What is the difference between investing in stocks versus trading stock options?
Before I discuss some other stock option strategies, I need to explain the fact that trading stock options is different than investing in stocks. Just because you think the underlying stock is going to increase in value does not mean you should buy just any related call option. Options are sensitive not only to the direction of the underlying stock it is based on, but also to the time left before expiration and how volatile that stock is. Thus, stock options are three-dimensional. Independent investors need to take into consideration all three factors – price, time, and volatility. Whereas investing in stocks is one-dimensional since price is the only factor, either up or down.
The Effect of the Passage of Time on Investing in Stocks vs Trading Stock Options
When investing in stocks, you have a cost-basis point – whatever you paid for the stock plus commission. Also, you can wait as long as needed, even years, to see how far the stock gets above your cost basis or breakeven price. You have the luxury of time to wait those years or even pass the stock to your heirs if you wish. Stock options are not like that. They all have a finite date of existence. If the underlying stock price does not get above your breakeven price by option expiration, you will lose money. So the object of winning in trading stock options is to choose the best strike price that maximizes your probability of profit.
Before learning how to maximize our chances of winning in trading stock options …
We need to understand the relationship between the strike price of the option and the current price of the underlying stock. This forms the basis of achieving the highest probability of profits trading stock options. For call options, any option which strike price is higher than the current price of the stock is considered out-of-the-money (OTM). For example, if Wal-Mart (WMT) is at $ 74, then all strike prices above $ 74 are OTM. Any strike that is priced near the current price of the stock is considered at-the-money (ATM). A WMT $ 73 or $ 73.50 strike price would have considered ATM. And, any call option strike price that is below the current price of the underlying security, in other words a strike price below $ 73, is considered an in-the-money (ITM) call option. Put options are the opposite.
Why is trading stock options so beneficial vs simply investing in stocks?
The whole idea and advantage of buying call options instead of paying for the stock itself is because of the amount of leverage you can get. With options, you only need to pay a fraction of what the stock would cost, yet you get to control the same amount of shares. Since one option contract is the equivalent of 100 shares of stock, you can theoretically control hundreds or thousands of shares of stock for just a few hundred dollars. But, even though you have this great leverage, you still need to know which strike prices will take the best advantage of that leverage.
How is trading stock options done successfully?
If you are going to buy call options, you will need to decide which strike price and which expiration months to choose. Usually you want to only buy higher-delta ITM options. What is delta ? Delta describes the relationship between the option price of movement and the price movement of the underlining stock. Delta is the best indicator in alerting us to how much the option price should theoretically move in conjuction with the move in the underlying stock. The reason for investing in stocks in the first place is to get a move in the stock, hopefully in a positive direction. It's no different with trading stock options. The best way to do that is to concentrate on picking options with the higher deltas, since the higher the percentage the more likely the option will reflect the movement of the underlying stock.