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Although options share many similarities with common stocks, there are also some important
differences. Two main differences of trading options rather than stocks 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.
Leverage Investment
A stock option allows investors to fix the price, for a specific period of time,
at which they can purchase or sell 100 shares of stock for a premium (price) - which is
only a percentage of what they would pay to own the stock outright. This leverage means
that investors may be able to increase their potential reward from a stock's price
movements by using options.
| Leverage Example:
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 common stocks are in how the investment is
structured.
- Common stocks 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 common stocks.
- Common stocks 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 stock. 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 stock.
- Unlike stock 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 common
stocks.
- Orders for options are transacted through brokers with bids to buy and offers to sell
just like stock buy and sell orders.
- Buyers and sellers of options and stocks can track performance and follow transactions
through the marketplaces on which they trade.
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This site discusses exchange-traded options issued by The
Options Clearing Corporation. No statement on this site is to be
construed as a recommendation to purchase or sell a security, or to
provide investment advice. Options involve risks and are not suitable
for all investors. Prior to buying or selling an option, a person must
receive a copy of Characteristics and Risks of Standardized Options.
Copies of this document are available from The American Stock Exchange,
86 Trinity Place, New York, NY 10006 or The Options Clearing
Corporation, 440 S. LaSalle Street, Suite 2400, Chicago, IL 60605.
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