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 choose stocks, options, or a combination of the two depends on several things, 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 stocks, options, and how trading options (or stocks) can be right for you.
Options vs. stocks: What’s the difference?
Even if you’re brand-new to investing, you likely know what a stock is. But in case you forgot, here’s a quick refresher:
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 capital gains or profits in your portfolio.
Some stocks have an added benefit: paying dividends. A dividend is a payout the company makes to you monthly, quarterly, or annually just for owning the stock.
Stock 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?
When you invest in stocks, you decide which stock you want to buy (or sell) and how many shares. If investing through a self-directed account, like ours, you can execute stock trades on your own.
But trading options involves a different process, although you can still make these trades in your self-directed account. There are two basic types of options: calls and puts.
Call options give you the right to buy stock shares at a predetermined 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.
1. Investing in call options
When you buy a call option, you ultimately want the underlying stock or security to increase in price. You can then exercise your option, buy the stocks at a lower price, and sell them to realize a profit.
The strike price is the price that you agree to pay to buy the underlying stock using a call option. It’s a way to measure whether the stock will go up or down in value. The premium is a fee you pay to buy an option contract.
When you purchase a call option from the option writer or seller, the two of you agree on the strike price.
2. 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. A good way to remember this is: You have the right to “put” stock to somebody.
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.
Why should you consider investing in options? Or stocks?
Options trading can offer some advantages compared to regular stock investing.
First, options don’t necessarily tie up as much 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. That makes it easier to gauge how much you stand to gain or lose by exercising an option.
But there’s a potential 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.
Can you invest in stocks and options at the same time?
The short answer is yes. But perhaps the better question is, should you?
As we mentioned, options trading can be riskier than stocks. But if it’s done correctly, options trading has the potential to be more profitable than traditional stock investing or serving 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 look at 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.
Building a portfolio once you understand the difference between stocks and options is still like eating out at a restaurant. Only now you can ID which dishes on the menu will help satisfy your cravings — your financial ones, that is.