When it comes to finding opportunities in the financial markets, options and stocks are two popular ways to do so. That being said, they are two completely different financial instruments, offering their own risks and potential rewards. Here we will look at how these two financial instruments are different, and which one you should consider trying out.
If you want to learn more about options trading, feel free to check out Saxo bank’s website for further information on this topic.
Difference Between Stocks and Options
While stocks and options are closely related to each other, there are still differences between them. For starters, a stock represents a portion of ownership in individual companies. Options, on the other hand, are contracts with other investors that let you speculate on which direction the market will go and where you think a certain asset is going. Though despite their differences, it is still possible for them to complement one another in a single portfolio.
Stocks, essentially have an indefinite lifespan and can continue to be traded so long as the company that issued it still exists and remains publicly traded. While in any given year, stocks can fluctuate significantly due to a variety of different factors, their overall performance should track how the business is doing. So, if the business is doing quite well, the stock price will gradually rise over time. However, if the company is experiencing hardship, then the stock will fall. Of course, if the company winds up going bankrupt, then the stock may end up ceasing to exist.
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For options, they give traders the right to buy a specific asset (so it can be a stock, bonds, commodities, etc), at a specified price at a predetermined time and date. So this means that an option has a fixed lifespan, as they have a specific expiration date. This is when its value is settled amongst investors, so afterward the option will then cease to exist. The value of the option tends to fall over time as well, so it is also called a wasting asset.
Options tend to come in two major varieties. In order to purchase an option, a buyer makes a cash payment called a premium in order to own the options contract.
Call options: These options allow their owners to buy the underlying asset at a specified price at a predetermined date. So, when the asset’s price goes up, the call option will increase in value. In general, investors tend to buy call options if they believe the underlying asset’s value will eventually rise.
Put options: This allows the owners to sell the underlying asset at a specified price at a predetermined date. So, when the stock price decreases, the put option will instead increase in value. Most investors end up buying a put option if they believe the underlying asset’s price will fall in the future.
Advantages of Options
Options have a few advantages over stocks when it comes to trading. Let’s look at these advantages one by one below:
Potentially Less Risky
While this may sound counter-intuitive, since options are known for being quite risky financial instruments, it is still possible to reduce risk if you use options correctly. The reason is that options require a less financial commitment in comparison to stocks, and they are a lot sturdier when it comes to being affected by current events and other economic factors (in comparison).
Options can also be used to hedge against certain types of risk, so in some ways, this can make them safer investments than stocks. For instance, when an investor purchases a stock, they will usually put it in a stop-loss order to protect their position. These stop—loss orders are designed to stop any losses that have fallen below a certain predetermined price set by the trader. However, the downside is that this only is only executed when the stock trades at or below the limit indicated by the order.
More Investment Alternatives
Another major advantage of options is that they offer more investment alternatives for the investor. This makes them a very flexible tool to use. For instance, you can use options to recreate other positions if needed. These positions are usually called synthetics.
Synthetic positions allow investors multiple ways to gain the same financial goal, making them incredibly useful. For instance, maybe an investor wants to get their brokers to short a stock. However, the cost of the margin requirement needed to do so may be too high. Some brokers may not even allow investors to short a stock, period. As such, in order to get around this, some investors may choose to use options instead.
A great thing about options is that they have the power to take advantage of margin and leverage. This means that an investor can open a large position with only a fraction of the cost. This means that even if a trader may not have a lot of funds, they can still find great opportunities as a result of an option’s leveraging power. That being said, while leverage can magnify trading positions, it can also magnify risks and losses too. This is because any losses incurred mean that the trader has to pay back what the total trade is worth, not just the fraction that they initially paid. So, make sure that you keep this in mind when you trade with options, or else it can quite literally end up eating into your funds.
Making Your Decision
At the end of the day, whether you choose to invest or trade with stocks or options is entirely up to you. The decision you make should be based on your financial goals, current financial situation, risk tolerance level, and trading style. For instance, if you are a beginner investor who prefers simplicity, you may just want to stick to trading options, which is a perfectly valid decision! On the other hand, if you are someone slightly more experienced or you just want to try something new and are not afraid of risk, then options trading may suit you more. Ultimately, whichever financial instrument you decide to use, you need to make sure that you understand exactly what you are doing first.