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Options vs. Stocks

Stocks are an asset that gives you a share of ownership of the company when purchased. Options are contracts that offer a trader the right but not an obligation to buy or sell the underlying assets.

Key Takeaways

  • Equity investing refers to buying shares of a company and earning returns through capital appreciation and dividend income.
  • Options are a contract between a buyer and seller. The buyer has the right, but not the obligation, to buy or sell an underlying security at a specific price (Exercise Price) and predetermined date (Expiration Date).
  • Equity represents a stake in the company, while Options are a contract that a trader enters into to hedge or speculate on price movies.
  • There is a wide range of option strategies that are primarily based on Call options and Put options.
  • Investors analyze many fundamental factors before picking a profitable stock, whereas Options derive value from the underlying using option pricing models.

Table of Contents

Equity

Companies raise capital by issuing shares in the open market. When investors buy stocks, they buy a portion of the company’s ownership. Equity investment represents ownership in a company, and stocks are the form in which equity is traded in the market.

You can buy a stock at a specific price to profit when its price increases over a period. As the company expands its business and witnesses growth in its revenue and profit, its value rises. The best part about equity investment is that you can have a stake in the company’s profit, but your liability is limited to your potion of ownership in the case of losses. This means you can never lose more than your original investment

Options

Options are financial derivatives, which means that they derive their value from the underlying asset. These underlying assets can be in the form of stocks, government securities, foreign currencies, commodities such as agricultural products, or industrial goods. In some cases, stock indices and Exchange Traded Funds can also be the underlying assets. Options allow the investors to buy or sell the underlying asset at a specific price and time. However, there is no obligation to do so. Options trading is done on the securities marketplace among all investors, including institutional investors, professional traders, and retail investors. The trade can be for single or multiple contracts. Notably, all options contracts have expiration dates, which can span across days or extend for years.

One of the most significant distinguishing factors between stocks and options is that stocks represent a part of a company’s ownership. In contrast, options are just contracts offering investors the right to purchase or sell the stock at a predetermined price (exercise price) or date. This date is known as the Expiration Date, and the Price is known as the Strike Price. Options let you bet in the direction in which the stock is proceeding within a certain period.

Let us take an example of a commodity option. A trader buys a call option to purchase wheat at $100 per bushel. If the wheat market price exceeds $100 per bushel, the trader will earn a profit. On the other hand, if the price falls below $100, the trader won’t make a profit, but their loss will be limited to the cost of buying the option.

Types of Options

There are various options based on their characteristics and underlying assets, but broadly, they can be classified into Call Options and Put Options. In this post, we’re going to discuss buying put and call options. Writing options is beyond this post’s scope since it carries significant risks, and it’s not appropriate for an introductory post! With that being said, let’s move on.

Call and Put Options

Call Options

The call option enables the option holder to buy the underlying asset at a particular price (exercise price) on, and sometimes before, the predetermined date. A call option holder speculates that the underlying asset’s price will move above the strike price or exercise price before expiry. A trader buying call options is bullish on the underlying asset. While exercising a call option, there are three situations that you can face in options trading.

  • In the money (Stock price > Strike price)
  • At the money (Stock price = Strike price)
  • Out of the money (Stock price < Strike price)

Put Options

A put option is just the reverse. It enables the option holders to sell an underlying asset at a particular price on or before a specific date. A put option holder expects that the underlying asset’s value to decline compared to the strike price before expiry. In a nutshell, put option holders have a bearish view of the asset. While exercising a put option, there are three situations that you can face in options trading.

  • In the money (Strike price > Stock price)
  • At the money (Stock price = Strike price)
  • Out of the money (Strike price < Stock price)

Investor and Financial educator, Bill Poulos, explains Call and Put Options in a very informative and entertaining way in this video.

American Style Option

This type of option has nothing to do with the location where the trader is purchasing the contract. It is related to the specific terms of the agreement. Usually, an options contract comes with an expiration date at which the holder has to exercise their right to buy (in case of a call) or sell (in case of a put). However, in the American style option, the option holder can buy or sell the underlying asset before the expiry date. This is an added benefit for the holder of the option wherein he is not bound by the expiration date.

European Style Option

European option holders do not enjoy the same privilege as American option holders. They can buy or sell a particular option contract only after the expiry date, not before that. Besides that, there are also a couple of differences between the American Style option or the European Style option.

