Trading stock market is a great way to make money. Lots of traders and investors make fortune out of the stock market daily. There are many ways you can take exposure to the stock market and make money.
Depending upon the time frame selected to trade stocks, different tools are available in the stock markets. For investing, you can head over to stocks or mutual funds. For trading, there are stocks, futures and options.
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.
Here, we will talk about the difference between stocks and options and find the better tool between trading options vs stocks!
Options vs Stocks
You can trade in stock markets using stocks as well as options. Both of them has their own pros and cons.
Trading stocks is pretty straightforward thing to do. You just need to buy stocks at a price and hold them in a hope to sell them at a higher price in future to earn the profits. Selling at lower price than the buying price leads to losses in trading.
Trading stock options is bit complex than trading stocks. This is complex because the options are difficult to understand for the retail investors. If you understand them well, they add much versatility to your trading and offer many opportunities to make decent profits.
Difference Between Stocks And Options
Knowing the difficulty faced by the retail traders due to complexity of the stock options vs stocks which are too simple to trade, let us know the basics of stocks and options first of all!
What Is Stock
A stock is unit of ownership of the company to which it belongs. Buying stocks of a company entitle you to the ownership rights in that company and makes you partner in the profits earned by the company.
Profits from stock investing are in the form of capital appreciation through increasing stock prices, dividend payouts and bonus shares issued by the company
Stocks giving dividends do so quarterly, annually or as announced by the company. They make a good source of regular passive income.
Stock prices move up and down based on earnings reports, news events, and other factors.
What Are Options
On the other hand, options in stock market are the derivatives. That means their value is derived from the underlying security. 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, an option is contract which gives the buyer or seller of the option contract a legal right to buy or sell the underlying security at predetermined price on or before the predetermined date.
Options are priced by using a formula that takes into account the current market value of the underlying stock.
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.
You can buy a call or put option without owning the stocks.
The most you can lose on a call or put option is the premium you pay to buy options. However, if you short sell or write a call option, your losses are unlimited in adverse stock movements.
The price of call options increases or decreases with increase or decrease in stock prices respectively. Conversely, the price of put option increases or decreases with decrease or increase in stock prices respectively.
The lot size defines the total number of stocks in an option contract. It is fixed for different stock options contracts. That means you can take the advantsge of options to get bigger exposure in the markets with small investment.
This is possible because of the cash leverage options provide. It is like futures trading or margin trading in stocks. Cash leverage insures that you can increase your profits potential with small investment.
However, cash leverage also exposes your to higher risks. You can lose money fast as compared to delivery trading of stocks where you buy stocks in any number as per your comfort, risk appetite or the cash available to you.
Trading Options vs Stocks
There is a difference between trading stocks and options.
Trading stocks is simple to execute. After appropriate research, You buy stocks as per your risk appetite and capital allocation. You can hold on to your stocks for any time period in a hope to sell them later at higher price.
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.
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.
If you expect a stock price to increase, you can either buy a call option or short sell put option (option writing). If the stock moves as you expected, the value of call option increases and the value of put option decreases. In both cases, you make money.
If you bet for decrease in stock price, you can either buy put option or sell call option (option writing). Again, if the stock moves as you expected, the value of put option increases and call option value decreases. Again, you make money in both scenario.
Hence options trading allows you going long on stocks as well as short selling stocks. Short selling is a trading strategy to make money of stocks when prices fall.
However, you can not hold options as long as you want. Each option contract has an expiry date after which the options expire and become worthless. Your investment becomes zero if the options expire as ‘out of the money’ options. Only ‘in the money’ options retain their intrinsic value.
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.
You can buy call option contract if you expect stock price rise while short of enough money by investing with options. You get the benefit of stock price rise with small investment on payment of option premium.
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.
Hence, they get the dual benefit of price appreciation and dividends using option exercising even if initially, they did not have enough money to buy stocks for delivery.
Options vs Stocks – Which Is Better
The main difference between stocks and options is that the stocks provide you the ownership in the company making you eligible for the profits earned, dividend payouts or bonus shares allotment by the company while options provide you cash leverage in the form of contracts with a right to buy or sell the stocks and also eligible for dividend payouts if you exercise the options on or before the contract expiry.
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.
Trading stocks is a simple thing to do. You can simply buy stocks and hold onto them with a stop loss. There is no time decay like options which lose value as they approach the expiry date. Moreover, you can buy stocks in a quantity you are comfortable in holding unlike options where you have to buy quantity as per lot size
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.