Options vs. Stocks (Which is Better in 2019?)
Today’s article examines the differences between options and stocks.
When you own a share of stock, you own a portion of a company.
You can trade those shares of stock, by buying or selling them at any time, and it means you are buying or selling portions of the company.
Options are specialized contracts that are made between investors to buy or sell shares of a company, they depend on certain circumstances under which those trades are executed.
Generally speaking, people own stock in a company because they believe that the company will grow over time, and the price of their shares will rise.
Options are for traders. Traders are less interested in the long-term direction of the stock. They are betting on the fact that a stock will move in a certain direction in a certain period of time.
When it comes to options vs. stocks, stocks are for investors. Investing has a positive expectation over time.
Options are more akin to gambling. The options trader believes that they have certain information that will allow them to benefit from the movement of the stock in the short term.
What are stocks?
When you own stock in a company, you own a portion of that company. Usually, you have chosen to own that stock because you believe that, over the long-term, the value of that stock is going to rise because the company will become more valuable as it grows.
The price of the stock in any given moment depends on many factors. Most stockholders are emotional people in some way, because they are human. They may lose sight of the long term and buy or sell based on short-term news or other factors.
What are options?
With options vs. stocks, it’s best to think of options as what they are referred to in the market: “derivatives”, because the way options are priced is directly linked to the price of the stock they represent. These derivatives come in the form of contracts that are made between investors.
There are many different types of options, but they are all derived from two basic forms: call options and put options.
With a call option, one investor buys the right, but not the obligation, to buy shares of stock at a particular price (called the “strike price”) on or before a particular date (“expiration date”).
Another investor agrees to that contract. Because he is putting himself at risk of having to deliver that stock at the strike price on or before the expiration date, he must be compensated for taking that risk. The investor buying the contract thus pays him that compensation, which is called a “premium”.
With a put option, one investor buys the right, but not the obligation, to sell shares of stock at a certain strike price on or before the expiration date.
Another investor agrees to that contract. Because he is putting himself at risk of having to buy that stock at the strike price on or before the expiration date, he must be compensated for taking that risk. The investor buying the contract thus pays him a premium.
What are the differences between options and stocks?
The best way to think about options vs. stocks is that options are a form of short-term trading akin to gambling while stocks are forms of long-term ownership expected to go up over time.
We can even use a resort casino as an example.
Let’s take the famous Wynn Resorts. Wynn Resorts is a company that has issued stock. You can buy shares in Wynn Resorts, and own a piece of the company. You would expect that, over time, the value of the company and its stock will go up.
You might also never visit Las Vegas, and are perfectly happy never to go there and just own Wynn Resorts stock.
Another investor doesn’t like Wynn Resorts stock to hold for the long term. He thinks the business is too volatile and uncertain. However, he knows Wynn Resorts stock moves quite a bit, up and down. He wants to take advantage of all that movement as a trader.
He decides to buy call options on Wynn Resorts. He buys the a contract that allows him to buy 100 shares of Wynn stock at $140 per share on or before June 15thof 2019. If Wynn stock goes above $140 at any time, he can trigger his contract and purchase those shares.
Suppose the premium he pays for that call contract is three dollars per share. Then it would make sense for him to trigger his call contract if Wynn Resorts stock exceeds $143 per share before June 15.
This is almost the same as walking up to a roulette wheel at Wynn Resorts and betting on black. He has no idea if the roulette ball will land on black or not any more than he knows if Wynn Resorts stock will exceed $140.
Advantages of Stocks
When it comes to choosing options vs. stocks, here are the advantages of stocks:
- Long term appreciation expectation
- No time limits on holding the security
- Part of complete portfolio strategy
Here’s a video that gives additional information on investing in stocks.
Long term appreciation expectation
Let’s stick with our casino analogies.
When you gamble at a casino, you have a negative return expectation. That’s because all the games are designed to be in favor of the casino. Otherwise, casinos would never make money and they’d go out of business.
So, over the long term, the mathematical expectation is that you will lose money in a casino.
Stocks have a long term positive return expectation. That’s because the way capitalism works is that companies will innovate and continue to grow. As they grow, they become more valuable, and their stocks become more valuable also.
Just look at this chart of the Dow Jones Industrial Average from when it was created in 1896. There are short-term bumps and downtrends, but over the long term, stocks go up.
No time limits
You may hold shares of stock for any period of time you choose – from a few seconds to forever. There is no time limit.
Investors generally will hold shares of stock as long as the company continues to grow, and continues to have a vision. Sometimes people sell stocks because the company’s story changes.
For example, General Electric was one of the most widely held and admired stocks for decades. But in recent years, investors have harshly sold the stock because management doesn’t seem to know what it’s doing. General Electric’s story changed.
Options are contracts that have a time value associated with them, and those contracts have an expiration date. Like it or not, that contract WILL be closed on the date of its expiration. You can’t wait around for your side of the trade to move in your direction if times runs out.
Part of complete portfolio strategy
Because stocks have a long-term expectation of going up, they are a central part of any smart investing strategy. Stocks, along with other securities like bonds, have a certain level of risk and certain level of stability that have been proven over many decades.
So while we cannot exactly say how stocks will perform in any given year, we can get a pretty good idea of what range of returns we can expect from them.
We have no idea whatsoever what to expect from options. They are fleeting contracts whose outcome cannot be predicted.
Advantages of options
There are major advantages with options vs. stocks, however, and here are a few to consider:
- Can limit risk
- Can enhance income
- Hedge a position
Here’s a video that gives additional information on using options.
Can limit risk
When you buy an option, you are choosing to limit your risk. You can only lose the premium that you paid for that options contract.
Suppose you buy one contract for Wynn Resorts, specifically you buy the right to purchase 100 shares of Wynn Resorts at $140 on or before March 15th. As I write this, that contract sells for $230. No matter what happens to Wynn stock, you will not lose more than $230.
Your upside, however, is unlimited. Perhaps Wynn Resorts runs back up to $200 per share. In that case, you could execute your contract, pay $140 per share plus the $230 premium for a total of $14,230. But those 100 shares are now worth $20,000.
Can enhance income
If you choose to sell options, you can enhance your income by collecting the premiums on selling those contracts. Just remember it comes with risk.
Suppose you sell a Wynn Resorts contract — to deliver 100 shares of Wynn Resorts on or before January 11that a price of $115 per share. You can sell that contract right now for about $500.
But you better have those 100 shares in your possession now, while Wynn is at $110. That way you not only sell the share for a $5 per share profit but also collect that $500 premium.
Hedge a position
Some investors use options to hedge.
Suppose you own 100 shares of Wynn at $110 per share. You fear the stock might fall. You can buy a put option, so that if Wynn stocks falls below a certain price, you have contracted to sell those 100 shares to another investor so you don’t own them anymore.