Sunday, March 23, 2008

Differences Between Stocks And Options

Many traders think of a position in stock options as a stock substitute that has a higher leverage and less required capital. After all, options can be used to bet on the direction of the stock price, just like the stock itself. But options have very different characteristics than stocks, and there is also a lot of terminology the beginning option trader must learn.

One important difference between stocks and options is that stocks give you a small piece of ownership in the company, while options are just contracts that give you the right to buy or sell the stock at a specific price by a specific date. It is important to remember that there are always two sides for every option transaction: a buyer and a seller. So, for every call or put option purchased, there is always someone else selling it. Thus the two types of options are calls and puts. When you buy a call option, you have the right but not the obligation to purchase a stock at the strike price any time before the option expires. When you buy a put option, you have the right but not the obligation to sell a stock at the strike price any time before the expiration date.

When individuals sell options, they effectively create a security that didn't exist before. This is known as writing an option and explains one of the main sources of options, since neither the associated company nor the options exchange issues options. When you write a call, you may be obligated to sell shares at the strike price any time before the expiration date. When you write a put, you may be obligated to buy shares at the strike price any time before expiration.

Trading stocks can be compared to gambling in a casino, where you are betting against the house, so if all the customers have an incredible string of luck, they could all win. But trading options is more like betting on horses at the racetrack. There they use parimutuel betting, whereby each person bets against all the other people there. The track simply takes a small cut for providing the facilities. So, trading options, like the horse track, is a zero-sum game. The option buyer's gain is the option seller's loss and vice versa: any payoff diagram for an option purchase must be the mirror image of the seller's payoff diagram.

Some More Basics Of Options

The price of an option is called its premium. The buyer of an option cannot lose more than the initial premium paid for the contract, no matter what happens to the underlying security. So, the risk to the buyer is never more than the amount paid for the option. The profit potential, on the other hand, is theoretically unlimited.

In return for the premium received from the buyer, the seller of an option assumes the risk of having to deliver (if a call option) or taking delivery (if a put option) of the shares of the stock. Unless that option is covered by another option or a position in the underlying stock, the seller's loss can be open-ended, meaning the seller can lose much more than the original premium received.

You should be aware that there are two basic styles of options: American and European. An American, or American-style, option can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American style and all stock options are American style. A European, or European-style, option can only be exercised on the expiration date. Many index options are European style.

When the strike price of a call option is above the current price of the stock, the call is out of the money and when the strike price is below the stock price it is in the money. Put options are the exact opposite, being out of the money when the strike price is below the stock price, and in the money when the strike price is above the stock price.

Note that options are not available at just any price. Stock options are generally traded with strike prices in intervals of $2.50 up to $30 and in intervals of $5 above that. Also, only strike prices within a reasonable range around the current stock price are generally traded. Far in or out-of-the-money options might not be available.

All stock options expire on a certain date, called the expiration date. For normal listed options, this can be up to nine months from the date the options are first listed for trading. Longer-term option contracts, called LEAPS, are also available on many stocks, and these can have expiration dates up to three years from the listing date.

Options officially expire on the Saturday following the third Friday of the expiration month. But, in practice, that means the option expires on the third Friday, since your broker is unlikely to be available on Saturday and all the exchanges are closed. The broker-to-broker settlements are actually done on Saturday.

Unlike shares of stock, which have a three-day settlement period, options settle the next day. In order to settle on the expiration date (Saturday), you have to exercise or trade the option by the end of the day on Friday.

A more complex type of security than the stocks with which they are associated, options can be used in a wide variety of strategies, from conservative to high risk.

Options Used In Directional Trading
When most stock traders first begin using options, it is usually to purchase a call or a put for directional trading, which traders practice when they are confident that a stock price will move in a particular direction and they open an option position to take advantage of the expected movement. These traders may decide to try investing in options rather than the stock itself because of the limited risk, high potential reward and smaller amount of capital required to control the same number of shares of stock.

