Inside Look: Options vs Stocks
When you buy a stock, you’re buying a piece of ownership in that company. As long as a company exists, that share of stock doesn’t expire.
When you buy an option, you’re buying the right to buy or sell a stock (or another asset) at a specified price within a specified time period. An option represents no ownership in a business and they have a finite lifespan.
Options are a derivative, meaning they derive value from the underlying asset. For example, an option that gives you the right to buy 100 shares of Apple for $200 for the next two months derives value from that right to buy, not from the ownership in Apple, which would represent a share in the earnings of the company and some notion of control over the company’s governance.
So lets dive in and check out some of the biggest differences options vs stocks have.
- Strike Price
- Expiration Date
- Underlying Price
- Implied Volatility (Premium)
The strike price of an option contract is the price where the contract can be exercised. For example, a $100 call option on Apple stock will allow you to buy Apple for $100 per share when you exercise the option.
Options have a finite life which is defined by their expiration date. After the expiration date, the option no longer exists and is worthless. For example, if you have an option that expires this Thursday, after Thursday, you can no longer exercise the option and the contract is void.
The price of the underlying instrument that option is derived from has a huge impact on the option’s price. For example, if Apple is trading at $200, and you have a call option for $150, your profit is $50 per share, minus any premium paid. On the other hand, if you have a call option for $250, your position is in the red.
Implied volatility is the option writer’s forecast of the future risk of that market. Low implied volatility indicates a small premium, while high implied volatility options carry high premiums due to the perceived risks present.
The level of implied volatility in an option determines the premium paid. The premium is the actual price of the option you’re paying.
Put it this way, when you buy an option, you’re paying the writer (person who takes the other side of your option trade) of the option a premium for the right to buy or sell a stock at a specified price. No matter what, the writer gets to pocket the premium for that option, and you have to pay it. The writer loses money when your gains on the option outweigh the price of the premium that you paid them.
Below is an example of premium in Apple options. If we look at the $242.50 calls, we can see it costs $6.30 in premium. This means that the option is profitable when apple is trading above $248.80, which is the strike price + premium paid.
A key practical difference between trading shares of stock and options is the leverage involved. Options offer much more leverage than stocks because of how the contracts are structured. In US markets, each option contract represents 100 shares of stock and the further out-of-the-money you go the less value the option will hold.
Options provide leverage because they offer the same price movements as a 100 share position in the underlying stock, while generally costing much less to purchase. In a stock like Apple which is currently trading at around $242.50, it would cost us $24,250 to buy 100 shares, while it only costs us $630 (or $6.30 per share in premium) to buy a $242.50 call option, which will expire in 15 days.
Let’s use an example. Suppose we think, for whatever reason, that Apple stock is poised to move to $270 in the next few days. We have the choice between buying 100 shares of Apple and buying an in-the-money call option to profit off of this move.
Assuming we buy the shares for $242.50, that would cost us $24,250 in buying power. Making our maximum theoretical loss on the trade $24,250, if shares go to zero. If shares move up to $270, we would profit $2,750 on the trade.
Now, let’s assume we choose to buy the $242.50 call option, which would cost us $630 in buying power, making our maximum theoretical loss on the trade $6.30 if Apple is trading below $242.50 strike price at expiration. If shares move up to $270, we would profit $2,120 on the trade.
When buying shares, an 11% move in Apple stock meant an 11% gain on our position. When buying shares, an 11% move in Apple stock means a 336% gain on our position.
A share of stock is valued based on the current and future earnings power of the company. You might conclude that a stable, growing company is a good investment at a valuation of 10x trailing annual earnings.
On the other hand, options aren’t valued on any fundamental criteria like the company’s financials or management. An option is valued based on the following factors:
- The strike price of the option
- The expiration date of the option
- The current price of the underlying instrument
- The implied volatility
The Black-Scholes model is the prevailing model used to get a fair value of options and other derivatives, and a result, most options end up reflecting the model due to how many arbitrageurs are present in the options markets.
Using Options To Express Different Market Views
When you buy or short shares of stock, your only way to profit is for those shares to move in the direction of your trade. With the use of options, you can create positions that can profit from different factors like volatility expansion or contraction, price staying within a certain range, time decay, etc.
A short strangle, which is an option spread consisting of a short of-of-the-money call and a short out-of-the-money put, will profit when the market stays within a given price range. The strategy doesn’t bet price moving up or down, but rather volatility contraction and time decay.
This is one example of how you can use options to creatively express views on instruments outside of pure price direction.
Pros and Cons
- Create spread trades to express a view on factors outside of price direction
- Cheap way to hedge some positions going into volatile events
- Options expire, and many expire worthless
- The increased leverage can work against you
- When you buy options, paying premium means the market has to move further in your favor to profit than if you were to just buy the shares outright.
So now that you know the differences options vs stocks have you’ll be in a better spot to make smarter financial decisions!