Many investors and traders have at one point wondered whether they should trade options or stocks. The primary difference between stocks and options is that owning stock essentially means that you own a piece of a company. Options give you the right to buy or sell the underlying asset (stock) at a predetermined price before the contract expires.
Investors use both options and stocks for various reasons. Options offer leverage for explosive gains. Stocks offer ownership in a company. This ownership includes its profits and dividends. Let's dig in and compare trading options vs. stocks as well as give an overview to help you understand which might be better suited for you.
Note: For the purposes of this article we will be discussing buying rather than selling call and put options.
The Short Version
- A stock is ownership of a company, while an option is a contract that gives you the right but not the obligation to purchase the underlying asset — that can be stock, bonds, forex, or other assets.
- Stocks are generally indefinite, while contracts have an expiration date.
- Options give investors more leverage but are riskier than buying stocks.
What's the Difference Between Options and Stocks?
Before diving into the differences between options and stocks, let's first review how each of them work.
How Stocks Work
Stocks represent an investor's ownership of an underlying asset, typically a company. The total value of all of a company's stock usually indicates of the current market value of the company.
Investors usually purchase stock of a company in the hopes that the company will grow and thus increase the share price of the stock. Certain companies also pay their shareholders a dividend. And some investors own stock primarily for the passive income dividends provide.
According to Wall Street global investment bank Goldman Sachs, the average stock market return has been about 9.2% annually over the last 140 years.
How Options Work
An option is a contract that gives you the right but not the obligation to buy a specific stock, bond, commodity or other underlying asset at a specific price point in the future.
It's a financial derivative. This means its value is dependent on the value of the underlying asset. An option's price is also influenced by other factors, including the strike price and time until the expiration date.
When an investor purchases an options contract they are buying the right to buy or sell the underlying asset at a set price, called the strike price, any time before a set expiration date.
An investor can purchase call options or put options.
Call options are purchased by investors who believe a stock's value will increase within a set time frame. Call options allow the owner to purchase the stock at a strike price before the expiration date. When the price of a stock goes up, so does the value of a call options contract, all else being equal.
Put options are purchased by investors who believe a stock's value will decrease within a set time frame. Put options allow the owner to sell the stock at their chosen strike price before the expiration date. When the price of a stock goes down, the value of a put options contract goes up, all else being equal.
The Key Differences Between Stocks and Options
One of the biggest differences between stocks and options is that stocks technically have an indefinite life as long as the company is still publicly traded. Stocks can be held through recessions and various market cycles. An investor can wait years or even decades before selling their stock investment.
Buying options usually means greater leverage — or potentially larger gains — than simply buying the stock. However, there are more variables to consider when buying an option. You have to choose a strike price. This means that you usually have to forecast not only the direction the stock is going but the magnitude of the move as well. Investors also have to choose an expiration date when buying options. As the expiration date of an options contract draws nearer, the value of the option decays, all else being equal.
Benefits and Risks of Options Trading
Options trading can feel a bit like gambling. If the stock price moves in your favor, the options contract nets you a quick gain. But your initial investment can be entirely wiped out if the stock price moves against you.
That's why options trading is typically not recommended for newer investors. But if you are an experienced investor or are ready to do research to understand how options work, options trading can be an exciting and lucrative experience.
And you can practice your ideas without risk by using a paper trading account. You lose no money this way, but you also will not benefit from any gains in your options.
Benefits and Risks of Stock Trading
Stocks are an excellent way to become familiar with the market and make your money work for you long term. The stock market also allows the opportunity to customize your stock portfolio to make it suit your individual needs.
Is Investing in Options or Stocks Right for You
When deciding between trading stocks and trading stock options you have to consider your individual situation. You should ask yourself questions like:
What is your time horizon? If you are looking to invest for the longer term (such as a decade or more), stocks may be better suited for you than options.
What is your risk tolerance? If you're looking to invest in options, your risk tolerance should be high since options are very volatile.
What kind of returns do you want? If you are looking for large and asymmetrical returns to your investment, investing in options could make sense as long as you understand the risks involved.
Are you trying to gain profits in the short term? Both stocks and options trading can make short-term profits, but leveraging options in the short term can potentially net larger profits.
How much knowledge do you have about financial derivatives? Options are derivatives and it helps to understand how they work (e.g., the option Greeks) if you are going to use them.
These questions do not represent an exhaustive list when deciding between options or stocks, but can serve as a start.
For example, if you have a lot of capital and want to earn passive income, then trading options makes almost no sense. You would likely want to look at stocks with long track records and high dividend yields.
On the other hand, maybe you have a small amount of disposable capital and are willing to risk it all for swift gains. Losing this capital will not impact your life in any way. And perhaps you are knowledgeable in financial derivatives and confident in your market analysis. In this case, trading options would be a good choice.
Can You Invest in Stocks and Options at the Same Time?
You can invest in stocks and options at the same time. In fact, there are advantages to investing in both.
Say you invested in ABC stock, which you follow closely. After your research, you expect the stock to perform well in the long term due to its strong fundamentals. But you are also aware that there is an upcoming event that may drive up the price significantly. Armed with this knowledge, you can make a short-term play with call options to take advantage of the potential upswing from the upcoming event while keeping your long-term investment in the underlying stock.
On the other hand, let's say you're bullish on XYZ stock in the long term but want to protect your investment. Buying put options contracts in this instance effectively hedges your long position in XYZ. That way, if the stock falls, the increase in your put option can offset some of your losses in the stock.
Options are generally more volatile and complex than simply investing in the underlying stock but can potentially offer large asymmetrical gains due to their leveraged nature. Options can also be an effective hedging tool if used while invested in the underlying stock. The beauty of buying options is that you can lose only what you put in. As long as you understand how options work, risk is manageable.
Stocks are not only good for trading but are good for long-term investing too. Stocks can combat inflation and you can hold them for as long as you want. Certain stocks also offer dividend payments, which can be great if you are looking for passive income.
Both options and stocks can be useful in an investor's portfolio. So an investor only stands to gain by understanding both options vs. stocks and knowing when to use each.
Disclaimer: The content presented is for informational purposes only and does not constitute financial, investment, tax, legal, or professional advice. If any securities were mentioned in the content, the author may hold positions in the mentioned securities. The content is provided ‘as is’ without any representations or warranties, express or implied.