- If you want to invest in the stock market, you can choose stocks or options, depending on your investment strategy.
- In a stock investment, you buy a fractional ownership interest in the company, which remains until you sell it in the market.
- Your stock investment will see a profit or loss, depending on public sentiment and the financial performance of the company over the years.
- Options, unlike stocks, are available for trade in the stock market for a specific period only. An option is the right to buy the stock at a specific price and within a specific period.
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What are the Major Differences Between Stocks and Options?
Here is how stocks and options differ from each other:
- Ownership: The purchase of stock grants proportional ownership rights to the investor. In contrast, the purchase or sale of options refers to buying the stock at a fixed rate on or before a given date.
- Purchase: The entire value of the stock is paid by the buyer as per the prevalent share price. Whereas in an options contract, instead of the entire value of the contract, just a percentage of the contract value (or premium) is paid by the buyer.
- Rights: Technically, a shareholder is also an owner of the company and enjoys voting rights. If the company declares a dividend on the profit earned, shareholders are entitled to receive the same.
For example, if a company declares a dividend of Rs.5 per share and you own 100 shares, you are entitled to a dividend of Rs. 500. On the other hand, stock option holders neither receive dividends nor enjoy voting rights.
- Expiry: Once you buy stocks in a company, your ownership of the stocks remains as long as the company continues to be operational. On the contrary, options contracts are time bound and expire at a future date. Investors lose the right to buy or sell the option contract after this pre-set date.
- Value: Stock prices depend on the supply and demand of the stock in the market. Other factors, such as the financial strength of the company, the market share of its products, and the future outlook of the company, also affect the stock price.
However, the value of an options contract is influenced by the following factors:
- The underlying price: if the underlying price of a share increases, the value of the call option on the share will increase too. In the same scenario, the value of the put option, or the option to sell, will decrease.
- The exercise price: if the exercise price is low, the value of the call option increases as the underlying asset can be bought at a lower value. In the case of a put option contract, its value will increase with an increase in the exercise price.
- Time to expiration: the longer the time remaining for the contract to expire, the greater the value of the option. The underlying asset has a higher potential for movement within a wider time frame, which increases its value.
- The risk-free rate of interest: when the rate of risk-free interest increases, the value of a call option increases while the value of a put option decreases.
- Volatility: increased volatility can increase the value of put as well as call options. This is because the underlying price is more likely to move due to the increased volatility.
- Benefit and cost of carry: the value of the underlying asset increases with the cost of carry and decreases with the benefits associated with it.
- Risks: Stock investors are at risk of losing their entire investment if the company performs horribly or shuts down. However, the long-term risk becomes lower if stocks with sound financials and future outlooks are selected.
Conversely, in an options contract, investors can even lose the entire premium amount paid. Being a time-bound contract, the risk of losing the premium is more in the options contract.
- To sum up, stock investments are simpler investments that require limited expertise.
- Options trading requires an in-depth understanding of the derivatives market, a larger risk appetite, and constant monitoring of the derivatives market.
- Both are not mutually exclusive. An options trader can become a stock investor if he chooses to exercise his call option.
- Similarly, a stock investor can buy an option contract to hedge against market movements.
- In both investments, a complete understanding of the stock and the trading mechanism is recommended.
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