This article originally appeared on The Financially Independent Millennial and was republished with permission.
If investing is of interest to you, then you’ve probably heard about stocks vs. options. How can you make the best choice when deciding which investment strategy to use?
After all, investing comes with risk attached – learning how to navigate that risk and make sound investment decisions is the key to building a good investment portfolio.
Knowing as much as you can about options and stocks will mean you can make better investment choices. In this comprehensive guide, I’ll explain the differences between stocks vs. options in detail. Armed with this knowledge, you should be better prepared to achieve your financial targets.
What Are Stocks?
A stock means you own part of a company that has sold shares on an exchange. These shares that you can buy are known as stocks. When you buy shares, you’re then a shareholder of that company.
Every company has a certain number of shares available on the stock market. Those stocks can be bought and sold on the stock exchange. Each company decides how many shares can get bought and can raise or lower how many shares are available on the exchange at any time.
The stock market can rapidly change from one moment to the next based on many factors. Anyone trading in stocks must remain aware of how their stock is performing to minimize the risk of a loss.
Benefits of Stocks
The first benefit of investing in blue chip stocks (unlike options) is that most investors will build wealth, as stocks nearly always rise over a long period. Individual stock prices fluctuate daily, but investing in companies with a proven track record of growth and investments means in the long-term, your wealth will grow.
Investing in stocks is extremely easy these days, thanks to modern technology. You can get started with just a mobile phone and an internet connection with many apps doing a lot of the hard work for you. This ease of access makes stock trading appealing for many beginner investors.
It also means you can often start trading using small amounts. Learning to trade for a few dollars a month is a great way to build confidence and understand how it all works. Once you’re established, then you can gradually invest more!
Stocks are good assets to have as they are considered liquid. Liquid means they can be converted to cash quickly, unlike other assets such as real estate. And, this may good if a situation arose that required you to get cash fast.
Drawbacks of Stocks
Investing in stocks comes with risk attached. The biggest one is that the price could drop dramatically, and you lose all your investment. Stocks can vary wildly from one day to another. Therefore, experts recommend stocks as a long-term investment strategy, and you should plan to keep the money invested for at least five years.
Another way to avoid losing all your investment is by diversifying your portfolio. Don’t put all your money into one stock. Invest in a variety of stocks to spread the risk.
Other drawbacks of trading in stocks include fees, capital gains taxes, and commissions. Commissions and fees vary. Some brokers don’t charge any at all. Make sure to shop around before opening a brokerage account to find the best deals for you.
While investors can’t avoid taxes, the rate you pay does vary depending on several factors. How much profit you’ve made, your income, and how long you’ve held the stock affects Rates. Generally, any investments held for less than a year attract a higher rate—another good reason to own stocks long-term.
What Are Options?
An option is when you purchase the right to buy or sell an asset (typically a stock) for an agreed price and at an agreed time. The seller has no choice but to allow you to exercise the option. The buyer pays for the right (but not the obligation) to have the option to buy or sell an underlying security for an agreed price on or before an agreed date.
There are two types of options – call options, and put options.
Call options are the most common. Investors who buy call options expect the stock price to end up above the strike price before the expiration. Profit gets made when investors can either sell the stocks on the open market for a higher amount than they paid or sell the option they originally bought for a profit.
Call Option Example
An investor may buy a call option on AAPL with a $120 strike price that expires 9/17/2021. The investor pays $6 for the call option (Options get sold in lots of 100, so the total is $600). If at expiration (9/17/2021) AAPL is trading at $130, the investor can either:
1 – Exercise the option by buying 100 shares of AAPL for $120 each and then sell them to the open market for $130 each making a net profit of $400 ($10/share gross profit – $6 premium * 100).
2 – Sell “to close” the call option before expiration for a profit.
Investors buy put options as a way to insure against a downturn. For example, investors can sell an asset at a specific price within an agreed time (expiration). These options work the opposite way to a call option. Investors buy put options hoping the stock price will drop. Profit gets made when investors sell the underlying security at a higher price than it’s worth.
Related read: How to Sell Covered Calls for Monthly Income
Put Option Example
You buy put option on AAPL with a strike price of $100, expiring 9/17/2021. The cost of this put option is $20 ($0.20 * 100 shares). On expiration, if AAPL is trading at $95:
You can exercise the option and sell AAPL to the Put option seller for $100 each. Doing so will earn you $5 minus the original $0.20 premium, times 100 (net total $480).
You can sell the put option at a higher price than you originally paid for it.
Benefits of Options
Investing in options usually costs less upfront than stock trading. And, this can be appealing if you’re starting to invest and don’t have much capital. You could get more for your money trading in options.
Trading in options can be more flexible than stocks. That’s because you’ve got several moves you can make when deciding how to play out your investment strategy.
You can exercise the option and buy the shares to add to your investment portfolio. Another option is to exercise the option and either buy or sell the shares at a profit. There are also various points through the process where you could sell the options contract to another investor.
One of the critical benefits of options is that the underlying stocks strike price is fixed. For the agreed period, the stock price agreed is the price you can buy or sell the stocks for up to the expiration date.
Drawbacks of Options
Options trading can be much more time-consuming than investing in stocks. You might want to exercise the option before expiration, which means keeping a close eye on the stock price. To help with this, you can set up alerts with most online brokers.
Some options strategies carry more risk than others. Some strategies are so risky that only experienced traders should attempt them. You must understand what you’re doing before making the trade. Make sure to do your research and don’t trade in anything you don’t fully understand.
Commissions, fees, and capital gains taxes can also be higher than the cost of trading in stocks. Keep in mind that the more you trade, the more your costs are going to be. Taxes are also higher on investments held less than a year, in some countries.
Stocks vs. Options: Making a Decision
When thinking about stocks vs. options, it’s entirely your choice as to which you prefer. Everyone has their investing style and appetite for risk that will drive their decision.
For beginner investors, or anyone preferring straightforward investing, stocks are usually the best choice. Options may become more appealing as you become a more experienced investor or if you prefer an investment that requires more active participation.
Don’t forget that you don’t have to stick with one or the other. There is no reason you can’t invest in both stocks and options should you want to. Just make sure you have a thorough understanding of any investment before going ahead with it.
Stocks vs. Options: Further Considerations
When considering stocks vs. options, keep in mind that they are intricately linked. You can hold both stocks and options for the same company. Plus, option prices get calculated based on the difference of the strike price and the current stock price, the implied volatility (IV), and the amount of time before expiration.
When planning your investment strategy, there are some questions you should ask yourself to determine how to proceed. What is your appetite for risk? Do you want to make long-term or short-term investments? Do you want to make a mix of investments? Where will you get the best return for the money you have available to invest?
Think about your answers to these questions. Don’t forget to keep in mind your financial goals and your current situation when making your decisions.
Ultimately, only you can decide which investment opportunities are best for you.
Importance of a Balanced Portfolio
Having a diverse and balanced portfolio is essential for achieving your financial goals and, ultimately, growing your wealth.
The best strategy balances the need for long-term returns while absorbing any economic shocks. For example, if all your money is in bank stocks and there’s a financial crisis, you could lose all your money. However, having a balanced portfolio means that although the asset values diminished, your other investments can help balance that loss until the market recovers.
Now that you understand the difference between stocks vs. options, you can make better financial decisions. Making the right choices now makes it much easier to reach your financial goals in the future!
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