Stocks vs. Options
Buying a stock means you are purchasing a piece of ownership in a specific company. As long as a company is in business, that share of stock doesn’t expire.
Buying an option, means you’re purchasing the right to buy or sell a stock (or any other asset) at a specified price within a specified period. Options do not represent ownership in a business, and they have a limited or finite lifespan.
Options derive value from underlying assets. Let’s say an option gives you the right to buy 100 shares of Tesla for $200 for the next two months. You derive value from that right to buy, not from the ownership in Tesla. Otherwise, it would represent a share in the earnings of the company and grants some portion of control over the company’s governance.
Here are some of the most notable differences in options vs. stocks.
- Implied Volatility (Premium)
- Underlying Price
- Expiration Date
- Strike Price
An option’s strike price contract is the price where the contract is allowed to be exercised. Let’s say a $150 call option on Apple stock will enable you to buy Apple for $150 per share when you actually exercise the option.
Options have finite lives. Their expiration date defines the duration. The option no longer exists and is deemed worthless after the expiration date. For example, say you have an option that expires this Tuesday. Beginning Wednesday, the contract is void, and you can no longer exercise the option.
The price of the underlying instrument that an option is acquired from has a significant impact on the option’s price. Say Apple is trading at $200, and someone has a call option for $150, their profit will be $50 per share, minus any premium paid. Alternatively, if they have a call option for $250, their position is in the red.
What is Implied Volatility
Implied volatility indicates the option writer’s forecast of the imminent risk of a particular market. Low implied volatility means a small premium, whereas high implied volatility options carry much higher premiums because of the expected risks present.
The level of implied option volatility determines the premium paid. This is the actual price of the option you’re paying.
Say someone purchases an option; they’re paying a writer (person who takes the other side of their option trade) a premium for the right to purchase or sell stocks at a set price. Regardless of what happens, the writer gets to pocket the premium for that option, and the trader has to pay it. The writer loses money when the trader’s gains on the option outweigh the price of the premium that the trader paid them.
A critical difference between trading shares of stock and options is the leverage involved. Options allow much more leverage than stocks do because of how contracts are structured. In US markets, each option contract signifies 100 shares of stock, and the further out-of-the-money you go, the less value the option holds.
Options can provide leverage because they allow the same price movements as a 100-share position in the underlying stock but cost much less to purchase.
You can value a share of stock based on the current and future earnings power of a company. You could conclude that a solid, growing company equals a safe investment at a valuation of 10x trailing annual earnings.
However, options aren’t valued on primary criteria like a company’s financials or administration. An option is only valued based on the following determinants:
- The implied volatility
- The strike price of the option
- The current price of the underlying instrument
- The expiration date of the option
The Black-Scholes model is a popular model used to get a fair value of options and other derivatives. This leaves most options to mirror the model based on arbitrageurs that are present in the options markets.
How To Use Options To Express Different Market Views
When you buy or sell shares of stock, the only way to profit is for the shares to move in your trade’s direction. Options allow you to create positions that profit from various factors like volatility expansion or contraction, price staying within a specific range, time decay, etc.
A short strangle is an option spread composed of a short off-of-the-money call and a short out-of-the-money put. This will help you profit when the market stays in a provided price range. The strategy doesn’t involve betting the price moving up or down, but it involves volatility contraction and time decay.
This is just one way you can use options to express views on instruments outside of pure price direction more creatively.
Pros and Cons
- Creates spread trades to express a view on factors outside of price direction
- A less expensive way to hedge positions going into volatile events
- Options expire, and many become worthless
- The increased leverage can have a negative impact
- When you buy options, paying a premium means the market needs to move more in your favor to profit if you were to purchase the shares outright.
When you know the differences between options vs. stocks, you’ll be in a better position to make smarter financial judgments!