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Options and stocks are two ways to put money to work in the market, but they offer sharply different profiles for risk and reward. Stocks offer high-risk, high-reward potential, while options take that a couple notches higher, with the possibility to double or triple your money (or more) at the risk of losing it all, often in the matter of a few weeks or months.
Here’s the story behind options and stocks, what they are and what kind of returns they can offer. Plus, we’ll look at a way to invest in stocks that raises your return while reducing your risk.
Differences between options and stocks
Stocks and options are closely related, but they’re very different things, especially when it comes to how much you can make or lose.
A stock is an ownership stake in a company, and it rises and falls over time depending on the profitability of the business. In contrast, an option is a side bet among traders over what price a stock will be worth by a certain time.
Stocks
A stock is a fractional ownership interest in a business and may trade on an exchange. A stock has an indefinite life and can continue to exist as long as a company exists.
In any given year, a stock can fluctuate significantly, but over time its performance should track the growth of the business. If the company grows earnings, the stock will rise over time. If its profit falls, the stock will fall. If the company goes bankrupt, the stock may cease to exist.
Options
An option is the right to buy a stock (or other asset) at a specified price by a specific time. Stock options may trade on a public exchange. An option has a fixed life, with a specific expiration date, after which its value is settled among investors and the option ceases to exist. The value of an option tends to decline over time, all else equal, and so it’s what is called a wasting asset.
Options come in two major varieties, and buyers make a cash payment called a premium to own an option contract:
- Call options allow the owner to buy the underlying stock at a specified price until a specific date. When the stock price goes up, the call option increases in value, all else equal. In general, if you’re buying a call option, you expect the stock price to rise.
- Put options allow the owner to sell the underlying stock at a specified price until a specific date. When the stock price goes down, the put option increases in value, all else equal. In general, if you’re buying a put option, you expect the stock price to fall.
The table below summarizes some of the key differences between stocks and options.
| Characteristic | Stocks | Options |
|---|---|---|
| Potential upside | High | Very high (and quickly) |
| Risk | High | Very high |
| Lifetime | Potentially unlimited | Limited, no more than about two years for public options, but often weeks or months |
| Brokerage commissions | No commission at major online brokers | $0.65 per contract is typical, though some brokers charge no commission |
| When you can trade | Any time the market is open | Any time the market is open |
| Tax | Can be taxed at short-term or long-term capital gains rates, depending on holding period | Can be taxed at short-term or long-term capital gains rates, depending on holding period |
The pros and cons of stocks
Having an ownership interest in a company via stock offers many benefits, but also some drawbacks.
Advantages of investing in stocks
- Stocks can deliver potentially high returns with reduced risk, if investing in a diversified portfolio of stocks, such as an index fund based on the Standard & Poor’s 500 Index.
- Stocks have a potentially infinite lifetime, since the stock can continue to exist as long as the company remains afloat.
- Stocks can pay dividends, and the best stocks grow their dividends each year, putting more cash into your pocket over time.
- A company may be acquired at a substantial premium to its market value, rewarding those who own the stock.
- Major online brokers have reduced trading commissions to zero, so it’s cheap to buy and sell stocks.
- Publicly traded stocks are usually highly liquid, and you can exchange them for cash on any day the market is open.
- The IRS provides a potential tax break for investing long term in stock, reducing the maximum capital gains tax rates if you hold an investment for longer than a year.
- Stocks can be packaged in exchange-traded funds (ETFs) or mutual funds, providing an easy way to invest in a diversified portfolio, often at a low cost.
Disadvantages of investing in stocks
- Stock prices can fluctuate significantly from year to year, meaning you may not be able to sell a stock for any given price or even what you paid for it.
- Stocks are not guaranteed by the government, so you could lose all your money, especially if you pick the wrong individual stocks.
- Stock prices depend on the performance of the company, so over time the stock will track the company’s growth. So you have to own the right companies to succeed.
- It takes a lot of effort to analyze individual stocks and understand where there could be opportunity or risk.
- While you may pay lower taxes for holding a stock for more than a year, you’ll still have to pay taxes on any gains, though you do get a tax write-off if you lose money.
The pros and cons of options
Options generally are a higher-risk, higher-reward opportunity than stocks. Investors considering them should know all their benefits and drawbacks.
