This is an age-old question, what is the difference between stocks and options? Which should you choose and why? Each has its positives and negatives. Each is better for a certain type of trade as well! So which is it? Options vs Stocks?
What is a stock?
Stocks are the simplest financial asset to understand. They’re also known as equities and they’re financial security that represents fractional ownership in a company. A company would issue shares of its company ownership to the secondary market, where you and I can purchase and sell shares. They do this to raise money for growth. There are many stocks out there and all of our favorite companies most likely have stock. Like Apple, Netflix, Starbucks, and so on. A stock can be traded over and over again, with the hopes that it gains in value.
Investors and traders alike take advantage of stock prices to see an increase in value in their positions. Then with again you have the choice to sell the stock and solidify the gain or keep holding onto the stock. A lot of companies have dividends that are paid out to the share holders.
What is an option?
A stock option is a derivative asset whose price is derived from the underlying stock. Meaning a stock option has higher leverage, higher risk, and higher reward. A stock option gives you the right to buy or sell a certain amount of shares of the underlying stock at a specific time. There are a lot of variables in options that include Option Greeks, call and put options, option strike, and options expiry. If you want to learn more check out the following article: https://tradeproacademy.com/what-are-stock-options-and-how-does-it-work/
What are the primary differences between stock and options?
There are a lot of differences between stocks and options even though they are technically from the same underlying product. The main difference between the two is that stock options are derivatives directly derived from the underlying stock.
Below are the main differences between the two.
|Equity assets||Derivative asset|
|Active or Passive market participant||More active market participant|
|Large Account size||Small to medium account size|
|No expiration (can hold indefinitely)||Expiration (has to make a move in a shorter period)|
|No leverage without a margin account||High leverage (higher risk, higher returns)|
In summation, stock options hold more risk to them than stocks. Although both are definite risks an option has a higher leverage and expiration date.
Stock options do allow you to control more of a stock for less, which comes with the leverage of the derivative asset, however, you are punished harder if you are wrong and rewarded better if you are right.
Let’s use an example, assume you were trading Microsoft (MSFT).
You bought Microsoft at $210 based on a key support level because you’re anticipating a move through $220. You bought $10,000 worth of stock, while your friend bought $10,000 worth of options.
You made the purchase on Dec 11th, 2020.
With $10,000 worth of Microsoft stock, you bought 40 shares on Microsoft stock. On the other end, your friend bought January 15 220C options for $322 each…
Based on the options chart below, so what on earth does that mean?
There are already way more variables in the options world. In this case, the chart above is the options pricing chart that tells you what the price of the MSFT January 15th expiry is, for the 220 Call options. This means your friend anticipates that MSFT will be AT LEAST 220 by January 15th.
With $10,000 he was able to buy: 31 contracts of Microsoft (10,000/322). He is taking on A LOT more risk because his position can go to $0 and lose everything by January, your Microsoft won’t drop down to $0/share. That means the company will go broke.
So by December 17th, 2020 we tagged $220/share.
With shares you gained: ($220-$210)*40 shares= $400 gain
With options, your friend gained ($725-$322)*31=$12,493 GAIN! Which is 125% gain on the investment.
$725 is the worth of 1 MSFT call option when MSFT hits $220.
Why would anyone trade stocks when the returns are so amazing on options? Because he took on A LOT more risk than the stockholder.
There are more complexities in the options market which makes it a little more difficult to grasp and execute, however, can be vastly rewarding once understood. Rather than having to use a much larger account size to be able to make substantial profits, which would be the case in the stock market, you can use a smaller account size for substantial profits in options.
How to trade options?
The number one question is how do you trade these beasts? Everyone wants financial freedom and to get into the financial market. It is often portrayed as an easy feat, however, it takes a lot of effort and willpower to become successful options or stock trader.
To trade options you will need a broker, like Interactive Brokers or ThinkorSwim. You will also need a live data connection through that broker. Finally, you will need charting software. This again can be found through your broker. Many people do their chart analysis on TradingView.
The charting can be used in one of two ways. To do your technical analysis on the underlying or you can do the technical analysis on the underlying and the options price chart.
Learning technical analysis is pivotal to options trading, as well as learning about options, the greeks, and other variables. What strikes to choose? What expiry to choose from?
For example, if I was looking to trade Microsoft on the options front. You can take a look at the example above, it takes a lot more to comfortably trade options.
For more information on options, check out the following article: https://tradeproacademy.com/essential-guide-for-puts-vs-calls-difference-between-them/
How to trade stocks?
Stocks are very similar to options in what is required to trade the asset. You will need a broker and a platform. You can trade stocks with leverage, you will need a margin account so you can have options like gains. Typically the leverage is 4x!
When it comes to trading stocks, you can buy and hold like an investor, you can swing trade them or even day trade!
Stocks typically require larger accounts so either swing trading them or investing is the better option. There are many ways to trade stocks, however, you want to have a specific strategy, and look to trade more established stocks due to liquidity. You want to make sure you can get in and out of stocks easily.
Remember, cheaper stocks are not always better, do your research and get an education. Join a community of like-minded traders and investors.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO AcademyTM is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.