Let’s discuss the complexities of options and how they differ from trading stocks. First of all stocks are simply one-dimensional trading vehicles, the dimension of “price movement.” For example, one can go long a stock if he/she is forecasting a rise in the price of the underlying asset. The stock trader doesn’t need to worry about time or changes in volatility affecting the outcome of his trade. The stock trader only needs to focus on the asset’s price movements.
So we all know that stocks are simple, directional investments, but what about options? Well, trading options is actually trading 3 Dimensions…time, volatility and direction. I guess this makes options three times more complex than stocks. Now, let’s look at a trading example to compare the difference. Look at 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.
