Many traders come into the world of Options Trading after trading Stocks for some time. Whether to complement their trading strategies or to explore a completely new trading methodology, Options offer alternatives that are either unavailable or entirely different than those found when trading only Stocks. If you are already familiar with trading Stocks you will find it very useful to go through a quick review of the main differences between trading Stocks and trading Options.
1. Ownership
When you own a Stock you own a piece of the underlying business or, in the case of Exchange-Traded Products, you own a piece of or a claim to the underlying fund. This is not the case with Options. When you trade Options you are dealing conceptually with contracts between two parties to potentially buy or sell the Underlying asset at a pre-defined price and on or before a set date. There is no ownership or claim to the underlying business at all, only the rights and obligations established as terms of the Options Contracts.
Stocks also grant shareholders voting rights proportional to their ownership and the right to participate in corporate Annual General Meetings, depending on the specific corporate structure. This is of course not something that Option traders are entitled to.
When it comes to dividends, special dividends, cash-distributions, spin-offs, spin-outs and similar corporate actions, only shareholders participate. Sometimes the terms of existing option contracts are modified because of corporate actions but by and large option traders are not directly affected by any of these. In the case of regular dividends, only traders who own shares as of the close of the day prior to the ex-dividend date will be entitled to receiving the dividend. Traders who are short those stocks on that date will be obligated to pay out the amount of the dividend. Options traders will not be directly affected at all by regular dividends.
In summary, Option traders do not directly participate at all in any corporate action; only indirectly as the price of the underlying is affected by those actions.
2. Expiration
Options expire, stocks do not. As long as the underlying exists you can buy it and hold theoretically forever. You can’t do that with options, as they will cease to exist after the expiration date.
3. Number of Shares or Contracts Outstanding
Stocks are traded in shares and Options are traded in contracts. Most equity option contracts have deliverables that are 100 of the underlying’s shares or units so the pricing reflects this. When you see an option contract trading for $3.50 for example, the least you can buy of it is 1 contract for which you will have to pay $3.50 per contract, times 100 shares/contract so a total of $3.50 x 100 = $350.00.
The total number of shares outstanding in the case of stocks is a finite number and determined at the corporate level. For option contracts there is no pre-set number of contracts available in the marketplace. New contracts are created and eliminated as needed based on trading around those options. The concept of a “short-squeeze” does not exist for options, only for Stocks as demand greatly exceeds supply of available stock to trade.
4. Flexibility
When you buy or sell stocks short you profit only from the stock price itself going in your favor and from dividends when you are long stock. When you start trading options you will realize that profits and losses depend on other factors as well: Strike Price, Time to Expiration, Implied Volatility, IV Skew, IV Term structure, Interest Rates, etc. This gives options many more dimensions to work on and makes them ideal to establish strategic positions unavailable to stock traders, especially when you combine them with other options and even stock positions.
For example, you can initiate a position that will profit if the stock price stays inside a range with no price movement at all (short strangle). Also, you could put on a position that profits if the underlying price stays at the current price or goes down or even goes up a little bit, as long as it doesn’t expire above a certain price (short call spread). The possibilities for bespoke strategies are endless and because of this, option strategies are able to accurately reflect your expectations for future market conditions in a way that stocks alone can not.
5. Leverage
Options are leveraged instruments and option strategies can take advantage of this while simultaneously limiting risk. For example, 100 shares of a stock that is trading at $250 would require you to use $25,000 to initiate a long stock position. If the $250 Strike Price call for that same underlying is trading at $7.00 and you think that the price will go up you can buy 1 contract of the $250 Call for $7.00, requiring you to use $700 in capital to carry that position.
If by expiration date the stock price does go higher and is trading at $300, your stock position will go from $25,000 to $30,000 for a profit of $5,000 or +20%. Meanwhile your option position will go from $700 to $5000 (the difference between $250 and $300 being $50) for a profit of $4,300 or a 614% return. You can easily see how you can use leverage to your advantage when using options instead of stock.