If your outlook is positive (bullish), buying a call option creates the opportunity to share in the upside potential of a stock without having to risk more than a fraction of its market value. If you are bearish (anticipate a downward price movement), buying a put lets you take advantage of a fall in the stock price without the large margin needed to short a stock.

Is Market Direction The Only Thing On Your Mind?
There are many different kinds of option strategies that can be constructed, but the success of any strategy depends on the trader's thorough understanding of the two types of options: the put and the call. Furthermore, taking full advantage of options requires changing how you think. Those option traders who still think solely in terms of market direction may appreciate the flexibility and leverage options offer, but these traders are missing some of the other opportunities that options provide.

Besides moving up or down, stocks can move sideways or trend only modestly higher or lower for long periods of time. They can also make substantial moves up or down in price, then reverse direction and end up back where they started. These kinds of price movements cause headaches for stock traders but give option traders the unique and exclusive opportunity to make money even if the stock goes nowhere. Calendar spreads, straddles, strangles and butterflies are some of the strategies designed to profit from those types of situations.

Complexities Of Option Pricing
Stock option traders have to learn to think differently because of the additional variables that affect an option's price and the resulting complexity of choosing the right strategy. With stocks you only have to worry about one thing: price. So, once a stock trader becomes good at predicting the future movement of a stock's price, he or she may figure it is an easy transition from stocks to options - not so. In the landscape of options you have three shifting parameters that affect an option's price: price of the stock, time and volatility. Changes in any one of these three variables will affect the value of your options.

There are a number of different mathematical formulas, or models, that are designed to compute the fair value of an option. You simply input all the variables (stock price, time, interest rates, dividends and future volatility), and you get an answer that tells you what an option should be worth. Here are the general effects the variables have on an option's price:

1. Price of the underlying
The value of calls and puts are affected by changes in the underlying stock price in a relatively straightforward manner. When the stock price goes up, calls should gain in value and puts should decrease. Put options should increase in value and calls should drop as the stock price falls.

2. Time
The effect of time is also relatively easy to conceptualize, although it also takes some experience before you truly understand its impact. The option's future expiry, at which time it may become worthless, is an important and key factor of every option strategy. Ultimately, time can determine whether your option trading decisions are profitable. To make money in options over the long term, you need to understand the impact of time on stock and option positions.

With stocks, time is a trader's ally as the stocks of quality companies tend to rise over long periods of time. But time is the enemy of the options buyer. If days pass without any significant change in the stock price, there is a decline in the value of the option. Also, the value of an option declines more rapidly as the option approaches the expiration day. That is good news for the option seller, who tries to benefit from time decay, especially during that final month when it occurs most rapidly.

3. Volatility
The effect of volatility on an option's price is usually the hardest concept for beginners to understand. The beginning point of understanding volatility is a measure called statistical (sometimes called historical) volatility, or SV for short. SV is a statistical measure of the past price movements of the stock; it tells you how volatile the stock has actually been over a given period of time.

But to give you an accurate fair value for an option, option pricing models require you to put in what the future volatility of the stock will be during the life of the option. Naturally, option traders don't know what that will be, so they have to try to guess. To do this, they work the options pricing model "backwards" (to put it in simple terms). After all, you already know the price at which the option is trading; you can also find the other variables (stock price, interest rates, dividends, and the time left in the option) with just a bit of research. So the only missing number is future volatility, which you can calculate from the equation.

Solving for volatility this way returns the so-called implied volatility, a key measure used by all option traders. It is called implied volatility (IV) because the implication of volatility given by an option's price allows traders to determine what they think future volatility is likely to be.

Traders use IV to gauge if options are cheap or expensive. You may hear option traders say that premium levels are high or that premium levels are low. What they really mean is that current IV is high or low. Once you understand this, then you can also determine when it is a good time to buy options - when the premiums are cheap - and when it is a good time to sell options - when they are expensive.

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