The Relationship Between Stocks and Stock Options
For many traders who are used to the world of stock trading, understanding the relationship between stocks and options is initially very difficult. There are similarities, but there are also vital differences.
The first difference is that an option is not a stock. It is a derivative, i.e. its value is derived from the price of the underlying stock. A call stock option gives the buyer the right, but not the obligation, to purchase a particular stock at a certain future time at a given price. Similarly, a put stock option gives its owner the right to sell the stock at the expiration date for a given price.
If someone buys 100 shares in Company ABC, he or she stands to lose the full purchase price if the shares drop to zero. With a call option, the buyer of the option can only lose the amount that was initially paid for the option, i.e. the premium.
Someone who shorts a particular stock, on the other hand, can lose an unlimited amount of money if the stock should rise instead of drop in price. The holder of a put option, however, can only lose the amount that was paid in terms of the premium.
Buying options therefore exposes the trader to limited risk, compared to the virtually unlimited risk of going long or short on a stock.
Despite the limited risk, the buyer of both a call and a put option stand to make substantial profits if the share price should increase (call options) or decrease (put options). In the case of call options the maximum profit is theoretically unlimited, while with put options the profit is limited to the share price less the premium of the options.
Stock options are leveraged trading instruments, i.e. they give a trader control over a much bigger amount of shares than the actual amount he or she is trading with. Three month ATM call options on a stock trading at $100 with a volatility of 17% will sell for about $4 (theoretical Black-Scholes value, the actual price will differ somewhat).
This means a trader can control 100 shares worth $10 000 for only $4 x 100 = $400. If the share price goes up by 15% the owner of these call options will more than double his investment.
One should of course remain realistic here: the probability of the options to actually end up ‘In the Money’ should always be weighed against the chance that they will expire ‘Out of the Money’ and hence become worthless.
Making profit in a falling market
The owner of a share can only make money if the share price goes up. The only way to make money in a falling market is by ‘shorting’ the particular share.
There are, however, various strategies that allow an options trader to profit from both falling and rising markets. Probably the simplest one is the straddle, which consists of buying both ATM call and put options. Fig. 9.07(a) below depicts a typical straddle.
This trade will be profitable if the price of the underlying share moves significantly upwards or downwards, something which is not possible with a simple stock investment.
It has to be noted, however, that a long straddle like this involves relatively expensive ATM call and put options, and the trade will only become profitable if the price moves more than the purchase price of both the calls and the puts combined. The probability of this trader losing his money is therefore higher than with buy only call options or put options.