Stocks and options are both common terms within finance. They are both securities, meaning instruments with financial value that can be exchanged and negotiated with.
The difference between them is whereas one represents an actual ownership, the other is a contract to buy the same ownership. Their value and usage on the financial markets are also different. In order to understand this, it is necessary to have a look at how key elements of both securities differ.
Stocks, or equity, are purchased ownership of a corporation. The owner of stocks has a claim toward the company’s assets and earnings.
An option, on the other hand, is the right to either buy (call option) or sell (put option) stocks for a set price (strike price). A fee (premium) is paid to buy this right. Options can have different underlying assets, that is, the right to buy or sell different assets, including stocks, currencies and raw materials.
An option will expire on a certain date, the exercise date. Stocks will not expire, and the owner may collect dividend earnings as long he owns them.
Take a simplified example for illustration of the differences. Let’s say two different investors both decide to sell stocks one month from now.
Investor 1 decides to buy stocks today for $100 and sell them directly once the month has passed. Investor 2 decides to buy a call option, with the right to buy the stocks one month from now for $100, which he then can sell on the market. He pays a premium upfront of $1.
If the price of the stocks after one month is $120, investor 1 makes a profit of $20. Investor 2 makes a profit of $20 minus what he paid in premium, so $19. In this scenario it would have been better to own the stocks, since they have a higher profit.
On the other hand, if the price of the stocks at the end of the month is $80, investor 1 has made a loss of $20. Investor 2 has bought the right to buy options at $100, but since this is more expensive than what they are currently worth, he will not exercise that right. He has made a loss of $1 for the premium.
The difference between the two instruments is that the potential earnings from stocks are higher, because there is no need to buy a premium. The potential loss is also higher. The value of the stock remains tied to the earnings of the corporation.
The owner of the option will never lose more than the upfront payment of the premium, so there is a floor to the potential losses. On the other hand, he might lose the premium. Consider the example above. If the premium was $20 instead of $1, investor 2 would not make a profit in either scenario.
An option’s value is made up of two components. The first is the intrinsic value, which depends on the difference between the strike price and the current price of the stock. The second is called the time value, which reflects the likeliness that the option will be exercised.
This is where the value structure of an option becomes complicated. The formula to calculate the value includes a probability function that will assess the likelihood of the option to earn money for the owner. Generally, the time value will decrease as time passes because there is less uncertainty of whether the option will be valuable.
On the other hand, if the price of the stock today is $119 and the option in the scenario above is about to be exercised tomorrow, the premium is likely to be very high. Compare it to a car insurance premium, which will cost more if an accident payout is deemed likely.
The owner of the option might at this time be able to sell his security and collect the difference between the premium he paid and the one he received. This depends, however, on whether he can find a buyer for it.
The value of the option seizes to exist after it expires, whereas the stock holder may still hold on to his assets for future revenues. Investor 1 could decide to hold on to his stocks in the second scenario to sell them when they make a profit. Investor 2 doesn’t have this option and will have a realised loss of the premium.
It is this complicated structure that makes options unsuitable for inexperienced speculators. There may be a floor to potential losses, but there is also the risk of having paid a premium for an option that expires worthless. For speculation, options are considered relatively risky. They are often used instead by risk managers to reduce risks of holding an asset very similar to buying insurance.
Stocks, on the other hand, have a much simpler structure and are therefore easier to trade, making it suitable for both beginner and experienced speculators.