You need to hear this…
Options trading may seem very similar to stock trading in many ways…
But a major reason why so many people blow up their accounts when they first start trading options is that they try to trade them the same way they would trade stocks!
WARNING: If you don’t understand the key differences between options and stocks, you’ll eventually pay the price!
You see, stocks trade in a very straightforward manner. If there are more buyers than sellers, the stock goes up. And with the opposite, the stock goes down…
But options prices are affected by a variety of other factors.
And I see students in my Discord channel having trouble understanding some of these all-important metrics…
With that in mind, keep reading and I’ll explain three crucial differences between options and stocks that every Evolver must grasp immediately.
How Implied Volatility Works
I think the most monumental difference between stocks and options is the existence of implied volatility (IV) in the options market…
IV is an estimate of a stock’s future volatility. It reads as a percentage figure attached to options contracts.
The IV on contracts could be 20%, 50%, or 500% — all depending on a combination of the option’s market price, the underlying stock price, the strike price, the time to expiration, and the current risk-free interest rate.
And it’s all to determine the overall IV — and the price — of the contracts.
In other words, this means that both puts and calls are more expensive if the contract’s IV is higher.
The market is pricing in a higher probability of a bigger price swing, forcing option buyers (like you and me) to pay more up-front premium for the right to profit off of the expected move.
EXAMPLE: External news-driven catalysts (like an upcoming earnings call) can cause massive swings in the IV on short-dated options contracts.
On the flip side, if a chart looks like a flat line with few price swings, the IV on those options will be lower because the odds that a huge move will take place are considerably less.
And aside from IV, there are a few more options-specific liquidity metrics you must understand…
But first…
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2 More Liquidity Metrics You Must Understand
You’ve hopefully heard about two other crucial liquidity metrics — volume and open interest.
In short, volume and open interest track liquidity and activity in the options market, but in different ways…
Volume
Volume is a running total of the number of contracts traded on a particular contract in a given trading day.
Think of volume as a short-term liquidity indicator — it helps to see the flow of contracts on a near-term basis.
For short-dated options traders (like me) volume is probably the most useful liquidity figure. It reveals the immediate action happening that day.
If a big news headline causes large-scale buys in a particular weekly contract, the volume on that contract will stick out like a sore thumb.
Volume can be used as a guide to understanding the general flow in and around high-flying momentum stocks, where positions with large size can often precede massive moves in a share price.
Being able to see the volume each day makes it easier to understand what other traders are doing on specific contracts.
Open Interest
Now, let’s talk bout open interest…
If volume measures short-term liquidity, then open interest is its long-term counterpart.
Open interest measures the total number of contracts held in open positions on a particular strike price.
Where volume counts the contracts traded that day only, open interest calculates all of the contracts sitting in traders’ accounts, including those that aren’t actively being traded.
If you’re a swing trader, open interest can be a very intriguing metric to look at…
I can’t tell you the number of times I’ve noticed tens of thousands of contracts sitting in open interest on a stock, only for some huge piece of news to drop a month later, sending the share price surging…
All this to say, both volume and open interest can give you hints as to what may happen to the underlying share price.
That said, DO NOT buy calls simply because the volume and open interest are high. These figures can lead to nothing far more often than they foreshadow a massive move.
Final Thoughts
These ideas won’t be new to seasoned options traders.
But for anyone just making the transition from stocks, getting a basic grasp on these liquidity metrics is absolutely essential.
Great options traders have a deep understanding of IV, volume, and open interest. Start embracing them in your trading and you may be pleasantly surprised with the results.
