Last updated on February 11th, 2022 , 09:34 am
Comparing stocks to options is like comparing apples to oranges. They are completely different types of securities.
If you own a share of a company’s stock, you own a portion of that company. This comes with added benefits and rights, such as dividends and voting rights. Stock ownership is referred to as “equity“.
Options are “derivatives“, meaning their value is derived from that of an underlying stock (or ETF, or any asset, for that matter). They have nothing to do with the company – think of them as “side-bets”.
Let’s take a look at a few key options characteristics before we move on.
One options contract typically represents 100 shares of stock. This is known as “leverage” and has the potential to magnify both profits and losses quickly.
All options are either calls or puts. A long call position is bullish, while a long put position is bearish. In both types of these options contracts, a “strike price” and an “expiration date” are set.
Unlike stock, all options will eventually expire.
An options “moneyness“, (which tells us where the options strike price is in relation to the stock price) at expiration will determine whether a contract has value or not.
Stock is generally a longer-term investment. Options are shorter-term trades.
TAKEAWAYS
- For long-term investors, stocks are almost always the better option.
- Like stocks, options contracts can be bought or sold. The holder (owner) of an option contract has the right to either purchase stock (calls) or sell stock (puts) at the contract’s strike price.
- Options are usually leveraged at a ratio of 100:1, meaning one contract represents 100 shares of stock. This leverage increases risks.
- Most (not all) stocks pay dividends. Options do not pay dividends.
- Both options and stocks are considered high risk. However, certain options trading strategies have considerably more risk than stocks.
Options vs Stocks
| STOCKS | OPTIONS | |
|---|---|---|
|
Ownership |
Represent direct ownership in a company; can vote and receive dividends |
No direct rights, but long options holders have the right to convert their contract to either long stock (calls) or short stock (puts) |
|
Multiplier Effect |
One share represents one indivisible unit of capital |
One options contract typically represents 100 shares of stock |
|
Expiry |
Shares of stock (equity) never expire |
ALL options contracts have an expiration date, ranging from one day to years away |
|
Security Style |
Stocks are generally long term investments |
Options are generally short-term trades |
|
Risk |
Medium to High Risk |
Generally high risk, but this depends upon the options trading strategy utilized |
This article looks at the main differences between stocks and options. In order to truly understand these differences, you must understand the mechanics of options trading, which can take some time.
The good news? projectfinance has created perhaps the most intuitive guide out there to aid you in this process. Check out our, “Options Trading for Beginners” guide here.
For those ready to move forward with the comparison between stocks and options, let’s get right to it!
1. Ownership: Stocks vs Options
Let’s start off with one of the major differences between stocks and options: Ownership.
Ownership Rights in Stock
When you own shares of a company’s stock, you own part of that company. Being an owner comes with its benefits. Here are a few perks that come with owning equity in a company:
- Right to inspect company records and books
- Right to vote on directors and major corporate decisions (mergers, etc)
- Right to Transfer your stock ownership
- Right to receive dividends declared by the board
Perhaps the most important right on this list is the ability to receive dividends. You may not want to spend your weekends digging through the payrolls of a company of which you own 10 shares of stock, but you’ll probably want to receive that dividend.
Though dividends may seem small on paper, they really add up over time! In fact, over the past 20 years dividends have accounted for 43% of the S&P 500s historic return! Take a look at the below image from BNY Mellon.
Data from BNY Mellon Investment Management
IMPORTANT! Not all companies pay dividends! Up-and-coming growth companies tend to invest superfluous income back into the company rather than distribute it to shareholders.
Ownership Rights in Options
Options Contract Definition: An options contract gives the owner the right to purchase (call) or sell (put) 100 shares of a company’s stock at a specified price (strike price) by a predetermined date (expiration date).
Traders’ long options contracts have none of the four rights listed above for stock investors. In a company’s eye, options traders do not exist.
Why?
Options contracts are “derivatives.” These contracts are exchanged between market participants who are not involved with the company. As we saw in the definition, options contracts give the holder the right to either buy (for call options) or sell (for put options) shares of the underlying stock at a specific price by a specific date. When this happens, it is called “exercising” your option.
When a long call is exercised, it is typically transferred into 100 shares of long stock. When that happens, you have all of the rights listed above. But before this transformation occurs, you will have zero rights.
Put options, however, are transferred into short stock. Short stock (like options) has no rights.
2. Multiplier Effect: Stocks vs Options
We mentioned in the above paragraph that an option contract represents 100 shares of stock. Let’s take a closer look at that now.
Multiplier Effect in Stock
One share of stock represents one divisible unit of capital. If you want to determine what percent ownership a single share of stock represents in a company, simply divide one share of stock by the total share of stock that the company has outstanding.