Also, in the above example if we are wrong in our assessment and the stock price goes down to $100 by expiration, in our stock position we would go from $25,000 to $10,000 for a total loss of $15,000 and a return of -60%. In the same example with our call we would lose our whole investment but it was only worth $700 instead of the $15,000 loss with buying 100 shares of the stock. You can see how you can leverage your profits while simultaneously limiting risk with options. Of course this is an oversimplification and there are many other risks we didn’t mention but you can see the basics of how options work and what they can do for you.
6. Protection
If you trade only stocks, the only protection you have if price moves against you is closing your position to prevent further losses. When you incorporate options to your strategies you can make use of the built-in features of both standalone options and option strategies to protect your whole portfolio or individual positions. By doing this you will be able to hold your positions for longer and ride out the normal market volatility without bailing on positions that would have been profitable if you stayed longer in those trades instead of being stopped out.
For example, if you want to protect a position you can buy puts or put spreads to ensure a minimum price for your assets while profiting from upside movement and dividends paid out during the life of the trade. Likewise, short stock positions can be protected with long calls or call spreads. This is similar to how insurance works in terms of paying a premium for that protection, but with the additional flexibility of being able to be either the policy holder or the policy seller if you decide to incorporate option selling into your strategies as well.
7. Bearish Positions
When you trade stocks there is only one way to profit from stock prices going down: short-selling. Short-selling has its own challenges and is not as straightforward a process as buying is. For example, you need to have a margin account to sell short. There are some stocks that are Hard-To-Borrow or None-To-Borrow where shorting can be difficult or downright impossible. Also, when the uptick rule is in effect (like it partially is today), short-selling is only permitted on an uptick in price action, making shorting difficult for stocks that are moving down already. Last but not least, shorting has limited profitability but unlimited risk and capital usage increases when price moves against you.
When you trade options you can have bearish positions that are equally as easy to initiate as bullish positions. You can buy puts, buy put spreads, sell calls, sell call spreads, buy put backspreads, etc. The list goes on and on. You can also establish bearish positions with limited risk and quasi-unlimited profitability (buy a put), or positions with unlimited risk and higher probability of profit (sell a call). The number of bearish strategies is endless and only limited by your creativity in putting them together, liquidity and market conditions.
8. Liquidity
Both stocks and options are liquid enough that most strategies can be established without problem. However, liquidity is better in stocks without a doubt. Bid/ask spreads are smaller as a proportion of asset price; volume is higher and larger sizes can be traded easily. Options have come a long way but there are still some instruments whose options either don’t exist or are not liquid enough to be seriously considered as viable to efficiently trade. In highly liquid options, liquidity is not a barrier to establish any kind of strategy but would have an impact when it comes to high-frequency strategies such as scalping. Bid/ask spreads for stocks can be as low as 0.0001% of the stock price whereas for options anything under a bid/ask spread of 3% of the option price is considered tradeable and highly liquid.
Stop losses are also a protective technique that works fairly well for stocks but that is challenging for options precisely because of liquidity issues. Stops get triggered easily even when conditions don’t merit it because of the relative illiquidity of options. Because of this, you need to be more careful and establish strategies with built-in stops to prevent major losses with options, for example by using spreads and defining risk whenever possible.
9. Trading Hours
Stocks are traded from Monday to Friday from 09:30 Hrs to 16:00 Hrs ET. Extended Hours are from 04:00 Hrs to 09:30 Hrs ET (Pre-market) and from 16:00 Hrs to 20:00 Hrs ET (After-hours).
Options are exclusively traded from Monday to Friday from 09:30 Hrs ET to 16:00 Hrs ET (a limited number of Stocks/ETPs trade until 16:15 Hrs ET).
As you can see, there are times when the underlying instrument is trading but its options are not.
10. Transaction Costs
In general, transaction costs for Stocks have historically been lower than for Options. This has been slowly changing though to the point where transaction costs for option trades are no longer prohibitive for retail traders trading on a regular basis.
Stocks can be traded on both cash and margin accounts and Options as well, but the number of option strategies is very limited on a cash account. Margin allows for all the different option strategies to be established, depending on the specific approval level of your account. Stocks can use margin for as much as 2:1 Stock Buying Power but Options need to be paid in full with no margin available to them, other than as needed for the Buying Power Reduction when selling options and related strategies.