My Take of Various Methods of Investing: A Basic Overview of the Various Investment Alternatives

The following article will be a culmination of my experiences and lessons with which I have gained through various investment methods.  I will outline many of the different types of investing and will also go into subcategories if I find it will be necessary.  Also, please do not take each word here as anything but a person's own opinions.  I am only offering possible suggestions from my experiences.

With the advent of electronic systems, many online savings accounts have popped up, many of them offering above-industry rates.  At the lowest level of risk, this is probably the most obvious alternative as there is practically no risk.  Many banks, such as Ally, Capital One, Sallie Mae, and American Express offer decent rates given the current interest rates (all offer around or above 1%).  I currently use Sallie Mae since they provide a good rate and is pretty convenient.  

At a slightly riskier level, you might want be interested in corporate notes, which offer slightly higher rates of return,, especially at higher tiers.  The risk that you incur as a result is the possibility of the corporation defaulting.  GE has a program called GE Interest Plus, and it provides a very good interest rate, and it seems to work just like an online savings account.  From what I have seen this is probably one of the better programs.

GE Interest Plus

If you are in for the long haul (multiple years), you may want to purchase CDs (certificate of deposit) or bonds. Government bonds, which is basically a debt where the issuer will pay interest to the person who purchases the bond. have a wide variety of terms, and the annual return increases the longer you commit to keep the money. Basically, the longer you are required to lock in the money, the higher the interest rate. There is relatively little risk as long as the country that is issuing the bonds does not go into bankruptcy.

The next step in risk are ETFs and mutual funds. ETFs are usually a performance indicator of a stock index, currency, commodity, a group of stocks/equities, and other financial products. Mutual funds are much more traditional as they are a bundled group of stocks. Mutual funds carry relatively little risk except for when there are significant market changes. ETFs are slightly more risky in that they are correlated with a market segment.

If you think that silver (SLV) or gold (GLD) is going to go up, if you want to get in on the action immediately, you should purchase an ETF. If you think that the stock market is definitely headed for a downturn, you might want to invest in FAZ which amplifies the returns and losses by 3x. If you are optimistic, then you can invest in FAS. There are also oil funds and a whole plethora of ETFs that you can explore to make creative investment decisions.

For example, if you think that the market is going to go down but you think there is a chance that it could still go up, you might not just buy FAZ outright. Unless you are purchasing less than two or three hundred shares, you might want to buy a few FAS shares (but not the same amount or else you can't gain much profit) to 'hedge' your risk. That is, you can eliminate risk by taking an opposing position to shred some losses if it does turn out that the outcome was not as expected.

Stocks are quite interesting because their beta can range significantly, but since a stock is solely based upon one company, it does carry a higher beta for the most part. A stock is traded just like an ETF (through a brokerage), but there should be a lot more thought going into the stock market because it does carry a lot more risk, and certain stocks could be very sensitive to certain types of news and others not as much. There is a lot more creativity required when trying to pick a stock and there are a variety of methods, the most traditional method is technical analysis, that is looking at past prices through a chart to detect any patterns and to make investment decisions based upon an analysis of the patterns. MACD (Moving Average Convergence Divergence) seemed to be the most helpful for me as it does give pretty accurate reversal signs assuming there is no breaking news. The other thing about stocks is you cannot really take what is given on the news when you are looking for price changes.

One of the biggest factors people think is news. For example, if there is a good earnings report, defined where the company make a great profit, but it was even two cents below the analyst's expectations, that could sent a stock tumbling 8 or 9 percent. Also, big decisions such as the interest rate would supposedly affect the market, but for the most part, analysts are pretty close to the mark, so the market does not move much. The market usually moves significantly if there is unexpected news. For long term investment, it is best to look at the company's financials (10-K forms). One of the best indicators for a solid investment is something that will have lasting value in the future, has a large amount of cash reserves for new developments, their price to earnings ratio (P/E ratio) is pretty low (P/E should not be a sole indicator, but a combination of all of this analysis would be much more telling).

If you are not much of a risk taker, veteran companies (MCD, CPB, JNJ, EBAY, MSFT) do not fluctuate as significantly as most stocks.

Medium risk stocks are a little older, such as some of the more established tech stocks and banks (AAPL, GOOG, JPM, GS).

If you are looking for high risk stocks, you should be looking at stocks that deal with commodities (PCX, KOG, SLW--usually around 2-3% change everyday), companies that are relatively new (Netflix, Baidu), and IPO days for new public stock releases (look at the first days of certain stocks; there is significant volatility).

One of the best free paper trading sites is Wall Street Survivor.  They have a lot of educational material, great prizes for top traders and much more.

Do not purchase penny stocks. There are so many temptations to buy them given all those advertisements, but they are highly unregulated and for the sake of trying to make a quick profit, you might end up losing a chunk of your capital.

Finally, like ETFs, there are hedging strategies, and once again, if you are starting with less than something around $15,000, then hedging might not be the most ideal option because of the transaction cost ratio. The more stocks you purchase, given a fixed rate commission, the less it costs per trade. If you are on a per-share plan, it theoretically does not make a difference, but your returns might not be enough to justify taking additional risk measures that would further cut into your profits.

