Last Updated: August 5, 2021
If you are looking to build an investment portfolio, you’re probably weighing the pros and cons of options vs stocks trading. Traditionally stocks appeal more to beginners and long-term investors and are the most common pick. On the other hand, options work very well for active traders who value flexibility.
Both are good choices and can give great value to your portfolio but also come with risks. If you want to know the difference between stocks and options, keep reading to learn more.
What Are Stock Options?
The textbook definition of stock options is: “a contract that gives you the non-obligatory right to buy or sell an underlying stock at an agreed-upon price and date.” Options allow investors to speculate on the price of certain stocks. In simple terms, this means that, by buying options, an investor can make a bet on the rise or fall on a specific stock by a specific date (commonly called expiration date) in the future. The standard contract represents 100 shares of the underlying stocks.
Depending on the style, they can be either American or European. American options are more common and can be exercised anytime between purchase and expiration. On the other hand, European-style options can only be exercised on the expiration date.
Call vs put options — side by side comparison:
- In the case of call options, the investor speculates that the price of the underlying stock will rise.
- In the case of put options, the investor speculates that the price of the stocks will fall.
The strike price is the price the stocks must be bought or sold at by the specified date. Depending on the trader’s risk tolerance, they can employ various strategies to determine the strike price. Greedy or careless traders risk suffering significant losses.
Here is an example of stock options trading. Let’s say the price of Apple stocks is currently $140. There is an Apple event approaching, and typically this is when its stocks rise. If an investor takes the position that Apple stocks are going to rise in the future, say somewhere around June, to over $150, they can buy 10 $150 June calls. Let’s say that these calls cost $15 each — the total cost of this purchase is $15,000. To earn a profit, the stocks need to rise above the sum of the strike price and the cost of the calls. If the price does not rise above the predicted $150, the trader can let the options expire and only lose the premium.
Like in the example above, the best time to buy and sell options is when you think the price of specific stocks will change.
If you want more information, take a look at this article for a more in-depth explanation of stock options.
What Are Stocks?
The textbook definition of stocks is: stock or equity is a security that represents the ownership of a fraction of a corporation. This means that the owner of the stock is entitled to a proportion of the corporation’s assets and profits corresponding to how much stock they own. Units of stocks are called shares.
That’s the basic overview of the difference between stocks and options. But there’s a bit more to it so let’s take a closer look.
The two main types of stocks are common stocks and preferred stocks. The common stocks are, unsurprisingly, more common, and it’s the type most people go for. They give the owner the right to vote at shareholder meetings and to receive dividends. Preferred stock holders usually have more limited voting rights (or none at all) but do have a higher claim to assets and earnings. In the event that the company goes bankrupt, they are first in line for the payout.
When making the stocks vs options comparison, it’s important to explain how you earn profit. You can earn profit from stocks by choosing stocks that give dividends. The other option is to hold stocks until they rise to a favorable price and sell them.
What Is the Difference Between Stocks and Options?
|Ownership of company||Yes||No|
|Compensation in case of bankruptcy||Yes||No|
When it comes to trading and investing and the options vs stocks dilemma, there are a few differences to keep in mind.
The main difference is that stocks represent the ownership in a company, while options are contracts with investors that let you bet on the direction of the price of the stock.
The second biggest difference is the one mentioned above — the way you earn profit. When it comes to options, you make money simply by buying or selling stocks. While you can do that with stocks, they’re more about the long game. You can buy low and sell high, but you can also earn money through dividends.
Another difference is that when it comes to trading options vs trading stocks, the former requires a more hands-on approach. Options are better for active or advanced traders because of the need for constant monitoring of the market due to expiration dates. Investors who choose stocks are often beginners and long-term investors who prefer a more hands-off approach to their investing.
Depending on the quantity, buying stock can be cheaper than buying options. Options are only available in lots of 100 shares of stocks. Conversely, stocks can be bought in whatever amount you want as long as someone is willing to sell them. Additionally, stocks can remain yours until you decide to sell them, while options are only good until their expiration date.
