When you buy a stock, you essentially purchase a slice of ownership in a company. And the size of that ownership depends on how many shares the company has on the market. Purchasing stock turns you into a shareholder because you own, or hold, shares — at least until you sell them. Stocks vary in price, from penny stocks worth fractions of a dollar to blue-chip stocks worth thousands per share. Stocks can be bought and sold during market hours through a brokerage account.
An option is a contract to buy or sell a stock. The contract gives the investor the option to purchase or sell a set number of shares at a set price by a specific date. The number of shares accessible through the contract depends on the contract multiplier. Most options contracts have a contract multiplier of 100.
An options contract is just that: an option. You’re not obligated to buy the corresponding stock, but you can if you choose to. Unlike stocks, options don’t represent ownership of a company. An option is merely a contract that locks in a stock price for purchase or sale over a set period of time.
Can be bought or sold through a brokerage account
Have inherent value based on the performance of the company they belong to
Can be held indefinitely, potentially earning dividends
Value fluctuates with the movement of the market and the performance of the company
Can be bought or sold through a brokerage account
Derive their value from stocks
Can’t be held indefinitely — they’re worthless past their expiration date
Have a set value at expiration
Both options and stocks have benefits specific to the way they’re traded.
Options contracts have plenty to offer — if you know how to trade them:
Flexible. Unlike stocks, which are limited in execution, you can profit from options contracts in many ways. Investors can exercise the option, purchase shares and hold onto the shares. They can exercise the option, purchase shares and sell the shares. Or they can sell the contract to another investor.
Less capital. Since options represent the value of an opportunity — not the full value of the stocks themselves — investors need less capital to get started. Unless they exercise the option and purchase shares, investors only pay the premium to purchase the contract.
Exponential profit. Options traders have the potential to earn a higher profit with less upfront capital by using leverage to anticipate the movement of a stock.
Stocks are a staple in many investor portfolios. Why? Because they’re easy to trade and have many benefits:
Buy low and sell high. When you buy a stock, you’re essentially betting that the price of that stock will go up. Whether you sell in a week, a month or a year, selling a stock for more than you paid earns you a profit.
Simple. It’s hard to argue with the simplicity of stocks. They’re one of the most straightforward, beginner-friendly securities on the market. You pay what the stock is worth at the time of purchase, and when you sell, you receive the current market value of the stock.
Dividends. Some stocks offer dividends: regularly scheduled payouts for shareholders based on the performance of the company. Investors can earn passive income just for holding shares of a dividend-paying stock.
Low expenses. Most trading platforms today offer commission-free stock trades, which means you can buy and sell shares to your heart’s content without worrying about fees eating into your profits.
Whether your trade stocks or options, you risk losing capital.
The value of a stock is inextricably tied to the performance of the company it belongs to. Another big factor is the market’s overall movement.
When you buy a stock, your money is locked into the investment until you sell. And while there’s no decision deadline — at least, not in the way options contracts operate — you may face losses by holding onto a poorly performing stock.
And what if the company you’ve invested in goes out of business? You’ll lose your investment entirely.
In some ways, there’s more risk associated with buying stocks than buying options contracts. If you buy an options contract and the stock tanks, the most you’ll lose is the premium you paid for the contract, which may only be a couple hundred dollars. But if you’ve poured funds into buying the stock outright and the company folds, you’ll lose everything you invested.
Options trades carry risk for two reasons: they’re complex and they require leverage.
Whether you’re buying or selling an options contract, there are many decisions you need to make. You’re not just betting on whether the stock will rise or fall.
Be aware of how economic events could affect the business over the course of the contract. Since options have an expiration date, you’re taking a time-sensitive gamble.
All investments carry risk, but there are specific risks associated with trading options that investors won’t encounter elsewhere. And that’s because options contracts use a contract multiplier to leverage the investment position. Most options contracts have a contract multiplier of 100, which means the option represents a contract for 100 shares.
Risks for buyers If you purchase an options contract, you’re an options buyer. Most investors, especially investors new to options, will fall into this category.
