Investing

Options vs Stocks: What’s The Difference?

Last updated on March 21, 2020 by
options trading

This is one of the most helpful guides on understanding options and how it compares to stocks. Full credit goes to u/lareigirl.

Stock investing is a straightforward concept, so we’ll build upon that to explain how options trading works.

Going “Long” on Stocks

Going “long” on a stock means that if the price goes up, your profits go up. Up = good, down = bad.

When you buy a share, you create a sort of contract with a stock exchange. This contract is stored on their internal, proprietary database: their ledger.

The plain-English contract between you and the exchange is: “Hey, I’m Mack Doodle, and I own one share of $FOO, purchased at $100. I have the right to sell it to a buyer at any point in the future, at a price determined by the market.” The contract is executed instantly.

It’s kind of like a game:

going long on a stock

Shorting a stock

Shorting a stock is the opposite “going long”. If the price goes down when you’re holding a short position, your profits go up.

Here’s how shorting works¹: Given a share price of $100 that you expect to drop, you can effectively borrow $100 from a broker and promise to pay it back in the form of one share. If the price drops, you can buy a share using this borrowed money and give it to the broker. You gain the difference.

Technically, it’s a bit more complicated. The above simplification is a heuristic I use because it’s conceptually accurate. You actually borrow stock, not cash. If you short 100 shares of $TSLA, the broker lets you borrow 100 shares from someone else’s account and sells them on your behalf, finally giving you the cash. You’re then on the hook for those 100 shares at some point in the future – you have to cover your short position. If TSLA goes down, you can buy them at a lower price and make money on that delta.

When you’re short and price increases, you either wait for it to come back down, or you eat the losses and buy a share at the higher price using the borrowed money plus some of your own money before giving it back to the broker. You’d lose the difference.

The plain-English contract between you and the exchange is: “Hey, I’m Mack Doodle, and I have borrowed $100 from you with the promise of paying you back in the form of one $FOO share, currently valued at $100. I am on the hook to eventually get my hands on a share for you at any point in the future. If the price of one $FOO share increases to $120, I will have to use the money that I borrowed from you to buy a portion of that share, and then $20 of my own money to buy the rest of the share. I will then give you the share at a personal loss of 20%. If the price of one $FOO share decreases to $80, I will be able to use the money that I borrowed from you to buy an entire share, and then keep the extra $20 for myself.”

This game is similar to the first, but flipped:

shorting a stock

Short means “up is bad; down is good”. Each of these instruments allow you to engage with the market through a contract that records the following:

Contract Type: Purchase Stock
----------------------------
Wallet ID: Mack Doodle
Ticker symbol: $FOO
Price at time of contract creation: $100
Price at time of contract execution: $100
Number of shares: 1
Buying or selling: Buying
Date contract signed: Just now
Date contract executed: Just now (manual execution)

Limit and Stop Orders

The Price at time of time of contract execution doesn’t have to be the current price, though. If you $FOO is currently priced at $100 and you want to go long when it hits $120 because you anticipate an upward breakout at that price, you can place a “buy stop order”. If you want to go short when $FOO hits $120 because you anticipate a downward correction, you can place a “sell stop order”. Even if the price of $FOO is $100, you can purchase the following contract:

Contract Type: Buy Stop Order
----------------------------
Wallet ID: Bobby Ronson
Ticker symbol: $FOO
Price at time of contract creation: $100
Price at time of contract execution: $120 [New!]
Number of shares: 1
Buying or selling: Buying
Date contract signed: Just now
Date contract executed: TBD (by price action) [New!]

This contract, in contrast to the first, will only execute if and when the price equals $120. It’s a more nuanced game, but not all that different from the two we’ve seen so far:

limit and stop orders

Once the share price trips the wire of your limit, the contract is executed just like the very first game we played.

This isn’t commonly used by retail investors (like you and me), but this concept is used frequently by quant/algo funds.

What are options

An option is a slightly more complex instrument.

The simple rule is that if a share price moves away from a specific value by a specific time, you profit. Note the added dimension of gameplay – a time limit. This compresses your confidence down into a timeframe, which translates to much higher risk, and also much higher reward. I think of options as facilitating aggressive investing – not just gambling. Though I think all investing becomes gambling at some timescale.