Pros of options trading
- Options can deliver very high returns and do so over a very short period of time, using the power of leverage to turn a relatively small sum of money into many times its value.
- While stock prices are volatile, options prices can be even more volatile, which is part of what draws traders to the potential gains from them.
- Options are generally risky, but some options strategies can be relatively low risk and can even enhance your returns as a stock investor.
- Like stockholders, owners of options can enjoy the potential upside if a stock is acquired at a premium to its value, though they’ll have to own the options at the right time.
- Major online brokers have reduced options commissions, and a few brokers even allow you to trade options at no cost.
- Options are liquid, meaning you can exchange them for cash at any time the market is open, though there’s no guarantee that you’ll get what you paid for them.
- It’s possible to qualify for lower long-term capital gains tax rates with longer-term options (those held for at least a year), though they’re not offered on all stocks.
Cons of options trading
- Not only does your investment thesis have to be right, it also has to be correct in the right time period. A stock that rises after an option’s expiration is meaningless to the option.
- Options prices can fluctuate significantly from day to day, and price moves of more than 50 percent are quite common, meaning your investment could decline in value quickly.
- Options are not guaranteed by the government, so you can lose money on them.
- Depending on exactly how you use options, you can lose more than you invest in them.
- Options are a short-term vehicle whose price depends on the price of the underlying stock, so the option is a derivative of the stock. If the stock moves unfavorably in the short term, it can permanently affect the value of the option.
- Options expire, and when they do, the opportunity to trade them is over. Options can expire worthless – many do – but traders can’t buy and hold options for long periods, as they can stocks.
- Options may be relatively more expensive to trade than stocks, though investors can find no-cost options brokers.
- Options are not well-suited to be packaged in an ETF or mutual fund.
Which is better for you?
Stocks and options can both be viable investing choices, but each works better in different scenarios:
When stocks are better
- You have at least some experience investing in the market, preferably a lot. Stocks require analysis and work, but options require even more. ETFs or mutual funds composed of stocks are better choices for beginning and even intermediate investors.
- You want to invest for the long term. Stocks can go up a lot over the long term, but sometimes you have to ride out downturns, and the short-term nature of options means an option can expire before the stock price moves in a favorable direction.
- You don’t want to follow the market super closely. While stocks require you to monitor them at least some of the time, it can be much less than the amount required by options – which expire on a fixed schedule.
- The stock is volatile. If you believe in a stock long term but it’s volatile, options prices will be high and it’s easy for options to expire worthless. Stock gives you a permanent stake, but you’ll have to ride out the ups and downs, and you can’t do that with options.
When options are better
- Options can be a better choice when you want to limit risk to a certain amount. Options can allow you to earn a stock-like return while investing less money, so they can be a way to limit your risk within certain bounds.
- Options can be a useful strategy when you’re an advanced investor. Experienced investors know how to limit their risk and they understand the risks they’re running when they use a given options strategy.
- Some options strategies can allow you to buy stock at better prices. For example, a strategy such as writing puts allows you to collect a premium for the potential to buy a stock at a lower price. Used judiciously, this strategy can help boost your overall returns.
- Options allow you to multiply your money at a much higher rate. You can make a much higher return using options, but you run the risk of a complete loss if you’re wrong.
- Options can allow you to generate income. Some stockholders sell call options against their stock positions or write put options as a way to create income. Such strategies can be attractive and relatively low-risk ways to use options.
ETFs can be an even better choice than individual stocks
For all but advanced investors, stocks are probably the better choice than options at all times, but an easier way to buy them is through stock ETFs. You’ll get diversified exposure to a stock portfolio, reduced risk and the potential for nice returns. ETFs serve beginning and intermediate investors well, but many advanced investors opt for ETFs, too, because of their simplicity.
With each share of the fund, an ETF allows you to own (indirectly) a piece of each stock in the fund. ETFs also allow you to buy a stake in the Standard & Poor’s 500 Index, a collection of hundreds of America’s best publicly traded companies. Over time, the index has returned an average of about 10 percent annually to investors who have bought and held.
In fact, buying an S&P 500 index fund is what legendary investor Warren Buffett recommends for most investors. Then he advises them to stay the course and keep buying when they can.
Bottom line
Stocks and options may offer drastically different returns and risks for investors, and those investing in either should understand how they work before getting involved. For as risky as stocks are – and make no mistake, they are – options can be even riskier.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
