What's the difference between stocks and options?
The biggest difference between options and stocks is that stocks represent shares of ownership in individual companies, while options are contracts with other investors that let you bet on which direction you think a stock price is headed. But despite their differences, these assets can complement one another in a portfolio.
One thing to note: Finding potentially lucrative investments within the stock or options markets might sound exciting, but before you dive into day trading or options trading, you may want to explore low-cost index funds and exchange-traded funds. These instruments bundle a number of assets (such as stocks or bonds) together, letting you diversify your portfolio through a single investment. Experts often recommend that investors use these funds to form the basis of a long-term portfolio — and they can serve as a good entry point for beginner investors.
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» Get started: Learn how to invest in index funds
If you’re intent on diving into the market via stocks or options, the guidelines below can help you make the right choice. Let’s start with a basic breakdown of the differences between stocks and options:
Stocks | Options | |
|---|---|---|
May be a good fit for | Beginners and long-term investors | Active traders who want flexibility |
Potential drawbacks | Risks, fees and taxes | Effort, additional risk and cost |
Type of investment | Equity | Derivative |
Stocks
If you’re looking for a straightforward way to begin investing for a goal more than five years away, such as retirement, stocks may be a good choice. While there’s no guarantee you’ll make money — the performance of any individual stock can be volatile — the U.S. stock market as a whole has continually proven to be a strong long-term investment.
The beauty of investing in stocks is simplicity: You buy a stock, hoping its price will rise so you can sell at some point down the road at a higher price. That applies whether you plan to hold a stock for years or try your hand at day trading — actively buying and selling stocks over short time frames like days or weeks.
» Need the basics? Get step-by-step instructions for how to buy stocks
For beginner investors, and especially people with a long-term strategy, stocks are a more common entry point into the stock market than options, because they’re more straightforward, tend to have lower expenses and allow for a hands-off approach.
After researching the stocks you wish to invest in — ones that you believe have a growth potential that fits your time horizon — you shouldn't need to obsessively check on them every day. You can simply keep an eye on them until the time comes when you need that money, or set an alert through your online broker to notify you when the stock’s price reaches a level at which you want to sell.
The drawbacks of stocks
The risk associated with stocks is straightforward: The price could plummet and you’d lose all or most of your investment. Because the performance of individual stocks can be volatile day to day, experts generally recommend investing in stocks with money you won’t need for at least five years. To further reduce risk, it’s typically best to avoid piling all your money into a single stock.
Beyond that, how actively you trade stocks can affect performance — and how much you’ll pay in commissions, fees and capital gains taxes on profits. Commissions for stock trading vary, but many online brokers have recently eliminated them completely, so shop around before opening an account. Your capital gains tax rate depends on whether you realize a profit on the sale of the stock, how long you’ve held it — rates are higher for investments held less than a year — and your income.
» Learn more: Best online stock brokers
Options
Looking for a more tactical approach to investing, one with a smaller investment requirement and flexibility regarding timing or downside risks? Options may be up your alley.
With options, the associated time period for your investment is inherently shorter, making them more appealing to traders who buy and sell regularly. All options contracts have expiration dates, which can range from days to years.
» Ready to learn more? Check out NerdWallet’s options trading 101 guide
While many people like the flexibility afforded by options — namely, time to see how a trade plays out and the ability to lock in a price without an obligation to buy — they do add complexity to the investing process. Rather than making one decision, such as betting that a stock’s price will go up, you must make three:
What direction the stock is headed.
How high or low it will move from its current price.
The time frame in which that will happen.
That’s options trading at its simplest; there are more complicated strategies for advanced traders.
Options trading requires you to learn a new vocabulary of terms like puts, calls and strike prices, which may lead you to believe these assets are riskier than stocks. That notion may be overstated, especially because investors can let an option expire and incur no further financial obligation other than the premium paid and associated trading costs. What’s more, long-term investors can use options as a hedging tool. For example, buying a put option will help mitigate potential losses if the value of a stock you own goes down.
The drawbacks of options
Options trading requires a more hands-on approach than investing in stocks. You may wish to exercise the option before expiration, and that means you’ll have to keep a watchful eye on the related stock’s price. You can set alerts through your online broker.
Also, some options strategies are riskier than others, so make sure you understand the trade in advance. Hint: Many experts recommend avoiding daily or weekly options, which tend to be a better fit for more seasoned traders.
Another downside of options trading is the related costs, which can be higher than for stocks. Options traders may pay a flat fee per trade — which is typically the same as the broker’s stock trading commission, if it charges one — plus a per-contract fee ranging from 15 cents to 75 cents. The more you trade, the higher your costs — and don’t forget, you may pay fees to sell, too. Finally, as with stocks, be sure to factor in capital gains taxes. You’ll be on the hook to pay taxes on profits; these taxes are higher for assets you’ve held less than a year.
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Making the decision: options vs. stocks
Deciding whether stocks or options are better for you is entirely a personal decision, based on your investing style. Beginner investors and those who prefer simplicity generally will stick to stocks for their straightforward nature. Those who favor an active investment approach and love to watch the market may find options appealing.
But don’t assume you have to stick to one asset. After all, options traders inherently become stock investors if they exercise call options. Meanwhile, many stock traders use put options as a hedging mechanism. Whatever you decide, just make sure you understand what you’re doing first.
