When investors move beyond stocks, they often venture into options. Although stocks and options have a lot in common, they also differ in some significant ways. Each investment opportunity has several levels of risk. While options are riskier, these derivatives can generate higher returns than stocks if you correctly time the market. Options traders benefit from precise timing which differs from stock investors who often benefit from time in the market. This guide will explore how these popular assets work.
What are Stocks?
Stocks are fractional ownership of a company. When you own shares of stock in a company, you own part of that company proportional to the number of shares the company has outstanding. For example, if you own 100 shares in a company that has 1,000 total shares, you own 10% of the company. Stock shares come with all the rights of ownership that exist with any capital asset. However, stock owners are last in the line of creditors when a company files for bankruptcy.
It's worth noting that when you buy a stock, you receive any dividends paid out to shareholders. However, when you are short a stock, you will be responsible for the payout of those dividends.
Pros and Cons of Stocks
As with most things, there are advantages and disadvantages.
Stocks offer several advantages for investors. These are some of the top perks.
- Direct ownership gives you the authority to vote on board matters.
- Stocks will have higher liquidity than their options, which makes them easier to buy and sell as well as have tighter spreads.
- You'll receive any dividend that is paid out.
- Once you own a stock, you don't have to worry about expiration periods.
While stocks have many benefits, these are some of the disadvantages to keep in mind.
- Unless you buy on margin, you have no leverage.
- Your risk when long a stock is the entire amount you invested.
- When you are short a stock, your risk is theoretically infinite.
- Some stock prices can be prohibitively expensive, excluding you from being able to purchase shares.
What are Options?
Options are contracts to buy or sell an asset at a given price (known as the strike) up to the expiration date. Unlike stocks, options contracts do not directly own part of a company but allow for the right to buy or sell a lot (100 shares) of a company's stock. If you exercised a call option, the right to buy stock, you would then own stock. Otherwise, you own a derivative product that obtains its value from the stock.
When you purchase an options contract you will generally pay a premium to own the rights to buy or sell that stock. The further away the expiration date is from the current date, the more the premium will cost.
Similarly, if you own an option, the value of that option will decay over time at an exponential rate the closer you get to the expiration date. "Naked" options refer to selling an option when you don't own the underlying asset or have cash set aside to cover the option, should the contract be exercised.
Pros and Cons of Options
Options have several pros and cons to keep in mind. These are the highlights.
Options traders get to enjoy these advantages each time they trade options.
- Options contracts provide leverage, which allows you to control more stock for the same amount of money.
- With anything other than a "naked" option strategy, your risk is generally limited to the premium.
- Options can be used to augment current or future positions in the stock market.
- Using options contracts can allow you to take advantage of price movements with much less risk.
Although stock options have several perks it is important to keep the risks in perspective.
- Because options contracts are only valid for a certain period of time, their value decays as they get closer to the expiration period.
- Investing in option contracts requires more active portfolio management.
- Trading with options will often require a margin account.
- Liquidity can be significantly lower, with some options contracts trading once every few days to weeks.
If you sell a stock short or sell naked options, you can be subject to a margin call. This can require you to liquidate your positions or put in additional capital immediately.
Similarities Between Stocks vs. Options
Be on the lookout for the characteristics that stocks and options share.
- Buying and selling: When you buy or sell an options contract or a stock, the orders go through your regular stock broker and can normally be filled online. Both stocks and options trade during normal sessions of 9:30 a.m. to 4 p.m. EST.
- Buying risk: When you buy an options contract, whether it's a put or call option, your risk is limited to the total amount you paid for that option. In the same way, when you buy a stock, your risk is limited to the total amount of stock you purchased.
- Selling risk: Selling a stock (known as shorting) leaves you open to unlimited risk as a stock's price could go to infinity. Similarly, when you sell a call option, you have unlimited risk as you are giving someone else the right to buy stock from you at a strike price when the stock could still go to infinity.
Differences Between Stocks vs. Options
As you get more familiar with stocks and options, you'll notice these too.
- Quantities: Purchasing options can only be done in lots that represent 100 shares of stock. When you purchase stock, you can buy any quantity you wish of stock so long as someone is willing to sell you that amount.
- Selling risk: The slight difference here from above comes from selling put options. Put options limit you to a total risk of the number of contracts you sell, multiplied by the strike price, multiplied by 100 shares per contract.
- Ownership: While stocks provide a direct investment into a company through partial ownership, options contracts only allow for the rights to buy or sell that stock but do not directly invest in the stock.
- Time: When you purchase or short a stock, your position remains open until you sell or cover your short. Options contracts only remain good until the expiration date.
- Investor type: While stocks are a core component to most portfolios, options contracts are typically only used by active investors as they require a more hands-on approach, given their expiration dates.
Mastering Stocks and Options
Stocks and options both have their pros and cons. Options involve more risk and require you to spend more time in your portfolio. However, these derivatives can outperform stocks. Investors can use stocks to benefit from long-term gains and rely less on timing. Some investors can benefit from incorporating stocks and options into their portfolios.
Frequently Asked Questions
Can I lose more money in stocks versus options?
In options, you can lose unlimited amounts on uncovered calls. Stocks can fall to $0.
Are options less risky than stocks?
Options have greater risks than stocks.
Can options act as a good hedge?
Covered calls and puts are two of the options you can use to hedge your portfolio from corrections.