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Stocks, Options, Mutual Funds, ETFs


Stock Markets tend to offer a large variety of tools and money-making vehicles for investors and traders. In order to make intelligent choice among them, one must answer 3 questions:

1) Am I a trader or an investor - most people are traders, without realizing this fact - such misconception partially accounts for their poor performance.

2) What is my time horizon - will I need the money in 2 years or in 40 years? If you need money quickly, long term strategies like trend following or mutual fund investing will not be appropriate. In general, the more time you have, the more different vehicles you can use to achieve financial goals.

3) How much time do I want to spend (and can spend) dealing with the stock market?

Day trading is very time consuming. Trend following can require thousands of hours of study and research to develop a trend following system. In addition, if you do not know how to program computers (or at least, Excel spreadsheet), you will need to pay someone to do it for you - can you afford the expense? If you want to look at your investments just once a year, you will need a different strategy than someone who is fascinated by the markets, and can spend 4 hrs per day plus weekends researching and planning trades.

If you are an investor - and your time horizon is short (less than 5 years) - forget the stock market - look into certificates of deposit and money market funds. You can gamble that the markets will favor you - but understand that it is gambling. 5 years is not enough to both recover from potential losses and to attain your goals.

If you are an investor, but your time horizon is long (5 years of more) - the number of strategies that can be employed in the stock market is still fairly small - you can do dividend investing (both individual stocks and income mutual funds), covered calls (options) writing, buy bonds ( hold bonds to maturity to eliminate interest rate risk to the principal), or buy entire companies outright (Warren Buffet does that).

If you are a trader with a short time horizon - 5 years or less - then day trading may give you high returns - but 5 years might not be enough time to recover from the early, inevitable, learning moments, i.e. mistakes. It may be wiser to stick to money market funds and bonds ( held to maturity - to eliminate interest rate risk to the principal).

If you are a trader with a time horizon of more than 5 years - your choices are plentiful indeed. You will need to tailor them to the amount of time you can spend dealing with the markets, and to your personality.
The point about personality is often overlooked, but is extremely important. There are people who cannot sleep at night - literally - if their accounts are down 5%. There are others who consider a 20% drop in account value as a normal occurrence. Some poeple can spend 3 hrs glued to a computer screen. Others cannot. Which one are you?

We will look at trading through different characteristics. Figure out where you would be comfortable - yes, you can pick more than one. :-)

First, we will look at time factor - how long is a position (stock) held - this influences how often you trade, your brokerage costs, and how much time you spend watching the markets.

Day Trading - going both long and short individual stocks or market indexes or options, never holding a position overnight - hence day trading - your trades are completed before the end of the day. Very intense, often one makes 400-500 trades per year; day trading requires as many hours to prepare as to trade (if you are trading, say the first two hours when the market opens, you will spend 2 hrs in pre-trading and post-trading work, for a total of four hours each day). If you are on the West Coast - this means getting up around 5 AM every trading day - stock market opens at 6:30 am PST and the pre-market trading, as well as the first hour of regular trading are considered best for day traders. This is in addition to hundreds of hours you must spend to research and develop the trading approach you will use. Preferred vehicles: individual stocks, ETFs, trading oriented mutual funds. Minimum required capital: $50,000.

Swing Trading - going both long and short individual stocks or market indexes or options, typically holding a position from a couple of days to 3-4 weeks. Much less intense than day trading, but also requires hundreds of hours to research and develop the system you will use. Depending on the system, you may have to deal with the markets on daily or weekly basis. Preferred vehicles: individual stocks, ETFs, trading oriented mutual funds. Minimum required capital: $50,000.

Long Term (Position Trading) - going both long and short individual stocks or market indexes or options, can hold positions for weeks, months, sometimes years, requires hundreds of hours to develop the system, may need to monitor market daily, weekly, monthly, for some strategies, only once per year. Actual trades are fairly infrequent, and often are placed after the market closes. Preferred vehicles: individual stocks, ETFs, most mutual funds. Minimum required capital: $2,000.

