Stocks and options are two of the popular investment types that investors might include in their portfolio. There are reasons to invest in each, and they both come with their own risks, timelines, pros, and cons.
When deciding whether to invest in stocks vs. stock options, or any type of security or asset, it’s important to consider your personal investing goals, experience, risk tolerance, and timeline.
What Are the Differences Between Options and Stocks?
| Stocks | Options | |
|---|---|---|
| Type of Investor | Beginners and long-term investors | Experienced and active traders |
| Potential Downsides | Risks, Taxes, Fees | Risks, Costs, Effort |
| Type of Investment | Equity | Derivative |
Options
Options, or stock options, are a type of derivative investment. Rather than buying shares of stock, options traders give investors the right to buy or sell shares at a specified price, (known as the strike price in options terminology,) on a particular date in the future.
With call options, traders typically are not obligated to buy, so they can make a decision based on how the market moves. The investor does not have any ownership in the company unless they choose to exercise the option and buy the shares.
Over the time period of the option, it gets exponentially less valuable. This is known as time decay. A purchase of an options contract is known as a call, and a sale is known as a put.
Recommended: Call vs Put Option: The Differences
Some investors exercise the right to buy or sell and use that option trading strategy to make a profit. Others never exercise the right to buy, instead focusing on trading the options contracts themselves for a profit. Options trading strategies can get complicated, involving buying and selling multiple options on the same underlying security.
Recommended: A Guide to Options Trading
Stocks
Stocks are portions of ownership in companies, also known as shares. Investors can buy shares in companies and become fractional owners of that company in proportion to the number of outstanding shares that company has. For instance, if a company has 100,000 shares and an investor buys 10,000, they own 10% of the company.
Investors who purchase stocks typically hope to buy them at a lower price then sell them later at a high price to make a profit. There are also other ways investors can earn profits on stocks. For instance, some stocks pay out dividends to owners. Every month, quarter, or year, an investor can earn money based on the number of shares they own.
Recommended: How to Start Investing in Stocks
5 Key Differences in Stocks vs Options
Both stocks and options are popular investments, and there can be a place for both of them in a diversified portfolio. Here’s a look at some of of the differences to keep in mind when it comes to trading options vs. stocks:
1. Risk
Both stocks and options come with risks. For stocks, the risk is that the value of the security will fall lower than the investor expected. For options, there are additional risks, including the risk that they will expire without being exercised.
2. Ownership
When an investor buys stock, they become partial owners of that company. When they buy options, they only have the right to buy or sell stock, but not actual ownership of shares.
3. Quantities
When buying stock, the number of shares an investor buys is the total number they have and control, and they can purchase any number of shares, including fractional shares. When buying options, each contract represents 100 shares of stock.
4. Timeline
Options are contracts that are only valid for a certain period of time until the expiration date. They lose value over time until they are worthless when the contract expires. When an investor buys stock, they can hold it as long as they want.
5. Time Commitment
Investors can buy stock and hold onto it without doing much work, whereas options traders are often hands-on and prefer an eye on the market for the duration of the contract.
When to Consider Trading Stocks
There are several reasons to consider trading stocks, depending on your goals, timeline, and risk tolerance. Like any asset, stocks come with their share of risks and downsides. Some of the pros and cons of stocks include:
Pros
It can be relatively easy to start investing in stocks. There are several other benefits as well:
• Investors don’t have to sell their stocks on any particular date, so they can choose the best time to sell.
• Some stocks pay out dividends to investors.
• Stocks are easier to research than options since they have market history.
• Being an owner of a company allows you to vote on certain corporate issues that can affect their investment.
• Stocks typically have more liquidity than options, meaning it’s easier for traders to buy and sell them at any given time.
Cons
Like all securities, there are risks involved with investing in stocks. Those include:
• Whether you buy and sell stocks quickly as a day trading strategy or hold onto them for years, you will need to pay short or long-term capital gains taxes if you sell for a profit.
• While trading stocks can be very profitable, it’s generally best as a long-term strategy, which means it can take many months or years.
• It can be emotionally challenging to watch the market, and one’s portfolio, go up and down in value over months or years.
• Making a big profit on stocks can require a large upfront investment.
• When investing in stocks, traders risk losing all the money they put in. With options, they only risk the upfront premium.
• If investors short a stock, they can lose much more money than they even put into the investment.
• Stocks in certain companies are very expensive, making it difficult for smaller traders to even buy one.
When to Consider Trading Options
There are several reasons investors choose options trading vs. stocks trading. But like stocks or any investment, options come with their share of risks and downsides. Some of the main pros and cons of trading options are:
Pros
Options trading can be complicated, but once you understand how it works, there’s significant upside potential. Other benefits include:
• Options may be an inexpensive way to participate in the market without tying up as many funds as stock trading requires.
• Options provide investors with leverage. Essentially the investor has some control and access to shares worth more than the money they put into the contract.
• Options can provide an investor with a certain degree of predictability about their investment, since they know the strike price and expiration date of the contract. This makes the investor’s decision whether to exercise the option or sell it easier.
• Some investors prefer a hands-on trading strategy, and options are a good choice for that type of investing.
• Options can act as a hedge against market volatility
Cons
Since fewer traders buy and sell options than stocks, there can be lower liquidity making it difficult to get out of an options contract. Other drawbacks include:
• If an investor buys a stock option, they must pay a premium to enter into the contract. If the stock doesn’t move the way they hope it will and they choose not to exercise the option, they lose that premium they had put in.
• Trading options requires an understanding of the market and more in-depth research into the particular contract, the underlying asset’s fundamentals, and what the market looks like within the timeframe of the contract.
• Options lose value over time.
• Trading options may require a margin account with a certain amount of money in it at all times.
• Trading options requires more ongoing management than stocks
• Options are not as liquid as stocks, making them harder to buy and sell.
• Not every brokerage offers options, so you’ll need to open an account at a broker that does.
The Takeaway
Stocks and options are two popular types of investments traders use to earn profits and build a diversified portfolio. Depending on your investment strategy, you might invest in just stocks, just options, or a combination of the two.
If you’re interested in starting to trade and build a portfolio with stocks, one great way is using the SoFi Invest® stock trading app. You can add your other investment accounts to easily see all your financial information in one simple dashboard.
Photo credit: iStock/fizkes
SoFi Invest®
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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Source: sofi.com