Are you planning to trade option to take advantage of stock movements? If that’s your plan you’d probably want to know if option trading affects the stock price.
First of all, what is an option? It’s a derivative contract or financial instrument that derives its value from underlying securities such as stocks.
An option contract provides the buyer with the opportunity to buy or sell, contingent on the type of contract they hold, and the underlying asset.
Unlike futures, holders are not forced to buy or sell the assets if it’s against their wish. Each contract will have a set date that the contract expires and the holder must have exercised their option. The stated price on the option is called the strike price. Option are traded by online or retail brokers.
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Can option trading affect stock price?
Theoretically, option do not affect the stock price but practically, we can’t say the same. Traditional experts say option trading does not affect the demand and supply of stocks because the option is just a ‘side bet’.
However, modern investors and experts have another opinion on this theory. What they do is that they observe the position dominating in the option market and consequently buy and sell shares in the spot market.
Does the option increase the stock price?
Option and stock price share a relationship. When the value of holding an option increases, then stock prices decrease too.
On the other hand, when the value of an option decreases, automatically, the stock price increases.
Option prices have a significant effect on stock returns. Stock prices reduce when option are expensive relative to call options. There’s a huge connection between option prices and the conditions in the underlying securities market (stock market).
Understanding The Relationship Between Option and Stock Price
To understand how option can affect the stock price, you first need to understand the relationship between the two.
Option buyers have the right to buy or sell shares at the strike price however, it depends on where the stock price is.
When the buyer is ready to use their option, the seller of the option is required to agree. This means that the buyer transfers the risk to the seller and in return, the seller gets a premium just like how insurance companies do it. Option Sellers are usually institutional investors and they’re also known as market makers.
The option is used when the stock price is approaching the strike price maturity. Hence, option sellers use complex tools to calculate and ensure they’re not exposed to too much risk. Two major tools are:
- Delta = Change in the option price for every $1 change in underlying stock price.
- Gamma = Change in delta for every $1 change in underlying stock price.
On a final note;
Yes, option have an effect on the stock price but it’s not permanent and it happens only when the option is about to expire.
Option trading is like a game, there’s no specific way to go about it. It’s time-consuming and it requires a lot of guesswork. Do not make decisions without putting all the risks involved into proper consideration.