Hedging can be a little more creative because you can purchase a stock that is negatively correlated with an ETF and with other stocks that might be competing industries. Financial innovation has become much more complex that developers of complex financial instruments have tried to make it easier to hedge and at the same time amplify profits.

Options are by far one of the riskiest investments available if not treated carefully. There are several purposes to options which I will gradually develop.

The textbook intent of purchasing options contracts is to purchase a form of insurance to purchase a stock at a later date at a fixed price, known as the strike. If you speculated that the stock would go up, you can buy insurance for a $100 per share stock for let's say $1 per share, or $100 per contract (made up of 100 shares) that you think will go up to $110. The $1 per share insurance is only an example, not necessarily a rule of thumb.

If the stock goes up to $110, you will have made a profit of $10-$1(contract)-exercise fees=$9-exercise fees per share. Having to purchase the stocks requires a lot of capital, and at 100 shares per contract, each contract would make you pay $10,000 for about $800 some dollars of profit. If the stock went down to $108 you would lose your $1 per share.

On the more riskier side of things, you might just buy the insurance contract to trade, assuming you have a very, very, very, very strong insight on a particular stock that might carry an option. Of course, there are very complex hedging strategies with options.

Let me briefly run through some basics:

• Call Option- If you plan to purchase this, then you think the underlying stock will be going up with limited risk and unlimited reward. If you plan to short this option, then you think the underlying stock will be going down, and you are faced with unlimited risk and limited reward. For shorting, you can only gain up to the price of the option when not exercising, and if the stock shoots up, you could lose more than your initial investment.
• Put Option-It is exactly the complete opposite in terms of the intent of purchase. If you plan to purchase, then you think the underlying stock will be going down, and if you plan to short, then you think you think the underlying stock will be going up.
• A question that might come up is, "Why would anyone in the world short an options contract when there is unlimited risk and limited reward?" This has do with hedging strategies and it is an effective strategy for certain market conditions which is described below.
• Strike Price: The price at which you choose to buy or sell the stock if you choose to exercise the options contract.
• Expiration Date: The time when the options contracts expire. This is very important to consider because all the options that are outside the range of being profitable (ie: stock price = strike price) will be worthless. There are other factors such as time value decay, which is a mixture value caused by time and volatility (assuming that the further away from the expiration date, there is a greater chance that the stock will move = more time value). Time value decays at an increasing rate as it nears expiration, so watch out!
• At-the-money-When Strike Price=Current Stock Price
• In-the-money-Strike Price<Stock Price for Call, and Strike Price>Stock Price for Puts (have option exercised choice if buyer of either contract).
• Out-of-the-money-the set of options contracts that do not fit the above two. Strike Price>Stock Price for Call, and Strike Price<Stock Price for Puts (will not have option exercised because unprofitable if buyer of either contract)

Also, you should note that options carry something called time value, which decays with time. Options should for the most part not be used as a long term strategy as they do expire.

Here are some tips to consider if you are considering on trading options. Again, people might have very differing opinions about this, but these have seemed to be the most reasonable for me.

1. Understand your risk parameters. Realize that options are many times more volatile than stocks, where one percent of movement in the stock might represent about 20-30% change in option. If you are doubting the fact that the underlying stock is not correlated with your option, then get out (assuming an outright position.
2. Do not trade based on emotions or purely on what comes out in the news. Earnings reports mean big gains or losses for stocks, but the big gains are not always actualized with options. People may be heavily biased to purchase a ton of call options if they think the stock is going to outperform analysts' expectations, but there might not be enough people who are shorting the option, and market makers might not feel there is much of an incentive to provide liquidity unless they create a large spread (which is usually the case). With emotions, it is easy to get carried away thinking that you can make even more, but that can easily turn into a loss. Also you might think that losses might recover, but because of time value the risk of it not coming back up should not be ignored.
3. Understand the market that you are going into. Look at the geopolitical events. What is your term view when you are investing?
4. Have you planned out a hedging strategy? Let me give you a few examples on some strategies which might be helpful. I will not give the specific names of these examples, but I will try to describe them to the best of my ability. Having a basic knowledge of options would be helpful.

Plan A: Assume there is a $50 Call of a premium of $1.25 and a $45 Put of a premium of $1.20.

If you think that there is going to be significant price movement that could be unexpected (ie: the fact that the movement is unexpected), but you are not sure in which direction, you may purchase simultaneously a call and put with approximately the same value. Going slightly out-of the money might amplify returns but the time value would erode at a quicker rate. Let's say that you are right and there a major natural disaster that affects a major industrialized nation. The stock plummets to $40, and your call premium becomes worthless and your $45 put premium shoots to $6.50. You paid $2.50 for each pair, and now you can receive $6.50 per pair. This is a great move since you gained over 150% in profit. Yet, if there is no movement and there is a 20 cent time decay, you will lose money on both sides. The closer it is to expiration, the more the time decay becomes.
Plan B: Assume the same, but you think there will be no price movement.

This is a slightly more risky measure, but instead of buying the options, you may sell both sides. Then you will receive the time decay value. This is highly not advised for near-expiration options as volatility increases might make your investment at risk. Also, this will require significant capital outlay because of options margin requirements. Generally, this might be more profitable for low price stocks (ie <$25/share).