To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page. These choices will be signaled globally to our partners and will not affect browsing data. We and our partners process data to: Actively scan device characteristics for identification.
I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Part Of. Day Trading Basics. Day Trading Instruments. Trading Platforms, Tools, Brokers. Trading Order Types. Day Trading Psychology. What Is Stock Options Trading? Key Takeaways Options give a buyer the right, but not the obligation, to buy call or sell put the underlying stock at a pre-set price called the strike price.
Options vs. Stocks • Which Should You Buy? • Benzinga
Options have a cost associated with them, called a premium, and an expiration date. A call option is profitable when the strike price is below the stock's market price since the trader can buy the stock at a lower price. A put option is profitable when the strike is higher than the stock's market price since the trader can sell the stock at a higher price. Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate.
You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. Related Articles. Investing Options vs. European Options. Partner Links. Related Terms How Options Work for Buyers and Sellers Options are financial derivatives that give the buyer the right to buy or sell the underlying asset at a stated price within a specified period.
How Bermuda Options Work A Bermuda option is a type of exotic contract that can only be exercised on predetermined dates. Index Option Definition An index option is a financial derivative that gives the holder the right, but not the obligation, to buy or sell the value of an underlying index.
Call Option A call option is an agreement that gives the option buyer the right to buy the underlying asset at a specified price within a specific time period. Put Option Definition A put option grants the right to the owner to sell some amount of the underlying security at a specified price, on or before the option expires.
Pros and Cons of Stocks
To acquire a position equivalent in size to the shares mentioned above, you would need to buy two contracts. The difference could be left in your account to gain interest or be applied to another opportunity providing better diversification potential, among other things. There are situations in which buying options are riskier than owning equities, but there are also times when options can be used to reduce risk. It really depends on how you use them. Options can be less risky for investors because they require less financial commitment than equities, and they can also be less risky due to their relative imperviousness to the potentially catastrophic effects of gap openings.
Options are the most dependable form of hedge , and this also makes them safer than stocks. When an investor purchases stocks, a stop-loss order is frequently placed to protect the position. The stop order is designed to stop losses below a predetermined price identified by the investor. The problem with these orders lies in the nature of the order itself. A stop order is executed when the stock trades at or below the limit as indicated in the order. For example, let's say you buy ABC, Inc.
This order works during the day, but it may lead to problems at night. The next morning, when you wake up and turn on CNBC, you hear that there is breaking news on your stock.
What Are Options? 📝
It seems the company's CEO has been lying about the earnings reports for quite some time now, and there are also rumors of embezzlement. The stop-loss order was not there for you when you needed it most. Had you purchased a put option for protection, you would not have suffered the catastrophic loss. Unlike stop-loss orders, options do not shut down when the market closes. They give you insurance 24 hours a day, seven days a week. This is something stop orders can't do.
This is why options are considered a dependable form of hedging. Furthermore, as an alternative to purchasing the stock, you could have employed the strategy mentioned above stock replacement , where you purchase an in-the-money call instead of purchasing the stock. The effectiveness of stop orders pales in comparison to the natural, full-time stop offered by options.
You don't need a calculator to figure out if you spend less money and make almost the same profit, you'll have a higher percentage return. When they pay off, that's what options typically offer to investors.
Four Advantages of Options
The final major advantage of options is they offer more investment alternatives. Options are a very flexible tool. There are many ways to use options to recreate other positions.
We call these positions synthetics. Synthetic positions present investors with multiple ways to attain the same investment goals, which can be very useful. While synthetic positions are considered an advanced option topic, options offer many other strategic alternatives. For example, many investors use brokers who charge a margin when an investor wants to short a stock. The cost of this margin requirement can be quite prohibitive.
Other investors use brokers who simply do not allow for the shorting of stocks, period. The inability to play the downside when needed virtually handcuffs investors and forces them into a black-and-white world while the market trades in color. But no broker has any rule against investors purchasing puts to play the downside, and this is a definite benefit of options trading. The use of options also allows the investor to trade the market's "third dimension," if you will—no direction. Options allow the investor to trade not only stock movements but also the passage of time and movements in volatility.
Most stocks don't have large moves most of the time. What types of securities can be tied to options? Bonds, stocks, index, exchange-traded fund ETF , and similar securities can all be traded through options contracts. A call option basically means that the buyer has the option to purchase a certain security for a certain price by a certain set date.