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.
- Leverage — The single biggest benefit to buying options rather than stocks is leverage. Buying an option can offer potentially greater returns than buying the stock. Especially when there is a large swing in the underlying stock price that is in your favor.
- Risk is manageable — Even though your option position is leveraged, your loss is limited to what you put in. Additionally, if you buy a put option, you can effectively short a stock while limiting your losses to the amount of money you put in.
- Avoiding short-term capital gains is possible — You can manage risk by employing LEAPS (long-term equity anticipation securities). These contracts typically last over a year and will allow you to avoid short-term capital gains tax.
- Time is of the essence — Options expire. So time has a huge influence on an option's value. If the price of the underlying asset moves unfavorably, you cannot simply hold your position and ride out the storm.
- You can lose your investment fast — Dramatic daily fluctuations in price can occur. This sometimes works in your favor, but it can also swiftly wipe out the value of your options contract.
- You have to get the strike price right — Even if the stock price moves favorably in relation to your strike price, your options contract can still expire worthless if it is not in the money.
- Commissions on trades — Though most brokerages offer commission-free trading for stocks, it is more difficult to find a brokerage that does not take commissions for trading options. This can make frequent options trading expensive and eat into your profits.
- No dividends — Even if the underlying stock pays dividends, options contracts receive no dividend payouts.
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.
- Indefinite life — Purchasing stocks is a great long-term investment strategy because stocks have an indefinite life. This means that as long as the company is publicly traded, you can cash out your stock investment. You don't have to worry as much about short-term fluctuations in the stock market as you always have the ability to hold your investment until market conditions become more favorable.
- Dividend payments — Some stocks pay dividends. A dividend is a regularly occurring distribution of a corporation's profits to its shareholders. Not all companies offer dividends, but if you have enough capital to purchase a healthy amount of stock from a company that does, you could net a handsome passive income.
- Usually no commissions — Most online brokerages no longer charge commissions on stock trading, so you can trade as much as you want without fear of charges eating into your profits.
- Combat inflation — Stocks can potentially be a good tool to combat inflation. For example, if you are expecting grocery prices to increase, you can invest in a grocery stock.
- Risk of losing your investment — Even though stocks are generally less risky than options, companies can still go bankrupt and your shares become worthless.
- Sensitivity to the broader market — Individual stocks are affected by the broader market. Even if your thesis is right, an economic downturn can still cause your stock to lose value.
- Variability — Stocks vary largely in size, quality and fundamentals. Picking the right stock is crucial. For example, if you invest a large portion of your savings in a company with poor fundamentals your account will suffer in the long run. Jumping on the next trend or investing in meme stocks without doing your own due diligence may not work if you don't understand the risks to these stocks.
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.
The bottom line
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.