Differences Between Stocks & Options

Fundamental Differences

The main difference between stocks and options is the fact that when investing in stocks you are actually buying a security that can go up or down in value but when investing in options you are buying a derivative. A derivative is essentially a trading instrument that derives its value from some other security. The value of the derivative is therefore closely linked to the value of that other security. This is known as the underlying security, but it can also be affected by other factors.

In the case of options, there are other securities besides stocks; it can also be other financial instruments such as commodities and currencies. The fact is that there is a whole range of different types of options that can be bought and sold means you can speculate on a wide variety of financial instruments when trading options.

When you buy stocks in a particular company, you are actually buying a share in that company. If the company performs well, then the chances are that your investment will increase in value and there are two ways in which you can make a return. First, you can choose to sell for a higher price than you bought for to reach a higher profit. Second, if the company you have invested in is profitable then they may award stockholders with an annual dividend (a share of those profits that is paid to anyone who holds stock in the company).

It's possible to make very good returns by holding dividend paying stocks for a long period of time, and you still own the actual asset that you can choose to sell at any time. You can also choose to short sell stocks in a company and make a profit if they go down in value.

The way options work is different; when you buy stock options you are actually buying a contract that gives you the right to buy or sell specific stocks at an agreed price. While these contracts come in a variety of different categories, they can all be classed as either calls or puts. Calls give you the right to buy a specific stock at a fixed price (this fixed price is known as the strike price) while puts give the right to sell a specific stock at a fixed price. If you buy calls, the price you pay for them does not get you any actual stock; it simply gives you the right to buy it.

So the fundamental difference between these two financial instruments is actually relatively simple. Buying stocks is paying to own a real share in a company, while buying options is paying for the right to buy (or sell) shares in a company. This difference gives trading options some significant advantages.

Advantages of Options Over Stocks

One of the biggest advantages of buying calls over buying stock is the fact that you can limit potential losses while still benefiting from potential profits. You might want to invest in a particular company, for example, that had a high chance of increasing significantly in value but also had a small risk of falling significantly in value. If you bought the stock you would benefit from any rise in value, but you would also be exposed to any fall in value.

For example, let’s say these stocks were trading at $20 and you decided to buy 1,000 shares. If they went up to $30, you could sell your 1,000 shares for a profit of $10 each. This would give you a total of $10,000 profit. Therefore any commissions you incurred for your trades, would just be an added bonus to your profit. However, if they fell to $10 before you decided to cut your losses, you would lose $10,000.

Now suppose you had decided to buy call options on the stock instead and you bought 1,000 calls at $1 each, giving you the right to buy 1,000 shares at the strike price of $20.

With the stock rising to $30, you could then buy the shares at $20 and immediately sell them at $30 for a profit of $10,000. You would, of course, have to factor in the original $1,000 you spent on the options contracts, but you have still made a total return of $9,000. This a little less than the $10,000 you would have made from buying the stock options, but the real advantage here is in limiting your losses.

If the stock fell to $10 then you would simply not exercise your option, and you would only have lost the $1,000 you originally invested. This example shows that although you may sacrifice a small percentage of your profits if the price moves as planned, you are greatly reducing your exposure to risk if the price moves the other way.

This example also highlights another major advantage of options over stocks, and that is leverage. To own the 1,000 shares at $20 in the above example, you would have had to invest $20,000. Assuming the price rose as highlighted for a profit of $10,000, this would give you a 50% return on your investment.

However, buying the 1,000 options at $1 would have meant an investment of just $1,000. With the shares rising to $30 and a total profit of $9,000 you would be getting an 800% return on your investment. Not only can buying options limit your risk, but it can also give you the potential for a much greater return relative to your initial investment.

This somewhat basic example should provide you with an idea of how trading options can be a beneficial way to invest. There are numerous ways that trading options can be used including hedging an existing position depending on what strategies you wish to utilize.

If you want to get involved with options trading then we would strongly recommend reading our tutorial for beginners: Getting Started