Understand what stocks are, how they work, and their fundamental role in options trading as the 'underlying asset'.
What is Stock?
A stock (also known as "equity") represents fractional ownership in a corporation. When you buy a share of a company's stock, you are literally buying a small piece of that business.
While stocks are the foundation of most investment portfolios, in the world of options, we refer to them as the underlying asset.
Core Characteristics
Every stock share carries specific rights and characteristics:
- Ownership: You own a portion of the company's assets and earnings.
- Voting Rights: Most common stocks grant the right to vote on corporate items (like the board of directors).
- Dividends: Companies may distribute a portion of their profits to shareholders as dividends.
- Limited Liability: As a shareholder, you are not personally responsible for the company's debts.
The Options Connection: In standard U.S. markets, one options contract typically controls 100 shares of the underlying stock.
Why Stocks Move
Stock prices fluctuate based on the law of supply and demand. However, supply and demand are driven by:
1. Earnings and Growth
If a company is profitable and growing, investors are willing to pay more for a piece of those future profits. Conversely, disappearing profits lead to selling pressure.
2. Market Sentiment
Sometimes, prices move based on how investors feel about the future, regardless of current financial health. This "fear and greed" cycle is a major driver of short-term volatility.
3. Macroeconomic Factors
Interest rates, inflation, and global events affect all companies. For example, rising interest rates often make stocks less attractive compared to "safer" investments like bonds.
Common vs. Preferred Stock
Most traders interact with Common Stock. It offers the highest potential for long-term capital appreciation but is last in line during a bankruptcy. Preferred Stock acts more like a bond, usually paying a fixed dividend and having a higher claim on assets, but with less potential for price "explosions."
Pro Tip: For options traders, the distinction matters most because of Dividends. When a stock goes "ex-dividend," its price typically drops by the dividend amount. This price drop is priced into options premiums!
Stocks in the Options Visualizer
In our visualizer, the "Stock" leg allows you to simulate owning (or shorting) the shares directly. This is useful for:
- Hedging: Offsetting option risk with actual shares.
- Covered Calls: Owning 100 shares and selling a call against them.
- Protective Puts: Owning shares and buying a put for "insurance."
Key Metrics to Watch
When analyzing a stock for options trading, keep these "Greeks" of the underlying in mind:
- Price: The current market value.
- Volatility (IV): How much the market expects the price to swing.
- Dividend Yield: The annual dividend payments relative to the price.