hear of very large positions being taken, e.g., a trade for 30,000 calls on an option that normally trades nowhere near that volume. Where does the counter party come from? Are the market makers always available to trade at any size? What sort of price penalty would someone pay in that sort of trade?

  9. Blue cat 04/09/2009 at 9:41 PM #

    One additional point about the FCX vs. RUT comparison. The implied volatility for the two RUT ATM call options is about 38-39. The implied volatility for the two FCX ATM call options is about 62-63. One would expect (I guess) that the higher FCX volatility would produce a broader spread, not a narrower spread.

  10. rluser 04/09/2009 at 10:29 PM #

    Hi Blue cat. Perhaps you will not like NDX and MNX because the index is weighted too heavily towards its biggest components. I like that the futures are onhand. It does have tight spreads comparable or tighter than RUT. You might look at the entirety of the penny pilot options. See http://www.cboe.org/hybrid/pennypilot.aspx

  11. Mark Wolfinger 04/10/2009 at 10:46 AM #

    I know of no listing for ‘tight’ b/a spreads.
    But, I ask: “do you really need that information?” Don’t you believe it’s more important to trades stocks you want to trade, and not just random stocks with tight spreads?
    My suggestion is: Tediously check b/a for stocks that interest you, until you find some that are suitable for trading.
    One more point. The published RUT b/a may be 20x as wide as FCX, but the real markets are probably no worse than 10x. I believe the markets are extra wide to take advantage of morons who enter market orders. Traders who enter limit orders find the markets are tighter than the published quotes.

  12. Mark Wolfinger 04/10/2009 at 10:57 AM #

    A broker does not simply walk into a trading pit and announce size orders. Such orders are carefully shopped around the trading world, before the order ever reaches the trading floor. Thus, the broker usually can ‘cross’ the orders (he has both a buyer and a seller and an agreed upon price), if the market makers (both physically present and those represented by computer terminal) don’t want to participate at the price. Sometimes the broker cannot cross the orders, but has a bid ask has a VERY tight range, coaxing MMs to take one side or the other.
    No, the MMs are not always available to trade ‘any size’ – unless you mean ‘at any price.’
    The price penalty really depends on how good of a job the customer’s broker has done. If the order has been shown to appropriate counter parties, the counter bid/offer should be reasonable enough that the broker may be able to cross the order, if the MMs don’t choose to participate.
    Of course, sometimes no one is interested at a decent price. Then the penalty depends on how aggressive the original order placer is vs. how risky (ability to easily hedge) the trade.

  13. Mark Wolfinger 04/10/2009 at 11:49 AM #

    The spread with depends more on the option volume, willingness of market makers to display narrow quotes and the ease/cost of hedging with stock or futures.
    It’s not only implied volatility.

  14. rluser 04/10/2009 at 6:13 PM #

    I am always shocked at the SPX option price quotes. I have not tried trading them, but an aircraft carrier could slide unnoticed through the quoted spreads.

  15. Mark Wolfinger 04/10/2009 at 6:42 PM #

    The real market is not as bad as the quotes, but I gave up trying to trade this product. And it’s a shame.