Both options and stocks can deliver quick profits amid substantial risk. Beyond that, these two trading instruments work very differently. Those differences affect your profit potential, loss exposure, and the skills you need to trade successfully. Here’s what you need to know.
Table of Contents
Trading options vs. stocks at a glanceÂ
Option contracts are sold by option writers (sellers) to option holders (buyers). The price paid for the contract is called the premium. The contract itself gives the holder the right to buy or sell an underlying security at a stated price within a defined time frame. If the holder chooses to proceed with the transaction, called exercising the option, the writer must fulfill it.Â
Stock trading involves actively buying and selling ownership shares in a company. Once a stock trade is complete, the buyer and seller in the transaction have no further obligation to one another.Â
The table below outlines how stock trading differs from options trading in terms of ownership rights, capital required, risk, time horizon, and income potential.
How stock trading worksÂ
Stock traders actively buy and sell stocks to produce short-term capital gains. This activity is separate from investing, which involves decades-long holding periods and compounded returns over time.
The basic stock-trading strategy is to buy shares at a lower price and then sell them quickly at a profit. This is not guesswork or good luck. Short-term traders monitor stocks closely and identify events that can move prices higher or lower.
For example, the markets may overreact to a negative headline, pushing a stock below its fair value. Short-term traders capitalize by purchasing the stock when it’s down, assuming the low price will be temporary. If it is and the stock price rises later, the trader can sell the position at a profit.
Stock trading risksÂ
The primary risk is that the stock price won’t move in the right direction quickly enough for the trader to sell and recoup the funds. Traders require available cash to take advantage of time-sensitive opportunities as they arise. Having capital tied up in positions that didn’t appreciate as expected either slows trading activity or forces the trader to sell, incurring losses. Â
Many short-term traders use borrowed funds to invest, which increases risk. Buying on margin, as it’s known, raises the trader’s loss potential and adds interest costs. Borrowed funds must be repaid, no matter how the stock performs.
How options trading worksÂ
There are two sides to every options contract, and each side has its own goals and risks. Options holders, or buyers, pay premiums for the right to buy or sell securities at a certain price within a defined time frame. If the security moves in the right direction, the option contract increases in value. The holder can sell the contract profitably or exercise the option to make a profit.
For example, consider an options contract that allows the holder to buy 100 shares of Walmart (WMT) stock at $95 per share. If the market price of Walmart stock suddenly rises from $95 to $110, this contract gains value. In the reverse, if Walmart stock falls to $90, the option to buy it at $95 is worthless.
Option writers (sellers) earn income by collecting premiums from holders. They keep the premium regardless of how the underlying security performs, but they must fulfill the contract if a buyer chooses to exercise it.
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Options trading risksÂ
Option holders risk losing their entire investment. If the security moves in the wrong direction, the options contract expires without value.
Writers risk having to complete an unprofitable transaction, such as selling Walmart stock for $95 per share when the market price is $110.
The writer’s loss potential depends on whether the option is covered or naked. A covered position is backed by shares or cash, while a naked position has no backing. If the seller already owns Walmart stock, the loss involves missing out on the gains above $95. If the seller doesn’t own Walmart stock, the losses could be substantial.Â
Which has more risk: Options trading or stock trading?Â
Risk varies across and within the different types of stock and options trading. A general ranking of these activities from lower to higher is as follows:
1.    Selling options on stocks you own
2. Â Â Â Short-term stock trading with cash
3.    Buying options Â
4. Â Â Â Short-term stock trading on margin
5. Â Â Â Selling naked options
There are two caveats here: First, the nature of a specific stock or options contract can add substantial risk, such that this activity ranking no longer applies.
Second, buying options is ranked as riskier than short-term trading because the probability of losing your entire investment is higher compared to stock trading. Even so, stock trading can result in larger losses in dollar terms. This is because buying stock shares outright usually costs more than buying options on the same number of shares. Â
Is options trading or stock trading better for beginners?Â
Options and stock trading are short-term activities that require a nuanced understanding of market dynamics and stock prices. Neither is as appropriate for beginners as long-term investing.
Confident long-term investors can move into selling covered options as a strategy to generate income from their portfolio. The next step would be short-term trading rather than option buying. Short-term trading is simpler to understand because the goal is straightforward: Buy low and sell high.
Can you use options trading and stock trading together?Â
You can use options and stock trading together. Advanced traders will buy options on stocks they trade as a strategy to reduce their loss potential. This involves taking an options position that gains value if the stock price falls. The earnings on the options contract would offset the losses you incur owning the stock, while the cost of the options (the premium) would reduce any gains.
Options trading vs. stock trading FAQsÂ
Can options trading wipe out your account?
Yes, options trading can wipe out your account. Option buyers can lose their entire investment, and option sellers without collateral can realize unlimited losses. Active trading in risky positions can quickly consume a lot of cash. Â
Is options trading riskier than stock trading?
Options trading can be riskier than stock trading, partly due to complexity. Buying options comes with a higher risk of losing the entire investment. For context, 30% of options expire worthless, according to widely quoted Chicago Board Options Exchange (CBOE) data. When that happens, buyers lose their full premium.Â
Selling options carries the risk of having to execute an unprofitable transaction. Losses there could be potentially unlimited if the seller does not have cash or stock backing.
Do options traders make more money than stock traders?
Options traders can make more or less than stock traders. Options can offer greater percentage returns, but the probability of a total loss on each contract is higher. Generally, options are more complex and harder to execute successfully. Â
Editorial disclaimer: Information on this page is for educational purposes and not investment advice or a recommendation to buy any specific asset or platform or adopt any particular investment strategy. Independently research products and strategies before making any investment decision.