Multiplier Effect in Options
One options contract almost always represents 100 shares of stock. This produces a ratio of 100:1.
You may have heard that options trading is a risky business, and you’d be right. Because of this multiplier effect, options contracts have profound leverage.
If a stock is trading at $50/share, it will cost you $50 to purchase one share.
If an options contract is trading at $2, it will cost you $200 to purchase one contract. Why is this? Because of the multiplier effect of 100! Therefore, in order to determine the true cost of an options contract, you simply need to move the decimal point of the quoted price two places to the right.
3. Lifespan of Stocks vs Options
Next up, let’s take a look at the different lifespans of stock and options.
Stock Lifespan: Potentially Infinite
Stocks have no listed expiration date. Over time, most companies will eventually go bankrupt, merge, or get bought out, but these events are often unseen. Some companies have been around for a very long time. State Street Corporation, for example, has been around since 1792!
Options Lifespan: Finite and Predetermined
Unlike stock, every single options contract has a predetermined expiration date. If by this date your long call or put option is “out-of-the-money”, it will expire worthless and you will have lost the entire premium paid.
As time passes and the underlying stock price drifts away from the strike price of an options contract, time decay will set in. This is known as “theta”, and is the reason why most beginner options traders are unsuccessful. Theta is one of the option “Greeks” which traders use to help manage risk.
It is true some options contracts are more long-term, with Long-Term Equity Anticipation Securities (LEAPS) having lifespans of more than two years. However, no option contract spans centuries, like many stocks do,
4. Investment Style: Stocks vs Options
Stock traders and options traders frequently have different investment philosophies.
Stocks Are Investments
Generally speaking, the mindset of stock investors and options traders is vastly different. Most people who purchase stock do so with the intent of holding the position long-term, riding the ups and downs of the company’s profits and losses, hoping, somewhere down the road (maybe years), to sell that stock for a profit.
Stock inventors generally utilize the “set it and forget it” method. After purchasing a stock, they don’t have to check the position every day, nor do they have to manage it. They just sit back, collect dividends (sometimes), and hope the price appreciates.
Option Are Trades
This is different for options traders. Why?
We mentioned before that all options have a strike price and an expiration date. If the underlying price moves away from an options strike price, a trader will need to take maintenance action to 1.) avoid further losses or 2.) avoid being “assigned” (for short options positions).
Over the long run, stock investors tend to outperform options traders. However, this isn’t always the case. The success of an options trader depends dually upon that trader’s savviness as well as a certain amount of luck.
Why luck?
Generally speaking, we have a better idea about what is going to happen to the price of a security over the long term. If you believe in Apple, buying shares of AAPL may very well pay off in the long-term. But what’s going to happen tomorrow at AAPL headquarters? Nobody can foresee this.
Because stocks don’t expire, they have the ability to ride out short-term volatility. Options? Not so much.
5. Risk: Stocks vs Options
Last up, let’s take a look at the fundamental risk profiles of both stocks and options.
Stocks Are High Risk Investments
When compared to treasuries, bonds, and money markets, stocks are considered risky assets.
So stocks are indeed risky. When you diversify your stock positions across numerous companies, however, this risk can be mitigated. Exchange-traded funds (ETFs) offer a great way for investors to diversify.
However, everything is relative. When comparing stock investing to popular options trading strategies, the former is indeed less risky in nature.
Options Are VERY High Risk
Options trading is an intricate and complicated world. There are indeed options trading strategies that you can put together that lower your overall risk when compared to stock. But this article is focused on the more popular strategies such as buying calls and puts.
When compared to buying stock, buying options is riskier.
This is a wide assumption and made from an “overall” viewpoint.
In theory, however, options typically have less principal risk than stocks.
Why?
A call option on AAPL is going to cost you a lot less than buying 100 shares of AAPL stock (which is the amount one options contract represents). Therefore, your total principal risk when trading options is less than that of stock! Check out the graph below, which shows how the max loss on stock is greater than a call option (where you will only ever lose the premium paid).
However, over time, time decay (AKA “theta“) sets in, and long options often lose money. AAPL stock probably won’t go to zero; an out-of-the-money call bought on AAPL, on the other hand, probably will go to zero.
Additionally, notice in the graph how the stock needs to move up quite a bit for a long call to breakeven (yellow dot). Breakeven here is determined by strike price + premium paid.
With stock, breakeven occurs the moment you purchase (or sell) the security.
Final Word
Buying a share of stock is one of the simplest ways to invest. You click a mouse button, and voila, you’re filled. All you need to do is (hopefully) collect dividends, and wait for the price to appreciate.
Options trading can get extremely complicated. Huge sums of money are made and lost every day in the options markets. If you’d like to learn more about options trading, check out our guides below!
