How Options Compare to Equities
Options are contracts through which a seller gives a buyer the right, but not the obligation, to buy or sell a specified number of shares at a predetermined price within a set time period.
Options are derivatives, which means their value is derived from the value of an underlying investment. Most frequently the underlying investment on which an option is based is the equity shares in a publicly listed company. Other underlying investments on which options can be based include stock indexes, Exchange Traded Funds (ETFs), government securities, foreign currencies or commodities like agricultural or industrial products. Stock options contracts are for 100 shares of the underlying stock - an exception would be when there are adjustments for stock splits or mergers.
Options are traded on securities marketplaces among institutional investors, individual investors, and professional traders and trades can be for one contract or for many. Fractional contracts are not traded.
An option contract is defined by the following elements: type (Put or Call), underlying security, unit of trade (number of shares), strike price and expiration date.
Although options share many similarities with regular equities, there are also some important differences. Two main differences of trading options rather than regular equities are that options trading can limit an investor’s risk and leverage investing potential.
Limited Risk for Buyer
Unlike other investments where the risks may have no limit, options offer a known risk to buyers. An option buyer absolutely cannot lose more than the price of the option, the premium. Because the right to buy or sell the underlying security at a specific price expires on a given date, the option will expire worthless if the conditions for profitable exercise or sale of the contract are not met by the expiration date. This is not true for the seller of an option.
An equity option allows investors to fix the price, for a specific period of time, at which they can purchase or sell 100 shares of an equity for a premium (price) - which is only a percentage of what they would pay to own the equity outright. This leverage means that investors may be able to increase their potential reward from a price movement by using options.
For an investor to purchase 100 shares of a stock trading at $50 per share would cost $5,000. On the other hand, owning a $5 Call option with a strike price of $50 would give the investor the right to buy 100 shares of the same stock at any time during the life of the option and would cost only $500.
Remember that premiums are quoted on a per share basis; thus a $5 premium represents a premium payment of $5 x 100, or $500, per option contract.
Let's assume that one month after the option was purchased, the stock price has risen to $55. The gain on the stock investment is $500, or 10%. However, for the same $5 increase in the stock price, the Call option premium might increase to $7, for a return of $200, or 40%. Although the dollar amount gained on the stock investment is greater than the option investment, the percentage return is much greater with options than with stock.
Leverage also has downside implications. If the stock does not rise as anticipated or falls during the life of the option, leverage will magnify the investment's percentage loss. For instance, if in the above example the stock had instead fallen to $40, the loss on the stock investment would be $1,000 (or 20%). For this $10 decrease in stock price, the Call option premium might decrease to $2 resulting in a loss of $300 (or 60%). Investors should take note, however, that as an option buyer, the most you can lose is the premium amount paid for the option.
Other key differences between options and regular equities are in how the investment is structured:
- Regular equities can be held indefinitely by a buyer, whereas options have an expiration date. If an out-of-the-money option is not exercised on or before expiration, it no longer exists and expires worthless.
- There are no physical certificates for stock options as there are for regular equities.
- Regular equities are issued in a fixed number by the issuing company, while there is no limit to the number of options that can be traded on an underlying equity. The number of options that are traded is based only on how many investors are interested in trading the right to buy or sell that particular equity.
- Unlike equity ownership, owning an option does not confer voting rights, dividends or ownership of any share of a company unless the option is exercised.
The greatest similarity is the way in which option and stock transactions are handled:
- Options are listed and traded on national SEC-regulated marketplaces similar to regular equities.
- Orders for options are transacted through brokers with bids to buy and offers to sell just like equity buy and sell orders.
- Buyers and sellers of options and equities can track performance and follow transactions through the marketplaces on which they trade.