As you start investing, you might run into different terms. Trying to understand how it all works can feel like a daunting task. One of the main issues to understand is the difference between options vs. stocks. Let’s look at what you can expect when you get involved with investing or trading stocks and options.
Options vs. stocks: A quick comparison
|Level of complexity||Can be a complex investment||Can be a simple investment|
|Best for...||Experienced investors looking for possible short-term gains||New or experienced investors looking to build potential wealth over time|
How do options work?
Basically, an option is a contract that gives you the right to buy or sell an asset at a predetermined price. However, it’s important to note that the contract is good only for a limited time. Once you learn how options work, and you decide to take advantage of the contract, you have to buy or sell the listed asset by the expiration date.
Realize, too, that an option is a contract; it’s not the asset itself. Options are derivatives, which means they are based on some other investment. Rather than owning the asset, a derivative is a different instrument based on the underlying asset. Potential assets that options can be based on include individual stocks, stock indexes, exchange-traded funds (ETFs), commodities, bonds, and even foreign currencies.
In general, there are two main types of options:
- Call option: This type of options contract is designed to let you buy units of an investment at a specific price. If you decide to exercise your option, the seller has to let you have the investment at the price listed in the contract.
- Put option: This type of options contract gives you the right to sell an investment at a set price. If you’re more interested in being able to sell an underlying asset, a put option can be the way to go.
There are a few other things you need to be aware of as you’re learning how options work.
- Premiums: An options contract comes with a premium based on a per-unit price. Many stock contracts, for example, assume 100 shares of stock. If the premium is 90 cents, you’ll pay $90 upfront to buy the option — and the right to sell, depending on your situation.
- Strike price: The strike price is the listed price that you have a right to, whether you’re buying or selling. If you buy an options contract that says you can buy shares of company ZYX for $50 per share, that $50 is the strike price.
- Market price: This is the price of the asset on the market. If your call option says you can buy 100 shares of ZYX for $50 apiece by a certain date, and the market price is $85, you’re actually getting a discount.
- In-the-money: With a call option, you’re considered in-the-money, or “ahead,” if the market price is higher than the price in the options contract. With a put option, it’s the opposite. Because a put option is the right to sell an asset at a certain price, you want to be able to sell at a price that’s higher than what you’d receive on the market. If the strike price was $50 on a put option, but the market price is $35, you’d be in-the-money because you can get more by exercising your option.
- Out-of-the-money: On the other hand, if the market price isn’t better for your portfolio than the strike price, you’re considered out-of-the-money.
- Expiration: Many options contracts stop trading on the third Friday of the expiration month and expire on the following Saturday. Double-check the month of expiration on your contract so you have an idea of when it will expire.
- Hedging: Some traders like to use options to hedge against the risk of other assets. For example, if you own shares of ZYX and you’re concerned about the current price dropping, you could buy a put option that allows you to sell ZYX at a certain price. If the price does drop and you decide to sell, you can do so at the higher strike price rather than take losses due to a falling market price.
No matter the type of option you buy, you have the same choices. First, you can sell the contract to someone else with the hope you’ll be able to sell it for more than you paid for it. Second, you can execute your option and buy or sell the asset at the strike price listed. Finally, you can simply let the option expire and do nothing. When you let an option expire, you lose the money you paid for it.
Who are options best for?
In general, options are considered riskier than other investment vehicles, such as stocks and bonds. As a result, options trading is typically best for those who have a higher risk tolerance and can handle increased volatility and potential losses. Options contracts can also be complicated, which can make them a better choice for experienced investors.
Pros of options trading
- It’s possible to have a smaller upfront cost than you’d see purchasing the underlying asset
- Leverage can be used to boost your gains
- You have the ability to engage in more complicated trading opportunities
- Options can hedge against the downside risk of assets in your portfolio
Cons of options trading
- Leverage can result in bigger losses for option holders
- You need to be able to predict short-term changes in the price of the option’s underlying asset
- You could end up paying short-term capital gains taxes due to the short-term nature of options
- After paying the premium, your contract could be worthless when it expires
How do stocks work?
Stocks represent a portion of ownership in a company. When you buy a share of stock, you’re essentially purchasing a small piece of the company.
In most cases, shares of companies that have “gone public” are sold on the stock market. This is a secondary exchange, which allows you to buy shares that others are selling. When you go through one of the best investment apps or brokers, these tools are essentially matching you up with someone who wants to sell shares of stock in a company. Later, when you sell your own shares of a company, you’re usually hoping that the price has increased and you can sell for a higher price than you paid.
