Options or stocks? Which investment is right for you? (2024)

While not quite apples and oranges, options and stocks are two different investments with a close-knit relationship. Both might have a place in your portfolio, independent of and, possibly, in conjunction with one another.

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Introduction to stocks and options

“Buy low and sell high” has become part of our cultural lexicon, thanks primarily to stocks. When you buy a share of stock, you assume an — albeit, usually small — ownership position in a company.

Generally, owning stocks allows you to make money one of two ways:

• Stock price appreciation: This occurs when the market price of a stock moves higher than what you paid for it. Of course, until you sell, you only have on-paper profits.
• Dividend payments: Some companies, typically well-established and profitable companies, regularly return a portion of their profits to shareholders via stock dividends. You can take these dividends as cash or elect to have them automatically reinvested into additional shares of the company.

For many investors, options are a foreign language. They can be intimidating. On one hand, this caution is advisable because, overall, options can be riskier than stocks. However, once you learn the basics of options trading, you can effectively incorporate them into your investing.

Also known as derivatives, options derive their value from an underlying asset, such as stocks. When you buy or sell an option, you enter a contract that gives the buyer and seller different rights and obligations.

There are two main types of options:

• Call options give the option buyer the right, but not the obligation, to buy the underlying stock at the option’s strike price on or before the option expiration date.
• Put options give the option buyer the right, but not the obligation, to sell the underlying stock at the option’s strike price on or before the option expiration date.

If you’re unfamiliar with options jargon, refer to our guide on how to trade options for a primer.

Part of what makes options trading attractive to investors is that there are dozens of strategies you can execute with options, some of which can deliver outsized returns relative to stock investing. However, these strategies come with various levels of risk that, while not necessarily greater, may be less straightforward than the risks associated with stock trading.

The benefits and drawbacks of investing in stocks

The main drawback of stock investing is that — drum roll, please — a stock you select may lose value. Even if you consider your purchase a long-term investment, it can be unsettling to sit with on-paper losses. You have to decide whether to wait out a losing position or cut your losses and move on.

Establishing a strong conviction in a stock holding requires considerable research, not merely into how a stock will move in the near term, but how a company will perform over the long haul. This process requires time, effort, experience and knowledge. And, even if you do your homework, it’s still difficult to build a diversified portfolio that can weather the market’s ups and downs using individual stocks.

At the same time, history shows that the stock market goes up consistently over time. For example, in 2023, the S&P 500 Index — an index that measures the performance of 500 large domestic companies — returned just under 24%. It has generated just over 92% of upside over the last five years, as of the end of 2023. If you have a long-term time horizon, you can make money in stocks, particularly if you use products such as exchange-traded funds (ETFs) to gain diversified exposure.

It has never been easier to invest in stocks. Many brokerages offer commission-free trading, have low minimum balance or investment requirements and allow you to purchase small amounts of stock via fractional shares.

Understanding options and how they work

Generally, you buy a call option if you think a stock will go up in value. You buy a put if you think a stock will go down.

One option contract gives you control over 100 shares of stock. The price you pay to buy an option is known as a premium. To illustrate, consider this hypothetical call option example.

A stock trades for $190. Its call option with a $200 strike price trades for a premium of $2.90 per share. If you think the price of the stock will be above $200 by the option’s expiration date sometime in the future, you can purchase one of these calls for $290 (the $2.90 premium times 100 shares of stock), not including trading costs.

You’re paying a premium for the right to purchase this stock for $200. You need to factor this premium into your math. You break even on this trade when the underlying stock is at $202.90 (the $200 strike price plus the $2.90 premium). If the stock hits $200 and you exercise your option to buy it, you don’t start making money — on paper — until the stock hits $202.90.

Put options work in reverse. They are often used to hedge — that is, protect against downside — in a stock or entire portfolio. Because put option premiums tend to increase in value as the underlying stock price goes down, you can make money on the put even if you’re losing money on the separate stock position. This brings up another point: You can always trade the option premium rather than exercise your option to buy or sell the underlying stock, as long as you do so before the option reaches expiration.

Many investors sell options using a variation known as covered calls. To sell, or “write,” a covered call, you must own at least 100 shares of the underlying stock. By selling the call, you agree to sell your shares to the party that bought the call at the option’s strike price on or before expiration. For putting your shares at risk of being “called away,” you receive a premium.

The benefits and drawbacks of trading in options

The biggest benefit of trading options versus stocks is that it requires considerably less money or buying power to purchase calls and puts than it does to buy or short-sell a stock directly. Our earlier example illustrates this.

You need $19,000 to purchase 100 shares of a $190 stock. However, you only need $290 to purchase the call option in our example. If the stock moves up, you can — all else being equal — expect the option premium to also increase in value. Without any intention of exercising your right to buy the underlying stock, you can sell the premium for more than you paid for it, thus closing your options trade for a profit and moving on.

The biggest drawback? All else isn’t equal. One of the main differences between options and stocks is that options have an expiration date.

The closer you get to the expiration date, the more time impacts the price of the option premium. This concept — known as time decay, or the erosion of an option’s premium — is part of what can make options trading more complicated than stock trading, if not daunting. Time decay tends to happen slowly at first, then accelerates at an increasing pace as the option expiration date draws near. At-the-money and out-of-the-money options expire worthless at expiration and are typically near worthless just days before. So, if the underlying stock doesn’t move in the predicted direction within a relatively short period, you could be left with a worthless option.

When to invest in stocks

Stocks don’t have this expiration date. Therefore, if you’re a long-term investor looking to build wealth or save for retirement, it probably makes more sense to invest in stocks versus options. If these are your goals, taking the time to develop an understanding of options might be more trouble than it’s worth.

When to trade in options

This said, while short-term traders often favor options, you can use them in concert with your long-term portfolio. For example, covered calls can help generate additional income in an existing stock position. If you’re OK with the possibility of having your shares called away, this can be a relatively straightforward way to use options.

If you have a strong conviction that a stock will make a near- or long-term move, you can use options to place that bet over time horizons that range from a couple of weeks up to a year or more. Here again, it costs less money to speculate on a stock this way via options than it does to buy the stock outright.