What’s the difference between options and stocks?

Building a portfolio can be like dining out. You have lots of choices (chicken or beef? fries or a side salad?), but not all of them suit your appetite.

When it comes to investing, 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.

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.

Investing in stocks also carries risk, since the market typically goes through periods of volatility. However, one advantage that stocks have over options is, 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 is being able to earn dividends during that time. 

While buying and holding stocks for several months, years or decades can be a smart strategy, it also has its 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 to stay engaged.

Stock options, also commonly referred to as 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.

You can buy or sell two basic types of options: calls and puts. Purchasing 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. Purchasing put options also gives 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. 

Typically put sellers expect the stock to remain flat or surge above the strike price, which makes the put worthless. Selling puts is attractive because you receive cash up front and you may never have to buy the stock at the strike price. So, if the stock rises above the strike price by the time it expires, you’ll make money. When you sell a call option, you are obligated to sell the underlying stock at the strike price so you can have a “short call position.” The call seller must have one of the following things: the stock, enough cash to buy the stock, or the margin capacity to deliver the stock to the call buyer. Call sellers typically expect the price of the underlying stock to remain flat or move lower 

However, there are risks associated with selling puts and calls. Even though a seller may earn a premium when selling a call option, they also take on all of the risks if the stock moves in an unfavorable direction. When selling a put option the potential for loss is much greater.  

Before we further explain how trading these two types of options works, let’s cover a few important terms.

If you are considering trading options, you might be enticed by some of the benefits 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 have 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.

Both stocks and options can be beneficial assets to your investment portfolio — but all trading and investing involve potential benefits and possible drawbacks that shouldn’t be taken lightly.

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.

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.

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.

Still have questions? Review these common queries on stocks and options.

Neither stocks nor options are better than the other. However, one might be a stronger fit for your financial needs. For instance, if you’re investing over the long-term, with retirement decades in the future, and a hands-off approach to investing, stocks may be your better option. If you’re ready to ride the markets and plan to be an engaged trader, options will likely be a more interesting investment for you.

When well managed, options have a higher potential to be more profitable than stocks. However, remember that comes with risks. So, if you’re planning to “set it and forget it” options might not be the right pick for you.

If you ask 100 .different investors this question, you’ll probably get 100 different answers. Like most things involving the market, there’s no such thing as one-size-fits-all. A successful strategy has everything to do with your portfolio, your financial goals and the market itself. That being said, there are many strategies to choose from and try out. Find the ones that work for you and your money.

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.