by Dave Coker

Created on: June 25, 2008

Anybody who has read the business section of a newspaper has seen the terms "stock" and "options". Sometimes these terms are used almost interchangeably. While under some circumstances stock and options may be identical, there are important differences an investor must be aware of. So what are the differences between options and stock?

Now that's a very good question. To answer it let's introduce some definitions.

STOCK

There are many ways that a business can raise capital, one of which is to issue - or sell - shares, which may also be known as "stock".

Stock represents fractional ownership of a company. Each share of stock purchased entitles the holder to a claim on the profits of the firm. The more stock owned, the larger the claim. While many companies will pay out a dividend per share, others don't. Regardless, stock represents ownership interest in the company, and the value of a share of stock will reflect the value of the company.

OPTIONS

Options are a part of a financial class known as derivatives. Derivatives are financial instruments that "derive" their value from other instruments. In other words, on their own derivatives have no value.

While there are many different types of options, for this article we will consider what are known as "plain vanilla" options, and, furthermore, a specific type of option known as a "call option".

A call option grants the holder the right to purchase stock, at a specific price, on or before a specific date, if the holder choses to do so. This purchase is known as an "exercise", as in the holder has exercise his options.

The key defining characteristics of an option, for the purposes of this article, are:

The underlying - options control a specific stock, known as the underlying.
The time to maturity - options don't last forever, and will expire on a specific date known as the maturity date.
The strike price - when an option is exercised, this is the price paid.

As options are derivatives they cost much less than stock.

AN EXAMPLE OF OPTIONS

Let's look at an example that will clearly illustrate some key differences between options and stock.

Assume two investors, StockInvestor and OptionsTrader each have $100. Assume they each would like to invest in BigCompany.

StockInvestor uses his $100 to purchase shares of stock in BigCompany.
OptionsTrader uses his $100 to purchase call options in BigCompany.

StockInvestor owns stock in BigCompany. StockInvestor is entitled to part of the profits BigCompany earns, for as long as he holds his shares.

OptionsTrader

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