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Option and Stock Trading - Is Either Suitable For You?

This article about Option and Stock Trading has been prepared for this site by StockTradingSignals.net .

Option and Stock Trading, Knowing The Differences

It is a common notion among people who trade options to view options as just a proxy of the underlying stock. Is it really that simple? The answer is yes and no. An aspiring trader must understand the characteristics and the differences between the two instruments in order to become successful.

Time Decay of Option.

One of the major differences between options and stock is that an option is very much affected by time as it has a time premium component embedded into the total price. Depending upon which side of the trade you are in an option trade, time decay occurs as an advantage (to the seller) or disadvantage (to the buyer) regardless of the stock movement.

Rate of Time Decay.

Option traders must be aware of the characteristics of options with respect to time-to-expiration. The steeper decay occurs when the expiration date approaches in the final month.

In general, if an options trader wishes to place a bet on the upward movement of a stock, but chooses to buy the option (limiting risk and increasing leverage) instead of the stock, a suggested approach will be to buy a long dated option (an option that has at least two months or more until expiration, longer is better but liquidity may be a problem) which will have a more gradual time decay, with the view that the upward price movement of the shares will more than offset the time decay. In addition, buying a long dated option also allows more time for the stock to perform from the point of purchase until the expiration of the option.

However, if the trader wishes to have time decay on his side, he may choose to sell a short dated (8 weeks or less) put option, so that the steep time decay towards the expiration will quickly erode the price of said option (this aids the option seller to make a profit).

As an option buyer, your best scenario occurs when the movement of the underlying stock well exceeded the time decay of the option. At the other end of the trade, the option seller will profit if the underlying move in direction is to his advantage. He or she should be fine even if the underlying stock stays fairly stable because the time decay will erode away the optionís premium. This gives him an increasing opportunity to close out his position at a lower price or even to hold the position until expiration. Either will result in a profitable trade.

On Volatility and Trend in option and stock trading .

In general, it is better for an individual trader to focus on the trend of the underlying stock (especially on breakouts) rather than the volatility. The volatility trading will be more valuable to the big financial institutions.

Dividend and Ownership.

One of the main differences between option and stock trading is that when owning stocks, the purchaser becomes a part owner of the company and is entitled to any potential dividend payout. Owning options however, does not entitle the option owner to any dividendsor any part ownership of the company.

Final verdict?

You will have to draw your own conclusions on which instrument is best for you when comparing the pros and cons of option and stock trading. Ideally, you should take some time to learn and really understand the characteristics and differences between an option or stock trade. Your understanding of the risks involved and knowledge of risk management will be your primary concerns before you can take steps to become a more and more successful trader. Good Discipline = Good Luck!

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