Stocks and options both involve dealing with company shares and equities, but are two different ways of investing. Between the two, stocks are more straightforward and easier to understand. However, they are less flexible, with lesser avenues for managing risk. Options, on the other hand, are comparatively more complicated, and require some time and effort to properly understand. In exchange, options are much more dynamic and flexible, and allow for more strategies and a greater degree of risk management.
In this article we’ll discuss what options and stocks are, how they work as investments, and which one may be more suitable for you.
Options vs stocks: Which one suits you?
|A type of financial derivative that derives its value from an underlying stock||Stock represents an ownership share in a company, and its value is tied to its performance|
|Higher risk, complex strategies, suitable for more advanced investors||Lower risk, simpler strategies, suitable for investors of all experience levels|
It is important to note that, when trading stocks using Contracts for Difference (CFDs), traders do not own the actual shares of the company. CFDs are contracts between traders and brokers, based on the price difference of the stock from the contract’s opening to closing without physical transfer of shares. As a result, CFD traders do not have any rights of ownership or voting rights in the company, nor are they entitled to any dividends paid by the company.
Are options right for you?
Options are a type of financial derivative that derives their value from an underlying stock. Accordingly, options do not represent direct ownership of shares, and thus do not entitle the holder to shareholder rights, such as dividends. Investors use options – essentially, contracts between a buyer and a seller that specify a strike price and expiry date – to speculate on the price of the underlying stock. Depending on their view of the market, an option trader will buy or sell an option.
There are two types of options – put options, which grant the right to sell shares, and call options, which grant the right to buy shares. Thus, an option trader can choose to: buy a call, sell a call, buy a put or sell a put. By combining these four actions in different ways, options investors can make use of several different strategies that allow them to potentially profit whether the market goes up, down or sideways.
However, knowing which strategies to choose, how to discern market signals, and how to evaluate the worth of a company, are all crucial factors that contribute to success when dealing with options trading. These reasons, coupled with the leveraged nature of options, mean that options are best left to advanced investors with the necessary knowledge.
Are stocks right for you?
Stocks represent shares of ownership in a company. For instance, if you purchase 10 shares of AAPL, you now own a stake in Apple Inc. Share prices are tied to the performance of the company. Should Apple post record profits, more investors will want to own a share of the company – this increased demand drives up the price of AAPL, which benefits existing stockholders.
Similarly, should Apple have a bad quarter and suffer a drop in revenue, shareholders are likely to start selling their AAPL shares, which causes the price of the stock to fall. For stock CFDs, traders are instead trading on the price difference between the stock from the contract’s opening to closing, without any physical transfer of the actual shares.
As an investment, stocks are much more straightforward than options. The gist of it is to buy into valuable companies and sell the stocks for a profit when they grow in price. When the price of a stock drops, investors can choose to sell off some of their holdings and take profits (provided they bought at a lower price) or continue holding the stock in the belief that the price will recover or reach a higher point. More sophisticated investors may short a stock to potentially profit from the drop in share price.
Similarities between options and stocks
They both deal in company shares
Options and stocks both deal in company shares. The price of an option contract is based (in part) on the price of an underlying stock. Hence, options contracts rise and fall in value according to the movement of stock prices. Meanwhile, with stocks, the price of the stock represents the value of your holdings. Your investment portfolio thus rises and drops in value according to the stock price of the shares you are trading.
Because of this, options and stocks both require an ability to accurately evaluate companies for their potential to grow and provide value. This means whether you’re investing in options or stocks, you’ll need to learn investing skills such as fundamental analysis and technical analysis.
They both use long-term and short-term strategies
Investors can use long-term and short-term strategies for options and stocks, according to their investing timelines and objectives. Options are often traded with shorter timelines (such as monthly or weekly), but you can also choose options with expiry dates several months or years out. The same applies to stocks as well, where traders are also able to use short-term strategies such as day trading to capitalize on the stock price movements over the day.
For long-term strategies, such as swing trading, traders aim to create trading opportunities based on the market movements of the stock price over a period of days or weeks.
