How is trading options different from buying and selling stocks?
In: Economics
A Pokémon card may be worth $10 today. I could buy it and if the price later goes to $12, I can sell it for $12 and make a $2 profit (20%). That is like buying and selling a stock.
Say instead of buying the card outright, I make a deal with someone who owns the card. I say, “I’ll give you $1 right now just for the right to buy the card at $10.50.” The owner says “ok but you have to decide by the end of the week if you want to buy it or not at that price.” So at the end of the week if the price is still at $10, I don’t cash in my deal because there’s no reason to buy it above asking price. I still lost $1. Alternatively, if the price is at $12, I’ll cash in the deal and buy his card for $10.50. I then own the card. If I want, I can turn around immediately and sell the card for $12 (the current price) to make a profit of $12 – $10.50 – $1 = $.50 or a gain of 50% (of the $1). This is one way options are used.
TLDR: The main difference is for stocks, you own actual shares of the company. For options, you own contracts with other people for rights and obligations to buy or sell at certain prices.
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When you trade a stock you are assuming that the price of a given stock will move in your favor. When you trade an option on the same stock you assume the volatility of it’s prices over a given time will move in your favor.
Here is a quick Eli5 illustration :
If you buy a stock at 10 and it then moves to 15 you have made a profit of 5.
If you buy a 1 month option also when the stock price is at 10 making now the assumption the price will move to 15 sometimes during this period you will not make a profit of 5. Indeed for the privilege of assuming a price range rather than cashing out the present value of the stock you will be charged upfront, a volatility price which will come off your only possible profit of 5. Volatility is very expensive particularly for a private investor.
So by now you have understood that, as a layman, you should never trade options as they are an extremely intricate way to bet the market. Prone to heavy overpricing by option sellers.
Either trade stocks (cash) or better do not trade anything and rather invest in what you understand for the amount you can easily afford to lose.
Conceptually: an option is the right to choose whether to do something. Hence, it is an *option*, quite literally, as you have the option to do something. Optionality comes at a cost, because on the other side of the option is an obligation. See how they’re mirrored? If you have the right to choose to do something, then the other party has the obligation to reciprocate.
In trading, an option is a right to either **buy** or **sell** a stock, at a certain **price**, at a certain **time**. A call option is the right to buy a stock. A put option is the right to sell a stock.
Example: *TSLA $900 CALL MARCH 18, 2021*: A TSLA call option lets the holder buy Tesla stock. if the call option is for March 18, then the holder can buy the Tesla stock any time on or before March 18. $900 is the price of the transaction, if it happens. This option gives the holder the right to buy 100 shares of Tesla at $900, on or before March 18, 2021.
What about the other end of the transaction? If you buy an option, someone has to sell it to you. Symmetrically, since you get to choose whether you want to exercise the option, the seller must fulfill the demands of the buyer.
We take the same example as above. If I sold you that option, I am obligated to sell to you 100 shares of Tesla at $900, on or before March 18. I am locking myself into this obligation, therefore I am going to charge a certain amount of money for it. How much should I charge? It depends on how much I expect the stock to move (volatility), how many days are left, how close I am to losing money, etc.
So, March 18 rolls around and its time to see whether our options did anything.
* If TSLA = $900, then I can buy 100 shares from the market and sell it to you for the same price. You paid me money for no reason.
* If TSLA < $900, you wouldn’t even ask to buy shares from me because you can get them for less than the contract price
* If TSLA > $900 + $option price, then you would profit because now you can immediately sell the shares you buy from me. Remember I am obligated to sell you 100 shares at $900. If TSLA is $1000, then you can turn around and make a quick thousand bucks.
Therefore an option is a ‘derivative’, as in its value is derivative of the value of the *underlying*, which is the stock itself. There is a lot to options pricing and trading strategies, but think of it as you are buying or selling **contractual rights to do something**
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