Trading stocks and buying options are two types of investments, though the former is more common than the latter. Each one has strengths, and each one carries potential downsides. The differences don’t preclude investors taking advantage of what each one has to offer. Here’s what you need to know about these two financial moves. Consider working with a financial advisor as you chose which types of investments are best for you.
Stocks vs Options: What’s the Difference?
Building an investment portfolio is a very personalized process. The different types of investments that you choose will vary according to how much you have to invest, your own investment style and what your goals are for your future returns.
Two possible investments that you could add to your portfolio include stocks, also known as equities, and stock options, also known simply as options. While these two are similar in many ways – and you can certainly choose to invest in both – there are a few important differences between them.
When you buy stocks, you are essentially purchasing ownership shares of a specific corporation. As a fractional owner of that company, you are now entitled to a proportional share of that company’s growth in terms of assets and profits. Corporations issue, or sell, stocks as a way of raising capital for the company’s operations. There are a certain number of shares available at a given time, though the company can always choose to issue more down the line. Stocks can be purchased through a traditional broker or an online brokerage such as Robinhood and SoFi.
When purchasing stocks, the goal is to “buy low and sell high.” In other words, you are hoping that you will be able to sell those stocks at a later date for more than you paid. Whether that happens days or decades from now, however, is up to you. If you want to actively buy and sell stocks, you can — but if you want to leave your stocks alone for years while they (hopefully) grow, you can do that, too.
A corporation may also issue dividends to shareholders from time to time. These bonus payments represent a portion of the company’s earnings and can be in the form of cash dividends or even additional stock. Stocks that offer dividends make it even easier to grow your portfolio and assets, on top of the stock’s value growth.
Buying stock options is a related, but much more active, form of investing. When purchasing options, you are essentially buying a contract (or making an agreement), rather than investing in the actual security. This agreement gives you the option – but not the obligation – to then buy or sell a specific number of shares in that stock at an agreed-upon price by a specific date.
This can be a beneficial strategy for many investors, allowing them to negotiate a stock’s price before observing what the market does. Once the option’s expiration date arrives, you can either purchase or sell the specific stock at the negotiated price, or you can let the contract expire and do nothing.
Purchasing stock options comes at a cost, also known as a contract premium, which you will pay upfront. If you choose not to buy or sell the agreed stock shares before the option’s expiration, you will simply lose your prepaid contract premium.
|Simple and straightforward||
Can be complex
May pay a dividend
|No dividends offered|
|Can be a passive investment option||
|Offers an immediate security asset||
Gives investors the ability to monitor the market before buying or selling
Deciding Between Stocks or Options
Not sure whether to add stocks or options to your investment portfolio? Here are a few questions you can ask yourself that may help you decide.
What are your investment goals? Knowing what you want from your investment journey can help dictate what to add to your portfolio. For instance, are you looking to have fun and make a little money while buying shares of companies you support? Then opting for stocks is probably the answer.
If you’re looking to track market trends and hedge risk while building your portfolio, options could be the better choice. And if you’re hoping to build a well-diversified portfolio that protects against market downturns and builds value for decades to come, you may want to utilize both.
Do you want to be an active or passive investor? How much of a hands-on investor are you, or do you want to be? If you prefer a set-it-and-forget-it approach, options probably won’t meet your needs. This route requires a fair amount of research before purchasing options. You’ll also need to make a decision before the option expires. In other words, options require fairly constant and close attention, from start to finish.
With stocks, you can simply purchase the shares you want and then leave them alone for years (if you want). You may even earn dividends along the way. Straight stock purchases also allow you to quickly buy into certain booming or trendy corporations (e.g. Gamestop and AMC) and sell whenever it feels right … even if that means managing your portfolio more like a day trader than a long-term investor.
What is your risk tolerance? Buying individual shares is already a more risky investment decision compared to, say, mutual funds. However, your risk profile may also play into whether stocks or options are the right choice for your portfolio.
Options can enable investors to monitor shares before actually buying or selling; if the price fluctuates, this may save them from making a mistake such as buying too high or selling too low. However, options also come at a cost; if you don’t wind up buying or selling shares before your option expires, that contract cost is simply wasted.
Determine how much wiggle room you have in your budget, how much you want to spend on certain stocks and what your goals are before opting for either stocks or options.
The Bottom Line
While there is some overlap in buying stocks and buying options, there are a few important differences to note. Buying stocks requires less research and less ongoing attention. Buying options requires a level of financial knowledge many investors do not possess and a level of attention many investors are not willing to devote to. For a number of investors, though, both stocks and options can play a simultaneous role in building a successful investment portfolio.
Tips on Investing
- If you’d prefer to leave your investments in the hands of a professional, a financial advisor is well worth looking into. SmartAsset’s free tool can quickly pair you with local financial advisors based on your personal needs and goals. If you’re ready to work with an advisor that can help you out, get started now.
- Not everyone is cut out for short-term trading strategies like options. Many investors are probably better off simply using a calculator to determine an ideal asset allocation and then engaging in passive investing strategies. That’s because long-term investing is much safer, as it features ordinary, but consistent returns.
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