For buyers, the contract multiplier simply represents an investment opportunity. As the buyer of an option, you’re not obligated to exercise the contract, so if your prediction was wrong about the movement of the stock, you simply let the contract expire worthless. At most, you’ll lose the premium you paid to purchase the contract.
Risks for sellers Options sellers, also called options writers, sell contracts to options buyers. They make money on the premiums that options buyers pay to buy a contract.
If an options writer sells a contract to an options buyer and that buyer chooses to exercise the option, the seller must fulfill the terms of the contract, no matter how steep the loss. And since there’s no limit on how high a stock can rise, options sellers put themselves at considerable risk and can see dramatic losses.
Crunching numbers: Is options trading better than stocks?
Let’s say you’re interested in investing in Company XYZ, which trades at $100 per share.
You purchase 10 stocks of Company XYZ, shelling out $1,000 total. You also purchase two call options for Company XYZ’s stock at a strike price of $110. Each option has a $5 premium, a contract multiplier of 100 and expires within 30 days. In total, you pay $1,000 to purchase the options contracts.
Here’s what happens to your initial investments in two scenarios.
The stock price goes up to $125
You make a $250 profit on your stocks
10 stocks x $25 profit per stock = $250
You purchased 10 stocks, and each stock went up by $25. You make a profit of $250. That brings the total value of your investment up to $1,250 — your original $1,000 plus the $250 profit.
You make a $2,000 profit on your options contracts
$125 value per share – $110 strike price = $15 profit per stock $15 per stock x 100 stocks/contract x 2 contracts = $3,000 $3,000 – $1,000 premium = $2,000 total profit
Since the stock met and exceeded the strike price of the two contracts, you can exercise your option to purchase another 200 stocks from Company XYZ. You buy 200 shares at $110, the agreed-upon strike price, and immediately sell them at $125 per share — the current market price. It costs you $22,000 to purchase the stocks, but you sell them for $25,000.
Your total profit from your options trade? $2,000. That’s the $3,000 profit from selling the stocks minus the $1,000 premium you paid to purchase the contract in the first place.
The stock price falls to $80
You lose $200 on your stocks
10 stocks x $20 profit per stock = $200
You purchased 10 stocks, and each stock went down by $20. You take a $200 loss, which brings the total value of your investment down to $800.
That said, there’s still a chance the company will recover, so you can choose to hold onto your shares, hoping the stock price will eventually rise.
You lose $1,000 on your options contract
The share never met the strike price of $110 within the agreed-upon time frame. You must let the contract expire worthless and the $1,000 premium you paid to purchase it is considered a loss.
Can stock ever become completely worthless?
Yes, if a company goes bankrupt and the stock drops to $0 before being delisted, it’s possible to lose your full investment. But stocks often take a long time to get down to $0, especially if they’re worth a lot when you buy in, which means you’ll likely have opportunities to sell before a stock becomes worthless.
While all stock-based investments are inherently risky, there’s a much higher chance of losing your full investment with an options contract than if you buy stock outright.
How to choose
Are stocks or options a better fit for your portfolio? Here’s how to decide:
Experience. Let your experience level guide your investments. Stocks are best for those just starting out, while options require more trading experience and market knowledge.
Capital. Options trades make use of leverage to amplify profits with less capital.
Margin trading. Most options trades are executed through margin accounts, which is a special investment account that lets you borrow funds from your broker. If you prefer to use the cash you have on hand, you may prefer stocks.
Timeline. Stocks are best for those using a long-term buy and hold strategy, while options have shorter turnarounds.
Risk tolerance. How much are you willing to lose? There are risks associated with both securities and the right asset for your portfolio will hinge on your risk tolerance.
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Disclaimer: The value of any investment can go up or down depending on news, trends and market conditions. We are not investment advisers, so do your own due diligence to understand the risks before you invest.
Both stocks and options have their place, each with a unique set of benefits and risks to consider. Before you invest in either, explore your account options across multiple platforms to find the best brokerage for your needs.
Shannon Terrell is a writer for Finder who studied communications and English literature at the University of Toronto. On any given day, you can find her researching everything from equine financing and business loans to student debt refinancing and how to start a trust. She loves hot coffee, the smell of fresh books and discovering new ways to save her pennies.
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