Why Are Stocks Simple And Options So Complex?
Let's discuss the complexities of options and how they differ from trading stocks. First of all stocks are simply one-dimensional trading vehicles, the dimension of "price movement." For example, one can go long a stock if he/she is forecasting a rise in the price of the underlying asset. The stock trader doesn't need to worry about time or changes in volatility affecting the outcome of his trade. The stock trader only needs to focus on the asset's price movements.
Before anything else, let me tell you that stocks are single-dimensional trading vehicles which consider none but the price movement dimension. If the price of an underlying asset is forecasted to rise, a trader can choose to go along a stock. A stock trader doesn't need to consider how changes in volatility and time can affect the conclusion of his trade. The only thing he has to look after is the movements on the assets price.
A stock takes a full year to move up 10%. The stock trader who bought and held on to his stock has just made 10% on this particular trade. However, the option trader might have made nothing at all or even lost money if he just bought an option.
Why does an option trader lose money in the aforementioned trade? The answer is simply Time Decay. His option simply failed to seize much Time Premium as the trade has taken quite long to develop. In addition to, volatility of the asset might just have fallen thereby resulting in the devaluation of the Call option. In brief, options are losing premium as time goes by.
Simply because of Time Decay an option buyer will lose money in this trade. As the trade takes a long time to develop, one's option just lost a significant amount of Time Premium. Moreover, Call option will likely lose value as the volatility of the underlying asset might have probably gone down. In short, options will be losing premium through the course of time.
After we understand options more in depth, these investment vehicles can make money in any type of market. Options are very adaptable and allow investors to be very creative once the understanding is there.
Article Source: FxTradingStock.com
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by: Donald Scott
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Date: Mon, 26 Jul 2010
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