Today we’ll be discussing the differences between investing with stocks and options. Let’s first tackle the less complex investing vehicle, stocks. Most of the world already knows, but in case you don’t, stocks are directional trading vehicles. If we are long the stock, then we make money when the prices of the asset rises, and we lose capital as the underlying asset drops in price. We can also sell a stock short in which the profit comes when the stock falls. In any case when investing with stocks, the direction is what matters. We don’t need to worry about market volatility or time.
Options, however, involve these other two dimensions just mentioned, plus the dimension of price as well. So options are actually three-dimensional trading vehicles based on price, time and volatility. To compare stock and options in a practical sense, let’s consider this scenario:
A stock takes a full year to move up 10%. The stock trader who bought and held on to his stock has just made 10% on this particular trade. However, the option trader might have made nothing at all or even lost money if he just bought an option.
The reason the option buyer may have just lost money is because of Time Decay. His option just lost a whole lot of Time Premium because the trade took so long to develop. Also, since the volatility of the underlying asset probably went down, this could have also caused the Call option to lose value. Options lose premium over time.
For this reason we really need to fully understand options before investing with them. Investors new to options often times buy Calls and Puts, attempting to make money on price direction, but if they fail to understand the 3 dimensions they are really trading, they will most likely never see consistent returns. However, once the understanding is there, one can trade options in any type of market. Options are flexible and allow an investor to be very creative.
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