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Difference between buying stocks and options
19 Feb 2021 (343 views)

I wish to explain the difference between buying stocks and options.

When you buy or sell stocks, you trade with the price as determined by the market. Usually, they are many buyers and sellers for the stock, so the price is determined fairly by the market.

You can also buy call or put options on these stocks. A call option allows you to buy the stock at a future date at a pre-determined price. You will only exercise the option if the actual price of the stock goes above the option price. If the price stays below the option price, you will not want to exercise the option, i.e. you allow the option to lapse.

You have to pay a premium for the call option. If it expires without being exercised, you will lose the premium.

A put option works in the opposite way. A put option gives you the right to sell the stock at a pre-determined price at a future date. You will only exercise the option if the actual price falls below the option price. If the price stays above the option price, you will not want to exercise the option, i.e. you allow the option to lapse.

You have to pay a premium for the put option. If it expires without being exercised, you will lose the premium.

A call or put option looks attractive to the investor because they hope to see a large gain, i.e. the difference between the actual price and the option price, if the market goes in their favor. If not, they will lose a fixed amount, being the amount paid as the premium.

I do not like to invest in options because the premium is calculated by the option seller. They have mathematical models to calculate what is the fair value of the option (based on the probability of the option being exercised) and they add a large margin to cover their expenses and profits. You can be sure that they do the calculations in their favor. The option buyer has to pay a premium that is much higher than the pure cost of the option.

If there is a large market for the options and there are many people competing to sell the options, it is possible that the market competition will bring down the option premium to a competitive level. However, in most cases, there is not much competition, so the margin is very much in favor of the option sellers.

For the above reason, I am not in favor of buying options. I prefer to buy the underlying stock, rather than the options.

Tan Kin Lian

 

 



Difference between buying stocks and options
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I wish to explain the difference between buying stocks and options.

When you buy or sell stocks, you trade with the price as determined by the market. Usually, they are many buyers and sellers for the stock, so the price is determined fairly by the market.

You can also buy call or put options on these stocks. A call option allows you to buy the stock at a future date at a pre-determined price. You will only exercise the option if the actual price of the stock goes above the option price. If the price stays below the option price, you will not want to exercise the option, i.e. you allow the option to lapse.

You have to pay a premium for the call option. If it expires without being exercised, you will lose the premium.

A put option works in the opposite way. A put option gives you the right to sell the stock at a pre-determined price at a future date. You will only exercise the option if the actual price falls below the option price. If the price stays above the option price, you will not want to exercise the option, i.e. you allow the option to lapse.

You have to pay a premium for the put option. If it expires without being exercised, you will lose the premium.

A call or put option looks attractive to the investor because they hope to see a large gain, i.e. the difference between the actual price and the option price, if the market goes in their favor. If not, they will lose a fixed amount, being the amount paid as the premium.

I do not like to invest in options because the premium is calculated by the option seller. They have mathematical models to calculate what is the fair value of the option (based on the probability of the option being exercised) and they add a large margin to cover their expenses and profits. You can be sure that they do the calculations in their favor. The option buyer has to pay a premium that is much higher than the pure cost of the option.

If there is a large market for the options and there are many people competing to sell the options, it is possible that the market competition will bring down the option premium to a competitive level. However, in most cases, there is not much competition, so the margin is very much in favor of the option sellers.

For the above reason, I am not in favor of buying options. I prefer to buy the underlying stock, rather than the options.

Tan Kin Lian