Stock prices can fluctuate for a number of reasons. If a company is doing well, has a strong business model, and is making profits, more people might want to benefit from owning a portion of the company’s stock, and the price could increase in response to demand. On the other hand, if bad news comes out, there might be more shares available for sale, and the price could drop as sellers try to get what they can.
Other factors can influence a stock’s price as well. Economic and market factors, as well as natural disasters and political changes, can also impact stock prices. Certain industries or sectors might be influenced more than others, depending on the situation.
Some companies also reward shareholders by paying dividends. Dividends are payouts of profits, based on the number of shares you own. For example, a company might pay a quarterly dividend of 50 cents per share. If you own 100 shares, you’ll end up with a payment of $50 every three months. It’s possible to grow a dividend portfolio and receive dividends on a regular basis, which can be one way to generate income, rather than just waiting for stock price appreciation.
Who are stocks best for?
Stocks can be a good choice for investors who are looking for a relatively simple way to build wealth over time. Getting started in the stock market is fairly easy thanks to online brokers and trading apps.
Newer investors might benefit from the instant diversity that comes from investing in stock mutual funds or ETFs. These pooled investments allow you to take advantage of a group of stocks, offering exposure to a variety of companies, rather than requiring you to try to pick a few winners and losers.
Novice investors can also benefit from investing in fractional shares, which provides a way to buy a portion of a share. If you can’t afford to pay more than $600 for a single share, you can still invest in Tesla and buy one-fourth of a share for less. Fractional share investing can make it easier to begin building a portfolio and benefiting from price appreciation and even begin earning dividends.
Advanced investors might engage in day trading, or look for ways to pick stocks that are more likely to increase in value rapidly.
In general, nearly everyone is likely to benefit from some type of portfolio strategy that involves using individual stocks or stock funds to grow their wealth over time.
Pros of stock trading
- Trades are often simpler to understand than options trading
- Potential to earn dividends if you hold the asset
- More likely to access a favorable long-term capital gains rate, as long as you hold the stock for more than a year
- The stock market as a whole has yet to see a 20-year period in which it loses overall, though past performance isn't necessarily a predictor of future results
Cons of stock trading
- Potential to lose your initial investment
- Short-term price fluctuations can cause stress for stockholders
- Frequent trading can potentially lead to increased fees and losses
Options vs. stocks: 3 key differences
- Type of asset: It’s important to note that with a stock, you actually own a share of the company. You can benefit if the company does well because you have ownership, though returns aren’t guaranteed. You could also potentially receive dividends and sell the shares later. An option is a derivative contract. If you’re trading stock options, you don’t actually own stock in a company. Instead, you have a contract that says you can buy or sell a stock at a certain price. You can sell the contract, but you don’t actually buy or sell the underlying stock.
- Risk: In general, options are considered riskier than stocks. When thinking about options vs. stocks, carefully consider your risk tolerance.
- Complexity: Options transactions can be more complex than stock trades. Although it’s possible to find complicated stock trading strategies, in general, a straightforward buy-or-sell transaction can be easier to understand than an options trade.
Are options better than stocks?
When considering options vs. stocks, one isn’t necessarily better than the other. Many people like the idea of options because they have the potential to provide gains in a short period of time. However, they could also result in bigger losses over a short time frame.
Stocks are usually considered a better choice if you want to grow wealth over time and see more stable increases in your net worth over a period of years. However, it’s important to keep in mind that gains aren’t guaranteed and you can also lose money investing in stocks.
Is trading options a bad idea?
For many investors, especially beginner investors, options could provide a number of challenges and result in losses. In many cases, it could be a better idea to focus on investing in stocks and ETFs for the long haul, and trade options only if you’re an experienced trader who can afford the potential losses.
Is it better to sell an option before its expiration date, exercise the option, or let it expire?
As with many things related to trading and investing, it’s important to carefully consider your own trading strategy and risk tolerance. Options are used for many purposes, including portfolio growth, hedging, and profits. Carefully consider why you’re buying and selling options, and the purpose they serve in your portfolio.
Can you lose your money trading stocks?
Yes. Any investment comes with the risk of loss. Carefully consider your financial goals and risk tolerance as you put together an investment strategy. And if you have questions, you may want to speak with a financial advisor for investment advice.
The bottom line
When it comes to options vs. stocks, it’s important to understand what each type of investment is for, where it fits into your portfolio, and your view of how to invest money. For many investors, options trading can be considered riskier than stock trading; however, all investments come with the risk of loss. If you’re just getting started with investing, it could make sense to start off with fractional investing in a stock fund or ETF until you’ve gained enough knowledge and experience to branch out.
If you want to invest in options or stocks, check out our picks for the best brokerage accounts.