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Having a diversified investment portfolio is one of the vital rules one must learn before they start trading. However, building such a portfolio can pose quite a struggle, as there are numerous investment opportunities, all coming with distinct features, advantages, and drawbacks.
Two of the most popular ways of putting your money to work in the market are stocks and options, with stocks being a clear favourite among investors, both experienced and those beginning their journey with trading. That’s because we’re all – more or less – familiar with the basic concept of stocks. They are a share of equity in an existing business. Options, on the other hand, are a more complex financial product, more popular among more advanced investors.
If you’ve been wondering whether you should opt for stocks, options, or both, this article will provide you with the answers you need to make your final decision. Below, we’ll break down what stocks and options are, the differences between them, and what they can offer.
In essence, a stock is a share of ownership in a company. For instance, suppose a company goes public and issues thousands of shares of stocks. Buying one means you own one-thousandth of that company. What’s the ultimate goal here? To buy at a lower stock price, sell at a higher, and therefore realize a profit, referred to as capital gains. Unfortunately, this is not always the case.
Although they can offer high rewards, stocks are considered one of the riskiest forms of investment. That’s because the stock market is volatile, and sometimes even one event, potentially insignificant, can wreak havoc on the marketplace. If that event hits the company you invested in, the stock price decreases, leaving you with a potential loss.
Still, historically speaking, trading stocks offer the highest return on investment (ROI), proving to be a strong long-term investment (a stock has an indefinite life). This, combined with the simplicity involved in trading stocks, makes them a preferred choice among beginning traders.
Pros and Cons of Stock Trading
As with all financial products, trading stocks provides a fantastic opportunity to multiply your funds. However, they do come with several drawbacks you ought to pay attention to as well. Let’s break them down:
Advantages of Stocks
- When investing in a diversified portfolio, stocks can deliver great potential returns at a reduced risk.
- Stocks come with an infinite lifetime, as they continue to exist as long as a company stays afloat and stays publicly traded.
- Stocks are much easier to buy and sell.
- Investing in stocks is a great way to cushion your portfolio against future economic inflation.
- As a shareholder, you’ll be entitled to receive dividends from companies that pay them, providing you with a steady income each month. And if the stock value increases, so does your dividend.
- Public stocks offer high liquidity, allowing you to exchange them for cash anytime the market is open.
- Many online traders have reduced their trading commissions to zero, meaning that you can trade stocks at a much lower cost.
Drawbacks of Stocks
- Stocks are volatile, and their prices tend to fluctuate from one year to another. They are also prone to external events and crises that may cause their prices to plummet.
- The stock value depends on the company’s performance. The better the company performs, the higher the price of your stock, and vice versa.
- Analyzing stocks requires can be a daunting task, but understanding where potential risks and opportunities lie is crucial.
- Since stocks aren’t guaranteed by the government, you may lose all your money.
Simply put, investing in an option means obtaining the right to buy (or sell) a stock or an asset at a specified price and by a specific time. This means options come with a fixed expiration date, after which the option loses its value and ceases to exist. Options are also referred to as a derivative investment, as it derives the value from an underlying security.
As for a standard options contract, it involves two parties – the buyer and the seller (the holder and the writer). Usually, the transaction involves 100 units of the security, be it a stock, currency, or fund.
Now, the contract will specify the strike price by which the action could be taken before the expiration date. If the strike price isn’t reached prior to the expiration date, the contract becomes worthless. If it does, the buyer or holder can, but isn’t required to take any action.
Options contracts also involve the premium fee. It’s the fee paid by the option holder at the outset in exchange for the right to exercise the contract. The fee is paid upfront, no matter whether the holder decides to exercise the options contract or not.
When it comes to options contracts, they come in two primary types – call options and put options:
- Call options: Allows the buyer to purchase the underlying stock (security) at a specific price (striking price) and by a specific time (expiration date). If the stock value goes up, so does the option value. However, if the market price doesn’t go beyond the striking price and the call holder decides not to act, the option expires after the established date.
- Put options: The exact opposite of a call option, the put option entitles the holder to sell the underlying stock at a striking price and by expiration date. Other than that, the same rules apply with the option expiring after the agreed date.
