Trading A Stock Versus Trading Stock Options - Part Two

provided by: Investopedia

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. They can also be tailored to meet expectations that go beyond a simple 'the stock will go up' or 'the stock will go down'. Once you move beyond learning options terminology (which we review in Part 1), you need to develop a thorough understanding of risk to trade options successfully. That also means understanding the factors that affect an option's price.

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.

Conclusion
Options have a great deal of potential, but you should always remember that they are different from stocks. Learning how to use options properly requires a little effort on your part; however, once you have a firm grasp of the essentials, you'll quickly find that options give you more flexibility to tailor the risk and reward of every trade to your individual needs.

by Jim Graham