Going long with a call option

Given a share price of $100 that you expect to climb beyond $120 by November 5th, you may purchase the option to “purchase a share - or call it into your wallet - for $120 at any point between now and November 5th”. If the price increases from $100 to $200 sometime between now and November 5th, you can exercise your option for an $80 profit. If the price never hits $120, and instead falls to a November 5th price of $40, you aren’t obligated to do anything; you can opt to eat the cost of the option. Here’s what the options game looks like:

call option

Going short with a put option

Given a share price of $100 that you expect to climb no higher than $120 by November 5th, you may buy the option to “sell a share (or put it out of your wallet) for $120 at any point between now and November 5th”. If the price falls to a November 5th price of $40, you can then exercise your option for an $80 profit. If the price rockets up to $200, you’re under no obligations and only have to eat the relatively small cost of the option.

Note that if the price never hits break-even, you’re responsible for your loss of principal; it’s not like there’s no downside.

put option

Options and stocks are two different types of financial instruments that are traded in two different markets. The price that you pay for an option is determined by supply and demand, in the same way that the price of a share is determined by supply and demand. The supply and demand for an option is derived from the supply and demand of the underlying shares. This is why options are referred to as derivative instruments. They’re higher up on the value funnel; they’re more volatile; there’s more potential for dramatic gains and losses:

stocks vs options

Here’s what an option contract looks like:

Contract Type: Buy Call Option
----------------------------
Wallet ID: Mack Doodle
Ticker symbol: $FOO
Price at time of contract creation: $100
Price at time of contract execution: $120 ["strike price"]
Number of shares: 100 [1 contract = 100 shares]
Buying or selling: "Buying" [Buying a call option = long]
Date contract signed: Just now
Date contract executed: TBD [See Note]
Date contract expires: November 5th [New!]
Option price: $200 [New!]

Once you hold an option contract, you can do three things with it: You can manually exercise it at any time before the expiry; it can automatically be exercised by the broker at expiry; you can sell the contract back into the market.

Let’s look at an example using a real stock: Tesla.

Let’s suppose that I have $10,000 that I would like to invest in Tesla, and that I’m so confident in Tesla that I’m willing to throw it all away on a highly leveraged, optimistic bet. At the time of this writing, $TSLA was trading at $221. I expect it to be far above $221 by Q4 2019. Here are my games:

Game 1: Going long with stocks

I can buy 10,000 / 221 = ~45 shares

My “break even” is at a share price of just over $221 since the “price to play” is simply the $5 trade commission that my broker charges me.

Worst case is the stock tanks overnight and I lose $10,000.

Ideal case is the stock climbs to $400 and I earn (400–221) * 45 or ~$8,000 (or potentially much more - stocks have no time limits)

My max loss is $10,000, or 100% of my investment; my potential gain is ~80%.

Game 2: Going long with options

The $225 December strike price will cost about $35 per share:

strike price example

I have the market power equivalent of 10,000 / 35 = ~285 shares, or just under 3 contracts. (partial contracts are not allowed, but for this example, let’s suppose they are)

My “break even” is at a share price of 221 + $35 option price = ~$256. If the price breaks $256 between now and December, I’m golden.

Worst case is the stock tanks overnight and I lose the $10,000 option contract.

Ideal case is the stock climbs to $400 by December and I earn (400–225) * 285 or ~$50,000

My max loss is $10,000–100% of my investment; my potential gain is ~500%.

Options magnify my potential reward while also magnifying the potential for losses; Tesla dipping 20% means I lose 100% of my principal.

Here’s my “contract”, in this case:

Contract Type: Buy Call Option
----------------------------
Wallet ID: Mack Doodle
Ticker symbol: $TSLA
Price at time of contract creation: $221
Price at time of contract execution: $225 ["strike price"]
Number of shares: 285
Buying or selling: "Buying" [Buying a call option = long]
Date contract signed: Just now
Date contract executed: TBD
Date contract expires: December 20th
Option price: $10,000

Conclusion

That’s about it! Keep in mind that this is a game, and our nationalized financial industry employs some of the most clever and greedy gamblers out there. The house generally wins, but just like poker – with the right mental models, discipline, and risk appetite, you can come out far ahead. It’s not unlike poker in that self-education and exercise translate to vastly improved odds at the table.