  American European
Instruments Stocks & ETFs Indexes
Settles to Stock Cash
Settlement price Last closing trade Opening price of index components
Last trading day Third Friday of the month Third Thursday of the month
Expiration Third Friday of the month Third Friday of the month
Exercise Rights Any day On expiration day
Taxes (Consult advisor) 100% short-term capital gains 40% short-term capital gains

Source: Navigation trading

Exchange-Traded Options

These are the most commonly traded type of options. Any option that is listed on a public trading exchange is known as Exchange Traded Option. Such options are accessible to all and can be bought and sold by anyone.

Over The Counter Options

“Over The Counter” (OTC) options are available to a limited public. These contracts are traded in the OTC markets and are slightly customized with more complex terms than most Exchange Traded contracts.

Employee Stock Options

Employee stock options are equity compensation or equity grants that companies offer their employees. It has several characteristics of call options. The employee stock options allow the employee to exercise his right to purchase the underlying asset, in this case, the company’s stock at a predetermined price during a particular period.

This option is usually offered to an employee as a part of his compensation package. These stocks are typically Restricted stock or non-transferable stocks. The conditions for the transfer and use of the restricted stock units are defined in the Vesting Schedule. A vesting schedule is crucial for startups because it mentions how the restricted stock for the founder or employees would be distributed.

Pros & Cons: Option Holder vs. Shareholder

The most significant difference between options and shares is that stocks stand for a portion of individual companies’ ownership. On the other hand, options derive their value from underlying assets restricted to a certain period. They represent contracts with other investors that enable you to speculate on the underlying price movement within a given time period.

In general, it’s the familiar risk-reward trade-off.

Risk-Reward Trade-off

Stock Benefits

Profit Potential

Equities have immense potential to reap good returns. Investors can earn profit from equity trading when the stock price moves upwards. For most investors, it’s best to hold equities over a long time horizon to reap the maximum benefits of compounding. Investors can also receive regular payments in the form of dividends when a company decides to distribute profit.

Hedge Against Inflation

According to Goldman Sachs, over the past 140 years, the average 10-year returns of US stocks was 9.2%. This is much higher when compared to the annualized inflation rate of 2.24% in the United States. This means that if an investor stays invested in stocks, the temporary ups and downs don’t impact overall portfolio returns over the long-term. It helps to generate inflation-beating returns over the long-term.

Benefits From Growing Economy

An expanding economy helps a company to prosper and earn increased profits. This further leads to job creation, income generation, and value addition to society. As the demand for the companies’ goods and services increases, it enhances its revenue and profits. By investing in equities, you will be able to reap the benefits of economic growth and exploit the economy’s expansion and contraction phases.

Ease of Investment

It is near effortless for most to purchase stocks because of the presence of well-regulated stock markets. You can buy stocks through a broker, online, or a financial planner. You just need to open a trading account, and you can start buying shares in minutes. Some newer online portals also offer commission-free trades.

Liquidity

Stocks are one of the most liquid forms of investments. Just like the ease of buying, it is simple for both investors and day traders to sell stocks in the open markets. You can turn your shares into cash in just a few days at low transaction costs. It is advantageous when you need money for emergencies. However, as stock markets are very volatile, early liquidation can also result in losses.

Stock Drawbacks

Risk

If the company you have invested in underperforms, there would be widespread selling of the stock, and its price would plunge. Hence when you sell the shares in this scenario, you could incur massive losses. At times, investors become too influenced by emotions leading to sharp and unjustified fluctuations in stock prices. Hence, as stock market movements are highly volatile and unpredictable, there is always an element of risk associated with equity trading.

Time Consuming

Understanding and valuing equity is not as complicated as options. However, it is still time-consuming. Once you buy the stock, you also have to spend a lot of time monitoring its movements. While most investors adopt a buy-and-hold approach, it is also essential to know when to exit a position or sell a stock to avoid a bad investment.

Residual Claim

On the one hand, equity ownership offers privileges like voting rights, while on the other hand, it assumes a secondary position during the payback time. In an unfortunate event where the company goes into liquidation, preferred stockholders and debenture holders are paid before the equity shareholders.

