Options and equities, while both are used to profit from the movement of a stock, have key differences. The main use of options is for hedging already established equities position, while equities are usually used to establish a directional view of a company.
For example, when a long-term investor buys put options, its often to protect the downside on their equity position. When that same investor purchases equity shares in a company, they believe the price is going to appreciate in the long-term.
Liquidity: Equity markets are significantly more liquid than options markets. For most investors, it is easy to move in and out of positions within minutes. This is especially true for stocks that are part of indexes like the S&P 500, as billions of dollars from passive index funds and mutual funds that can only invest in S&P 500 stocks effectively have to own a large percentage of the stocks.
Time is on your side: Unlike options, there is no time frame in which your trade has to work, outside of opportunity cost, investors are not punished for being early into market moves. In an option trade, your view must play out before the option contract expires.
Less risk, generally: While the risks of options and equities have pros and cons in of themselves, stocks are generally viewed as less risky. The volatility of any given stock position is going to be exponentially lower than that of an options position. Additionally, there is no time decay risk.
Limited Upside: The majority of stocks move in line with their respective index, regardless of which index that is. It is unlikely to move up more than 20% within a year. For a trader or investor starting with a smaller amount of money , it can be upsetting to find that, even with all the time he put in, his gains will be limited. While there are countless stories of traders doubling, or tripling their initial capital in a short period of time, most would attribute that to a lucky stock pick, and would doubt it’s sustainability. In contrast to equities, with a few successful options trades, and well managed losses, it is not an uncommon occurrence for on to multiply their money in a short time frame.
Limited Leverage: Due to the Federal Reserve’s Regulation T, investors can only borrow up to 50% of the price of securities that they purchased on margin. This rule applies to equities markets, however, and not to derivatives markets. While use of excessive leverage is generally a very risky proposition, an investor with $5,000 in starting capital can only hope to borrow up to $10,000 to trade in stocks.
Have to risk more to gain less, generally: This may seem counterintuitive to what was mentioned earlier in regards to equity risk, but when one puts money in a stock, they can theoretically lose all of that money if the stock goes to zero. With an option, one can only lose their initial investment. While the two may seem similar, the amount of capital put at risk to make the same gains is different.
For example, XYZ stock is trading at $90, and you think it is going to go up $10 to $100. You want to purchase 100 shares, which would net you a $1,000 gain. In order to achieve this, you would have to put $9,000 at risk. To participate in the same movement in the options market, it may cost you a $350 (rough number based on 90 days-to-expiration in-the-money calls for $90 stocks).
Leverage: One options contract allows you to participate in the movement of 100 shares of a stock, with your risk capped at a specific level, and a significantly lower cost.
For example, let’s assume you believe a $90 stock is going to go up to $100 within the next three months. Instead of buying 100 shares at a cost of roughly $9,000, you can buy an in-the-money call option that is dated to expire in 85 days. This may cost you around $550. If, at the end of 85 days, the stock is trading below your strike price (let’s assume you picked 90) your option expires worthless. However, if the stock makes the move to $100, your option contract would have increased and may be worth ~$1500.
This leverage can aid an undercapitalized trader grow their account quicker.
Directional Bets on Events: Options contracts allow you to take directional bets on market events, like earnings or macroeconomic factors. Because of the massive risk of an unexpected earnings report against your stock position, holding shares of stock through an earnings report is significantly more risky than using options to express your view and limiting your downside.
For example, you believe XYZ Company is going to report better than expected earnings. Instead of buying shares in the company, (it is not uncommon for a stock to fall 10% or more after an unexpected earnings report) you can cap your risk by buying a call option.
Time Decay: Options contracts all have an expiration date, at which point they are either worthless or can be exercised to receive shares of stock at your strike price. If you believe a stock is going up in the next 3 months and use a 3 month option to express that view, the stock must make the move you’re expecting within in 3 months, or else your options can expire worthless. Not only do you have to get the direction of the market correct, but you must get the timing right.
Strike Prices: In addition to getting the timing of the market correct, one must select specific price levels where a stock will move to be correct.
For example, you believe stock XYZ, which is currently trading at $90, to go down below $70, so you buy put options with an $80 strike price and 30 days to expiration. However, you overestimated the stock’s downside, and after 30 days, the stock has only moved down to $82. Your options expire worthless.
Sophisticated Strategies: Using sophisticated options trading strategies like strangles and spreads, you can even hedge your options positions.
For example, a call spread involves buying a call and simultaneously selling a call with a lower strike price. While limiting your downside, the strategy also hedges for incorrect market calls.
Equities and options have a symbiotic relationship. Long-term investors need options to hedge their positions and that liquidity helps options traders. On the other hand, options traders keep options markets liquid and more efficiently priced, giving hedgers a good price.
There are various reasons to trade both options and equities, however “cowboy” style traders who take a lot of risk for high reward, will naturally gravitate towards options.