Sunday, October 26th, 2014

Difference between Stock and Options Trading

 

The difference between stock and options trading is a matter of risk hedging and leverage. Otherwise there is no difference between stock and options trading of stocks. In each case traders must learn and follow both the fundamentals that drive stock prices and technical analysis of market sentiment which leads to volatility outside of what fundamentals might dictate. Both direct trading of stocks and trading of stock options can be done from trade station or, rare for these days, with a phone call to a stock broker. Beginners need to learn about stocks, how to set up a trade station, both fundamental and technical analysis of stocks, and basic trading strategies. Traders make money trading within channels, adopting a contrarian view as a trend runs its course, or by scalping small profits as stocks and stock options fluctuate throughout the day. One difference between stock and options trading is that in options trading one can pay to stake out a price position that limits risk. The other difference between stock trading and stock options trading is that in trading options one can enter and leave a position with a relatively low investment of capital and make much more money for each dollar put at risk than in directly trading stocks.

Options Limit Risk

You are excited about the prospects of owning ABC stock as it has been going up steadily for several months. You are also concerned about the fact that its upward progress has been broken by several corrections. You want to take a position in this stock but not just before it corrects and you lose a third of your money. The difference between stock and options trading in this situation is clear. Buy a call option on ABC stock. If the stock does in fact go up further you can execute the contract. You will buy at the contract price, known as the strike price. You will own the stock and have purchased it for a price similar to what you might have paid if you had simply decided to purchase the stock in the first place. However, you might buy ABC stock in a volatile market and realize the worst of your fears. The stock immediately suffers a correction and you have lost a third of your invested capital. You can wait for it to recover but that may or may not happen.

Options Provide Leverage

Let us say that you only want to get into XYZ stock because you believe that it will run up a bit more before leveling off or retreating. You believe that you can make short term profits. If you buy the stock and it goes up you can sell and make a profit. But, if you buy a call on the stock you can do so with less money that you would need to put up to buy the stock. When ABC stock goes up the value of your options contract goes up to. It goes up about the same amount as the stock did. Thus you can exit your options contract with a profit similar to that which you would have made buy purchasing and then selling the stock. The difference is that perhaps you paid a dollar a share to purchase the call option and would have paid perhaps $100 a share to buy the stock. If the stock goes up $10 a share and the value of the call contract goes up $10 a share your return on invested capital will be $10 per dollar invested for the call contract and $10 per $100 invested for buying and selling the stock. The difference between stock and options trading in this case is a return on investment of 10% for buying and selling stock versus 1000% return on investment for trading stock options. One can engage in online options trading just as one can engage in online stock trading. The difference between stock and options trading has to do with risk and leverage.

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