Stock prices go up and they go down. Knowing what factors drive stock prices will help an option trader anticipate price changes and thereby trade profitably. Basic to the pricing of stocks and options are supply and demand. The three basic factors that drive supply and demand and therefor stock prices as well as option prices are fundamentals, technical factors and sentiment in the market. Any one of these can be the major force driving stock prices or a minor contributor depending on the situation.
Over the long run fundamentals are what drive stock prices higher or lower. How much does the company earn and how likely is it that their business plan will result in strong long term earnings? In the aftermath of the 1929 to 1932 stock market crash Benjamin Graham developed the concept of intrinsic stock value. This concept was opposed to the 1920s idea that you could “play the market” like a trip to the casino and make money because the market “always went up.” Rather this rational approach long term investing looked at projected earnings as a guide to valuing a stock today. The problem intrinsic value for option traders is that while it works great for long term investors it does not always help predict short term fluctuations in the market. Nevertheless, paying attention to a stock’s price to earnings ratio or the CAPE ratio provides insight and a base to work from even for traders who focus on short term price fluctuations. And, if your focus in on LEAPs such as with synthetic stock purchases of Amazon, understanding the fundaments of the “death star” is doubly important.
Technical Analysis Indicators
A pure technical analysis approach to factors that drive stock prices says that all of the fundamentals are immediately priced into the market. Thus one can use indicators based on statistical analysis and predict future stock movement based on prior movement and current prices. Tools like moving averages are commonly used to analyze current prices and trends. Successful option traders use more than one technical analysis indicator to guide their trading. Because traders read the market using these tools and trade accordingly, the readings of the moment will tend to affect how traders trade and thus further drive the market.
Market sentiment is the sum total of what all investors and traders are thinking and how they are likely to invest or trade in the coming weeks, days, hours, or minutes. A few years ago researchers noted that by simply to looking at what stocks are being searched for on Google one can spot stocks that will go up or down in price the following week! Commonly used market sentiment indicators are these:
- VIX Index
- Put Call Ratio
- Safe haven assets
- “Risk on” assets
- High / Low Index
- Stock price breadth
- CNN’s Fear and Greed Index
Market sentiment may have to do with short term concerns, long term worries, or long term investment planning. The most valuable insights for option traders come from analysis of short term market sentiment as this is what drives stocks up and down day by day no matter which way the long term trend is going.
Stock and Option Liquidity
Liquidity has to do with your ability to get the price you want when trading and to be able to get out of a contract when you see a loss coming. A major reason why professional option traders focus on the S&P 500 or stocks like Apple, Microsoft, or Amazon is that these trade at huge volume and liquidity so there is never a problem getting trapped in a bad trade without a way out and technical analysis indicators work far better with these that with penny stocks.