Options vs Stocks: Which Should You Invest In?

How Stocks and Options Work

Both stocks and options trade on exchanges, but typically on different ones. Stocks trade on equity exchanges like the Toronto Stock Exchange (TSX) or the New York Stock Exchange (NYSE). Options on Canadian stocks trade on a derivatives exchange like the Montréal Exchange (MX). Options on US stocks can be found on the Cboe Options Exchange, among others.

To illustrate the difference, consider a simple example. Suppose an investor named Alex, is looking at a stock currently trading at $50 per share. Alex has two ways to gain exposure to that company:

• Buy 100 shares outright at $50 each. That’s a total outlay of $5,000. Alex now owns 100 shares directly, and the position moves in tandem with the share price.
• Buy one call option (which is a contract on 100 shares) with a strike price of $55 expiring in 60 days, for a premium of $2.00 per share. That’s a total outlay of $200. Alex now has the right to buy 100 shares for $55 before expiry, without owning them yet.

If the stock rises to $60 per share before the option expires:

• Alex’s stock position has a paper gain of $1,000 on a $5,000 outlay. This is a 20% return.
• Alex’s call option is now worth approximately $5 per share ($500 total) on a $200 outlay. That’s a 150% return. This is the power of leverage, where a smaller upfront investment can lead to larger percentage gains.

But what if the stock barely moves? If two weeks pass and the stock is still at $50 per share, Alex’s call option might now only be worth $1.25 per share, down from the original $2.00 per share, purely because of time decay eroding its value. The stock investor’s position is unchanged at $5,000. This is one of the most important differences between stocks and options for beginners to understand.

For a deeper dive, visit our how to invest in stocks guide.

Stocks vs. Options: Key Differences

The difference between stocks and options affects many parts of investing, including ownership, time horizon, risk, and complexity. Many investors hold both, using each for different purposes. Here are the key differences:

• Ownership: stocks are equity. You own part of a company. Options are derivative contracts that derive value from a stock but do not confer ownership.
• Time Horizon: stocks can be held indefinitely. Options have expiration dates. Being right about direction but wrong about timing can still result in a loss.
• Risk: stock buyers risk only the amount invested. Option buyers risk only the premium paid. Option sellers (writers) can face theoretically unlimited risk on certain strategies.
• Capital requirements: stocks require full upfront capital. Options offer leveraged exposure with less capital, but this amplifies both gains and losses.
• Complexity: stocks are relatively straightforward. Options involve more variables. These include strike prices, expiry, premiums, and pricing measures called “the Greeks” (such as delta, theta, vega, rho, and gamma) which affect how an option is priced.
• Liquidity: stocks generally have higher trading volume and tighter bid-ask spreads than their corresponding options which makes them generally easier to buy and sell at any given time.
• Purpose: stocks are typically used for long-term growth and income. Options are more often used for speculation, hedging, or generating income through premium collection (selling options).
• Management: stock investing can be relatively hands-off. Options require active monitoring. Expiration dates, time decay, and changing market conditions all demand ongoing attention.

Options vs. Stocks: Side-by-Side Comparison

When to Consider Options

The right approach depends on your personal circumstances including your experience level, risk tolerance, and time horizon. Below are some situations where options trading may be worth exploring. If you’re new to investing, starting with simpler strategies and seeking professional guidance is a prudent first step.

Limited Capital

Because one option contract typically controls 100 shares, a relatively small premium can provide exposure to a stock compared to buying those shares outright. Returning to Alex’s example: buying one call option on our $50 stock cost $200 versus $5,000 to buy the shares directly. That capital efficiency can appeal to investors with smaller starting amounts.

However, limited capital alone doesn’t make options suitable. The risk relative to that outlay is higher. The entire premium can be lost if the trade doesn’t work as planned.

Limiting Risk Through Hedging

One of the more practical uses of options is hedging: protecting an existing stock portfolio from significant downside. Think of it like buying insurance on your car. You pay a premium to guard against a worst-case scenario.

Suppose Alex now owns 100 shares of our $50 stock and is worried about a short-term decline. By buying a put option with a $45 strike price, Alex gains the right to sell those shares at $45 (effectively setting a floor value) even if the market price falls further. If the stock drops to $35, Alex can still sell at $45, limiting the loss.

Keep in mind that hedging has a cost. The premium paid reduces overall return if the decline never materializes. Hedging can reduce downside risk, but it does not eliminate it. You can learn more about exercising options in our options exercise and assignments webinar.

