Building a portfolio can be like dining out. You have lots of choices (chicken or beef? French fries or side salad?), but not all of them suit your appetite.
Stocks may be your go-to pick, but options can also be a wise choice for your portfolio. Whether you’re deciding between options vs. stocks or leaning toward a combination of the two, you’ll want to look at several factors, including your goals, timeline and risk tolerance.
Investment know-how also comes into play, and that’s where we can help. Read on to learn more about the difference between stocks and options, and how trading options (or stocks) can be right for you.
Options vs. Stocks: What’s the difference?
Before you can make a confident decision about which types of investments best fit your style, you have to understand the fundamentals.
What are stocks and how do they work?
A stock is an ownership share in a company. When you buy one or more stock shares, you purchase part of the company that issued the stock. When you invest in stocks, the goal is to buy shares at one price, then sell them at a higher price. When you do so, you realize profits, a.k.a. capital gains, in your portfolio.
Some stocks have an added benefit: paying dividends. A dividend is a payout the company makes to you typically on a monthly, quarterly or annually basis just for owning the stock.
When you invest in stocks through a self-directed account, like with Ally Invest, you decide which stocks you want to buy (or sell) and how many shares and can execute those trades on your own.
What are options?
Stock options, also commonly referred to as simply options, are different. When you invest in stock options, you essentially purchase the right to buy or sell shares of an underlying stock for a set price at a future date. There’s no direct ownership of the company at all.
You also don’t have an opportunity to earn dividends with options trading. But you do have the potential to reap capital gains from your investment.
How does options trading work?
You can invest in two basic types of options: calls and puts. Call options give you the right to buy stock shares at a predetermined price (the strike price) on or before the option’s expiration date. Think of this as “calling” the stock to you. Put options give you the right to sell shares of stock at a certain price on or before the option’s expiration date. In other words, “putting” the stock away from you.
Before we further explain how trading these two types of options works, let’s cover a few important terms.
Strike price: The set, agreed-upon price at which an option holder can buy or sell the security.
Expiration date: The day an options contract expires, and you can no longer execute the contract.
Option premium: The price you pay to buy an option contract.
Investing in Call Options
When you purchase a call option from the option writer or seller, the two of you agree on the strike price, or what you’d pay to buy the underlying stock. You ultimately want the underlying asset to increase above the strike price. That way, you can then exercise your option, buy the stocks at a lower price and sell them to realize a profit.
Investing in Put Options
When you buy a put, it gives you the right (but not the obligation) to sell a specific stock at a specific price per share within a specific time frame.
In terms of what you want to happen with a put option, it’s the reverse of a call. Buying put options can help you take advantage of the downward movement of a stock. Instead of hoping the price rises, you want it to drop so you earn the difference between the strike price and the stock’s price in profit.
Investing Considerations for Options and Stocks
Both stocks and options can be beneficial assets to your investment portfolio — but all trading and investing involves potential benefits and possible drawbacks that shouldn’t be taken lightly.
If you are considering trading options, you might be enticed by some of the advantages they offer compared to regular stock investing. For example, buying options doesn’t necessarily tie up as many of your investment dollars as buying shares of stock might. That’s good if you’re an investor who has limited money to invest.
Second, options are flexible. You can decide when and if to exercise a call or put option. They can also give you some predictability, since you and the seller decide on the strike price — which makes it easier to gauge how much you stand to gain or lose by exercising your options strategy.
But there’s a possible downside you should keep in mind. Options trading can have a greater potential for loss than trading stocks because you’re making a bet that a stock price will move one way or another. If your assumption about a stock’s price movement turns out to be wrong or you get the timing incorrect when buying or selling, you could lose money instead of turning a profit.
Investing in stocks also carries risk, since the market can go through periods of volatility. But an advantage stocks have over options is that there’s no pressure to sell.
You can buy a stock at one price and sell it right away, potentially earning some short-term capital gains. Or you could buy it and hold it for years, selling when the time is right for you. An added incentive to maintain your portfolio’s position? Being able to earn dividends during that time period.
While buying and holding stocks for several months, years or decades can be a smart strategy, it also has its own drawbacks. You may find investing this way takes more patience than you prefer or that it is difficult to endure short-term ups and downs. You might also decide that you like a strategy that requires more hands-on portfolio attention in order to stay engaged.
Stocks vs. Options Quick Hits
|What are they?||Ownership share in a company||Contract that gives you the right to buy or sell shares of an underlying stock for a set price at a future date|
|What kind of investors are they best for?||Beginner investors, long-term investors, hands-off investors||Active traders, advanced investors|
|What are potential benefits?||May require less hands-on attention, possible dividend payments||Greater potential returns, possible hedge against volatility|
|What are potential drawbacks?||Potential loss, slower returns||Requires more effort, increased risk of loss|
Can you invest in stocks and options at the same time?
Short answer: Yes. But should you?
As we mentioned, options trading can be riskier than stocks. But when done correctly, it has the potential to be more profitable than traditional stock investing or it can serve as an effective hedge against market volatility.
Stocks have the advantage of time on their side. While past history is no guarantee of future performance, you can research a stock’s track record to decide whether adding it to your portfolio makes sense.
Options take it a step further and require you to have a sense of what the underlying stock’s fundamentals are like and how that correlates to a defined timeframe. That means doing research about things like what’s on the company’s balance sheet and how the stock has reacted to economic or political changes that affect the market.
Both stocks and options can help you diversify your investment strategy. Diversification matters for managing risk. But in the end, whether you want to trade options and/or stocks may come down to what type of investor you are.
More focused on the long-term? You may benefit more from buying and holding stocks. On the other hand, if you’re more of a hands-on, active trader, then options might be something to consider.
A self-directed trading account, like one from Ally Invest, can offer D.I.Y. traders access to both options and stocks with minimal trading fees.
Perfecting Your Portfolio Palate
Building a portfolio once you understand the difference between stocks and options is still like eating out at a restaurant. Only now, it’s like you’ve read the online reviews, browsed the menu and can more easily ID which dishes will help satisfy your cravings — your financial ones, that is.
Stick with stocks or opt for options: The choice is yours when you open a Self-Directed Trading account.