Investing in the stock market can be a great way to grow your wealth, but it can also be a risky venture.
For those looking to invest in the market, there are two main options: stocks and options. While both offer the potential for high returns, they come with different levels of risk.
Stocks are a more traditional way to invest in the market, offering the potential for high returns over the long term. However, they also come with a higher level of risk, as the value of a stock can fluctuate greatly based on market conditions.
Options, on the other hand, offer even higher potential returns, but with an even greater level of risk. While they can offer the possibility of doubling or tripling your investment in a short amount of time, they also come with the possibility of losing your entire investment.
Differences between Stocks and Options
Stocks
Stocks are fractional ownership interests in businesses that trade on various exchanges. They have an indefinite life and can continue to exist as long as the company exists.
The value of a stock fluctuates significantly in any given year, but over time, its performance should track the growth of the business. If the company grows earnings, the stock will rise over time, and if its profit falls, the stock will fall. If the company goes bankrupt, the stock may cease to exist.
Options
Options are side bets among traders over what price a stock will be worth by a certain time. An option is the right to buy or sell a stock (or other asset) at a specified price by a specific time. Stock options trade on a public exchange.
An option has a fixed life, with a specific expiration date, after which its value is settled among investors, and the option ceases to exist. The value of an option tends to decline over time, all else equal, and so it’s what is called a wasting asset.
Options come in two major varieties, and buyers make a cash payment called a premium to own an option contract:
- Call options allow the owner to buy the underlying stock at a specified price until a specific date. When the stock price goes up, the call option increases in value, all else equal. In general, if you’re buying a call option, you expect the stock price to rise.
- Put options allow the owner to sell the underlying stock at a specified price until a specific date. When the stock price goes down, the put option increases in value, all else equal. In general, if you’re buying a put option, you expect the stock price to fall.
The table below summarizes some of the key differences between stocks and options.
| Characteristic | Stocks | Options |
|---|---|---|
| Potential upside | High | Very high (and quickly) |
| Risk | High | Very high |
| Lifetime | Potentially unlimited | Limited, no more than about two years for public options, but often weeks or months |
| Brokerage commissions | No commission at major online brokers | $0.65 per contract is typical, though some brokers charge no commission |
| When you can trade | Any time the market is open | Any time the market is open |
| Tax | Can be taxed at short-term or long-term capital gains rates, depending on holding period | Can be taxed at short-term or long-term capital gains rates, depending on holding period |
In summary, stocks and options are different in terms of their potential upside, risk, lifetime, brokerage commissions, when you can trade, and tax implications. Stocks are fractional ownership interests in businesses that trade on various exchanges, while options are side bets among traders over what price a stock will be worth by a certain time.
The Pros and Cons of Stocks
Advantages of Investing in Stocks
Investing in stocks has several advantages that make it an attractive option for many investors. Some of the advantages are:
- Potential for High Returns with Reduced Risk: Investing in a diversified portfolio of stocks, such as an index fund based on the Standard & Poor’s 500 Index, can deliver potentially high returns with reduced risk.
- Infinite Lifetime: Stocks have a potentially infinite lifetime, since the stock can continue to exist as long as the company remains afloat.
- Dividend Payments: Stocks can pay dividends, and the best stocks grow their dividends each year, putting more cash into the investor’s pocket over time.
- Acquisition Premium: A company may be acquired at a substantial premium to its market value, rewarding those who own the stock.
- Low Trading Commissions: Major online brokers have reduced trading commissions to zero, so it’s cheap to buy and sell stocks.
- High Liquidity: Publicly traded stocks are usually highly liquid, and investors can exchange them for cash on any day the market is open.
- Potential Tax Breaks: The IRS provides a potential tax break for investing long term in stock, reducing the maximum capital gains tax rates if the investment is held for longer than a year.
- Easy Diversification: Stocks can be packaged in exchange-traded funds (ETFs) or mutual funds, providing an easy way to invest in a diversified portfolio, often at a low cost.
Disadvantages of Investing in Stocks
Investing in stocks also has some disadvantages that investors should consider. Some of the disadvantages are:
- Price Fluctuations: Stock prices can fluctuate significantly from year to year, meaning investors may not be able to sell a stock for any given price or even what they paid for it.
- No Government Guarantee: Stocks are not guaranteed by the government, so investors could lose all their money, especially if they pick the wrong individual stocks.
- Company Performance: Stock prices depend on the performance of the company, so over time the stock will track the company’s growth. Therefore, investors have to own the right companies to succeed.
- Effort Required: It takes a lot of effort to analyze individual stocks and understand where there could be opportunity or risk.
- Tax Implications: While investors may pay lower taxes for holding a stock for more than a year, they’ll still have to pay taxes on any gains, though they do get a tax write-off if they lose money.
Overall, investing in stocks has both advantages and disadvantages, and it’s up to the individual investor to weigh them and decide if it’s the right investment option for them.
