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Stocks and options present distinct paths to get exposure to the stock market, but these two asset classes work in very different ways. Let’s review the key differences between stocks and options, and take a closer look at their advantages and disadvantages.
Stocks vs Options: What’s the Difference?
When you buy shares of stock, you acquire an ownership stake in a public company. Depending on the stock, you may get dividend payments and the right to vote at company meetings.
Options are derivative contracts based on a variety of different underlying assets, including stocks. Option contracts help you attempt to profit from price gains or losses—but when you buy options, you’re entering a contract rather than buying shares of stock.
When you buy stock, you become a shareholder in a public company. If the company performs well and its stock gains in value, you benefit from appreciation. Some companies pay dividends, which provide you with cash flow in addition to appreciation.
It’s pretty easy to buy stocks, thanks to low-cost investment apps and online brokers. Fractional shares let you buy stock in very affordable increments, and most brokers have completely eliminated trading commissions on buying or selling stock.
Stocks can be good long-term investments. While prices may rise and fall in the near-term, the stock market trends higher over time. Stocks have historically returned 10% per year, or 6% to 7% after inflation.
Short-term volatility makes stocks best suited to investors who are prepared to hold onto their shares through any bumpiness. A good rule of thumb is to only use stocks for financial goals that are five or more years in the future.
Investing in stocks can also appeal to day traders hoping to make a quick profit, but this is a risky strategy. To be successful as a day trader, you need to know the right time to both enter and exit the market, something which is nearly impossible to do consistently.
With day trading, you need to constantly monitor stock prices and be ready to jump in or out of the market at any time. Long-term investing is less complicated, requiring only periodic check-ins to make sure your portfolio isn’t out of balance.
Advantages of Stocks
- Long-term growth. The stock market averages 6% to 7% real return.
- Easy to understand. Unlike some other asset classes, stocks are fairly simple to understand.
- Simple to buy. Fractional shares and zero commissions make it easy to start investing in stocks.
Challenges of Stocks
- Risky asset class. Investing in individual stocks exposes you to the risk that the company won’t do well and your stock will lose value.
- Due diligence required. It takes time and effort to learn about the stock market before you start buying. You also need to carry out thorough research on the individual stocks you intend to buy.
- Ongoing portfolio maintenance. Your stock portfolio needs to be monitored regularly to make sure it remains aligned with your goals. Selling off losers and picking new stocks is an ongoing job.
Options are referred to as derivative contracts because they derive their value from another asset, such as a stock, a bond, a commodity or a currency. Traders use options to speculate about the future direction of asset prices.
Options contracts give an investor the option to buy or sell an underlying asset at a predetermined price—the strike price—within a certain time period.
You pay a fee—called a premium—to purchase an options contract. You could pay a $50 premium, for example, to purchase an option that lets you buy 100 shares of company ABC at a price of $50 per share until its expiration date three months in the future.
An option to buy stock is called a call option, while an option to sell is a put option. Here’s a helpful mnemonic: Think of calling on someone to buy their car versus putting up your own car for sale.
Here’s how options work: If you think shares of ABC will be worth more than $50 per share at some point in the next three months, you’d buy the option contract mentioned above. However, if you think ABC will likely decline in value over the next three months, you’d buy a put option that lets you sell the stock for $50—even when it’s worth less in the market.
Put options are also often used to hedge a portfolio position. If you own 100 shares of ABC stock, you could buy a put option that will ensure you can sell your shares for at least $50 per share over the next three months, thus minimizing your downside exposure until the option expires.
A key distinction between stocks and options is that options have a preset expiration date, which can range from one week to several years. So while you could buy a stock today and theoretically hold it in perpetuity, watching its value hopefully rise over time, an option contract becomes worthless after its expiration date.
Options require even more attention and research than stocks. You need to diligently monitor the price fluctuations of the underlying asset to determine if and when you should exercise the option before it expires.
They can also be deceptively costly, since you pay a premium for every new contract you buy. If you aren’t making money on your options contracts, these premiums could really add up, becoming a drag on your investment returns.
Advantages of Options
- Easy leverage. Options are a common way to get leverage: Invest a small amount of money in exchange for a large potential return.
- Hedge your bets. Options can be used to hedge a stock position against future losses.
- Inexpensive speculation. Options can be used to speculate on the direction of a stock price without needing to own the stock itself.
Challenges of Options
- Very high risk. Leverage increases your risk, making it easier to lose your entire investment.
- Short-term exposure. Most options contracts expire in days or months. Costs can really add up if your options strategy is not sound.
- Require lots of attention. Options require you to be constantly monitoring and managing your portfolio.
Stocks vs Options: Which Should You Buy?
Most long-term investors never need to consider using options contracts. Buy-and-hold investing is about uncovering growth stocks or value investments that can be held over long periods of time.
Even then, some long-term investors use options contracts to minimize risk via hedging strategies. A well-deployed options strategy can protect a buy-and-hold stock portfolio from temporary declines in the overall stock market.
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