First, let’s take a look at each one in turn.
With stock trading, you are making an equity investment. When you purchase shares of stock of a company, you own those shares.
While the value may fluctuate up and down over time, you can keep those shares for however long you like. In fact, you never have to sell them. Instead, you could pass them down as an inheritance.
If the stock pays dividends you will receive those as well. If and when you sell those shares of stock is entirely up to you.
If you buy 100 shares of stock at $20 per share, you own $2,000 of stock. If it goes up to $30 per share, you now have $3,000. If it goes down to $10, your $2,000 investment is now worth $1,000.
With options, this is not the case. An option is simply a contract that grants you the right to buy or sell 100 shares of stock in a company (each option is 100 shares of stock).
This option has very specific rights. The option grants the right to buy or sell the 100 shares of stock of a specific corporation at a specific stock share price at a specific time.
You do not have any equity in that stock. All you have is a contractual right to buy or sell the 100 shares of stock at a specific price and time.
The value of an option is dependent on the current price of a stock and how much time until the option expires. While the current value of a stock will vary, the value of the stock price in the option is fixed.
In addition, the length of an option contract is only a few months or less. Thus, the price to buy or sell the option contract will vary.
There are two types of option contracts. They are the call and the put. With the call option, an investor is buying the right (the price of the option) to purchase 100 shares of stock in a specific company at the specified share price any time between now and a specific future date.
If you purchase a call, you are hoping the value of the stock goes up. A simple example would be if you buy an option that gives you the right to purchase 100 shares of stock at $50 per share.
Let’s say the price of the stock goes up to $55 before the option expires so you purchase the 100 shares at $50 per share.
But they are now worth $55 so you made $500 ($5 times 100 shares) minus the cost of buying the option contract.
If the stock never goes above $50 per share, it expires worthless to you since you wouldn’t buy 100 shares at $50 a share if the stock is worth $48 per share.
If you are the seller of the call option, you collect the price of the option contract that the call buyer purchases from you.
Let’s say it’s $100. The call buyer pays you $100 for the right to purchase a specific stock at a specific price by a specific time.
In the example above when the stock rises to $55, you must sell 100 shares to the call buyer at $500 per share. You are out $400 ($500 minus the $100 you were paid for the option).
Selling calls could be seen as very risky. The price of the stock could have gone much higher than $55 per share.
However, selling calls can be seen as a conservative trading and investing strategy if you already own the stock. Let’s say you purchase 100 shares of stock at $40.
You start selling call options with prices of $50.
If the option expires worthless you made the cost of the option ($100 in the example above) and you still own the stock so you could sell another call option.
Each time an option expires worthless you collect that price of the option contract.
Let’s say the price of the stock rises to $55. You will have to sell the 100 shares to the option buyer for $50. Yes, you missed out on $5 per share but you profited $10 per share because you originally bought the stock at $40.
Plus, you made the income from selling options for however many you sold that expired worthless.
When you own the 100 shares of stock, selling call options can be a very rewarding and conservative options trading strategy.
The opposite of a call is known as a put. When you buy a put you are buying the right to sell 100 shares that someone else owns.
When you sell a put you are selling the right to someone else to sell you 100 shares of stock. At a specific price, of course.
The option put is the opposite of the call. When you buy a call you are hoping the price of the stock rises. When you buy a put you are hoping the price falls because you are selling shares instead of buying them.
If you buy a put on a stock that is $50 you are hoping the price of the stock falls below $50 because you get to sell those shares at $50.
When it comes to options trading, strategies can be very risky or pretty conservative. If you sell an option but don’t own the stock, you are still obligated to deliver those 100 shares if the buyer cashes in on the option, regardless of how expensive it may be for you.
If you already own the shares, it’s not a risky strategy at all.
With options, the seller has the advantage because of the time factor involved.
With stock trading, the time factor isn’t there. It may be part of the equation for some that trade stocks but it’s not absolute. Think day traders who are always looking to close out a position (sell) the same day they bought.
But it’s not necessary. As mentioned above, when you outright purchase stock you can hold it for however long you like.
Stock trading can be more complicated as it seems to have as many trading strategies as there are traders. And it can depend on the type of trader as well in terms of length of time to get in and out of a stock purchase.
Some are looking to trade in and out within minutes. Others, in days, weeks or months. And then there are the traders that are really investors, where they will hold a quality stock for years.
But stock trading does have certain common elements, it’s just how they are interpreted that can vary widely. One is fundamental analysis.
This is simply looking at the financials of a company such as its sales growth, profitability, earnings per share, etc.
Then there is technical analysis and chart reading. This is where stock traders don’t necessarily look at an individual company (although they may look at a specific industry) but look at the performance of the stock itself.
This means looking at things like stocks 200-day moving average (the average of the stock’s price over the past 200 days), and volume (how many shares are being traded every day and how that compares to previous days).
Stock trading can get overwhelming and complicated, not to mention risky.
While stock trading can be profitable, it may make more sense to take a look at options trading. You can even use stock trading strategies to decide which options to buy or sell.
But with options, you can more easily tailor your risk tolerance to your strategies because certain option strategies contain very little risk and others are quite risky (but can be very profitable).
The bottom line is don’t rush into either option trading or stock trading. There is a lot to learn and neither is as easy as the late night infomercials make them seem!