When taking stock of how to invest in the market, you have options — both literally and figuratively.
You can buy stocks, which represent shares of ownership in individual companies, or options, which let you bet on which direction you think a stock price is headed. While there are important differences between stocks and options — and the type of investors who gravitate to each — these assets can complement one another in your portfolio.
But when you need to choose between stocks and options, the guidelines below can help you make the right choice.
Stocks: Best for beginners, long-term investors
If you’re looking for a straightforward way to begin investing for a goal more than five years away, such as retirement, stocks are a great choice. While there’s no guarantee you’ll make money — the performance of any individual stock can be volatile — the U.S. stock market has continually proven to be a fantastic long-term investment.
The beauty of investing in stocks is simplicity: You buy a stock, betting its price will rise so you can sell at some point down the road at a higher price. That applies whether you plan to hold a stock for years or try your hand at day trading — actively buying and selling stocks over short time frames like days or weeks.
» Need the basics? Get step-by-step instructions for how to buy stocks.
For beginner investors, and especially people with a long-term strategy, stocks are a clear winner over options, says Aaron Anderson, senior vice president of research at Fisher Investments. That’s because in addition to lower expenses and a more straightforward approach, stocks allow for a hands-off investing style, he says.
After researching the stocks you wish to invest in — ones that you believe have a growth potential that fits your time horizon — you don’t need to obsessively check on them every day. You can simply keep an eye on them until the time comes when you need that money or set an alert through your online broker when the stock’s price reaches a level at which you want to sell.
Potential drawbacks: Risk, fees, taxes
The risk associated with stocks are straightforward: The price could plummet to zero and you’d lose your entire investment. Because the performance of individual stocks can be volatile day to day, experts generally recommend investing in stocks with money you won’t need for at least five years. To further reduce risk, don’t pile all your money into a single stock.
How active a trader you are will affect performance — and how much you’ll pay in commission fees and capital gains tax on profits. Commission fees for stock trading vary, so shop around before opening an account. (Compare fees among NerdWallet’s picks for the best brokers for stock trading.) Your capital gains tax rate depends on whether you realize a profit on the sale of the stock, how long you’ve held it — rates are higher for stock held less than a year — and your income.
Options: Best for active traders who want flexibility
Looking for a more tactical approach to investing, one with a smaller investment requirement and flexibility regarding timing or downside risks? Options may be up your alley.
With options, the associated time period for investment is inherently shorter, making them more appealing to traders who buy and sell regularly. All options contracts have expiration dates, which can range from days to years.
» Need a refresher? Check out NerdWallet’s options trading 101 guide.
While many people like the flexibility afforded by options — namely, time to see how a trade plays out and the ability to lock in a price without an obligation to buy — they do add complexity to the investing process. Rather than making one decision, such as betting that a stock’s price will go up, you must make three:
- What direction the stock is headed
- How high or low it will move from its current price
- The time frame in which that will happen
That’s options trading at its simplest; there are more complicated strategies for advanced traders.
Options trading requires you to learn a new vocabulary of terms like puts, calls and strike prices, which may lead you to believe these assets are riskier than stocks. That notion is overstated, especially because investors can let an option expire and incur no further financial obligation other than the premium paid and associated trading costs, says Wade Guenther, a portfolio manager at Horizons ETFs Management. What’s more, long-term investors can use options as a type of insurance, he adds.
“There should be a good appetite for investors to use options as a hedging tool,” Guenther says, adding that this is a way for beginners to become familiar with options trading. Buying a put option will help mitigate potential losses if the value of a stock you own goes down. The price you pay for the option, what’s called the premium, is akin to an insurance premium, he says.
» Excited about options? Check out NerdWallet’s picks for the best options trading brokers and platforms.
Potential drawbacks: effort, additional risks, cost
Options trading requires a more hands-on approach than investing in stocks. You may wish to exercise the option before expiration, and that means you’ll have to keep a watchful eye on the related stock’s price. You can set alerts through your online broker.
Also, some options strategies are riskier than others, so make sure you understand the trade in advance. Hint: Don’t opt for daily or weekly options, which tend to be reserved for more seasoned traders.
Another downside of options trading is the related costs, which generally are much higher than for stocks. Options traders usually pay a flat fee per trade, ranging from zero to $6.95 at the major brokers, plus a per-contract fee ranging from 15 cents to 75 cents. The more you trade, the higher your costs — and don’t forget, you’ll pay fees to sell, too. Finally, as with stocks, be sure to factor in capital gains taxes. You’ll be on the hook to pay taxes on profits; these taxes are higher for assets you’ve held less than a year.
Making your choice
Deciding whether stocks or options are better for you is entirely a personal decision, based on your investing style. Beginner investors and those who prefer simplicity generally will stick to stocks for their straightforward nature. Those who favor an active investment approach and love to watch the market may find options appealing.
But don’t assume you have to stick to one asset. After all, options traders inherently become stock investors if they exercise call options. Meanwhile, many stock traders use put options as a hedging mechanism. Whatever you decide, just make sure you understand what you’re doing first.
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Anna-Louise Jackson is a writer at NerdWallet. Email: email@example.com. Twitter: @aljax7. The article Options vs. Stocks: Which Is Right for You? originally appeared on NerdWallet.
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