Understand Stocks Before Buying Options

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Options are a type of derivative. That is, their value derives from another financial instrument. If you buy an option on AAPL stock, for example, the value of the option depends primarily on the price of AAPL stock. Many, maybe most, option traders begin their careers by buying stock. A strong understanding of the stock market in invaluable to the option trader. When you buy a stock, you actually own a piece of something, typically a share in a business, though you could also buy into a fund (an ETF) that contains a collection of stocks. When you buy shares in a company, you tie a part of your financial well-being to the fortunes of that company. You hope that the company is profitable, and you expect that your investment will appreciate as the company moves forward. But you also know that businesses have to assume certain risks that have the potential to depress the market price of their shares. The market price of a share of a company reflects the consensus judgment of a company’s value made by investors who consider a variety of factors. Just a few of these are the company’s profitability, its growth potential, its product line, the talent pool it draws on, its record on paying dividends, and external factors. The market price reflects a crowd-sourced opinion of what the company is worth. When you buy a share of AAPL, you are acting on an opinion that the current market consensus on the price of its stock is low and you expect it to rise. When you sell your shares, you are acting on an opinion that the market has over-valued the stock and that its price is likely to fall. The gain you can achieve by holding stock depends on the dividends you receive and any increase in the share price. Your risk is equal to the equity you hold in the stock. The worst case is if the stock price were to descend to 0. That’s unlikely, but individual stock issues can become highly volatile and experience considerable gains and losses. An extreme example of volatility can be seen in Gamestop (GME). The chart of its pricing between early 2021 and summer 2022 tells its story.

I know young traders who made and then lost tens of thousands of dollars buying and selling Gamestop. Many bought at precisely the wrong time, and never regained their full loss. Others, of course, sold at the top and walked away with fortunes. What motivated those who bought at the top and those who sold at the top? Let me suggest that retail traders who bought at the top were motivated by greed. Those who sold were motivated by fear–fear of losing gains they’d achieved. All traders experience greed and fear. Successful traders need to be able to rationalize those emotions; that is, they need to unemotionally consider data that can justify actions to satisfy greed, or to respond sensibly to fear. Such data can also come from the price chart. Earlier I wrote that market price reflects a consensus of what a share is worth. Individual traders may think the stock is worth more, others less, but the market at large makes the final judgment. You may have noticed that as we closed in on 2022, Gamestop’s price began to vary between $20 and $50 per share. That’s still a pretty broad range, but these parameters tell us something about those trading GME. When they see the price heading towards $50, as a group, they become fearful and begin to sell their holdings. Conversely, when shares fall towards $20, they see an attractive price offering a good opportunity for profit. These levels of support and resistence can become objective data that inform your decisions on buying or selling stock. They will also play an important role in option trading.