Stocks have a reputation for being fairly straightforward, while options are often seen as a sophisticated, complicated, and potentially risky investment. The truth is somewhere in the middle. Stocks have been publicly traded since 1790, while options have only been around for about 40 years. Most people hear about stocks all the time, but options are only starting to gain traction with investors.
Those trying to decide whether to add stocks or options to their portfolio will want to learn more about these investments and where they fit into their wealth management plan. This guide explains the basics of both of these investment tools and analyzes the differences between options vs. stocks to guide you in the right direction for your investment strategy.
An Overview of Stocks
A stock gives you part ownership in a company. You pay a certain amount of money for the stock, and in exchange, you own a share of the company. You earn a profit if the stock’s value increases between the time you purchase the stock and sell it, and you suffer a loss if its value decreases during that time.
There are both private and public stocks. Private stocks are in companies that are owned by their founders, managers, and a group of private investors. The company needs to approve your purchase of its stocks. Public stocks, in contrast, are publicly available and traded on a stock exchange, and anyone who can afford the price can buy these stocks.
An Overview of Options
Options are financial derivatives that get their value from their underlying stocks or securities. They are essentially contracts that allow an investor to “bet” on whether they think the underlying asset’s value will go up or down during a specific time frame.
- The buyer pays a premium for an options contract, and then, depending on the contract, they get the option to buy or sell.
- A call option allows the holder to buy the asset for an agreed-upon strike price within a specific time frame.
- A put option, in contrast, allows the holder to sell the asset for an agreed-upon strike price within a certain time frame.
Here’s a quick, simplified example. An investor buys a call option that says they have the right to buy 100 shares of stock for $20,000 in the next 30 days. The investor watches the market, and in 25 days, the shares are worth $30,000, so they exercise their option to buy. They have just purchased an asset worth $30,000 for only $20,000, meaning they earn $10,000 if they sell right away.
What happens if the stock price falls and is only worth $10,000 at the end of the 30 days? The investor in this situation would lose money if they exercised their option to buy. They luckily don’t have to buy — they have the option. They can simply walk away, losing only the premium they paid for the contract.
Differences Between Options vs. Stocks
Options contracts often use stocks as their underlying asset, but they don’t function like stocks. Stocks are an asset you purchase, and you earn or lose money depending on whether they increase or decrease in value. Options require you to sign a contract and hedge a bet that a stock’s value may go up or down. Here is how these investments vary in other key ways:
Equity
Stocks give you equity in a company. That can sometimes include dividends, voting rights, and other ownership rights. Options are not an equity investment; they are a derivative.
Liquidity
Options tend to be less liquid than stocks. You can typically liquidate a stock at any time without affecting its current market price. Options, in contrast, take longer to liquidate, and the transaction generally affects the value of the underlying asset.
Capital
Buying options requires less capital than buying stocks, because you only have to pay the premium on the options contract. You don’t have to pay the entire value of the underlying stocks. Buying the same amount of stock outright takes more capital.
Options trading also brings more versatility to the table. You have many choices about how you set up the contract. Stocks just come with two choices — buy or sell. That simplicity makes stocks more attractive to some investors, while others prefer the versatility of options.
Deciding Between Options vs. Stocks
You’re probably wondering which investment is right for you now that you understand the key differences. Here is a breakdown of the elements to consider when making your choice:
1. Type of Investor
Stocks, because of their simplicity, tend to be the best investment choice for beginners. Active traders who want more choices and flexibility may want to explore options trading.
2. Risk Tolerance
Stocks always come with the risk that you may lose your entire investment, but most investors mitigate that risk by diversifying their portfolios with a wide variety of stocks. Options contracts carry a built-in risk, like any other investment vehicle, but you can limit your risk to the contract premium.
3. Effort
You can buy stocks and basically forget about them if you want. Options contracts, in contrast, require a more active approach. You need to check the value of the underlying asset regularly so you can exercise the option at the most advantageous time.
4. Costs
Buying stocks requires you to pay the purchase price of the stock. You also must pay commissions, fees, and capital gains taxes on your profits, and these costs may increase, depending on how often you buy and sell. You pay the premium for the options contract, allowing you to potentially earn money from a stock without paying for its purchase price. You also face additional trading costs.
5. Time Period
You can buy and sell stocks quickly, but investors often buy them and hold them for a long time. Options contracts are more short-term investments. Their expiration dates range from days to years but are typically within a few months.
You don’t have to choose between options vs. stocks — you can include both in your portfolio. Many investors use options to hedge against the risk of their stocks. Buying a put option, in particular, gives you the right to sell the stock at your chosen strike price at any time before the expiration date. That helps reduce your risk of loss if the value of the stock goes down.
Contact Bogart Wealth for Help With Investments and Wealth Management
Some investment savvy is undoubtedly valuable when trying to decide between options vs. stocks. Bogart Wealth has a team of investment pros to help you learn more about stocks, options, and the best investment strategies for you.
We help our clients optimize their investments, and we are committed to providing them with peace of mind through the preservation and maximization of intergenerational wealth. Contact our offices today with any questions about options vs. stocks.
