Stocks and options both are significant financial assets to enhance a portfolio’s returns, but options possess a more tactical approach to investing. They are volatile, and their volatility impacts the performance of options as options are stocks’ derivatives. Stocks are more appealing to long-term investors, whereas options are the choice of active traders looking for short-term investments. You can trade both on the stock exchanges, but both differ in significant ways. Here is the post explaining the difference between options vs stocks and their pros and cons, making you choose a better spot to make smarter financial decisions. Keep on reading to learn more.
Options vs Stocks
|Investors/Traders||Beginners and long-term investors||Active and experienced traders|
|Type of investment||Equity||Derivatives|
|Considerations||Risky investment, fees, and taxes||Analytical, higher risk and investment cost|
- An overview of stocks and options
- Pros and cons of stocks and options
- Difference between a stock and an option
- How to trade stocks and options
An Overview of Stocks and Options
Stocks and options are like a thing and its shadow. Let us understand what elements differ them.
A company creates stocks when a company sells off a part of its ownership to the inventors in return for their invested capital. Stocks that you buy represent a piece of your ownership in that particular listed company. These pieces of ownership are called shares that make you a shareholder. A stock’s value fluctuates every few seconds.
Listed companies issue a specific number of shares in the stock market available to trade on the stock exchanges. A company can issue more shares or can diminish the number of shares. Shares are traded on the stock exchanges in real-time.
Options belong to the asset class known as derivatives. A derivative’s value depends on the price and performance of the underlying financial security such as stocks, bonds, or other financial securities. Thus, options are the derivatives that derive value from the underlying asset.
An option where the underlying asset is a stock provides the option holder with the right to buy or sell the particular stocks at an agreed price within the stipulated time frame. Thus, an option is a contract consisting of terms and conditions regarding its value, expiration date, and other details. Generally, options contracts are based on a set of shares, like 100 shares. The writer of the option contract is the option seller who takes an unlimited risk in options trading.
When you buy an option based on stocks, you are not purchasing the company’s actual stock and will not be considered an investor in the company. Option holders do not get benefits provided to shareholders like dividend payouts.
Following are the basic and important terms associated with options that one should understand:
It is a type of option for someone who wants to buy the underlying stocks. A call option is the right to purchase and not the obligation. It will give the holder the right to buy the underlying stocks at the agreed price within the specified time.
It is also a type of option giving the holder the right but not the obligation to sell the underlying asset. Puts are most commonly used to hedge against the risk of a fall in a stock price below the contracted price.
It is the option price to exercise an option, also known as the exercise price. For instance, an Rs.200 call option on stock allows you to buy the particular stocks for Rs.200 per share when you exercise the option.
The premium is the actual price of an option that a buyer pays for an option. Low volatility brings a small premium, whereas high volatility brings a high premium because of the increased risk.
It is the latest price at which a trader wants to buy an option.
It is the latest price at which a trader wants to sell a particular option.
Difference Between Stocks and Options
Leveraging is the key and practical difference between stocks and options. An option is a much more leverage asset than stocks because of its structure. It involves much less investment in the form of a premium. You can buy the same number of stocks as an underlying asset through an option for a lower amount than you require to purchase direct stocks. Thus, options costing is much less to purchase.
For example, a stock that is currently trading at Rs.500 would cost you Rs.50,000 to buy 100 shares, while as an underlying asset, it only costs you Rs.1800 (Rs.18 per share for option premium) to buy an Rs.500 option. Thus, it increases your purchasing power.
Share prices depend on the fundamentals, financials, management, stability, growth prospects of a company. If all these aspects are at a high level, the valuation will also be higher. Investors can expect long-term significant earnings on their stocks of such companies.
On the other hand, options value depends on the performance of the underlying stocks in the market. Options are speculative as the option holder is predicting the stock price and its performance in the future.
3. Potential to Profit
When you buy or sell shares, the only way to make profits is to sell them at a high price. In case the share price moves in the opposite direction of your trade, you will be at a loss. On the other hand, with options, you can create profitable positions from both sides by predicting whether the price will move up or go down.
Stocks are the direct investment into a company that offers partial ownership, but options are the contracts that provide the rights to buy or sell stocks because you are not investing in the company directly.
Stocks do not have any validity or expiration period until and unless you are buying them for intraday trading. You can keep the stock position open until you want to sell them. On the other hand, options are the contract for a specified timeframe. It will be void after that.
6. Investor/Trader type
Generally, shares are the core component of a portfolio. On the other hand, options are typically chosen by active traders only as they have enough experience. Options valuation requires much more effort than research on a stock.
Percentage returns on an option are often high, but leveraging could magnify the loss percentage as well. If the underlying stock price does not increase or decrease as predicted for an option’s time frame, an option holder has to face losses. Options are riskier than stocks.
Also Read: Top Stocks To Buy in 2021
Trading Options vs Stocks
Stocks trading refers to buy or sell shares on the stock exchanges where stock prices change in seconds. You are required to open brokerage accounts with a brokerage firm. You can place a trade by instructing your stockbroker or at the trading platform. Your request will be matched up with a seller or buyer looking for the same stocks on the stock exchange.
Traders follow several strategies to figure out which stocks should be bought and sold. The best approach is diversification that hedges the risk involved in stock trading. You can research and choose a mix of stocks across industries with the potential for good returns like technology and healthcare.
Options trading is considered more strategic than stock trading. It is all about determining the probability of future price events. The process of trading derivatives is similar to stock trading. Go to a brokerage firm and open brokerage accounts along with a margin account. However, you will need to provide much more details to your brokers, like your trading experience, annual income, and financial goals. There are additional financial requirements like minimum income that vary from broker to broker.
Options traders use sophisticated strategies like a strangle, butterfly, straddle, collar to maximize their returns. You need to set your requirements, the strike price, the investment amount, time frame. Such questions and strategies can be tricky for beginners. Therefore options trading something kept for veteran traders.
Benefits And Drawbacks
You can invest in the options and stocks of the same company without any restriction. Read on the benefits and drawbacks of both instruments.
Benefits of Options
- Options leverage your position. You can buy more stocks for the same amount of money.
- Options require a lower amount of initial outlay than buying direct stock.
- The investor has time to watch how things play out in the market.
- Options can protect investors from the risk that stocks own into volatile events.
Drawbacks of Options
- Options are contracts with expiry, and the value declines as the expiry date come near.
- Options require active portfolio management.
- Leveraging can expose an investor to unlimited losses.
- You can not trade in options without a margin account. Margin requirements can run up trading costs.
Benefits of Stocks
- Stocks are more liquid than their options.
- You will receive regular income in the form of dividends with long-term stock investments.
- You can make long-term or short-term investments as per your financial objectives.
- There is no expiry of stocks.
- A trading account and a Demat account are enough to trade stocks.
- If you have your trading plan and clear strategies clear, you can manage risk in stock trading.
- Your risk will be limited unless you trade on margin.
Drawbacks of Stocks
- Capital gains and taxes will reduce your profits. The lower the investment period, the higher the rates of capital gain taxes.
- The leveraging facility is available for day traders only.
- How actively you trade stocks will affect your performance.
- You need to pay brokerage commissions.
You have gone through the difference between stocks and options and how to trade them. Now, you can determine what investment opportunities are perfect for you. In the end, to choose between options and stocks, you should know your financial situation very well. Ask yourself these questions:
- What is your risk profile? How much risk are you ready to take on your funds?
- What is your investment horizon – short-term and long-term?
- How much profit do you want to make?
- What are your financial objectives?
For more finance-related concepts you can have a look at the FinanceShed, and stay tuned for more updates.