Options vs Stocks
All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Our writers nor our editors receive direct compensation of any kind to publish information on TheTokenist.io. Our company, Tokenist Media, is community supported and may receive a small commission when you purchase products or services through links on our website. See more information here about how we make money.
Stop a stranger on the street and ask them what “stocks” are and you are likely to hear a fairly accurate answer.
Most of us understand the basic concept of a stock – a share of equity in the profits of the issuing entity.
But what are “options?”
Perhaps you have heard the term. Maybe in the past you assumed it simply meant you have options when it comes to investing. And this is true.
But in the investing world, the term options doesn’t just mean choices. It is also a specific type of asset with a specific place in a diversified investment portfolio.
In fact, options have some interesting similarities with stocks, which is why it can be important to examine the two asset classes side by side. In this article, we take a close look at options vs stocks so you can decide when and how to include each in your own investment holdings.
What Are Stocks?
In the simplest explanation of the term, a “stock” is a share of ownership in a company’s potential profitability.
Stocks are said to be one of the riskiest types of investments because changes in the marketplace can have a deep impact on the issuing company’s own profitability.
There are two main categories of stocks: preferred stocks and common stocks. Within these two main categories there are different types of stocks, including big cap stocks, small cap stocks, micro-cap and nano-cap stocks and penny stocks.
There are also fractional shares of stocks, which represent a percentage of a single share of stock.
Stocks may carry a high potential for risk, but historically stocks have also carried what is arguably the highest potential for return on investment.
In most cases, it is important to view investing in stocks as a long-range investment strategy, because over time stocks will help your portfolio adjust naturally for inflation as well as delivering the potential for future profitability.
What Are Options?
An option gets its name from how this asset class functions. In the investing world, the word “option” translates to mean “contract.”
An option is also a type of investment that is classified as a derivative. Here, the term “derivative” means that it is tied to (derived from) the value of another security or asset or group of assets.
If that isn’t complicated enough, an options contract is an open contract, which means the buyer/seller has the option to but is not required to buy or sell the security by a certain date and at a certain price (the “strike price”).
Because of this, each options contract comes with a set expiration date. The options owner (holder) must act by that date or lose their option to do so.
What types of securities can be tied to options? Bonds, stocks, index, exchange-traded fund (ETF), and similar securities can all be traded through options contracts.
There are two main types of options: call options and put options.
A call option basically means that the buyer has the option to purchase a certain security for a certain price by a certain set date.
The call option holder is banking on the market price rising above the strike price (the agreed-upon sell price) before the expiration date. If this occurs, the holder can realize a profit by exercising their call option.
If the holder chooses to exercise the call option, the seller (“writer”) is then obligated to fulfill the terms of the call option.
If the market price does not increase beyond the strike price or the call holder chooses not to exercise the option by the agreed-upon date for any other reason, it simply expires.
A put option is the exact opposite of a call option. With a put option, the put option holder retains the option to sell the given security at a certain strike price by a certain set date.
The put option owner (holder) is banking on the security price decreasing before the expiration date of the contract. If this occurs, the put option holder can realize a profit by exercising the option.
Here again, if the seller decides to exercise their put option, the buyer must purchase the security at the agreed-upon price.
Investing in Options Explained
There are six main components in any options contract: the buyer and the seller, the strike price and the expiration date, the bullish position and the bearish position. There is also the premium fee.
To understand what these terms mean, let’s take a look at the basics of the options contract itself.
Elements of an Options Contract
In any options contract, you have a simple agreement. That agreement is between a buyer (holder) and seller (writer).
In most cases, the contract itself will cover 100 units of the relevant security, whether that is a stock, a commodity, a currency, a fund or some other asset. However, in some cases the contract will diverge from this norm, as in the case of stock splits or mergers.
The contract will specify the strike price, which is the price by which action may be taken prior to the expiration date. Here, it is important to remember that the strike price only represents the point in time at which action (such as to buy or sell the relevant security) can be taken, or exercised.
An options contract does not require the buyer or holder to take any action if or when the strike price is reached. However, if the buyer or holder decides to take action, an options contract does require the seller (writer) to take action.
For a put options contract, reaching the strike price means the security can be sold. For a call options contract, reaching the strike price means the security can be bought.
The expiration date is the point at which the options contract itself expires.
You may hear the terms “bullish” and “bearish” used when it comes to options trading. The term “bullish” refers to a position (or anticipation) that a security will increase in value. The term “bearish” refers to an anticipation that a security will decrease in value.
