Options or stocks? Which investment is right for you? (2024)

While not quite apples and oranges, options and stocks are two different investments with a close-knit relationship. Both might have a place in your portfolio, independent of and, possibly, in conjunction with one another.

Introduction to stocks and options

“Buy low and sell high” has become part of our cultural lexicon, thanks primarily to stocks. When you buy a share of stock, you assume an — albeit, usually small — ownership position in a company.

Generally, owning stocks allows you to make money one of two ways:

• Stock price appreciation: This occurs when the market price of a stock moves higher than what you paid for it. Of course, until you sell, you only have on-paper profits.
• Dividend payments: Some companies, typically well-established and profitable companies, regularly return a portion of their profits to shareholders via stock dividends. You can take these dividends as cash or elect to have them automatically reinvested into additional shares of the company.

For many investors, options are a foreign language. They can be intimidating. On one hand, this caution is advisable because, overall, options can be riskier than stocks. However, once you learn the basics of options trading, you can effectively incorporate them into your investing.

Also known as derivatives, options derive their value from an underlying asset, such as stocks. When you buy or sell an option, you enter a contract that gives the buyer and seller different rights and obligations.

There are two main types of options:

• Call options give the option buyer the right, but not the obligation, to buy the underlying stock at the option’s strike price on or before the option expiration date.
• Put options give the option buyer the right, but not the obligation, to sell the underlying stock at the option’s strike price on or before the option expiration date.

If you’re unfamiliar with options jargon, refer to our guide on how to trade options for a primer.

Part of what makes options trading attractive to investors is that there are dozens of strategies you can execute with options, some of which can deliver outsized returns relative to stock investing. However, these strategies come with various levels of risk that, while not necessarily greater, may be less straightforward than the risks associated with stock trading.

The benefits and drawbacks of investing in stocks

Disadvantages of stocks

The main drawback of stock investing is that — drum roll, please — a stock you select may lose value. Even if you consider your purchase a long-term investment, it can be unsettling to sit with on-paper losses. You have to decide whether to wait out a losing position or cut your losses and move on.

Establishing a strong conviction in a stock holding requires considerable research, not merely into how a stock will move in the near term, but how a company will perform over the long haul. This process requires time, effort, experience and knowledge. And, even if you do your homework, it’s still difficult to build a diversified portfolio that can weather the market’s ups and downs using individual stocks.

Advantages of stocks

At the same time, history shows that the stock market goes up consistently over time. For example, in 2023, the S&P 500 Index — an index that measures the performance of 500 large domestic companies — returned just under 24%. It has generated just over 92% of upside over the last five years, as of the end of 2023. If you have a long-term time horizon, you can make money in stocks, particularly if you use products such as exchange-traded funds (ETFs) to gain diversified exposure.

It has never been easier to invest in stocks. Many brokerages offer commission-free trading, have low minimum balance or investment requirements and allow you to purchase small amounts of stock via fractional shares.

Understanding options and how they work

Generally, you buy a call option if you think a stock will go up in value. You buy a put if you think a stock will go down.

One option contract gives you control over 100 shares of stock. The price you pay to buy an option is known as a premium. To illustrate, consider this hypothetical call option example.

A stock trades for $190. Its call option with a $200 strike price trades for a premium of $2.90 per share. If you think the price of the stock will be above $200 by the option’s expiration date sometime in the future, you can purchase one of these calls for $290 (the $2.90 premium times 100 shares of stock), not including trading costs.

You’re paying a premium for the right to purchase this stock for $200. You need to factor this premium into your math. You break even on this trade when the underlying stock is at $202.90 (the $200 strike price plus the $2.90 premium). If the stock hits $200 and you exercise your option to buy it, you don’t start making money — on paper — until the stock hits $202.90.

Put options work in reverse. They are often used to hedge — that is, protect against downside — in a stock or entire portfolio. Because put option premiums tend to increase in value as the underlying stock price goes down, you can make money on the put even if you’re losing money on the separate stock position. This brings up another point: You can always trade the option premium rather than exercise your option to buy or sell the underlying stock, as long as you do so before the option reaches expiration.

