Key differences between trading stocks and options
Hi there. This is Sushant Reddy from Big Blind series on options trading. In this tutorial, I’ll quickly highlight the key differences in trading stocks and options.
A lot of people intuitively understand trading & investing in stocks. To appreciate options trading, one has to understand the implicit difference between trading stocks and options. I have always believed that strategies, outlook & risk perception for both asset classes is completely different. You might be a great stock picker or value investor but the skillset needed for successful options trading is completely different. While there are a lot of points to discuss, I’ll highlight only the key differences of trading in stocks and options.
A successful stock trader might not necessarily be a successful options trader and vice versa
1. Concept of Expiry
Every options contract comes with an expiry date — the fact that such contracts have a limited shelf life makes them very different from stocks. Stock investments don’t have an expiry date and an investor can choose to hold stocks for as long as she wishes.
To give you a sense of importance of time, I’ll give an extreme example:
Let’s say you bought a single option of ICICI Bank on 05 May 19 with a strike of 400 and an expiry date of 30 May 19. You would have paid 19.7 rupees for each such option. On 05 May 19, ICICI Bank was at 400 rupees.
Now imagine that you are on 29'th May and ICICI Bank rose to 430— you are super happy because if it stays the same, you are going to make 10 rupees profit on your trade in 1 day.
On 30'th May something bad happens and ICICI Bank ends up at 399 — your earlier day’s profit goes up as a poof of dust and you end up losing all the money spent on buying that option.
Now Imagine that on 31'st May ICICI Bank stock rallies back to 420 — I wouldn’t blame you if you think that life is cruel. Over the next few tutorials we will understand how time affects the option pricing.
Time is like a gravitational force in the options trading world. It can be your biggest friend or worst enemy
2. World beyond directional betting
When you trade a stock, you either wait for it to go up or go down. There are only 2 ways in which you can make money — an option contract allows you to take a bet not only on the direction of stock but also on things like volatility, range of movement etc. Even better, you can combine options to create strategies that make money with a specific probability.
For eg, you can design a strategy that will end up making profits when ICICI Bank share will be between 420 and 440 on expiry date. You can design a strategy that can make money exactly 60% or 70% of the time. Such flexibility offers you immense scope to get creative in how you use options.
3. Concept of leverage
Leverage is the X factor that can lead to significantly higher profits and understanding how to use Leverage to your advantage is the essential holy grail of options trading.
So what exactly is leverage?
Let’s say you are interested in buying 100 shares of HDFC Bank that is currently trading at 2300 per share. You would need a total capital of 2,30,000 to take a position that pays you 100 rupees (or loses you 100 rupees) for every rupee increase (or decrease) in share price of HDFC Bank.
Now let’s say instead of buying stocks, your friend Amit bought 100 options on HDFC Bank. Let’s look at the current price of HDFC Bank option with a strike of 2300 and expiry of 25 days.
100 such options would have costed Amit 10,300 rupees (103.05*100). Now on the day of expiry, if HDFC Bank rises to a price of 2400, both you and your friend Amit would have made a profit of 10,000 rupees. The only difference is that you invested 2.5 Lacs to get 10,000 profit (a 4% return on investment) whereas your friend Amit has invested 10,300 to get 10,000 profit (~100% return on investment).
So by investing 10,000 in options, your friend Amit is exposing himself to the same upside as you have. Only difference is that you invested 25 times more capital than him. The ability to expose yourself to a much higher upside (and downside) by investing lot less capital is called Leverage.
In plain terms, Leverage is the ability to punch way above your weight
To summarize, options are time bound, offer a lot more flexibility and offers a lot of leverage. If you have any comments or questions, please ask them right below.
