Stocks vs. Options: Similarities, Differences, Profits, and Risks
Pretty much every aspiring investor has wondered what will get them to Wolf of Wall Street levels faster — options or stocks? And which of those financial instruments is riskier? That’s what we’ll find out in the following article, which explores every aspect of the stocks vs options battle. Read on!
The Difference Between Stocks and Options
To be able to compare options vs stocks, we first need to learn what they are and how exactly they differ.
What Is Stock Trading?
Stocks or shares represent a fraction of the ownership of a company. By buying stocks, you get a corresponding portion of that company. For instance, if you have 100 stocks of XYZ company, and it has 10,000 stocks in total, you own 1% of it. Depending on the type of stock, you may have the right to vote at stockholder meetings, get dividend payments, etc.
What Is Stock Options Trading?
Options are derivatives, which means they draw their value from the underlying asset. It may be a commodity, stock market index, or in this case — stocks. To explain stock options simply — stock options allow you to secure a position to trade the stock at some predetermined time in the future (expiration date) and a predetermined price (strike price).
It is a matter of options vs equity. Options give you the right to buy stock. And by purchasing a stock, you become an equity owner. Equity means ownership in a company.
So, instead of buying or selling XYZ company stock at $50 today, you can get a call (buy) or put (sell) option for next month (quarter, year, etc) at $40 or $60. So, why buy options instead of stocks? Stock options mitigate risks and give traders flexibility. They can drop out of the deal anytime, risking only the premium they’ve paid for the options contract.
Stock Trading vs Options Trading — Which Is More Complicated?
Stock trading is pretty straightforward. You buy a stock at a certain price today, and you become its owner. Then you hold on to it until the price increases enough to make a profit, or you can keep it as a long-term investment.
Investing in stock options is a bit more complicated by comparison. Every options contract comes with a different quantity of stocks, dates, and prices.
But, it’s the complexity that makes it such an excellent tool for alleviating risks. Traders can write or buy several options on stocks, covering their positions for every direction the stock price takes.
Stocks vs Options — How Do You Make a Profit?
Now that we know the theoretical difference between a stock and an option, let’s take a look at the more practical side of things — how both types of assets can make you profits.
How Do You Make Money on Stocks?
There are two basic you earn through stocks:
- Capital gains
The most obvious way of earning money on stocks is the rise in the stock price. You buy the stock on the cheap, wait for the price to go up, and sell it on the stock market, making a profit. Naturally, if the price goes down, you would suffer a capital loss.
Companies distribute part of their profits to stockholders in the form of dividends. But dividend payments are not guaranteed. Namely, the board of directors decides if the profits would be further invested in the company (retained earnings) or shared with the stockholders (dividends), that is, if the company makes a profit at all.
- Share buybacks
In this case, the earnings are more theoretical. Companies occasionally buy back part of their own shares, creating demand and lifting stock prices, which, in turn, creates opportunities for shareholders to sell their stocks at a higher price.
How Do You Make Money With Options?
This is where our options vs shares comparison gets a bit more complicated. There are two parties in the options trading market — options buyer and options writer. The options buyer can purchase a call or put option on stocks, while the options writer sells that contract and has to enable its completion. The ways they earn their profits are different.
- Option buyers
If you think shares of XYZ company will be worth more than $20 at some point in the future, you will purchase an option to buy stock for that strike price and expiration date of your choosing. But, if you think the share will go below $20, you buy a put (sell) option for that price. You will be able to sell it, even if the market price is much lower.
- Option writers
Buying and selling stock market options offer different kinds of earnings. While buying can get you almost unlimited profits, selling them offers just the option contract premium. That’s the amount the buyer pays for the contract.
No matter how much the stock moves, the options writer’s premium is the same. Why do traders do it, then? Well, there are some benefits. For instance, they get the premium upfront, which is collectible no matter how the stock price goes or if the buyers back out.
Options writers are actually counting on options time decay. They are betting that the contract will expire or that the stock won’t reach the strike price. That way, they don’t have to honor their part of the contract, and they are left with the premium.
Stocks vs. Options — Which One Is Riskier?
Because they are different in essence, options and stocks come with their own risks. Let’s see what they are.
Risks of Stock Trading
In the case of stock trading, participants commit all the assets needed for the trade. When you buy a stock, regardless of if it is a short or long-term investment, you are exposed, and that stock influences your portfolio value.
Risks of Options Trading
Options eliminate that risk because you can opt-out at any time. Instead of coming in with the whole capital needed, you just pay for the options contract premium, which is just a fraction of the price. If we can compare option price vs stock price, we can see that options usually go from 1% to 5%. However, this is not a rule, and the prices can have a much greater range.
