I’m going to break down the complexities and differences between options and trading stocks. First off, stocks are simply one-dimensional trading vehicles, the dimension of “price movement”. For example, you can go long a stock if you forecast a rise in the price of the underlying asset. You, as the stock trader, don’t need to worry about time or changes in volatility affecting the outcome of your trade. You only need to focus on the asset’s price movements.
So now we know that stocks are simple, directional, investments. Now let’s talk about options. Trading options is actually trading three dimensions; time, volatility, and direction. You could say this makes options three times more complex than stocks. Here’s a trading example to compare the difference. Look at this scenario:
What if Google moves up 25% in 2 years? Well, those stock owners would have just made 25% by holding on to their investment all that time. However, if an option trader held on to his Call options for 2 years, most likely there would be very little if any gain on the trade.
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.
Now you see that in order to trade options, we really need to be well informed. Novice option traders usually buy Calls and Puts, and then don’t understand why they lose money when the underlying asset goes the direction they were hoping. It’s important to remember, when trading options, that you are trading a 3 dimensional asset.
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Tags: business, finance, investing, option trading, options, stock market