Options Vs Stocks: Definitions, Differences, Similarities.
Options and Stocks are popular terms in the investing world. If you’re an aspiring investor or you’re interested in investing, you should know the right investment to make in the marketplace via stocks and options. Most of us have first hand knowledge of stocks and options. Ask someone what “stocks” and “options” are and you’ll probably get a fairly good answer. Yes, options may denote choices but in the investing world, it’s far more than that. In this article, we’ll take a closer study at the popular comparison Options vs Stocks. We will try to examine the differences and similarities that exist between them and know how to make the right choice. So, let’s dive in!
What are Options?
Options are financial instruments which belongs to a group of securities known as derivatives. In other words, options are asset class which are dependent on the value of underlying security like a bond or a stock. Options grants you the right to purchase or sell a stock or asset without being under any obligation so long you adhere to the rules of the option contract.
Before buying an option, there are factors to be considered. These include the following:
1. The Strike Price
This is the predetermined price at which an underlying security or commodity can be bought or sold when it’s exercised.
2. The Expiration Date
Option contracts can last for a given period time. They can last for two, four, twelve months depending on the expiry date. For options, the time frame for investment is relatively shorter thus making them more appealing for traders who often buy and sell. The value of an option will decrease over time at a proportional rate the closer it get to the expiry date.
3. The Premium
The price of an option contract is known as premium. Options contracts are usually composed of 100 shares of underlying security. The buyer pays premium fees for all contract. For instance, if the premium of an option is 65 cents per contract, the purchase of one option would cost $65 ($65 x 100 = $65). Note: If an option’s expiration date is further away, the premium cost gets increased.
Looking for a prudent way of investing, one which offers flexibility in terms of timing and smaller investment benefit? Options might just be the right one for you.
Advantages of Options
Though options have been around for years now, it’s just getting the much needed attention. Initially, many investors didn’t want to venture into options; they believed options was sophisticated and risky, all thanks to the financial crisis of 2018. Options are quite advantageous to an investor. Here’s a few of them:
Less Risk: Buying options are safer than owning equities because less financial commitment is needed compared to equities. Options are the most reliable form of hedge thus making it less riskier than stocks. Purchasing an option helps to reduce potential losses when the value of the stock declines. According to Wade Guenther, a portfolio manager at Horizons ETFs Management, the option premium is analogous to insurance premium.
Leverage: The capital requirement of options is less than of stocks thereby making options cost efficient and having huge leveraging power.
Higher returns: Options offers a higher percentage return to investors. All thanks to the leverage power of options where you can possibly spend less money and earn same profit.
Flexibility: Options creates for flexibility as you can adjust your strategy to align with your financial goals such as generating monthly income and building diverse portfolio.
Disadvantages of Options
Low liquidity: Due to the various strike prices and expiration dates, options might have low volume except it’s ranked amongst the most popular stocks. Options trading once every few days to weeks will have lower liquidity.
Limited time: The value of options decreases over time as you hold on to them. Options contracts can only last within a stipulated period of time, they can lose worth as the expiration date becomes closer.
Higher spreads: Due to the absence of liquidity, options might have higher spreads. What this means is that an option trade will lead to more indirect costs as you’ll have to let go of the spread when you trade.
Higher commissions: For each dollar invested, options trade will be higher in commission. In situations where both sides of spread are involved, you’ll have to pay higher commissions.
Complex: Most beginners and advanced investors don’t understand options.
What are Stocks?
Stocks are shares of ownership in individual companies. Stocks are bought and sold mainly on stock exchanges, however private sales exist as well and are the bedrock of many individual investors’ portfolios. These transactions have to be in compliance with Government rules and regulations, in order to protect investors from fraudulent system.
When you buy stock shares in a company, you become a shareholder i.e you own part of the company in terms of the number of shares owned. Gaining ownership doesn’t necessarily mean you have control over the company. Instead, you get to contribute in company matters and articulate your concerns on investment returns based on the performance of the company.
As a shareholder, you can vote on company decisions which will be impactful in the nearest future. Decisions may vary from merging with other companies to choosing members for its board of directors. Typically, the more shares you own, the more your opinions are highly revered and accepted.
Are you looking to invest for your retirement or a 5-year goal plan? Stocks are the best investment. According to Aaron Anderson, senior vice president of Research at Fischer Investments, stocks are suitable for beginners and long term investors.
Advantages of Stocks
High returns: Among the various asset classes, stocks have the highest returns. As reported by the Federal Reserve, the past 50 years has seen the stock market growing by an average of more than 10 percent.
Liquidity: There’s always buying and selling of shares in the stock market thus making stocks a liquid investment. Stocks have tighter spreads and are easier to buy and sell compared to options.
Income from dividends: The company distributes a portion of its earnings as dividend to investors at the end of the company’s financial year.
Disadvantages of Stocks
High risk investment: The volatile and fluctuating price of stocks makes it risky. Market fluctuations maybe as a result of factors within the company. If the company performs poorly, investors might panic causing them to sell stocks at inferior prices.
Time: Investing in stocks takes time and adequate patience.The individual will have to research, find a profitable stock and monitor the stock prices.
Stockholders paid late:This is one of the major downside of investing in stocks. If the company liquidates, an investor would not get paid on time until those that are highly ranked gets paid.
Similarities between Options and Stocks
- Both stocks and options are tradeable securities.
- Buyers and sellers of stocks and options can follow transactions and track performance via marketplaces.
- Options and stocks are traded on regulated marketplaces.
Differences between Options and Stocks
- While stocks doesn’t expire, options possess expiration dates which renders them worthless at some point in time.
- Stocks are predominantly business investments which increases over time while options are trading instruments which are dependent on underlying security.
- Buying stocks comes with ownership benefits in the company while options doesn’t come with benefits.
- Stocks are for longer period, usually between 6 to 10 years while options are for shorter time.
- Stocks are mostly used by individual, pension fund managers and traders, while options have limited users like portfolio managers.
The Bottom Line
If you’re torn between options and stocks, you will need to evaluate your financial status and ask yourself these questions:
- Are you interested in a long term or short term investment?
- What is your risk tolerance?
If you can answer both questions correctly it’ll be easier for you to make a better decision.