In the world of trading, trading stock options are very similar to futures trading. Both of these instruments involve the process of purchasing stock at a pre-determined price and subsequently sell them when the price rises above its original value. In the case of stock options, you have the right, but not the obligation to call (buy) or sell (put) a specific underlying asset at a prearranged price on or before any given date.
Example of Stock Option
Let’s say that a trader has bought a call or a right to buy 100 shares of CSX Inc, at a pre-determined price of $40 per share which is the strike price. The date of expiration is March of 2008, and he pays $5 for the option. If CSX trades below the $40 mark, then the trader would not exercise their option and would have lost the price he paid on the option.
However, if CSX trades at $50 on or before the date of expiration, the option will be worth $10 which is the difference between the price the option is set at. This gives the individual who bought the put option, the right to sell that option at the strike price before the date of expiry.
Similarities of Stock Options with Common Stocks
Like stocks, stock options involve the buyer making bids while sellers make offers. While those bids and offers fare for shares in case of stocks, for stock options, it is the right to buy 100 shares per option contract of the underlying stock. This can be at any given price per share or any period of time.
Stock Option Investors and stock investors both have the ability to follow trading volume, price movements and other information pertinent in nature. They can do this on a day by day or even on a minute by minute basis. The buyer or seller of the stock option can quickly learn the price at which the order has been executed.
Factors to Consider
When it comes to liquidity, stock options aren’t very liquid. For instance, only a few thousand options are traded on the DOW 30 stocks. The reasons for this lowered volume is the broad choices of options one has. You can have several strike prices and expiration dates available at any given time. Another fortunate aspect of stock options is that they aren’t susceptible to market manipulation. This is because its value is determined by a mathematical formula created by Black and Scholes, rather than the forces of demand and supply. In the IBM example shown above, traders do have a significant spread between the bid and the ask, which is $0.10(3%) of the stock option price.
What Leverage to Choose?
Leverage will depend on the stock option you choose, as the price of the option depends on the time until expiration as well as the volatility of the underlying stock. It also depends on the inner value of the stock option i.e. the stock option is in the money. Stock Options in general offer high leverage.
For instance, IBM stocks were trading at $110.16 on Dec 27, 2007. If you wanted to purchase hundred shares of IBM, you would need $11016 in funds. The January call bearing a strike price of $110 with 23 days left to expire was priced at $3.30. This means that for only $330, you can purchase hundred IBM shares within the next 23 days. Here the leverage is 1:30.
What Are the Capital Requirements?
If you day trade stock options, they are subject to pattern day trading rules introduced by both the NASD and NYSE in August and September of 2001. Under these directives if a trade executes four or more day trades within a five-day business period, he is required to maintain a minimum equity of $25000 in his margin account at all times. If we put that into perspective, you would require a minimum of $28000 to $30000 if you wish to day trade stock options.
How Volatility Affects
Stock options that are traded in the money or at the money have increased volatility. In the above IBM example, the stock option had only 23 days to expire. The current price was at $3.30 and it was trading as high as $3.95 throughout the day. The close of the previous day was $4.30. Thus in this case, we can conclude that the intraday volatility for this option was almost 20%, while the overall volatility was close to 30%.
Differences between Stocks and Stock Options
Common stock holders get certain voting rights and rights to dividends. Stock Option holders only participate in the benefit of the stock’s price movement.
Stock options have no limitations when it comes to existing. However, this is not the case for common stocks, where there is a limit. This is because the number of outstanding options which is known as pen interest depends only on the number of buyers and sellers interested in conferring this rights after receiving them.
Unlike common stocks which come with certificates, stock options don’t. Instead the buyer or seller’s brokerage firm prepares printed statements to provide information on the option positions. This is an innovation of stock option markets, i.e. certificate-less trading which sharply decreases paper work.
Stock Options have a limited life compared to common stock. The latter can be held indefinitely in the hope of its appreciation. However, stock options have an expiry date. This means that if you do not close out or exercises your stop option before it expires, it ceased to exist as a financial asset.
Stock Options and common stocks both have similar advantages and disadvantages. The leverage is higher in the case of stock options but still lower than forex or futures markets. The volatility can be scary for some traders and liquidity is also very low. Novice traders should grasp the concept of day trading well before they even attempt to start using stock options. Look to trade them on daily or weekly charts.