Have you tried your hand at investing in the stock market? If you have had a measure of success doing so, you might be thinking of trying your hand as an options trader.
Before diving right in, though, there are some things you should know about the differences and similarities between investing in stocks and options trading. Let’s start with the similarities.
What Investing in Stock and Options Trading Have in Common
Stock exchanges are national SEC-regulated marketplaces where equities are traded. Options are also traded in SEC-regulated marketplaces. Additionally, as is the case with stock trading, options trading takes place through a broker who handles buy and sell orders. You can track the progress of your investment by watching the SEC-regulated marketplaces on which you trade.
How well your options trading turns out depends on the value of the underlying stock, which of course is another commonality between stock investment and options trading.
However, here the similarity ends and options trading diverges greatly from stock investment in several key areas.
How Stock Investment and Options Trading Differ
OptionTradingGuide.com has this plain statement to make: “Options represent a higher-level form of investment, and carry a much higher amount of risk.” Meanwhile, Investopedia says about options: “In many cases they can provide a superior risk/reward ratio over simply purchasing the underlying equity.”
So, which is true? The answer is “a little of both.” And the reason for that answer lies in understanding the inherent differences between investing in stocks and options trading.
Difference Number One: What You Get for Your Money
When you purchase stocks, you own a piece of the company in which you have invested. Even if that piece is very small, you own a share (or shares) in the company. With options trading, however, you do not actually own shares of the company unless you exercise the option within the timeframe specified by your options agreement.
Purchasing an option, then, merely gives you the right to, at some future date, buy or sell stock at a specified price within a specified timeframe. It does not obligate you to buy anything. It acts simply as a kind of placeholder for your right to buy or sell stocks at a certain price and time. Options, then, only have value in relation to the value of the underlying stock.
Additionally, options give you more versatility than investing in stocks. Options trading allows you to make money whether stock prices go up or down. With certain trading strategies, you can actually be wrong about what will happen with a stock and still end up making money.
Difference Number Two: Options Have an Expiration Date
When you invest in stocks, you can hold those stocks indefinitely. Indeed, there are stocks that have been held in a family or in a trust over the course of several generations. Conventional wisdom indicates that it is usually a good idea to hold on to stocks for a while, since stock values generally do adjust upward over time. Therefore, stock investing is often a matter of playing the “long game.”
Options trading, however, allows for no such timeframe. Normal listed options generally expire at or before nine months have passed. Though there are some options, known as LEAPS, that may have expiration dates up to one or two years, the fact is that options must be exercised before their stated expiration date or they become entirely worthless.
This is one of the main reasons options trading is considered riskier than stock investing. With stock investing, given enough time even a stock with poor performance might become valuable. But with options trading, the time for a stock to increase in value is a much narrower window of opportunity.
Difference Number Three: Options Limit the Risk to the Buyer
If, after reading the information above you believe that options trading is way too risky for you, there is another difference between stock investing and options trading that might change your mind. If you are the buyer of an option, you cannot lose more than you actually paid for the option, even if the underlying stock price drops dramatically.
In other words, if you invest $500 in a stock option with the hope that the price of the underlying stock will go up, and then that stock actually goes down, you will only lose $500, the cost of your original investment in the option.
For this reason, conventional wisdom is that you should only invest in options trading the amount of capital you are prepared to lose.
While your loss is limited, your potential gains are not. No matter how high the price of the underlying stock goes, when you buy an option and exercise that option, your earnings are only limited by the price of the stock itself.
Difference Number Five: You Control More Equity for Less Money
Because buying an option costs much less than buying the actual underlying stock, you have much more leverage for less of an investment. NASDAQ illustrates it this way: “For an investor to purchase 100 shares of a stock trading at $50 per share would cost $5,000. On the other hand, owning a $5 call option with a strike price of $50 would give the investor the right to buy 100 shares of the same stock at any time during the life of the option and would cost only $500.”
Since you are controlling 100 shares for one contract, it will not take much of a movement in the price of the underlying stock for you to reap substantial benefits from exercising an option for a stock that is increasing in value. If the stock does not increase in value, however, once again, your loss is limited to the initial premium you paid for the option.
The Bottom Line
Options trading differs considerably from investing in the stock market. And it is not for everyone. However, for those who take time to learn about how options work, they can be a source of great gain. Are you ready to give options trading a shot? If so, we’re here to help. Try Market Timer for one month and see what options trading is all about.