When buying a call option, you expect the stock price to go up. If you go for a put option, you expect it to go down.
Pros and Cons of Options Trading
Generally speaking, trading options involves a higher-risk, higher-reward opportunity than stocks. However, there’s more to them. Like stocks, options have their set of pros and cons, which every investor should know about before investing in them.
Advantages of Options
- Options can provide very high returns over a short period, as they use the leverage to multiply smaller sums of money by many times their value.
- Like stocks, options are highly liquid, and you can exchange them for cash anytime the market is open.
- You can qualify for lower long-term capital gains tax rates by holding to options for a longer period.
- Many online traders have reduced options commissions, with some allowing to trade options at no cost.
Drawbacks of Options
- To gain profit from options trading, not only do you have to be right with your investment thesis, but you also need to be correct at just the right time.
- Although they provide leverage, options are sold in units of 100, meaning you might need to invest in them more than you have expected.
- Although stocks are volatile, they are nothing compared to options, which can fluctuate even by as much as 50%. This means your investment can decline in value very quickly and might cause you significant losses if you don’t act at the right time.
- If you fail to sell or buy an option after its expiration date, it becomes worthless, unlike stocks whose lifetime can be infinite.
- Similar to stocks, options aren’t guaranteed by the government.
Choosing Between Stocks and Options
By now, you should have a better understanding of how stocks and options work, as well as what advantages and disadvantages they provide. Now it’s time to get to the bottom of the problem – which one should you invest in?
Well, we’re afraid there’s no straightforward answer, as it all depends on numerous factors. Keep in mind that both stocks and options come with their own distinct features, offering different rewards and coming with a different level of risk. What does it mean for you? Well, before making the decision on which financial instrument to include in your portfolio, you should first analyze several different scenarios.
Let’s discuss in more detail when stocks and when options might be the suitable investment:
When Might It Be Right to Invest in Stocks?
First things first, stocks are a long-term investment. If that’s what interests you, then you can consider trading stocks. The key here, though, is to remain patient. As covered, stocks fluctuate. Often, long terms of increasing stock value can be followed by downturns. This brings us to the next point.
Analyzing the stock market takes some effort. Not as much as with options, where you need to be constantly on your toes, but still. On the other hand, since stocks aren’t as volatile as options, you don’t need to follow the market very closely. Sure, it doesn’t mean you should just buy a stock and leave it be, but there’s certainly no need to check how it performs every five minutes.
When Might It Be Right to Invest in Options?
Contrary to stocks, options can provide great returns in a short period. If your goal is to generate quick yet hefty profit, options can work a treat here. However, options do include a much higher risk, as you gamble a complete loss if you’re wrong or act too late.
Options may also be a good choice for advanced investors with a more strategic approach. If you understand in and outs of the marketplace, you may be able to use options to limit your risk and generate higher profits. This, however, requires a more advanced knowledge and a lot of time put into analyzing the current market trends.
Can You Invest in Both Stocks and Options?
In theory, yes. In fact, many experienced investors use options in conjunction with stocks to hedge a position (buying one investment to reduce the potential losses from another investment). For instance, an investor could buy a put option to protect against downside risk.
Stocks and options can also be used to generate a higher profit. Suppose the upside potential is limited, an investor can then write a call option and therefore generate a return on the stock now.
Final Take on Trading Stocks and Options
Here’s a quick summary of how stocks and options differ from each other:
|Possible ROI||High||Very high|
|Timeframe||Potentially infinite||Limited by the expiration date|
|Type of investment||Equity||Derivative|
|When can you trade||Any time the market is open||Any time the market is open|
Hopefully, this guide has answered all your questions regarding trading options and stocks. As you can see, both instruments can work brilliantly, providing you with a great return on your investment. There are several differences you ought to take into consideration before investing in either stocks or options.
Despite a few similarities, stocks and options have different characteristics, with stocks being, in theory, a long-term financial instrument and options being something entirely opposite. The risk and reward ratio is also different, with options offering potentially bigger returns at a higher risk.
Which one should you choose then? It depends. The key here is to understand the differences between the two, consider their pros and cons, and analyze various scenarios. And remember, no matter whether you opt for stocks or options, both instruments involve risk.