Breaking Down Options vs. Stocks
Trading stock options are a little more complex than just trading stocks. However, there are a number of reasons why some investors prefer options trading. Learning about what stock options are, how they differ from traditional stocks, and what the primary advantages and disadvantages are can help you determine if options trading is for you.
- There are two kinds of stock options: calls and puts.
- Unlike owning stocks, owning an option doesn’t give the trader any shares of the stock; they only own the right to buy or sell.
- Stock options allow a smaller upfront investment and greater flexibility than trading traditional stocks.
What Are Stock Options?
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A stock option is a contract that gives a trader the right, although not the obligation, to buy or sell a particular stock at a specific price within a set period of time. Each contract typically represents 100 shares of the underlying stock.
There are basically two different types of stock options: call options and put options. Call options give a trader the right to buy. Usually, a trader will buy a call option if they predict a specific stock is going to go up because it means they can lock in a specific price per share and profit if the price on the open market goes up.
On the other hand, if a trader thinks that a particular stock is going to go down, they may buy a put option. Again, this lets the trader lock in a strike price, and if the price of the stock drops below that price, the value of the put option increases. Investors often use put options as a kind of insurance, a strategy called a protective put. They use put options as a way to make sure that any losses they suffer don’t exceed the strike price for the option.
Options vs. Stocks
So what is the difference between stocks and options? Options, like stocks and futures, are subject to binding agreements. However, options give you the right to buy or sell an asset or security without the obligation. The key differences between options and stocks are:
Stocks don’t have expiration dates. You can hold onto them for however long you like as long as the company remains active. However, a stock option, like a futures contract, will expire at some point in the future, at which point it becomes worthless.
Ownership of the Underlying Security
An option doesn’t actually give you any shares of the underlying security. When you own stock directly, you actually own that security and can hold onto it for years if you like, selling it when and if you’re ready. You also have voting rights as a shareholder. When you own an option, you own the right to buy or sell the security. However, unless you exercise that option, you don’t own the shares.
Options Are Derivatives
A stock option is a contract that gets its value from the performance of the underlying assets. A derivative gets its price from fluctuations in the underlying asset. So with a derivative investment, the trader doesn’t own the underlying asset but instead is betting on whether the value will go up or down.
There are No Set Number of Options
With a stock, there are a limited number of shares. For example, the company may decide when it goes public that it’s going to sell two billion shares of its stock. However, with stock options, the options are virtually limitless because you don’t have to actually own the shares.
Similarities Between Stocks and Options
While stock options and stocks are very different, there are some similarities.
Both stock options and stocks are tradable securities. They both have bid and ask prices and are constantly traded.
Listed on the Exchanges
Stocks and stock options are both listed on the major exchanges. The exchange tracks the flow of orders for each stock.
Advantages of Trading Stock Options
Are options better than stocks? Options can give investors more strategic leeway than they would get if they were just buying or selling stocks directly. Traders can treat options as insurance to protect against major losses in their portfolios. They also can use them to grab a stock for less than it sells on the market, or potentially sell it for more than if they were selling the shares directly. While there are some inherent risks for trading stock options, there are definitely a number of advantages:
Low Upfront Financial Commitment
When you buy a stock option, you lock in a set price for the right to buy or sell shares of the stock. The upfront investment you make when you buy the investment is far less than what you would pay if you bought the shares directly. That means that you could pay less money upfront but can benefit in the same way percentage-wise if the trade goes the way you think it will.
Options Offer More Flexibility
There are a lot of strategies that you can deploy before an options contract expires. You could exercise your option and buy the shares, adding them to your portfolio. You could also choose to buy the shares and then turn around and sell some or even all of them for an immediate profit. Another option is to sell the “in the money” options to a different investor.
An ITM option is one where the strike price is already surpassed by the price on the open market. With this approach, you never even come up with the funds to buy the shares directly in order to turn a profit.
The last option is to sell an “out of the money” option before it expires. While an OTM option has no intrinsic value, if there’s still plenty of time before the option expires, you may still be able to sell it to another trader to recoup the cost.
Lock in a Set Price
An options contract is like putting a stock on layaway. When you secure an options contract, you’re freezing the price of the stock at the strike price for a set period of time. With an options contract, you are guaranteed the right to buy or sell the stock up until the time that the stock expires.
Drawbacks of Trading Stock Options
If you’re going to get into trading stock options, there are some drawbacks that you need to be aware of:
Substantial Risk for the Option Seller
While a trader can use stock options as a way to minimize risk, if you’re the person selling options, also called the option writer, you risk much greater losses than just the price of the contract. When an investor sells a put or call, they are obligated to buy or sell shares if the option buyer decides to exercise the option. That means they may be obligated to fulfill the terms of the contract, even if the prices are unfavorable. While the price can, theoretically, drop as low as zero, there’s no limit on how high the price of the stock can rise.
Options are, by nature, short term. They only carry value for a limited period of time, and only then if the price fluctuates to make the option more valuable.
Traders buy options because they expect the market prices to move within weeks or months of buying the option. In order to succeed in options trading, they must choose the right time to buy and the right time to exercise their option or sell the contract.
If the investor times it wrong, their option may be worth nothing, and it could expire before they have a good opportunity to profit from it. Trading stocks, on the other hand, allows for long-term investing. A trader could hold onto the stock for years or even decades to allow the investments to play out before doing anything.
Taxed as Regular Income
It’s always important to understand how different types of trading will affect your tax liability. Except in very rare situations, profits from options trading are taxed as short-term capital gains, which is essentially the same as your regular income. The rates are as high as what you pay for your personal income tax. Many traders carry out their options strategies in a tax-deferred account, like an IRA.
While there are risks with trading stock options, especially for options writers, there are huge opportunities for making a great income. The most important thing you can do is focus on understanding the basics of trading options. After learning the basics, you can find a strategy that works well for you and stick with it. The best traders are those who recognize that they aren’t going to win every time. They only trade with the amount they’re willing to lose, and they stick with a strategy that lets them win more than they lose.