Katherine Gustafson is an author and personal finance expert from Portland, Oregon. She writes about investing for Wealthsimple as well as having written for Forbes, Business Insider, TechCrunch, and LendingTree. Katherine is a past recipient of the Izzy Award for outstanding achievement in independent media. She has a BA from Amherst College and an MA from Boston University.
Stocks and options are closely related but not the same. Both are assets you can trade and profit off of, but an option is based on a stock and can’t exist without it. A stock, on the other hand, exists regardless of whether there are any options derived from it.
Despite their close relationship, stocks and options are different assets and are traded in their own ways. Read on to learn more.
An overview of stocks and options
Stock is created when a company decides to sell a piece of itself to investors to raise money. Each of those pieces is called a share, and each of those investors is called a shareholder or stockholder.
When a company opens up sales of its stock to the public—called “going public”—anyone with enough money can buy shares and invest in that company. Some companies choose to sell shares without going public.
An option is an asset based on a prediction of what a stock’s trading price will do within a given time period. An option is a contract that guarantees its owner the ability to buy or sell the related stock—usually in groups of 100 shares—at a given price, either on a certain date or within a set time period. Once the option reaches its time limit, the option holder can decide to buy or sell the number of shares associated with the option, sell the option itself, or let the option expire.
What’s the difference between a stock and an option?
The difference between a stock and option is like the difference between a thing and its shadow—one is an existing entity and the other is an ephemeral derivative created by the entity. Here’s a closer look at their relationship.
What is a stock?
Stocks are created when a company sells off shares of its property and earnings to a select group of investors or to the general public for the purpose of raising a large amount of capital. Once you own a stock, you own a small percentage of that particular company. It’s an asset with a value that will change regularly as the company’s fortunes go up and down. A stock’s value fluctuates every few seconds as people buy and sell stock, making stock prices notoriously unpredictable.
What is an option?
An option is an asset derived from a given stock that provides the option holder the right to buy or sell the stock at a specific price by a specific time. Options are usually reserved in sets of 100 shares. If you own an option, you don’t own the actual stock and are not yet an investor in the company. As such, option owners don’t get benefits reserved for stockholders, such as dividend payouts… or bragging rights.
One can acquire an option on a stock exchange much like stocks—these are called “listed options,” and their prices are tied to the price of the underlying stock. In the U.S. it’s common for listed options to expire on a given day—usually the third Friday of the month in which it’s stipulated the option will expire. An option holder can simply let the option expire if he or she doesn’t want to buy or sell the underlying stock at the option price or sell the option itself to somebody else.
Another way to acquire stock options is to receive some as part of an employment compensation package. This is probably the most common use of stock options. When you start working for a startup, you may be given options that provide you the ability to buy the company’s stock for a specific price within a set period of time.
Here are a few key terms associated with options: A “call option” is for someone who wants to buy a stock; it locks in their right to purchase the stock at the agreed price within the contracted timeframe. A “put option,” on the other hand, is for buyers of stock—it guarantees the option to buy at a set price within a set time. The “strike price” is the price at which the option is allowed to be executed. The “premium” is the price the buyer pays for the option.
How to trade stocks and options
Before you can trade stocks or options, you need to buy some stocks. You can’t trade stocks you don’t already own, right?
There many ways to go about doing this, from forming a relationship with an investment manager or financial planner to signing up with a robo-advisor service. Once you’ve got some stock in your portfolio and the know-how to buy and sell, you’re ready to trade.
How to trade stocks
Trading stocks means that you are buying and selling shares of a company’s stock not from or to the company itself but from or to other investors who own—or want to own—that stock. Each stock trades at a given price that changes by the second. To buy (or sell) a stock at the current price, place a market order via your broker or your investment platform. Your order will be matched up with a seller (or buyer) who is also interested in transacting at that price. You’ve got yourself a trade.
Figuring out which stocks to buy and sell is another thing altogether—the secrets of which many seek and never find. Instead of trying to predict “winners,” the best strategy is to buy a mix of stocks across a few industries, including some heavy hitters that generate predictable good returns and a sprinkling of some lesser-known startups in hot sectors like tech and healthcare.
How to trade options
It’s a bit more difficult to trade options than to trade stocks; you’ll need to go through a brokerage and will probably have to divulge your level of trading experience, your income, and your financial goals. Once you’re in the door, the process of trading options is fairly similar to that of trading stocks.
You set out your requirements: Do you want to buy or to sell at the strike price? What amount are you going to invest? What is the time frame you will agree to?
These questions can be tricky for new investors to answer because trading options is basically speculatin—you’re taking a guess at whether the stock price will rise above or fall below the strike price by the option’s expiration date. That’s something even veteran traders often have a hard time estimating.
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