Options vs. Stocks: Which Is Right for You?
If you have some money that you are looking to invest in something, you might have to make a few choices rather shortly. For example, if you are a beginner, or you plan to invest long-term, you should definitely consider investing in stocks.
However, if you have some experience, you wish to make a short-term investment, and do it for a lower amount of money, then it might be worth considering options, instead.
These two types of investments are similar in some ways but quite different in others. You may invest in one, the other, or both, depending on what type of trader you are, which approach you may like best, but also how much money you have at your disposal.
But, if you are still trying to make up your mind regarding what to do, and you wish to know which is better, stocks or options, then let's take a look at what each of them are exactly, how do they compare, their advantages and disadvantages, and more.
Stocks vs Options
The best way to start is to look into stocks and options alike, and ensure that we know what they are and what investing in them means.
Stocks are perhaps the most straightforward asset you can invest in. They represent shares of ownership in individual firms. Of course, there are alternatives, such as mutual funds, where you invest in entire groups of different firms' stocks at once.
Mutual funds are typically considered safer, as the chances of all stocks in the same group seeing a price drop simultaneously are quite low. It can still happen, of course, if there is a market-wide price drop, but on the whole, this is not something that happens every day.
Individual stocks, however, can move up or down depending on a number of factors, such as the company's roadmap, decisions, shareowners' views and feelings regarding the firm, the quality of the firms' products or services, geopolitical situation, historical performance in certain moments of the year, and more.
But, in the end, it all comes down to you wanting to invest at a certain price, and see that price go up over time. That way, when you decide to sell the purchased stocks, you will get more than the amount you originally entered the market with.
As mentioned earlier, this is the simplest approach to investing. There is more to it than just this, of course. You should also keep in mind the cost of buying and selling stocks, taxes on your profits, and similar expenses.
Who should invest in stocks?
Stocks can be volatile, meaning that their prices can go up or down, sometimes over long periods, or more rarely, in sudden waves that can cause the stock to jump or drop more strongly. This is often caused by specific events.
But, the best reason you may have to invest in stocks is that you wish to go for long-term investment — one that may last for years on end. This would be a good idea if you want to invest in something and ensure that you will see strong profits by the time you retire, which can be decades from now.
But, you don't have to necessarily wait for that long — you can sell the stocks in a year, or two, or five, or ten. You can go for longer than that, shorter than that, or any point in between. It solely depends on you.
In the meantime, some shares that you buy might pay you dividends. Since you bought some firm's shares, you are its partial owner, and thus, you are entitled to a portion of its profits. This is not the case with every stock, but in some cases, you will be paid a certain amount, so keep that in mind, as well.
Stocks are also great for beginners due to the very same simplicity mentioned earlier. This was best explained by Fisher Investments' senior VP of research, Aaron Anderson, who said: "The beauty of investing in stocks is simplicity: You buy a stock, betting its price will rise so you can sell at a higher price."
Naturally, there are risks, even with stocks. The company you invested in can go bankrupt and shut down, in which case your investment will fail entirely, and you won't get your money back. The odds of this are slim if you invest well, but it can still happen. Alternatively, the stock price may drop for some reason, and when you sell your shares, you would end up having less money than you did at the start.
This is why you should still keep an eye on the stock price's performance, but you don't have to do it daily.
On the other hand, we have options. Investing in options is great for those who are looking for a more dynamic, as well as a more tactical approach to investing. You don't have to hold them for years in order to benefit from price growth.
With that said, you can also go for day trading stocks, but we mentioned that their price is not usually that volatile that daily moves could make you a great amount of money. With options, however, you can see decent earnings while trading short-term.
In a way, investing in options is still close to investing in stocks, although you don't buy companies' shares directly. Instead, you are betting on which way the price is going to go.
This provides you with greater flexibility than stock trading, as you get to earn money regardless of whether the price goes up or down — as long as you were able to predict the movement accurately enough.
When it comes to stock investing, your goal is to find and invest in the company that you believe has the greatest potential to go big and invest as much money as you can into its shares. Of course, this is only in theory. In practice, you should diversify your portfolio and play it safe, rather than put all of your eggs in one basket.
However, when it comes to options, you really need to ask yourself three questions:
- Which way is the price going to go?
- How far up or down it will go when it starts moving?
- When will it move?
As you can see, this is a bit more complex, as you need to be able to predict what will happen with greater accuracy. Not to mention that options do have an expiration date. However, the good thing is that you can choose to exercise them before they expire, at any time you want. This lets you react to the price movement, but it also means that you need to keep an eye on the market and track its performance more regularly.
