One area of investor education that I’ve been putting off is learning about trading stock options online. This is because as risky as the stock market can be if you don’t know what you’re doing, the risk associated with options is even greater if you don’t know what you’re doing.
So why bother learning then? Because the reward can outweigh the potential risk. The reward in this case is extra protection — “stock insurance” if you will — on your investments in case of market downturns, and potential for greater profits in the case of continued market rallies.
So here are some of the basics. I’m still learning, so seasoned options traders can correct me where I’m wrong. But I’ll share with you what I know as I learn it.
How the Options Market Works
Just as there is a market for trading stocks – in stock exchanges and in virtual markets online – there are markets for trading options on exchanges (such as the Chicago Board Options Exchange) and trading options online. Trading options means people buy and sell options. Average investors will buy and sell options through specialized online electronic options brokers, which are usually full-service discount brokers that also offer options trading capabilities.
Just as the share price of a stock represents the combined market sentiment (or knowledge, if you will) about the future of the underlying company – how much value it holds – option prices represent the perceived or known estimates of the future variability of that stock.
The options market prices the variability that is likely to occur in the stock market going forward. Options are not predictions of stock market directions, they are just predicting the variability of those choices.
The Price of an Option Is Its Premium
The options market can be conceived in terms of insurance. Just as you pay premiums in order to have home or auto insurance, you pay a premium to buy your stock insurance. In other words, you pay a premium just to be “in the game.”
You’ve probably heard of put options and call options. A put option is conceived of as insurance against a decline in the stock price. If you think your stock has had a good run and the risks are now higher that it will correct, you might want to buy a put option on the stock. But you have to pay a premium to do this. The premium (option price) goes up and down in value, just like your stock price goes up and down in value.
For example, back in February 2009, put options were about four times more expensive than they are now. That means that more people were trying to buy that insurance at that time. Today, option premiums are back to a normal trading range.
Option premiums are calculated based upon estimates of future volatility in the markets.
As markets decline, the value of options premium rises because it reflects the fear factor in the market.
Options Prices Reflected in the VIX
The VIX is the Volatility Index, maintained by the CBOE (Chicago Board Options Exchange). The VIX is a measure of amounts of trading activity and is usually taken by analysts as a proxy for how much fear is in the markets.
More specifically, the VIX indicates what options premiums cost on the S&P 500 Index. It shows the volatility implied by the options taken out on the S&P 500. So the VIX levels go down when the overall trading range of the market (the differences between bid and ask prices) narrows.
As you can see, the options market and its relations to the stock market can get pretty complex quite quickly. All of this just scratches the surface, but there’s much more to know. In a future post I’ll look more closely at these relationships as well as put and call options themselves.
Be advised that I have never traded options up to this point and that any options trading is quite risky. Even investors who have taken courses on options through companies affiliated with brokers like Think or Swim have lost thousands of dollars, despite all that they knew. I am just providing this as information, since I am curious and you probably are too.
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