Options Benefits

Cost-Efficient

Options have a good amount of leveraging ability. The investor can obtain an option position as they can take a stock position but at a much lesser cost. This strategy is also known as the stock replacement and is immensely practical and cost-effective.

For instance, if an investor wants to purchase 200 shares of a $50 stock, she must spend $10000. However, if the investor buys two $30 calls (with each contract denoting 100 shares), the total expenditure would be $6,000 (2 contracts x 100 shares/contract x $30 market price).

Hence we can see the difference in the amount of outlay when we buy stocks and option contracts. However, it is not as simple to execute. You need to choose the correct option to replicate the stock position.

Limited Risks

We mostly think that options trading is riskier than investing in equities, and it is, but if used effectively, some options trading can also mitigate risks. Entering into an options contract demands lesser financial obligations when compared to equities. If you buy a call or put option, there is no obligation for you to complete the trade.

In case your speculation about the direction of the stock or the timeframe is inaccurate, you can still lose only the amount paid for the contract and the fees.

Perfect Hedging Tools

Options are the ideal tools that help you to limit your exposure to unsolicited risk through hedging. Hedging refers to a strategy wherein you can take a position in one market to counter the fluctuations in an opposite position in the same or another market.

For example, if you purchased Twilio early and made a tremendous amount of gains, however, you were afraid of a market crash, instead of selling Twilio incurring large capital gains, you could buy puts instead.

Enhanced Returns

Shares allow you to profit only when the stock price increases or decreases. On the flipside, options enable you to bet on the direction of a stock with significant profit potential when buying out-of-the-money call or put options; although, for most scenarios, this falls into one of the ten most common mistakes for novice options traders.

And smart options players should get rewarded handsomely. They have to be correct on both the direction and timing of the underlying.

Options Drawbacks

Higher Learning Curve

Understanding how to profit from options trading is relatively more time-consuming than stock trading. Many investors get lured into options trading, considering the possibility of excellent gains. However, the nuances of options trading can be slightly complex to understand. It also takes a lot of experience to master the art of establishing the ideal profit-making positions.

Limited Time Horizon

Unlike investing, where you only need to be correct on the company’s value, to profit with options, you have to be right on both the value discrepancy and when the market will appreciate that discrepancy.

Higher Commissions

When compared to stocks, commissions for options trading are relatively high, especially Weekly options. Sometimes, yearly commissions can be as high as 30% of the invested amount. Also, the profit from options trades attracts a high rate of short-term capital gains tax.

Increased Volatility

As options are derivatives of underlying assets, even a minor movement in the underlying price can cause sharp fluctuations in option pricing. To understand the behavior of the options price, traders must understand the price-volatility dynamics. Technically, high volatility is a good thing when it comes to option pricing models; however, for novice day traders and speculators, these shart price moves can lead to mental anguish.

Stocks vs. Options Comparison Table

Factors Stocks Options
Type of investors Beginners and those with a longer investment horizon Active and experienced traders with a profit motive
Duration Short-term as well as long-term Usually short-term
Complexity Long-term equity investment has straightforward principles and approaches. Understanding options trading strategies is relatively more complex.
Time limitation Discretion of the investor. It can be a day-trade or long-term investment for years. Trade has to be executed by the Expiration date. Else, the option becomes invalid.
Basis of Valuation Stock valuation is based on a lot of fundamental factors (qualitative and quantitative) driving the company. Options derive their value from the underlying asset and do not directly depend on fundamental factors.
Nature of investment Equity- May or may not be speculative. Derivative- speculative

The Bottom Line

Whether to opt for stocks or options is ultimately a personal choice and depends a lot on your investment style and objectives. It is difficult to conclude if one is better than the other as both avenues have distinct characteristics. While investing in stock, especially for a longer horizon, is relatively straightforward, Options trading involves specialized strategies.

Most options trading is a highly speculative phenomenon involving significant risk and reward. Before you trade options, you must clarify your investment objectives and why you wish to opt for options trading.

Beginners who wish to adopt a passive investment style may want to start with equity investment. Similarly, traders who want to monitor their trades actively and speculate on the market movement can find derivatives appealing. Though options and stocks have different characteristics and objectives, they can complement each other.

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Leo Smigel

Based in Pittsburgh, Analyzing Alpha is a blog by Leo Smigel exploring what works in the markets.