Many investors sell options using a variation known as covered calls. To sell, or “write,” a covered call, you must own at least 100 shares of the underlying stock. By selling the call, you agree to sell your shares to the party that bought the call at the option’s strike price on or before expiration. For putting your shares at risk of being “called away,” you receive a premium.

The benefits and drawbacks of trading in options

Advantages of options

The biggest benefit of trading options versus stocks is that it requires considerably less money or buying power to purchase calls and puts than it does to buy or short-sell a stock directly. Our earlier example illustrates this.

You need $19,000 to purchase 100 shares of a $190 stock. However, you only need $290 to purchase the call option in our example. If the stock moves up, you can — all else being equal — expect the option premium to also increase in value. Without any intention of exercising your right to buy the underlying stock, you can sell the premium for more than you paid for it, thus closing your options trade for a profit and moving on.

Disadvantages of options

The biggest drawback? All else isn’t equal. One of the main differences between options and stocks is that options have an expiration date.

The closer you get to the expiration date, the more time impacts the price of the option premium. This concept — known as time decay, or the erosion of an option’s premium — is part of what can make options trading more complicated than stock trading, if not daunting. Time decay tends to happen slowly at first, then accelerates at an increasing pace as the option expiration date draws near. At-the-money and out-of-the-money options expire worthless at expiration and are typically near worthless just days before. So, if the underlying stock doesn’t move in the predicted direction within a relatively short period, you could be left with a worthless option.

When to invest in stocks

Stocks don’t have this expiration date. Therefore, if you’re a long-term investor looking to build wealth or save for retirement, it probably makes more sense to invest in stocks versus options. If these are your goals, taking the time to develop an understanding of options might be more trouble than it’s worth.

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When to trade in options

This said, while short-term traders often favor options, you can use them in concert with your long-term portfolio. For example, covered calls can help generate additional income in an existing stock position. If you’re OK with the possibility of having your shares called away, this can be a relatively straightforward way to use options.

If you have a strong conviction that a stock will make a near- or long-term move, you can use options to place that bet over time horizons that range from a couple of weeks up to a year or more. Here again, it costs less money to speculate on a stock this way via options than it does to buy the stock outright.

Stocks versus options: an apples-to-oranges comparison

Investors often want to know if stocks or options generate better returns. While that’s a legitimate curiosity, it’s important to realize that this isn’t, in many ways, an apples-to-oranges comparison.

As such, and because options are wasting assets, it’s difficult to determine with any precision if stocks have outperformed options — or vice versa — over extended time frames. We can begin to understand this by delving into some numbers on options trading.

In 2023, as “headlines about the scale of options trading, reaching close to $1 trillion” became common, Nasdaq argued that the data were “just plain misleading.” So, the owner of the Nasdaq stock exchange did its own research and crunched some numbers to prove its point.

At the time, Nasdaq noted that “the options market trades contracts ‘worth’ close to $650 billion each day,” compared to $500 billion in the underlying stock market. Remember that each option contract controls 100 shares of the underlying stock.

From there, Nasdaq pointed out that “typical value of equity and ETF options premiums spent each day, which includes intrinsic plus extrinsic value, adds up to only $14 billion.” Intrinsic value refers to the difference between the strike price of an option contract and the underlying stock’s market price. Extrinsic value is “the price of the option minus the intrinsic value.”

As SoFi explains, “Out-of-the-money option premiums are entirely made up of extrinsic value while deep-in-the-money options often have a small proportion of extrinsic value. Options that trade at-the-money might have a substantial proportion of extrinsic value if there is a long time until expiration and if volatility is high. On the other hand, a short-dated at-the-money option would likely feature little extrinsic value.”

With all of this in mind, Nasdaq concluded: “The approximately $650 billion ‘value’ traded represents what would happen if all options traded were in the money at expiration, which is impossible given most options traded are out of the money at the time of trade and options include both calls (stock higher) and puts (stock lower) to achieve this.

In fact, options premiums, representing both intrinsic and time value for options, are far lower – thanks again to the fact that most trading happens in out-of-the-money options with deltas often well below 50.”

Delta is an options Greek that measures the corresponding change in an option’s premium for each $1 change in the underlying stock. For example, an option with a Delta of 0.5 is anticipated to move by $0.50 for each $1 move in the underlying stock.

