Are you familiar with buying and selling stocks, but would like to expand your investing to options? This guide will help you understand the differences, advantages, and challenges with trading options or stocks. The key to successful investing with both stocks and options is understanding and spotting the possibilities. A great investor makes informed decisions about how to invest, getting the best returns when it’s time to sell.
- A stock is a share of a publicly-traded company. Investors usually buy stocks low and then sell them high.
- An option is a purchased right to buy or sell an asset at a certain value within a length of time.
- A trader can own stocks as long as they like, while options are time-limited.
- Stock trading has a consistent strategy, while stock options are a little more complicated but a worthwhile tool.
What Are Options and Stocks?
Stocks represent a percentage of ownership in a company. When someone buys shares in a stock, they own a stake in that company, which rises and falls in value. For example, if you buy 10 shares of a technology company’s stock valued at $20 per share, and then that stock later rises to $40 per share, selling all of those shares at that time will double your investment.
An option is a purchased contract that gives a trader the right to buy or sell an asset, such as a stock, future, index, or commodity at an agreed price within a certain date. With stock options, the owner consistently has the right, but not the obligation, to buy (a call option) or sell (a put option) a stock at a specific price within the time limit. Options also have a price, called a premium, similar to the premium of an insurance policy.
Options and stocks will appeal to different types of investors. However, excluding options from your strategy could mean leaving opportunities off the table.
Differences Between Options and Stocks
When buying stocks, only one assumption is being made: that the stock value will rise in the future. Options, however, have more complexity. First, the trader must guess whether the asset will appreciate or depreciate. They must also guess how high or low the value will go because the option will only apply to that amount. Lastly, a trader buying an option must predict the time frame in which the rise or fall will occur.
Stock options can be useful as insurance for plummeting stock. For example, if you have a share of stock valued at $100, and a put option to sell it at $75, you’ll be able to cash out the share for $75 during the period of the option, even if the stock value drops to $50 or even lower.
Stock options can also be used as a safe way of cashing out. If someone has shares in a stock that is doing well, but they expect the bubble might burst soon, they could buy a put option at a desirable price and use it when or if the stock price does drop back down.
If a trader thinks a stock might behave a certain way (up or down) within a specific time frame, buying an option could be a smart decision. The premium paid might be a small price compared to the potential earnings made or losses avoided.
Why Trade Options Vs. Stocks?
The main advantage of basic stock trading is that it’s straightforward and has no time or value limits. An investor can watch their own stocks or have a broker watch them and offer investment advice. For long-term investors who don’t intend to try and cash out or react to market changes very much, stocks are easy to handle. They can invest in a diverse profile of reliable companies and cash out on those stocks years into the future after they’re increased in value.
Conversely, one of the appeals of options is that they offer a guaranteed price. The market is always changing, and there are no guarantees on how a stock will change in a given time. Options offer the ability to buy stocks at a certain price, or sell at a certain price, without worrying about whether the stock might rise more or suddenly fall.
Challenges of Buying Options Vs. Stocks
The main risk with stocks is a mistaken investment. It is possible to invest in a company’s stock only for the value to fall. Another potential issue is broker fees and capital gains tax. Every time a trader buys or sells stock through a broker, that service costs a fee. The more transactions made, the more those broker fees will add up. Capital gains tax will also apply to profits made when selling a stock.
Of course, buying options carries risks as well. One possibility is that the stock’s value approaches the amount set in the option, but never actually reaches it.
For example, imagine the value of a biotech stock is $10 per share. An investor predicts that within the next year, that stock will drop to $2 per share, and then climb back up. The investor purchases a call option for the company’s stock to buy it within the next year once it drops to $2. However, the stock might only ever drops to $3 during that time. Alternatively, the stock might reach $2 within the time window but then drop to $1 soon afterward. This is why thorough and educated predictions are important.
Buying Stocks: Tactics and Goals
Stocks work well as both a short-term and long-term investment tactic, depending on the stock type and strategy used. Day traders, for instance, aim to buy a stock at a low point and then sell it at a higher point within the same day, turning a profit. However, for the average person investing some spare funds over five or more years, their tactics are a lot more relaxed and consistent. Typically, a long-term stock trader will research several distinct stocks, diversifying the investment.
The goal in long-term investing, such as investing for retirement, is to cash out in the future when the stocks have all or mostly risen to a greater value. For this reason, established companies that show no sign of dying out are a safe bet. Ultimately, a trader can use stocks in their investment strategy in many ways, combining short-term and long-term investments and experimenting with different types of companies, industries, and more.
Buying Options: Tactics and Goals
One of the most common reasons to buy a stock option is to invest in a stock by buying at lower than market price. For example, if a stock normally averages around $40 per share, but you purchase an option to buy 10 shares of that stock at $10 per share, as long as the stock didn’t drop to even lower than $10 within that time, you got a better deal than what the market trends would have offered.
As with buying and selling stocks, a trader can buy options for both short-term and long-term investment plans and all manner of industries and companies. The security they offer to get a guaranteed price can be appealing, as long as the guaranteed price turns out to be a better deal than what the market would have offered in that time-span.
Similarities Between Options and Stocks
Buying options and stocks both have a similar, universal trade premise of buy low and sell high. Both involve the risk of buying something in the hope of selling it for more or selling something in the hope that it won’t rise anymore. Options are simply a more complex tool for getting the best possible returns on an asset, and they can be very useful to investors with a little experience.
With both stocks and options, a thorough understanding of the market and a strong investing plan are necessary for success. Picking stocks that make sense is essential in both cases, and taking on assets that you can handle with your lifestyle is also important. Not everyone starts out as a day trader, buying and selling stocks and options within 24 hours. Many traders comfortably and gradually build wealth through a series of smart, long-term investments with an eye for the future.
Getting Started with Options and Stocks
To a new investor, stocks and options can still feel a little intimidating, and the best way to conquer that feeling is to get insights from elite traders. Get your questions answered with the free Raging Bull Bootcamp, turning you into a better trader. In just seven days, you’ll get a wealth of knowledge and inspiration from master traders like Kyle Dennis, Jeff Williams, Taylor Conway, Jason Bond, Jeff Bishop, Petra Hess, and Davis Martin.
Are you comfortable with stock trading so far, but want to nail down options trading like a pro? Don’t miss Jeff Bishop’s free, updated Option Profit Generator eBook. You’ll discover every piece of untapped potential in every option you buy, the secret to what makes an option worth buying, and more from the master.