Difference Between Options and Stocks: Everything You Need to Know
The difference between options and stocks is a fundamental distinction in the realm of investing. 3 min read
Options and Stocks Overview
The difference between options and stocks is a fundamental distinction in the realm of investing. An option is a derivative, meaning it is a type of security—or investment instrument that can be exchanged for value although at some risk—that derives its value from the underlying assets backing it, such as stocks, precious metals, currency, or commodities. A stock, on the other hand, is a financial instrument that shows ownership in a business while also signifying a claim to the assets and profits of the business. In the simplest terms, a stock gives one partial ownership of a business, while an option does not, although the true distinction is a bit more complex than that.
Differences Between Options and Stocks
Both options and stocks can be traded to extract value, although there are some key differences in the fundamental nature of each. Some of these key differences include:
- Influence. Because owning stocks means that you will own an actual part in a company, you can then exert your influence on the direction of the company by voting on key issues raised at annual stockholder meetings. You can also receive a percentage of a paid-out dividend, should the company choose to pay one out. Owning options, on the other hand, does not entitle you to company ownership, so it does not entitle you to receive dividends, vote on key issues, or enjoy any other company-related influence a stockholder may have.
- Profitability. Stocks may decrease or increase in price depending on the company’s perceived value in the market, which is a function of how desirable ownership in that company is believed to be. This price fluctuation is where the potential value is derived, being summed up in the old adage of buy low and sell high. Thus, stocks are only profitable when their price increases, while options can be profitable with both increases and decreases in value. To extract value on options through a decrease in the underlying security, one could purchase a put option, which would allow them the right to sell a stock below a certain price within a certain timeframe and turn a profit.
- Expiration dates. Options have expiration dates. Stocks do not. This means a stock can be held for as long as a company is active, while an option must be used within a certain timeframe. Option expiration dates are usually nine months or less from when the option was purchased, while longer-term options called LEAPS, or Long Term Equity Anticipated Securities, can have expiration dates up to three years away. If any option is not used by the time of its expiration date, any money invested in it will be lost.
- Risk. Stocks are considered to be a much safer investment than options. Stocks form the basis of nearly every investment portfolio, being considered as reliable as long-term securities. Option trading, on the other hand, is considered to be high-risk, high-reward: it is common for option traders to lose all their money in a very short span of time. Options traders do not have the luxury of riding out market dips as stock traders do: if a price is not profitable at the option’s expiration date, they will lose money. Because of this, experienced option traders usually use options as part of a larger investment strategy involving a selection of stocks. One such strategy is known as a Covered Call.
In sum, stocks allow greater stability and the chance to be involved in the direction of a company, while options offer the possibility of greater, faster reward, often at a 10:1 ration over stocks. However, because of their high-risk nature, it is often recommended that one diversify their holdings, which if done correctly through a combination of stocks and options, may allow one to turn a profit regardless of a stock or market’s rise or fall. That said, regardless of whether one is going to trade in stocks, options, or both, they should do extensive research on the related terminology and concepts before doing so.
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