So let’s talk about the differences between investing with stocks and options. First we’ll tackle the less complex investing vehicle, we all know as stocks. To start with, you should know that 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’s price decreases. Also, we can sell a stock short in which the profit comes when the stock falls. Direction is key when investing with stocks. We need not worry about time or market volatility.
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:
Say the stock of Apple Computers, AAPL, moved up 20% in one year. That means the stock holders would have made 20% in return for holding on to the stock for that whole year. If an option trader was holding a Call contract all year, though, the stock holder probably just lost his investment. This is a common happening even though the newbie to options might not understand why. This is related to the Option Greek known as Theta which measures Time Decay.
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.
So, hopefully you can see that in order to trade options, we really need to be educated. Entry level option traders usually buy Calls and Puts, and they don’t understand why they lose money when the underlying asset goes they direction they are hoping. Remember, when trading options, you are not trading a single dimension; you are really trading a 3 dimensional asset.