Capital Efficiency for Diversification

Because options require less upfront capital than buying shares directly, they can allow investors to spread exposure across more sectors or indexes with the same amount of money. That being said, options-based diversification is an advanced approach, and more positions means more complexity, not automatically less risk.

Profiting from Expected Market Changes

Unlike stocks which generally benefit only from price increases, options can be structured to profit from upward, downward, and even sideways price movements. Buying a put option, for example, can be profitable when a stock falls.

Advanced strategies like straddles and strangles aim to profit from large moves in either direction, regardless of which way the price goes. Options are also sensitive to changes in implied volatility (the market’s expectation of future price movements) which can change the value of an option even if the underlying stock price stays flat. To learn more about these pricing factors, watch our Options Greeks video. These are advanced strategies generally not suited for beginners.

Generating Income Through Options

Selling (or “writing”) options is a way to generate income through premiums collected. This can be a more conservative approach than speculative buying but it is not risk-free. Two common strategies:

• Covered calls: you sell a call option on shares you already own and collect the premium. The goal is for the stock to stay below the strike price so the option expires worthless. In this case you would keep your premium collected and the shares. However, your upside is capped if the stock rises past the strike price.
• Cash-secured puts: you sell a put option while setting aside the cash needed to buy the shares if exercised. You collect the premium but commit to buying those shares at the strike price if called upon to do so.

When to Consider Stocks

For many investors, particularly those who are newer to investing or who prefer a less complex approach, stocks are a natural starting point. Here are some scenarios where stocks tend to be a strong fit.

Long-Term Investing

Stocks align well with long-term investing in a way that options do not. Options have expiration dates. And time decay works against the buyer every day. Stocks can be held indefinitely, allowing investors to benefit from compound growth and the long-term appreciation of quality businesses, without the clock working against them.

For goals like retirement planning or saving for a child’s education, stocks suit the timeline. Holding through market ups and downs can smooth out short-term volatility and reward patience over time.

Beginner Investors

Stocks are an intuitive starting point. You own a part of a company and benefit when it performs well. There are no expiration dates to track, no strike prices to evaluate, and no premiums to analyze. They are also easier to research. Public companies have years of financial history, analyst coverage, and market data available.

Options involve considerably more variables and a steeper learning curve. Getting comfortable with stocks first builds a foundation that many investors find valuable before layering in the additional complexity of options trading. Many experienced investors choose to never trade in options.

Investors Who Prefer a Hands-Off Approach

Because options require less upfront capital than buying shares directly, they can allow investors to spread exposure across more sectors or indexes with the same amount of money. That being said, options-based diversification is an advanced approach, and more positions means more complexity, not automatically less risk.

Dividend Income

For investors looking for a regular income stream without active trading, dividend-paying stocks can be a compelling choice. Dividends are periodic payments (typically quarterly) that some companies distribute to shareholders from their profits.

Dividends are not guaranteed and can be reduced or suspended, but established companies generally aim to maintain or grow them over time and typically give shareholders advance notice of any changes. Dividends can also be reinvested through Dividend Reinvestment Plans (DRIPs) to purchase additional shares which can compound your returns. Once you own dividend-paying shares, the income arrives without further trading on your part.

Simpler Tax Treatment

The tax implications of stock investing are generally more straightforward than options trading. Capital gains are typically only triggered when you sell stock at a profit, giving you some control over timing.

Options trading can involve many short-term transactions and multiple types of tax events. These include the expiry of worthless contracts, exercise or assignment of options, and closing positions before expiry (for a gain or a loss). This complexity can make record-keeping and tax reporting considerably more demanding. Because tax rules vary by individual circumstances and account types, you should consider consulting with a qualified tax professional for advice specific to your situation.

Conclusion

Stocks and options are not mutually exclusive. Many investors can use both as part of a diversified portfolio strategy. The difference between options and stocks comes down to purpose, complexity, risk tolerance, investment experience, and time horizon.

If you are just starting out, stocks are typically the more accessible entry point. As your knowledge grows, options can complement a stock portfolio in meaningful ways, but they reward preparation.

Ready to start investing in stock or options? You can open a BMO InvestorLine Self-Directed account online and begin at your own pace.

Prefer to have an expert reach out to you? Let us contact you. You can also speak with a BMO Investment Specialist by calling 1-888-776-6886 or visit your nearest branch.