They offer trading opportunities in bullish and bearish markets
Stocks and options can offer trading opportunities in both bullish and bearish markets, although you’ll need to choose the right strategies in order to succeed. Just like how you can purchase a stock at a low price and potentially make a return when it reaches a high, you can also buy a call option when the stock is undervalued, and similarly make a return when the stock price rises.
Differences between options and stocks
Options offer greater capital efficiency compared to stocks
One major reason why investors may use options is to achieve greater capital efficiency. You can use an option contract to potentially benefit from the price movements of a stock, without putting up as much capital required for directly owning the stock. In effect, this means you can open a position with lesser capital involved, which translates to a greater return on investment should the trade go your way. If the trade goes against you, your losses are also capped to a smaller amount. See the trading examples below for a further illustration of how this works.
Do note that despite this property, options themselves are not leveraged, and neither are you required to trade them using leverage.
Options have an expiry date, while stocks do not
A significant difference between options and stocks is that the former has an expiry date, while stocks do not. Recall that an option is essentially a contract between a buyer and a seller, who agree to undertake a certain action should the stock price reach a certain level. The contract lasts until the stipulated expiry date. What this means is that you cannot hold an options contract forever; there will come a time when the contract expires and the relevant outcome – determined by the stock price at the time – will come to pass.
In contrast, stocks CFDs do not come with an expiry date. Once purchased, they are yours to hold until you decide to close the trade position. Whether the stock price rises or falls, there is no predetermined expiry date affecting your holding period.
Trading example: options vs stocks
Let’s run through a hypothetical trading example to compare investing in options vs stocks. Here are the assumptions:
- Stock symbol: ABC
- Stock price: $100 per share
- Investment timeline: 1 year
Opening the trade
Do note that when traders are trading CFDs, there might be extra charges from the broker for holding a position overnight. It’s important for traders to understand the charges that might be incurred before trading any CFDs for the long-term. For this example, we will ignore these charges and focus on the basic aspects of stocks CFD trading. The first step is to buy 100 shares of ABC Co. to open the trade. If you bought the stock CFDs directly, you’d need to spend $100 x 100 = $10,000
If, instead, you decide to use an option, you can purchase a call option with a strike price of $100, expiring in 1 years’ time. This means you can purchase 100 shares of ABC stocks at $100, at any time before the expiry of the contract, no matter what the stock price might be.
The call option costs a fraction of what you pay for the stock; let’s say around $1,200 for our example. Also, each option contract always represents 100 shares, which means in this example, purchasing 1 call option is equivalent to purchasing 100 shares of ABC stock.
When the stock price goes up
One year later, the price of ABC has risen to $120 per share. Let’s see what happens to our positions. If you had purchased the stock CFD, your portfolio would now be worth $120 x 100 = $12,000. Hence, your profit would be $12,000 – $10,000 = $2,000. If you had purchased the option contact, your profit would be ($120 – $100) x 100 – $1,200 = $800.
When the stock price goes down
What happens when the stock price goes down – let’s say to $75 at the end of the year? In this case, if you bought stock CFD, your portfolio would now be worth $75 x 100 = $7,500. This is a loss of $2,500. And here’s what happens if you use an option instead. At expiry, the price of ABC is $75. This is below your call option’s strike price of $100. Your option would expire worthless, and you would lose the entire sum you paid for the option. Hence, your loss in this case is $1,200.
Which one gives you a better return on investment?
|ABC price went up||Profit: $800 ROI: 66.67%||Profit: $2,000 ROI: 20%|
|ABC price went down||Loss: $1,200||Loss: $2,500|
As shown in the table above, using a call option requires significantly lower capital compared to straight up purchasing the stock. While the profit made on the trade is smaller, the ROI is much better, given the smaller capital involved. Also, should the stock price fall lower at expiry, you’d lose 100% of your premium. However, if you held stock, the same degree of price drop would result in a much larger loss in dollar terms – over two times more in our example.
Options, a better way to invest in the stock market?
While the figures used in our hypothetical example above are estimates, they illustrate differences between using options to invest and buying stocks CFDs outright. Whether you should choose stocks or options will ultimately depend on your investing goals and personal preferences.
No matter what you choose, be sure to arm yourself with the necessary knowledge before jumping in. Start your trading journey with a live trading account now to trade stocks using CFDs.