What are the Differences between Stocks and Options Trading?

By definition, stocks are actually shares of a particular company that can be traded through the act of buying or selling by an investor. If you happen to own a particular stock from a company, you are entitled to certain rights, which may include a profit share from earnings. You may also have the liberty to sell your share of stock if you no longer desire it.

A stock option on the other hand, is not the stock or share of the company itself, but it is actually the rights for a certain stock. It allows you to buy and sell company stock at a set price in a certain time period. However, you do not gain the profits from the company itself.

Take note that in doing transactions for stock options, there will always be a buyer and a seller, and this may not always hold true when compared to stocks. When you sell stock options, you are actually creating a certain degree of security for the company as well as for yourself. In this way, the parties involved can make sure that money is actually made to the frequent trade that happens.

So, even if you are an experienced stock trader that fact does not automatically mean that you can apply all your experience, knowledge, and the same theoretical guidelines to the options trading. Options are not stocks. Options are easy to understand, but are far more complicated to trade. The only similarity between Stocks and Stock Options is the fact that they can be bought and sold just like a stock.

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 the stock. 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.

3 Major Differences between Stocks and Options:
  1. Options expire. Stocks last forever (unless the company goes bankrupt). In other words, while you can hold the stock of an active company for years, an option will expire, worthless, at some point in the future. Options trade during the trading hours of the underlying asset.
  1. Options are derivative products. Their value is derived from the value of another asset. Stocks are assets, and have an intrinsic value.
  1. Option owners have rights, but do not own anything tangible. So, owning an option doesn’t give the holder any share of the underlying security.  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.
  1. Option prices depend on many factors, each of which affects the price of an option in the marketplace. Some of the factors for your review:
    • The price of the underlying asset. As the asset moves higher, calls move higher, puts move lower. If you own a call option, you have the right to buy stock at a specific price (strike price). For example, if you own one Nov 40 call, you can buy 100 shares at $40 per share. Wouldn’t you pay more to own that call if the stock is $39 than if it’s $35? Would you pay even more if the stock price is $43? I hope you replied ‘yes.’ That’s why calls are worth more as the stock rises.
    • 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). A call gives you the right to buy shares and a put gives you the right to sell shares. Thus you cannot expect put and call prices to move in tandem. When the stock moves higher, call options increase in value and put options decrease in value.
    • The time to expiration. All options lose value as time passes. When you own an option, you want to see the stock move higher (call option) or lower (put option). The more time that remains before an option expires, the greater the chance that a favorable more will occur. Thus, more time makes all options more valuable. It’s true that more time allows the stock to make an unfavorable move, but that’s not the significant factor in determining a price of an option. It’s the potential payoff, and the probability of receiving that payoff, that determines an option’s value.
    • 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. Call options can be used as an alternative to owning stock. When you buy stock, you must use cash, and that cash could be invested to earn interest. Thus, the more interest you earn on your cash, the more you should be willing to pay for a call option. This is not a significant factor in determining an option’s value.
    • 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. When you buy stock, you want to pay the lowest possible price. Thus, the right to buy stock at $25 per share is more valuable than the right to buy stock at $30 per share. For that reason, call options increase in value as the strike price decreases. When selling stock, you want to receive the highest possible price. Thus, it’s more valuable to own the right to sell shares at $60 than the right to sell shares at $55. Puts are worth more as the strike price increases.
    • The dividend paid by the underlying asset. A high dividend reduces the value of a call and increases the value of a put. When a stock pays a dividend, its price declines by the amount of that dividend. That occurs when the stock ‘goes ex-dividend’ (the buyer is not entitled to receive the dividend). The higher the dividend, the more the price declines. Because a lower stock price is not good for the call owner, as the dividend increases, the value of a call option decreases. Similarly, the value of a put option increases. These options do not suddenly change price when the stock goes ex-dividend. The model (modified Black-Scholes) that determines the fair value of an option ‘knows’ that the stock has a dividend in its future, and the effect of that dividend is already priced into the option when you buy or sell it.
    • 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. When you own an option, you want the stock price to change by a large amount because when the stock moves far beyond the strike, the value of your option increases. When stocks are not very volatile and undergo daily price changes of a few pennies, a big move is unlikely. But when the stock price frequently changes by 5% in a single day, a few of those moves in the same direction can provide a handsome profit. Thus, the options of more volatile stocks are worth a great deal more than options of non-volatile stocks.
Note that not all trading stocks have the stock options. Options tend to only be available to large, established, blue-chip companies and maybe for some smaller ones. Penny stocks, for the most part, have no options. Check out sites such as the Chicago Board Options Exchange or optionsXpress to see if certain stocks have associated options. There are about 3,000 to 4,000 available for trading stocks in the U.S. markets.

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