Interested in options and stocks but not sure about the difference between the two?
While both methods of investing come with their own risks and rewards, they can be quite different.
In this guide, we’ll explore the key similarities and differences between options and stocks to help you make an informed decision.
While you are free to choose any tool but choosing the right one for you is of utmost importance to make money in the stock market.
What Are Options
Options are a type of derivative security, meaning they derive their value from an underlying security. The Option prices change with change in underlying security prices.
Underlying security can be anything like stocks, stock market indices, commodities or currencies (forex trading). In case of stock options, the underlying security is stock.
By Definition, Options are contracts that give the buyer the right, but not obligation, to purchase or sell an asset at a specific price at a predetermined time.
When buying and selling options, you don’t actually own any shares – instead you’re betting on the price and direction where you expect the stock will go before its expiration date.
Options are priced by an option pricing model. Trading stock options requires you understand the options basics.
The difference between call and put option is that a call option gives the buyer of call option to buy stocks at a defined price in the form of strike price at or before defined date while a put option gives the buyer of put option to short sell stocks at a defined price on or before the defined time.
Option premium is the cash amount you need to pay to buy an Option. Your maximum loss remains limited to the premium amount you pay to buy options. However, if you short sell or write a call option, your losses are unlimited.
The price of call options increases or decreases with increase or decrease in stock prices respectively. On the other hand, the price of a put option increases or decreases with decrease or increase in stock prices respectively.
The lot size of an option defines the total number of units in an option contract. Different stock options contracts have different lot sizes.
Options are highly leveraged trading tools. That means you can take the advantage of options to get bigger exposure in the markets with small investment. Cash leverage ensures that you can increase your profits potential with small investment.
However, cash leverage also exposes you to higher risks. You can lose money fast as compared to delivery trading of stocks. With delivery, you buy stocks in any number as per your comfort, risk appetite or the cash available to you.
What Are Stocks
Stocks are exclusive ownership positions in a publicly traded company. A stock or a share is unit of ownership of the company to which it belongs.
When you buy a stock, you become a part-owner – with all the rights that come along with it. The rights include voting privileges at shareholder meetings and potential dividend payouts should the company be financially successful in future.
Your profit or loss on any given stock is determined by its price action over time. If the stock goes up in value, you’ll make money on your investment but if the stocks go down, you’ll lose money.
Profits from stock investing are in the form of capital appreciation through increasing stock prices, dividend payouts and bonus shares issued by the company
Stock prices move up and down based on earnings reports, news events, and other factors.
Stocks giving dividends do so quarterly, annually or as announced by the company. Thus, they make a good source of regular passive income.
Key Similarities Between Options and Stocks
Both stocks and options are traded on exchanges, meaning the trades are monitored by governmental regulatory agencies.
Additionally, both are subject to taxes on any gains or losses in value over time. Options use underlying stocks/securities as their basis. The movements of these stocks have a large effect on the option’s pricing.
In order to be successful in either you must have a thorough understanding of markets and have good analytical skills to make sound investment decisions.
Pros and Cons of Trading in Options and Stocks
There is a difference between trading stocks and options.
Stocks are relatively low risk, making them a great choice for those looking to build a long-term portfolio or savings. You are free to buy any number of stocks as per your risk tolerance. Moreover, you can stay invested in stocks as long as you want.
During the holding period, you also get the dividend payouts if any announced by the company, bonus stocks issued by the company and capital appreciation due to rise in stock prices.
On the other hand, while options can have lucrative returns they do come with a significantly higher degree of risk and may not be suitable for all kinds of investors.
Stocks options are bit complex. However, they offer multiple strategies for trading stocks. You can make money trading options if you buy options or sell options or use a combination of buying and selling options.
However, unlike stocks, you have to buy options in lots which increases your risk. Secondly, options have an expiry date after which they become worthless.
Moreover, you do not get any dividend payout announced by the company unless you exercise the option on or before the contract expiry date. There is difference between selling and exercising options.
Buying call options at a price and squaring off (close) the buy position at another price on or before the contract expiry date to exit the market is called as selling vs exercising options where you execute your right to take the delivery of stocks on or before the contract expiry date.
American type options allow exercising options on or before contract expiry while European type options allow exercising at the contract expiry date only. This utility of American options gives a better alternative of investing in options vs stocks.
However, during the contract period, if company announces any dividend and you want to get that dividend payment, you can exercise the options by paying full value of stocks bought. This makes you eligible for dividends also.
Traders will need to weigh the pros and cons of both stocks and options when making their investment decisions.
Conclusion- Trading Options vs Stocks – Which Is Better
Ultimately, the choice between options and stocks depends on your goals and risk tolerance.
If you’re looking for a low-risk investment with long-term returns, stocks are the best option. For investors willing to take on more risk in pursuit of higher returns, options may be the better fit.
Retail investors should avoid trading options because options are a risky tool due to cash leverage and complex pricing model. There are several factors apart from the stock price which influence the option prices. Without understanding them properly, the retail traders can lose money fast.
Holding large positions in options can be uncomfortable in shaky markets and the fear of losing big can force you to close your position much earlier.
However, if you understand options well and can manage the risks accordingly then the better tool is options trading vs stock trading. Cash leverage provided by the options can work for you and earn you big profits in short time frames.
Carefully consider each before making a decision about which method is right for you!