Simply put, there are far too many complicated, mathematical moving parts and different points in the life cycle of an option contract to compare returns. This level of sophistication, which can be difficult for even seasoned investors to wrap their heads around, is one reason why, relative to stocks, options can present considerably more risk.

Potential risks

For most beginning investors, it makes sense to cut your teeth on stocks.

As noted, the idea of “buy low, sell high” is essentially part of pop culture lingo. It’s easy to wrap your head around. While this doesn’t mean stock trading is without risk, it’s definitely more straightforward than options trading. If a stock drops in value, you typically have time to hold it — and even buy more — as you wait for a rebound. Options contracts have expiration dates and are impacted by time decay. Therefore, you don’t have the same luxury.

This said, you can control 100 shares of a stock with a fraction of the capital required to buy or short-sell 100 shares of a stock. When you buy a call or put option, your risk is defined. You can only lose the premium you paid for the contract. While you can only lose your initial investment when buying a stock, you take on the potential of unlimited losses when selling a stock short.

Tying it all together, a 2022 study out of the Massachusetts Institute of Technology (MIT) and Stanford University concluded that most retail investors buy options at the wrong time (when risk is elevated) and “display a trio of wealth-depleting behaviors: they overpay for options relative to realized volatility, incur enormous bid-ask spreads, and sluggishly respond to announcements.” The authors concluded that, “These translate to retail losses of 5-to-9% on average, and 10-to-14% for high expected volatility announcements.”

The cost of investing in stocks and options

Commissions and fees

We’re living through a time, by and large, of commission-free stock trading. However, as the Financial Industry Regulatory Authority (FINRA) warns, zero commissions does not necessarily equal zero fees.

A non-profit arm of the federal government, FINRA’s job is to protect investors and help regulate the industry. It likens zero-commission trading to “doorbuster sales and other marketing strategies” designed to bring in customers, noting that “Brokerage firms offering free trading often level charges and make money in other ways, such as through interest income from margin loans, robo-advisory service fees, commissions on options or other types of securities and more.”

To this end, while some brokerages offer commission-free stock and options trading, option contract fees are still somewhat common. At many traditional brokers, contract fees range from $0.50 to $1, while newer, online-first brokers have mostly eliminated them:

Margin

When a brokerage lends an investor money to trade on margin, that loan comes with an interest charge. While margin rates can vary considerably across brokerages, Fidelity’s current rates are typical of many large, full-service platforms:

Short-selling stocks requires a margin account. Some brokerages charge cost-to-borrow fees. These fees not only vary from broker to broker but can vary by stock. Interactive Brokers provides a calculator so investors can visualize how much a specific short sale will cost.

The tax implications of investing in stocks and options

Capital gains taxes on stocks

The capital gains tax you’ll incur, if any, depends on two primary factors:

• Whether it’s a long- or short-term capital gain
• Your income and filing status

The Internal Revenue Service (IRS) classifies capital gains on stocks held for longer than one year as long-term gains. If you hold the stock for a year or less, it’s a short-term capital gain.

The IRS treats short-term capital gains like ordinary income. Therefore, the agency taxes these gains on the basis of your tax bracket:

The long-term capital gains tax looks like this:

If your income is higher than the upper thresholds for the 15% bracket, the IRS levies 20% on your long-term capital gains.

IRS treatment of options premiums and exercises

With a few wrinkles, the IRS handles capital gains on options premiums you trade and contracts you exercise much the same way it does capital gains on stocks.

For long calls and puts closed before expiration, how long you hold the contract determines whether any profit is considered a short- or long-term capital gain. The same applies to a contract that expires worthless. If you exercise a call option, it raises the underlying stock’s cost basis, and you won’t get taxed until you close the stock trade, assuming you turned a profit. How long you hold the stock determines whether it counts as a short- or long-term gain. When you exercise a put, the process is similar, except you can deduct the premium you paid for the put from the amount of your capital gain.

For short calls and puts, the IRS treats profits from expired contracts and the trading of premiums as short-term capital gains. If the option is exercised, meaning you were assigned, the IRS handles short calls the same way as long calls. For short puts, you can reduce the cost basis of the underlying by the amount you collected when you sold the put option.