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.
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
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.
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