There is a significant difference between regular trading and options trading. When trading regular stocks, the price only moves up or down based on demand. With options, however, there are various ways in which an option’s price can move, and sometimes the factors behind these movements may be unclear to novice traders.
An option allows traders the right to buy or sell an asset, expressed as a contract, at a pre-determined price before a set date. Options are traded on financial markets. Their value depends on several factors, including market volatility, time left until expiration and the “interest rate” (or implied interest rate) of the underlying instrument. The latter is why options are also called “derivatives.”
The most common type of options is “call options,” which give you the right to buy shares at a specific price by a particular time, and “put options,” which allows you to sell specific shares at a set price by a particular time. In an options trade, one party would be buying while another selling. Unless the contract is “covered,” both parties need to put up collateral. The collateral can be shares of the underlying instrument or other assets deposited into an account that holds all active contracts.
Listed options are traded on exchanges worldwide under standardized rules and regulations. These standardized contracts have established expiry dates and strike prices, meaning you know exactly how much your right to buy or sell will cost before entering into it. By contrast, non-listed options are more difficult to value as they aren’t controlled by exchange and tailored to specific requests.
Today we’re going to be discussing two such differences: liquidity and volatility.
Should you buy a share of Apple (AAPL) or IBM (IBM), your order will go through without much trouble at all (if you can afford the price, that is). If you want to trade regular options, though, the ability of there to be ‘enough’ people at both buying and selling ends may depend on how liquid the stock is. This means that the more people trading the stock, make it easier for new traders who don’t know what they’re doing (which usually means novice traders) to buy and sell these shares.
Options on less frequently traded stocks tend to be harder for inexperienced traders because of their low trade volume: it’s like getting a basketball player into an empty gym with little training. Regular options don’t require any special training or equipment, and that’s one of the reasons why most people choose them over listed options; it’s much easier to get into the game.
It is simply the indication of how much an option’s price fluctuates over time. For example, if you buy or sell shares in Apple, their price does not tend to change by more than 1-2% per day (usually). However, if you were to buy or sell options on Apple, their stock could go up/down by 5-10% depending on the news that day and other factors that affect supply and demand for Apple stock. There are no surprises when trading regular stocks: it goes up or down based on economic trends and projected earnings reports at steady rates throughout the year until it reaches their target value.
So the next time you get to thinking about how much an option costs, remember that buying/selling regular stocks is so straightforward compared to using options. Not only do you need more cash, but you also have no guarantee that the price of your option will behave predictably: it can go up or down based on factors that may or may not be in your favour. New investors interested in trading options should visit Saxo capital markets and use a reputable online broker to help them get started.