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:
Let’s say that AAPL moved up 20% in one year. The stock holders would have made 20% in return for holding on to the stock all year long. Now, if an option trader was holding a Call contract all year, he may have just lost his investment.
We know why the stock holder made money, but why would the option buyer lose money? Everyone thinks there is leverage in options, and it’s true, but in this case, the leverage didn’t work out for 2 reasons. One, the asset took too long to move, so the option time value decayed. Secondly, the asset moved up, causing its volatility level to fall, and this also helped the option price to move down.
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.
