The number and variety of investments that are available to choose from is constantly growing. To those who are not directly involved with the market, keeping up with this kind of thing can prove to be far too difficult. Fortunately, with just a little bit of research, anyone can find everything that they need to know to trade in at least a few different types of markets. One of the most frequent questions that people not involved with the market have is about the difference between stocks and options.
What are stocks?
Stocks are simply representative pieces companies that are publicly traded. “Stocks, or equities, are issued by companies and represent proportionate ownership interest in those companies” is the way that Alliance Bernstein puts it. These are something that anyone can purchase or sell in order to gain profit for themselves. When one goes to purchase stocks, they are buying tiny pieces of the companies they wish to own. People will choose the stocks of companies that they believe will grow their profits well. When the investor is right in the choices they make, they are likely to make money off of those purchases. As the company begins to have more profits, the value of the company overall is going to go up as well. This means that the stock price will go up. If the investor then sells the stock at a price higher than when they purchased it, then they are able to make profits for themselves.
What are options?
Options are quite a different animal in comparison to the rather straightforward explanation of stocks. Option can best be described as an investment tool used to manage risk or increase risk depending on the circumstance. They are a side bet of sorts on a particular investment that allows the holder to be able to profit a lot for small amount of money. A more legal definition might mention that an option is a contract between the buyer and seller that gives the buyer the right but not the obligation to buy or sell a stock at a particular predetermined price.
The only downside is that the holder has to take on a lot more risk than they would if they were just holding the stock. When one purchases an option on a stock, they are making a bold statement about if they believe the stock will be up or down a certain amount and in a certain period of time. For example, one may purchase an option on a stock that only has any value if the stock goes up above the price that it is currently trading at by a predetermined price. The stock must also go up above that predetermined price within a certain period of time. That time could be 6 months, one year, two years, or even more.
The amount of time that the stock has remaining and the amount that it must go up will determine its value. If the stock fails to reach the predetermined price before the predetermined amount of time, then the option will expire worthless. This means that all of the money used to buy the option will be lost for the investor. That in itself is a sign of the massive increase in risk associated with the option. Assuming that the option is able to exceed the predetermined price within time, then the option is considered to be “in the money”. That means that the option will almost certainly have more value than when the investor originally purchased it. They are then able to sell the option and take the profit or exercise the option and still maintain the same amount of profit. In most cases, the option will just be sold for a quicker profit.
As you can see, options are quite a bit more complex than stocks. This is likely why we do not hear about them as much in the media. It is also probably the reason why the public at large is generally unaware of how this type of investment operates. Some say that this is for the better given the amount of risk and likelihood of loss of money involved with options.