Options writers, however, are risking a lot more. They are obliged to honor their part of the contract, no matter how unfavorable it is for them. And if they wrote options for stocks they don’t own (uncovered), they have to buy them on the market, no matter the price.
Can You Lose More Than You Invest in Options?
In short, you can’t lose more than you’ve invested if you are a call option buyer. As an option seller, you can lose much more than you’ve invested, especially if you sell uncovered (naked) options. That’s when the seller doesn’t own the stocks.
Stocks vs. Options — What’s Better for Beginners?
Investing in stocks is much better for people looking to invest long-term. It is a sort of fire-and-forget, hands-off type of investment that will potentially bring solid profits in the long run.
However, it requires complete dedication and a significant investment if you want to day trade stocks or do any short-term stock trading.
When we look at the stock market through a short-term prism, the prices don’t move that much (of course, there are exceptions). So, to make a profit, you need to buy a lot of stocks. One dollar per-share profit is not much, but when you multiply that by 1,000, it adds up.
Well, are options better than stocks? Options trading is for people looking for an active, tactical approach to investing. It requires a much smaller investment and gives you flexibility regarding timing and risks.
Trading Options vs Trading Stocks — What Do You Need to Start?
As part of our stocks vs options comparison, let’s take a look at how you start trading them.
Getting started is relatively simple. You decide on how much you want to invest, open a brokerage account, and you can begin trading. You can do this through a brokerage company or open a brokerage account on reputable trading platforms, which is a much simpler solution.
How Much Money Do You Need to Start Trading Stocks?
Some platforms don’t even require a deposit for simple stock trading. However, if you want to day trade stocks, the Financial Industry Regulatory Authority (FINRA) mandates that you have at least $25,000 of equity.
If you want to start with stock options investing, the procedure is relatively complicated. Because it is not as straightforward as stock trading and there are a lot of possibilities for creating huge losses, all potential options traders must undergo checks by a brokerage company.
The U.S. Securities and Exchange Commission regulations state that potential options traders must fill out the broker’s options agreement. In it, they need to provide evidence that will help the broker assess their understanding of options and trading strategies (long-term stock options or short-term stock options), general investing knowledge, and the financial ability to take on the risks that may (and will) come.
After it, the brokerage assigns an options trading level, which determines the types of trades you can do. Trading levels go from 1 to 5, with one being the lowest.
How Much Money Do You Need to Start Options Trading?
It depends on the type of trade you want to do. Technically, if you’re going to purchase stock options, you only need the amount for the contract premium. But if you want to sell options, your broker will probably require you to deposit more money into your account to cover potential losses. The amount will depend on the strategy, type of stocks, strike prices, dates, etc.
But, if you want to engage in day trading options, the Financial Industry Regulatory Authority requires you to you have at least $25,000 of equity. That’s one area where day trading stocks vs options is no different.
FAQs on Stocks vs Options
What are options in the stock market?
Options are financial derivatives that draw their value from the underlying asset, in this case, stocks. Option buyers secure the opportunity to buy or sell a specific stock at a predetermined time, at a predetermined price (strike price). However, they don’t have to complete the transaction. The only thing they are risking is the premium they’ve paid for the contract, but that is just a fraction of the stock’s price.
Are options securities?
Options are securities. Securities are financial instruments and assets that can be traded in the open market.
What is the difference between a stock and a share?
People use these two terms interchangeably, but they are different. While share represents a unit of ownership of a specific company, stock is a more general term. So, you could say – I have 150 shares in XYZ company, and I usually invest in blue-chip stocks.
Is options trading profitable?
Options trading, like any business, can be profitable if you do it right. That implies sticking to proven options trading tips such as staying informed, constantly learning, and developing your investment instincts. The main benefit of options trading is the low risk involved because you are not committing the entire capital needed for trade but just a fraction of the stock price.
Are options riskier than stocks?
Options in the stock market are usually less risky than stocks. As the buyer of an option, you are only risking the contract premium, and that’s just a tiny percentage of the value of the stock.
Why do some stocks not have options?
Some stocks don’t have options because they don’t comply with specific regulatory standards. Stocks with low prices, low trading volumes, and low market caps are usually not eligible to have options.
How do you decide when to buy stock options?
The stocks vs options dilemma is quite common with investors. The best way to solve it is to think about your goals. Stocks are for you if you want a long-term investment with a hands-off approach. If you want to trade actively, options are the better choice.