Most investors are familiar with stocks and the stock market. Popular stock benchmarks like the Dow Jones Industrial Average and S&P 500 are widely quoted in the news. The health of the stock market is often equated with the health of the economy.
Stock options are another way to participate in the movement of stocks, and they can offer investors an alternative to direct ownership of stocks. We will look at both stocks and options and discuss how investors might use these tools.
We hear the term “stock market” on a regular basis. But what does owning shares of a company’s stock actually entail?
Owning shares of stock in a company actually makes the shareholder an owner. This doesn’t mean you can walk into to the company’s headquarters and take over, but it signifies that you have a claim on the company’s earnings.
There are two classes of stock: common and preferred. Not all companies issue preferred shares. Common shares are the shares whose prices generally are quoted in reference to the stock of companies like Apple, Exxon Mobil and others.
Common shareholders have the right to vote at the company’s annual meeting (either by mail, online or in person in some cases) and to receive any dividends paid by the company to common shareholders.
With preferred stock, shareholders have a preference on any dividends declared by the company — meaning these shareholders would receive their payments before common shareholders in the event there would be a problem making dividend payments. Preferred stock does not carry voting rights, however.
How stocks are traded
Stocks are traded during the period when the stock markets are open — for example, from 9:30 a.m. to 4 p.m ET at the New York Stock Exchange. Shares can be bought or sold online using a brokerage account. For those working with a broker, orders can be placed with the broker, whose firm will execute the trade on your behalf.
When trading stock, you generally will incur a transaction cost of some sort. Full-service brokerage commissions generally are among the highest. Examples of full-service brokers include Merrill Lynch and Morgan Stanley. Online transaction costs generally are cheaper, with some firms offering a number of commission-free trades to induce new clients to move their business to the firm.
You will need to have an account with a custodian in order to trade stocks. There are many options available to you, ranging from traditional full-service brokerage firms to discount brokers like Charles Schwab, Fidelity and TD Ameritrade.
Pros and cons of stock investing
Some pros of stock investing include the following:
- Investing in stocks can be a means of accumulating wealth. As the underlying company grows over time, the price of its stock has the potential grow along with its business.
- Stocks can serve as a hedge against inflation.
- Shareholders can benefit from preferential tax rates on long-term capital gains if they hold their shares for at least a year.
- Stocks are traded throughout the day, and transactions generally are implemented almost instantaneously, especially on shares of widely traded stocks.
- There are a variety of order types that can be used to set limits on the downward movement of your shares or to buy when a price trigger is met.
Here are some cons of stock investing:
- Investing in stocks takes a level of research and knowledge that entails understanding the company’s underlying business and the factors that might influence the stock’s performance. This can take time and effort. Whether you are buying the shares to hold for a period of time or you plan to day trade, it’s important that you understand what you are doing.
- Owning individual stocks can make it difficult to diversify your investment portfolio, especially for small investors. This might entail holding a concentrated position in just a few shares; if one or more of the stocks hits a rough patch, it can have an outsize impact on your wealth.
Stock options offer the option holder the right to buy or sell shares of the underlying stock at a set price within a certain time frame. Beyond options that are traded on exchanges, employee stock options are issued by some companies as a form of compensation to their employees (or vendors and contractors in some cases).
Options can become quite valuable depending on whether the underlying stock moves in the direction the investor expects — up or down — as long as the move happens before the option expires.
Key option terms
A call option allows the option holder to purchase the stock at a set price within a set time.
A put option allows the buyer to sell shares of the stock at a set price within a set period of time.
The strike price is the price at which the option can be exercised.
The premium is the amount the buyer of the option pays for the option, and it represents the maximum profit the seller of the option can realize.
The option seller will be obligated to sell shares to the option holder if the call option is exercised or buy them in the case of the exercise of a put option. They can face a significant risk of loss.
For example, if a call option for 100 shares of a stock is exercised at the strike price of $10 per share, the option seller needs to furnish those 100 shares to the option holder. If they own the shares (a covered call), they would transfer the shares to the option buyer. If they don’t own the shares, they will need to go into the market, buy the 100 shares at the market price and furnish them to the option holder.
How options are traded
Options are traded on exchanges like the Chicago Board Options Exchange (CBOE). Options trade as contracts, with one contract covering 100 shares of the underlying stock or other security (exchange-traded funds, etc.).
The price you would pay for an option (or would receive if selling one) — the premium — has two components. The intrinsic value is the difference between the strike price and the market value of the underlying stock. The time component has to do with other factors, including the time until the option expires and the volatility of the stock. The price of the option contract will fluctuate based on these factors.
Three common options trading strategies
The long call is an options strategy in which the investor buys a call option with a strike price below their expectations for the stock’s price. They then can exercise the option and buy the stock at a below-market price if they are correct (and the option hasn’t expired).
In a covered call, the investor sells a call option at a strike price above the current price of the stock they own. If the stock remains below the strike price, they keep both their shares and the premium they earned when selling the option. If the stock surpasses the strike price, the investor will lose their shares but keep the option premium.
The long put is a bet on the decline of the price of the stock. The investor buys a put option. If the stock price falls to a level below the strike price, the investor may sell shares at the strike price. For example, if the strike price is $50 per share and the stock falls to $30 per share, the investor makes $20 per share, less the cost of the option. If the stock price is above the strike price, then the option will expire worthless and the investor is out the cost of the options.
Pros and cons of options trading
Here are some pros of options trading:
- Options trading generally requires less of an investment than buying the shares of the underlying stock outright.
- For option buyers, the maximum downside risk is the amount paid for the option. If it expires worthless, that is the extent of your loss.
- Buying and selling options can provide relatively large gains for a relatively small investment.
Some cons of options trading include the following:
- Like any other trading endeavor, successful option traders take the time to master what they are doing. That means it might not be the right path for “dabblers.”
- Option sellers can lose a great deal of money if the stock moves drastically away from the strike price. You have virtually unlimited liability to provide shares for a call option buyer or to buy shares from a put option buyer.
- Options come with a time limit. If the stock doesn’t move in a direction that benefits the option trader, the option can expire worthless.
How stocks and options are similar (and different)
Trading options has some similarities to trading stocks, including:
- Success in both endeavors will be related to accurately picking the right stocks to focus on and the direction the stocks will move.
- Choosing the right stocks and their underlying options to trade takes research and an understanding of the markets.
There are differences to be aware of, however:
- Investing in stocks can be a long- or short-term endeavor. Options, by their nature, have a short-term focus.
- Options are a “bet” on the movement of a stock and are short-term by nature.
While there are no hard-and-fast profiles of a typical stock or option investor, here are some common traits:
- Stock investors typically will look at the fundamentals of the company as well as the relative price of the shares compared to their historical levels. Stock investors are interested in the price of the shares as well as the performance of the company. Stock investors may be short-term traders or long-term investors.
- Options require less money than the shares of the underlying stock. Options traders often are those who want to profit from the price movement of a particular stock without having to own the stock itself.
- It is common for investors to utilize both stocks and options. As an example, an investor who owns a stock might write options as way to make some additional money from the stock. Or they might purchase a put option to hedge against a drop in the stock’s price. There are many strategies investors can use that combine owning stocks and trading options to enhance their overall investing returns.
Investing in stocks and trading options are not mutually exclusive. In fact, options can be used as a method to complement your stock trading activities. Call options can be a way to speculate on the price of particular stock without having to commit the capital to buy the shares. Conversely, put options can be a good way to hedge against a drop in the price of a stock in which you currently hold shares.