Stocks and options are two common ways to participate in the stock market. They have different risk profiles and different potential outcomes. Investors and traders can use either or both methods to participate in the public markets. This article will provide an explanation alongside a deep dive into the pro’s and con’s of both stocks and options.
Stocks and Options Definitions
A stock is a fractional ownership in a company. Each share represents a small piece of the business and anyone can purchase shares through an exchange. Over time the stock price should increase as the business grows and increases revenue. In the short term, stock prices can be volatile and influenced by external factors such as economic environment, political climate, or black swan events such as the COVID-19 pandemic.
An option is the right to buy a stock at a pre-specified price and by a certain date. Each option contract typically represents the right to purchase 100 shares. People can buy or sell option contracts and there are two types of option contracts:
- Call options allow the owner to purchase 100 shares at a specified price by a certain date. You typically purchase call options if you’re betting on the underlying stock price to increase by the expiration date of the option contract
- Put options allow the owner to sell 100 shares at a specified price by a certain date. A put option increases in value if the stock price goes down
Pro’s and Con’s for Stock Trading
Stocks are the most common and straightforward method to invest in the stock market. They’re great for beginners and people looking to buy and hold for the long term. Purchasing stocks at regular intervals can be a great way to Dollar Cost Average (DCA) over time.
Stocks have the following benefits:
- When purchasing a stock, you own that stock forever. Stocks don’t expire and unless the company goes bankrupt, stocks usually don’t disappear in value
- Over time the stock price should increase if the company is growing revenues. As a holder you capture the increase in stock price if you decide to sell
- Holding a stock for over a year in the U.S qualifies you for long term capital gains tax upon selling. Long term capital gains tax provide a more favorable tax rate as opposed to holding a stock for less than a year
- Stockholders can receive dividends as a profit share for being a part owner of the business. Some investment strategies involve owning high dividend stocks and holding the underlying shares
- As a stock owner you often have the right to participate in shareholder votes that can impact the business
- Stocks typically have high liquidity in the public markets which means you can often find a buyer or seller on the other side of the trade
- Stocks can also be traded for a period of time after hours which provides an extended trading window for buying and selling
While there are many reasons to purchase stocks, there are also some drawdowns listed below:
- If the company goes bankrupt, you have the potential to lose the entire value of your shares. The downside is essentially the total value of the stock price
- Stocks don’t offer any leverage. Purchasing shares can require a large capital investment without the opportunity to leverage your assets like in the case of options or real estate investments
- Generally speaking, picking the right stock can be difficult and a time intensive process. As an alternative to purchasing individual stocks, many people decide to invest in Exchange Traded Funds (ETFs) which are baskets or collections of stocks
Pro’s and Con’s for Options Trading
Options are a more advanced investment strategy that often involves higher risk with the potential for higher rewards. As previously mentioned, there are two types of options that can represent a bet on the increase or decrease of the underlying stock price.
Some of the benefits of options include:
- Limited downside since the maximum money you can lose is the premium of the options contract. If you purchase a call option and the stock price drops below the strike value at the time of expiration, the maximum amount you can lose is the initial premium price
- Options are a leveraged way to make a bet on the price of the underlying stock without requiring a lot of capital. Options allow you to leverage the price of 100 shares for far less than the amount required to purchase 100 shares
- Options provide the flexibility to bet on the increase of decrease of the underlying stock price by purchasing either a call option or a put option
- Long term options that are held for over a year also qualify for the favorable long term capital gains tax
While keeping in mind the benefits, options also have many downsides that include:
- A more advanced understanding of the different factors that influence the price of the option contract such as time decay, the correlation between the movement of the underlying stock price and the options contract, and many others
- When purchasing options, you need to be right on two things: the direction of the stock price, and the timing. Purchasing a call option means you’re betting on the underlying stock price to increase, but you also need to bet on the timeframe since option contracts have an expiry date. This increases the risk associated with trading options
- Option contracts typically have much lower liquidity than the underlying stock which means that purchasing and selling option contracts can be challenging. The spread is often large and there are situations where you may not be able to sell your option contracts if there are no buyers
- Option contracts have a time decay that decreases the value of the options contract exponentially the closer you are to the expiry date. As a result, option contracts are very volatile to short term fluctuations, especially near the expiry date
- As an option holder you don’t own any of the underlying shares which means you don’t receive dividends or any voting power
There are many ways to participate in the stock market. Stocks and options represent some of the most common methods for investors and traders. The risk profile of stocks and options vary drastically, and so do the use cases for each.
Stocks are a great asset for beginners and people that prefer to buy and hold long term. Stockholders own a fraction of the company and can benefit from incentives such as dividends, lower capital gains tax, and an appreciating asset if the business grows.
Options are utilized by more advanced investors and traders. They require more experience to fully understand the different factors that influence the change in the price of the options contract. Option traders are typically short term traders or investors looking to hedge their stock positions.