As a modern investor, you have a wide variety of investment options. The question is whether the increased variety is necessarily a good thing. For instance, options are often touted as a simple and safe investment, but are they really?
The Dark Side of Options
The Chicago Board Options Exchange is one of the larger options exchanges in the world. In 2013, there were 1,147,449,222 options contracts written and traded on this one exchange. Each option had a seller and a buyer, which means one investor made a profit while the other lost money. While you can make money with options, it should be clear you can also lose it – particularly as a novice options investor.
What about ease of investment? A common perception among people new to options is the price of the option is based solely on the price of the underlying stock associated with the option. While the movement of that stock price will impact the value of the option, there is a second issue an investor must take into account known as “time decay.”
Time decay is the decrease in value of an option as it approaches its expiration date. A call option written on April 1, 2014 with an expiration date of April 1, 2014 has a three month time value. As time passes, this value “decays” because there is less time for the option to meet its strike price. If we jump forward in time to April 15, 2014, for example, the option has lost much of its time value because only 15 days remain for the option to be exercised before it expires on April 1, 2014. As a result, the price of the option changes in a negative manner.
There is yet another downside to options that many investors are unaware of until they have been trading options for more than a year. The problem? Nearly every option trade is considered a short term investment for tax purposes. This means you pay between 20 and 39.6 percent in short term capital gains tax on options profits. That’s a serious financial hurdle by any measure.
Options are touted as being safe and easy investments. They are anything but. Fortunately, there is an alternative investment that better fits these characteristics.
A Safe Alternative
Diversity is the key to limiting risk within your portfolio. The problem is figuring out the exact companies in each industry that you should include in your portfolio. Mutual funds originally provided a solution, but an expensive and inflexible one. An exchange traded fund, known as an ETF, now offers the best solution.
ETFs are funds designed to invest in a specific category of companies. For example, PowerShares QQQ Trust [Stock Symbol “QQQ”] is an ETF investing in stocks found in the NASDAQ-100. This includes companies such as Amazon.com, Netflix, Tesla, Starbucks, Viacom and DirectTV. By investing in this ETF, you can spread your money across a wide variety of quality stocks without incurring the cost of investing in each independently.
What about safety? The fear of every investor is to invest significantly in a company only to watch the stock price plummet. Consider Netflix. From March 2014 through the last week of April 2014, the stock price dropped a ghastly 30 percent going from $454 a share to $314. This type of drop undoubtedly led to sleepless nights for investors even though Netflix is a great long term investment.
Now consider if these investors had taken a position in Netflix through the PowerShares QQQ ETF. The price of the ETF did drop in reflection of the Netflix issues, but only from $89 to $85. That is a drop of less than five percent and the price has subsequently recovered to over $100 as of April 2014.
The inherent safety found in ETFs is born out by these two price drops. By spreading an investor’s contribution over 100 leading NASDAQ companies instead of just investing directly in Netflix, the extreme stock price drop of the movie rental company was muted. That, my friend, is about as safe an investment as you are going to find in the stock market.
The safety inherent in ETFs can be further enhanced by taking the concept one step further. Instead of investing in just one ETF, a smart investor will expand their portfolio to cover multiple ETFs in different niches. For instance, four of the standard bearing funds in the ETF niche includes the previously mentioned PowerShares QQQ ETF and:
- SPY SPDR S&P 500 ETF – Invests in companies in the S&P 500
- VWO Vanguard FTSE Emerging Markets ETF – Invests in 800 plus companies in emerging markets
- IJR iShares Core S&P Small-Cap – Invests in over 600 companies in the S&P Small Cap 600 Index.
By investing in each of these funds, an investor is not only able to protect against price drops of individual companies, but entire sectors. Again, this measure of safety is difficult to find anywhere else in the stock market.
Don’t be misled. Option trading is neither the simple nor safe investment opportunity it is made out to be in marketing pieces. If you are looking for safety and diversity, exchange-traded funds represent the superior investment.