Moreover, compensation can be given in case of bankruptcy when investing in stock which makes them a somewhat safer option. This safety net is not extended to options.
Options vs Stocks: Risks and Benefits Analysis
Both have a place and complement each other in a diverse portfolio. Before you make the decision, you need to know which one best fits your investment style. This is where investment/trading proficiency comes into play. It’s not just about knowing the difference between options and stocks, but also which one of the two, or a combination of the two, will benefit you more.
Understanding stocks is easier because they are straightforward. When purchasing stocks, you buy a part of all the shares of a corporation. This essentially means that you are entitled to the corporation’s assets and profit. This means that stocks are more common, and they usually come with lower expenses than options investing. Generally, you will buy stocks and hold them for a certain amount of time, hoping that the stock price rises so you can sell at a profit. Some corporations give quarterly dividends to all shareholders proportional to the number of shares they hold.
Minimizing risk is the second most important goal after profit. And stocks do have a few risks:
- Fees & Commissions — this is directly influenced by how actively you trade. But if you are not an active trader, you’re better off if you buy and sell stocks instead of options.
- The price could plummet — you buy stocks, and you hold them because you hope to sell in the future for a higher price. But nothing guarantees that the price will rise. Even worse, it could fall. Unless you hold them until it rises again (if that happens), you could be forced to sell at a loss. This means that you risk the entire amount you invest.
- Capital gain taxes — when you receive the dividend, or if the stock rises, you have to pay taxes on that.
If you are leaning more on the side of options, here are a few things that make them quite compelling. Firstly options carry a lower risk. While there are situations where buying options is riskier than stocks, most of the time, the risk of options can be reduced. They don’t require as big of a financial commitment, and they are unaffected by gap openings.
Secondly, they are a better value for money, meaning you can purchase more with less money. For example, you can buy 300 stocks from corporation A for $100, which will cost $30,000. Alternatively, you can buy three calls for $20, which will cost $60.
Finally, options offer a lot of flexibility. Options investing comes with more strategic investment alternatives. You can use them to create other positions. These positions are called synthetics. Synthetics are a financial instrument that simulates other instruments while altering key characteristics. Synthetics offer investors custom cash-flow patterns, maturities, risk profiles, etc.
Despite all of the benefits, no investment is without risk. Here are some risks related to investing in options:
- They are short-term. While you can buy stocks and hold them for how many years you want, options have an expiration date. This means that there is a limited amount of time for your investment thesis to bear out. If it doesn’t, you will have lost the invested premium.
- They can expose sellers to unlimited losses. When you, as an investor, write a put or call, are obligated to buy or sell shares at a specified price within the contract time frame. Since there is no limit on how high a stock can rise, the purchase price can become exorbitant.
Options vs Stocks: Which Is Right for Me?
This is a personal decision that should be carefully evaluated on a case-to-case basis. Try answering questions like: what is your risk tolerance, or which one will give you more for your money. This should give you an idea of the direction you might want to take.
With this in mind, there are a few good rules of thumb you should consider:
- Beginners vs experienced investors
To put it simply: beginners usually choose stocks. They are straightforward and easy to understand. To really trade options with any degree of certainty, you need more experience and education, especially when it relates to the risks involved.
- Active/hands-on investors vs passive/hands-off investors
One of the biggest differences between stocks and options is the timing aspect of the latter. To truly receive the benefits of investing in options, you need to be an active trader with a hands-on approach to investing. Stocks, on the other hand, allow more passive handling.
- Long-term vs short-term
As we mentioned above, options come with an expiration date. This means that the time for the investment to bear out is limited. If you prefer a longer game, then stocks are the option for you. You can buy stocks and hold them for as long as you wish — no time limit, no expiration date.
When it comes to investment strategies, keep in mind that you’re not reduced to the binary choice of options vs stocks. You do not have to pick one or the other. Most portfolios of seasoned veteran investors will normally include a combination of the two where they complement each other.