Successful long time traders require an arsenal of tools and strategies to profit in different market conditions. One common avenue for a stock trader is to venture into option trading. While option trading contains many elements of stock trading, there are key differences in the areas of knowledge, involvement and commitment, costs and potential gains that need to be considered before deciding if option trading is an avenue worth investing time and money in.
Stock trading requires knowledge surrounding chart interpretation, company fundamentals and market conditions. Skilled option traders will be familiar with this material, after all, option prices are related to stock prices, but will also know option specific subjects such as put call ratio, the Greeks and option pricing. Furthermore, the flexibility of options also gives way to a plethora of trading strategies which range from basic to very complex, requiring further practice and study to master. Therefore, as a whole, option trading may be more difficult to pick up when compared to stock trading.
Involvement and Commitment
Option price movements are derived from movements in the price of the stock; however, the relationship between the movements is rarely one-to-one. Often small price changes in the stock can result in a large, dramatic change in the price of an option. These fluctuations can occur in a short period of time, meaning option trading may require a higher level of involvement than stock trading.
For example, a stock trader may buy a stock at support, intending to hold it for a number of days until the price recovers, where the trader will sell out. With options on the other hand, a trader may find themselves facing multiple entry and exits points during that period, especially if the stock highly volatile, requiring the option trader to be more proactive to ensure maximum returns.
Trading stock requires the purchase of the stock and this initial outlay may be difficult and limiting for beginner stock traders. On the other hand, buying stock means acquiring an asset which can appreciate or provide dividends indefinitely. Buying options is relatively cheaper, requiring only a fraction of what it would cost to buy the stock, however, buying options will not deliver dividends and they will expire worthless unless exercised or sold before expiration.
The potential gain compared to the outlay required is what draws many people to option trading. A relatively small movement of the stock price in the right direction can deliver a large jump in price of the option. Stories of large returns are not uncommon, and are often touted at option trading courses. These gains can take a matter of days or weeks, whereas a patient investor may need to wait years to before seeing similar returns. It’s important to remember though, that options will decay every day until the expiration day. If the market is flat or there is low volatility, the option will expire worthless, and the outlay is completely lost. Owning stock, on the other hand, allows the trader to sell the stock at any time (there is no expiration date) and may limit the loss to only a small percentage.
In summary, a stock trader will need to measure up the level of commitment required in learning new ideas and strategies before moving into option trading. While there may also be an increase level of involvement required, stock trader will welcome the lower costs and greater potential gains. Whatever a trader may decide, option trading represents a robust and potential rewarding avenue for the committed trader.