Therefore, call options will always attract bullish-minded buyers and bearish-minded sellers (writers). Put options, in contrast, will attract bearish-minded sellers (writers) and bullish-minded buyers.
The premium fee is the fee the holder pays at the outset in exchange for the right to exercise the options contract. The premium fee is due up front regardless of whether the options contract is exercised or not. In general, there is one premium fee per options contract.
Here is an example: there is an options contract on the table for 100 shares of a security. The premium fee is $0.21. To calculate the premium cost, multiple 100 by $0.21 and you get $21. That is the premium fee to hold the options contract on that security.
The premium fee is payable up front even if the holder never chooses to exercise the options contract.
You may also hear traders refer to an option’s “intrinsic value.” This means the asset is valued above the set strike price. Whenever the asset price is trending above the set strike price, that asset is said to have “intrinsic value” or to be “in the money.”
The easiest way to understand this is to look at another example. Let’s say that each share of a certain security has a strike price of $100. But the security is actually trading at $110. In this case, the intrinsic value of this “in the money” call option is $10 per share.
There is no doubt it can take some time to master the terminology and technique of trading call options. But once you do, you gain access to another potentially lucrative investment opportunity with some perks you won’t find through trading straight stocks.
Why Should You Choose Options Over Stocks?
While options do not always involve stock shares and can encompass other types of securities such as currencies, commodities, bonds or even shares in mutual funds, for our purposes here, we will assume “options” refers to an options contract for purchasing shares of stock.
So why should you choose to invest in options over simply purchasing shares of stock outright?
The key to success when trading options is to take an active role in the transaction. In other words, trading options is not for the passive or hands-off investor. Making profits through trading options requires keeping a close eye on price movements throughout the term of the contract.
It is also worth remembering that there is an up-front cost, or premium fee, for trading options that can eat into future profits.
Here are the major pros and cons of choosing options over stocks.
Options Trading Pros
- Lower up-front investment required to begin trading
- Limited risk exposure due to preset expiration date
- Better choice for short-term investment gains
- Zero obligation if the market moves in an unfavorable direction
Options Trading Cons:
- Premium fee is due up front and can add up.
- Trading options comes with a complex learning curve.
- Hands-off investors will not fare well trading options.
- Limited time period can quickly render options worthless.
When Should You Invest in Stocks Over Options?
Stocks have historically outperformed the majority of other asset classes over time. While it is possible to turn a quick profit by trading stocks, overall it tends to take time to realize the greatest gains.
This is one of several ways that trading stocks differs from trading in options contracts.
Here are the major pros and cons of choosing stocks over options.
Stocks Trading Pros
- Highly liquid (especially common stock in big-cap stocks).
- Easy to sell and buy without first mastering a steep learning curve.
- Stocks can help to cushion your portfolio against future economic inflation.
- Stocks that pay dividends can potentially provide both short-term and long-term investment gains.
Stocks Trading Cons
- Market volatility makes stocks a high-risk investment overall.
- Common stock holders will be paid after creditors, bond holders and preferred stock holders if a company goes into bankruptcy, which means there is a chance of losing your entire investment.
- It can be hard to maintain a diversified portfolio by investing in straight stocks.
- Trading fees can cut into profitability.
Can You Invest in Both Stocks and Options?
There is nothing that says you cannot invest in both stocks and options at the same time.
So perhaps the better question is whether you would want to.
Now that you understand the different function stocks and options can serve in your investment portfolio, it is hopefully becoming clearer that trading stocks and trading options requires two different sets of learning tools and skill sets.
In general, trading options is the purvue of the active, hands-on trader who is seeking short-term gains.
In contrast, trading stocks tends to be the bailiwick of the trader who has their eye on the long-term prize – outwitting inflation while outperforming the market as a whole over the long-term.
That is not to say the two can’t or won’t ever overlap. To decide which is the best investment for your needs and goals, options vs stocks, start by analyzing what kind of trader you are.
Do you have a strong degree of interest in learning the often complex ins and outs of options trading and the time to take a hands-on, active role in your short-term trading decisions day to day?
If you answered “yes,” then options trading may be the right fit for you.
Do you have less time right now to shepherd your investment portfolio through the sometimes stressful daily market fluctuations as you save towards retirement or a big long-term future financial goal?
If this sounds more like you, trading stocks may be a better choice for you at this present time.
What’s a Better Long-Term Investment: Stocks or Options?
Like all securities, stocks and options each have their place in a diversified investment portfolio.
However, when comparing options vs stocks, here most financial experts are in agreement that stocks represent a better long-term investment than options.