The Pros and Cons of Options
Advantages of Trading in Options
Options trading can be a lucrative opportunity for investors who are willing to take on higher risk in exchange for higher potential returns. Here are some advantages of trading in options:
- High Returns: Options can offer very high returns over a short period of time, leveraging a small investment into a much larger one.
- Volatility: Options prices can be even more volatile than stock prices, which can be attractive to traders seeking potential gains.
- Low-Risk Strategies: While options are generally considered risky, some strategies can be relatively low risk and can even enhance returns for stock investors.
- Upside Potential: Like stockholders, options owners can profit if a stock is acquired at a premium to its value, but they must own the options at the right time.
- Reduced Commissions: Major online brokers have reduced options commissions, and some even offer no-cost options trading.
- Liquidity: Options are liquid, meaning they can be exchanged for cash at any time the market is open, although there is no guarantee of getting the original purchase price.
- Tax Advantages: Holding longer-term options for at least a year can qualify for lower long-term capital gains tax rates, although not all stocks offer this option.
Disadvantages of Trading in Options
Despite their potential for high returns, options trading comes with significant risks that investors should be aware of. Here are some disadvantages of trading in options:
- Timing is Critical: Options must be sold at the right time, as a stock’s price can rise after an option’s expiration, rendering it worthless.
- Volatility Risk: Options prices can fluctuate significantly from day to day, and price moves of more than 50 percent are common, which can result in quick declines in value.
- No Government Guarantee: Options are not guaranteed by the government, so investors can lose money on them.
- Potential for Losses: Depending on the strategy used, investors can lose more than they invest in options.
- Short-Term Vehicle: Options are short-term investments whose value depends on the price of the underlying stock, making them a derivative of the stock. If the stock moves unfavorably in the short term, it can permanently affect the value of the option.
- Expiration: Options expire, and when they do, the opportunity to trade them is over. Many options expire worthless, and traders cannot buy and hold options for long periods like they can with stocks.
- Higher Costs: Options may be more expensive to trade than stocks, although some brokers offer no-cost options trading.
- Not Suited for ETFs or Mutual Funds: Options are not well-suited to be packaged in an ETF or mutual fund.
Overall, options trading can be a high-risk, high-reward opportunity for investors. While there are potential advantages, investors should carefully consider the risks and drawbacks before engaging in options trading.
Which is better for you?
When it comes to investing, there are different options available. Stocks, options, and ETFs are some of the popular choices. But which one is better for you? Here are some factors to consider:
When stocks are better
If you have at least some experience investing in the market, preferably a lot, then stocks may be a good choice for you. Stocks require analysis and work, but options require even more. ETFs or mutual funds composed of stocks are better choices for beginning and even intermediate investors.
If you want to invest for the long term, then stocks can be a good option. Stocks can go up a lot over the long term, but sometimes you have to ride out downturns, and the short-term nature of options means an option can expire before the stock price moves in a favorable direction.
If you don’t want to follow the market super closely, then stocks may be a better option. While stocks require you to monitor them at least some of the time, it can be much less than the amount required by options – which expire on a fixed schedule.
If the stock is volatile, then stocks may be a better option. If you believe in a stock long term but it’s volatile, it’s easy for options to expire worthless. Stock gives you a permanent stake, but you’ll have to ride out the ups and downs, and you can’t do that with options.
When options are better
Options can be a better choice when you want to limit risk to a certain amount. Options can allow you to earn a stock-like return while investing less money, so they can be a way to limit your risk within certain bounds.
Options can be a useful strategy when you’re an advanced investor. Experienced investors know how to limit their risk and they understand the risks they’re running when they use a given options strategy.
Some options strategies can allow you to buy stock at better prices. For example, a strategy such as writing puts allows you to collect a premium for the potential to buy a stock at a lower price. Used judiciously, this strategy can help boost your overall returns.
Options allow you to multiply your money at a much higher rate. You can make a much higher return using options, but you run the risk of a complete loss if you’re wrong.
Options can allow you to generate income. Some stockholders sell call options against their stock positions or write put options as a way to create income. Such strategies can be attractive and relatively low-risk ways to use options.
ETFs can be an even better choice than individual stocks
For all but advanced investors, stocks are probably the better choice than options at all times, but an easier way to buy them is through stock ETFs. ETFs serve beginning and intermediate investors well, but many advanced investors opt for ETFs, too, because of their simplicity.
With each share of the fund, an ETF allows you to own (indirectly) a piece of each stock in the fund. ETFs also allow you to buy a stake in the Standard & Poor’s 500 Index, a collection of hundreds of America’s best publicly traded companies. Over time, the index has returned an average of about 10 percent annually to investors who have bought and held.
In fact, buying an S&P 500 index fund is what legendary investor Warren Buffett recommends for most investors. Then he advises them to stay the course and keep buying when they can.
Wrapping Up!
Investors should approach stocks and options with caution and a thorough understanding of their risks and potential returns. While stocks are known for their volatility, options can be even riskier. It is important for investors to conduct independent research and make informed investment decisions. Past performance is not a guarantee of future price appreciation.