Who should invest in options?
As mentioned, the time period associated with investing in options is much shorter, and there is, in fact, an expiration date. This makes options quite attractive to those who regularly trade, as opposed to those who can just invest into something and forget about it for the next several years, or even decades.
As for how long you will have, that depends on you. An expiration date can range from days to weeks, months, or even years. As you can see, there is a certain amount of flexibility to it, and you don't even have an obligation to buy or sell actual stocks.
Of course, it should be noted that this is only the simplest explanation of how it all works. There are also various strategies that can improve your odds of making a decent profit, as opposed to losing your investment.
Furthermore, you will also have to expand your vocabulary to include various terms, such as calls, puts, strike prices, and more. Next, there are trading costs, the premium you have to pay, and you also need to keep taxes in mind here, as well. On the positive side, options can be used as a type of insurance for long-term investors, as they can be used as a hedging device.
Are there advantages to trading options over stocks?
When it comes to which is a better approach, that is not really something that we can answer, as both have their fans, and they both offer a great way to make a profit.
With that said, one can be better than the other for specific people, depending on their trading style. Stocks are overall a good way to invest some extra money and forget about it, and as such, they are great for active and passive investors.
However, if you want to diversify your portfolio further, you can invest in stocks, and then go for options with some extra money.
There are benefits that make options worth considering in addition to stocks, such as:
1. Greater cost-efficiency
As mentioned, options have excellent leveraging power, and you can take a position similar to stocks, but make great savings along the way. For example, if you were to buy 200 shares of a stock that costs $80, you would have to pay $16,000.
Alternatively, if you go for options, you can buy two $20 calls, where each of them would represent 100 shares. This route would cost you only $4,000 as you would buy 2 contracts for 100 shares each, and at a market price of $20. That would leave you with $12,000 that you would have, otherwise, spent on buying shares.
Naturally, you also need to pick the right call in order to have it pay off, which does bring certain complexity to the move, but overall, it is much cheaper to go for options than stocks themselves.
2. Reduced risk
This is a bit more complex matter, as buying options can come with more or less risk than owning shares, and it all comes down to how you choose to use them.
Obviously, the reduced risk comes from the fact that you invest less money, as explained in the previous segment. However, they are also safer due to the fact that they are the most dependable form of a hedge. You can increase the security of your investment by placing stop-loss orders and thus protect yourself from large losses.
3. Earn greater profits
As we have seen so far, you can make almost the same profits with options as you would with stocks. Meanwhile, you need a lot less money for options, which means that, if you are willing to use the same amount for options than what you would for investing in stocks, you could, theoretically, make a lot more money a lot quicker.
Of course, your potential profits and your real profits do not necessarily have to be the same. If you make the wrong choice while investing, you could easily lose your money, instead of having excellent returns on your entire investment. This is why you need practice, experience, information, and deep knowledge of how the market works before you start investing thousands of dollars into options, or stocks, for that matter.
This is a risk vs reward type of thing, and options do provide greater rewards, but at greater risks. For example, if you buy shares, you will only lose 100% of your investment if the company goes bankrupt and there are no assets left. This rarely happens, so the worst-case scenario is that you will sell your shares at a somewhat lower price than what it was back when you bought them.
This will result in losses, but you will get some money back. When it comes to options, on the other hand, you are guaranteed to lose your entire investment if the option expires and you don't sell it or exercise it. To mitigate this, you should decide on what your investment objectives are, and try to meet them. Choose a strategy, and stick to it, no matter what.
If it ends up being a bad strategy, change it when you are ready to start again but don't allow yourself to change your mind halfway through. Once you select a path, you must follow it through to the end. Otherwise, you are guaranteed to experience losses.
At the end, which is better, stocks or options? Well, that depends on you and your investment style. If you are a beginner or a long-term investor, stocks will bring a lot fewer obligations and headaches, and you may even have the right to be paid dividends if they happen to come with the shares you had bought.
If you are a more active trader, and you wish to earn the same amount but at a lower investment cost, options are a much better alternative. They do require greater knowledge of the market, and they are more complex as you need to answer several questions correctly when investing in them.
However, once you get the hang of it and learn how the market 'breaths,' you will stand excellent chances of making sizable profits for only a fraction of the money you would need when investing in stocks.
Author: Ali Raza - A journalist, with experience in web journalism and marketing. Ali holds a master's degree in finance and writes extensively about the financial markets and fin-tech industries.