Are Stock Options a Good Investment? 3 Advantages To Know
There are many ways to grow your personal wealth and diversify your portfolio. Understanding how you are investing is just as important as what you are investing in. When you are thinking about how to approach your investments, it is good to have options, but are stock options a good investment?
Read: 3 Things You Must Do When Your Savings Reach $50,000
What Is a Stock Option?
A stock option gives you the right to buy or sell a stock at a preset price. For example, many companies offer employee stock options that allow you to buy stock in the company, or buy the option, at a discounted price. As options serve as contracts, be aware that there is typically an expiration date so you only have a set amount of time to exercise your options. In general, there are two types of options:
- Calls: A call option contractually gives the buyer the ability to buy a specific stock for an agreed-upon price for a defined period of time. This option also bets that a stock will rise.
- Puts: Though you are not obligated to, a put option gives you the right to sell a stock at an agreed-upon price, also known as the strike price. This option also bets that a stock will fall.
Advantages of Stock Options
One of the biggest reasons people avoid options is a lack of understanding as to how they work. Now that you know the basics of how they work, you may be more inclined to consider them, or at least explore how they can work for you. There are three main advantages of options:
- Efficient and economical
- Potentially high returns
- Strategic possibilities and lower risk
1. Efficient and Economical
Stock option plans allow you to obtain a position similar to a stock position but at a fraction of the cost. Qualified stock options can also be used as leverage, which can carry a bit of weight. Take the following examples between buying options and buying stocks.
Investing in Stocks Example
|Number of Shares of Stock||Price of Stock||Total|
Investing in Options Example
|Number of Shares of Stock||Price of Stock||Total|
|100 shares||$20 Call — contract representing 100 shares||$2,000|
This is a simple representation but it is good to get an idea of what price comparisons between the two could look like. The efficiency in both cost and effort could be enough to tip your scales when deciding how to invest.
2. Potentially High Returns
When options go as you hope they will or as they are supposed to, you will have spent much less money to make roughly the same in profit. Given this, if you opt to invest in options rather than stocks, you’ll have the potential for a much higher percentage return. You should always be aiming for the best return on your investment possible, which in many cases means you should invest in options over stocks.
3. Strategic Possibilities and Lower Risk
With the flexibility of options, there is potential to create better positions. A synthetic position is like a choose-your-own-adventure that allows you to achieve your investment goals while picking from several different options, all with the intent of reaching the same goal. This is a useful strategy as you can profit in every type of market.
There also tends to be less risk with options if you use them correctly. Not only do they require less initial investment than other equities but they can also be a more reliable way to hedge. This is not to say options cannot be high risk, but given the high reward ratio, they may be worth it.
Final Take: Are Options a Good Investment?
The standard unit for options on stocks is 100 shares per contract. You can buy these option contracts for much less than you would pay to invest in the stock itself, yet still have the potential for the same, if not a higher return. There are no guarantees when investing in the market in any capacity, but knowing your options is always a good starting point.
FAQHere are answers to some frequently asked questions about investing in options.
- How does a stock option work?
- Stock options work by giving you the right to buy or sell a stock at a preset price or grant price of the stock. Many companies offer employee stock options that allow you to buy stock in the company, or buy the option, at a discounted price. Option contracts often come with expiration dates.
- What are stock options in simple terms?
- A stock option, in simple terms, boils down to a contract between a company and an employee, or two other separate parties, that gives the owner of the option the right, but not the obligation, to purchase or sell stocks at an agreed-upon price, also known as the strike price. Essentially, you have the option to buy the underlying stocks if you own a stock option.
- Are options better than stocks?
- Options can be better than stocks in many ways as they have several advantages such as they are more cost-efficient, less risky, can have the potential for high returns and other strategic possibilities.
- Are stock options worth it?
- Stock options, like any investment, can be high risk and high reward. Though with options, the financial risks can be lower than stocks, yet still yield just as high a reward. For example, if you are an employee with options, and your company does well, you have the potential to experience significant gains.
- Can stock options make you rich?
- If an option trade goes the way you want it to, you as the option buyer could make a sizeable return on your investment, especially if a stock price goes far past the strike price. This gives you the chance to profit greatly and make you rich, just be aware of when the option grant started and when the option expires.
Our in-house research team and on-site financial experts work together to create content that’s accurate, impartial, and up to date. We fact-check every single statistic, quote and fact using trusted primary resources to make sure the information we provide is correct. You can learn more about GOBankingRates’ processes and standards in our editorial policy.
- Business Insider. 2022. "What is a put option? Understanding how to trade them."
- Fidelity. "First steps for call options."