What is a Stock?
A stock represents a share in the ownership of a company. When you buy a stock, you're essentially acquiring a small portion of that business. Your potential return depends on a variety of factors, including how well the company performs financially and broader market conditions.
Key characteristics:
- Ownership: You own a proportionate share of the company
- No maturity date: You can hold the stock for an indefinite period
- Returns: May come from share price increases and dividends, although neither is guaranteed
- Capital Outlay: You pay the current market price per share when buying
Illustrative Example:
Buying 100 shares of Tesla at £250 would cost £25,000. If Tesla share price later rose to £300, the value of the holding would increase to £30,000, a notional gain of £5,000 (20%).
This example is hypothetical and does not constitute investment advice or a recommendation to buy or sell any security. Share prices can go down as well as up.
What are Options?
An option isa financial derivative contract that gives you the right (but not the obligation) to buy or sell an underlying stock at a specific price before a set date.
There are two basic types:
- Call Options:The right to buy a stock
- Put Options:The right to sell a stock
Key characteristics:
- No Ownership: You don’t own the underlying stock - only the right to buy or sell anunderlying stock at a specific price before a set date.
- Leverage: A relatively small upfront cost can provide exposure to a larger notionalposition
- Limited Duration: Options have a defined expiration date.
- Defined Risk: Your maximum loss is typically limited to the premium paid (for buyers of options only)
- Time Decay: Options can lose value over time , particularly as the expiration date approaches
Illustrative Example:
Buying a call option for Tesla at a £260 strike price, and a premium of £10, would cost £1,000 (vs £25,000 for buying 100 shares outright). If Tesla share price rises sharply, the percentage gain on the option could exceed that of holding the stock - However, if the price remains below the strike or falls, you may lose the entire premium.
This example is hypothetical and does not constitute investment advice or a recommendation.Options are considered high risk investments and are not suitable for all investors. Please ensure you fully understand the risks and costs involved before trading.
Stocks vs Options: Side by Side
Real-World Scenario:Tesla Stock vs. Tesla Call Option
Important: These examples are for illustrative purposes only. They do not constitute investment advice or a recommendation. Options are complex products and not suitable for all investors. Capital is at risk.
Let’s assume an investor believes that Tesla (TSLA),currently trading at £250, may increase in value.
Scenario A: Buy the Stock
- Buy 100 shares = £25,000
- If TSLA rises to £300 → Unrealised gain = £5,000 (20% return, excluding costs)
- If TSLA drops to £220 → Unrealised loss = £3,000 (-12% return, excluding costs)
Scenario B: Buy a Call Option
- Strike price = £260
- Premium = £10 × 100 shares = £1,000
- If TSLA rises to £300 → Intrinsic value = £40 → Notional Profit = £3,000 (300%return on premium, excluding fees and taxes)
- If TSLA stays flat or drops → Maximum potential loss = £1,000 (-100% of premium paid)
Summary:
Options offer significant leverage and clearly defined maximum loss(limited to the premium paid by the buyer). However, they involve high level of risk and are not suitable for all investors and market conditions.
When Might Investors Use Stocks vsOptions?
Stocks are commonly used when:
- An investor seeks direct ownership in a company
- The goal is to generate income through potential dividends
- They prefer investment instruments that are generally less complex and may carry lower short term risk compared to derivatives
Options may be used when:
An investor wants market exposure with a smaller initial capital outlay, they have a specific view on short-term price movements and are willing to accept the associated risks. They are implementing strategies for hedging or tactical trading, and have sufficient understanding of options and their risks
Recap
Both stocks and options offer paths to profit, but they serve different purposes.
- Stocks are are typically used for long-term investing and provide ownership in a company
- Options are derivative contracts that can be used for speculation, income strategies, or hedging - but they carry higher risk and require a clear understanding of how they work. The downside for buyers is limited to the premium paid, but the risk for sellers can be significantly higher.
Understanding these differences is an important step toward making informed decisions. Next, we’ll explore Call Options: what they are, common use cases, and how they function in different market conditions.
But remember: Options trading is not suitable for all investors. They are complex, high-risk products that can result in rapid and significant losses. It is essential to understand the mechanics, risks, and costs involved before trading.