We can also look at different vehicles - things to buy or sell - each has characteristics which dictate how you use them, how much time and research you need to do, and the choices you have.

Stocks - provide most flexibility and least limitations. Allow for borrowing money on margin. Can be day traded, swing traded, traded for long term. Can be sold short. Require considerable research.

Stock Options - buying options conveys the right, but not an obligation to purchase or sell a stock at a pre-agreed price. Problem with options is that unlike stocks, they have a limited lifetime. At the end of the "option period" they expire - if not exercised - they become worthless. Not for the faint of heart.

Mutual Funds - mutual funds hold a number of individual stocks, selected by the fund manager. You may day trade mutual funds (very few), you can swing trade them (very few), or do long term trend following type of trading (all). You may also augment these approaches with managing the fund managers (presumption being that the managers can do better than you selecting stocks) - buying a number of mutual funds, for example 5, then at the end of the year, removing the least productive fund, and replacing it with a different one from the universe of over 7000 available mutual funds. Another approach would be to decide on a fixed ratio of the funds - say 5 funds, each to hold 20% of your capital, and at the end of the year, to sell off some of those that performed well, and buy more of the underperformers to restore the 20% ratio among all funds. The idea is that you are selling high (the ones that performed well) and buying low (the ones that underperformed - assumption is that their day will come, and you will get excellent performance since you are buying them when underpriced). One of the drawbacks of mutual funds is that most can be bought and sold only at the end of a trading day. If the stock market is falling - you can usually sell your stocks as soon as you make the decision, but with a mutual fund, your sell order will not be executed until 4pm Eastern Time. If the market is falling hard, this could mean additional 2-3% loss, compared to someone who held stocks and was able to sell at the beginning of a down day.

Index mutual funds - index funds are mutual funds designed to track a specific basket of stocks - typically a well known index, like Dow Jones Industrials, or S&P 500 ( 500 biggest US companies). They have low fees compared to regular mutual funds, and research has shown that about 70% of mutual fund managers underperform the market. With index funds, you get the market performance for very low fees.

Exchange Traded Funds (ETFs) - they are very similar to mutual funds, in that they usually track an index (a basket) of stocks, but have an additional advantage of being traded like a stock - they can be bought and sold throughout the day, and can be sold short (you can sell them anticipating that their price will drop, then repurchase them and pocket the difference). Many ETFs are country specific - they invest in stocks of a single country, allowing you to make trades targeting countries other than US. However, ETFs are not perfect - click here to read about ETF flaws .

Finally, there are different "stories" people tell themselves about the inner workings of the market. Often called "strategies" - they supposedly reflect how markets work and what influences prices.

Trend Following - belief that it is possible to spot trends in the market, and that they persist long enough to make money. Buy-and-hold is a super long term trend following strategy - based on a belief that over a period of decades, the stock market will trend upward. One can be a day trading trend follower, a swing trader who is a trend follower, or a position trader who is a trend follower. You simply look for trends that fit your trading timeframe. As the saying goes - The Trend is Your Friend.

Sector Rotation - as the economy goes through recession, recovery, expansion - different sectors of the economy tend to be more profitable. Sector rotation strategy looks to shift through those sectors seeking best returns (for example - financial sector, retail stores sector, industrial machinery). You can trade individual stocks using this strategy, or sector mutual funds, of sector ETFs.

Technical Analysis - analyzing various statistics derived from stock price and volume data, traders arrive at trade entry and exit points (prices). Pure technical analysts do not care if the company makes toothpaste or tanks - price and volume statistics are all that matters. Trend followers tend to use technical analysis to define trends, prices to enter a trade, and prices to exit a trade.

Fundamental Analysis - analyzing the company as a business - its products, cash flow, financial situation, competitors. So called Value Investors (including Value mutual funds) use fundamental analysis to decide which stocks to buy.

As you can see - time frames, vehicles, and strategies can be combined in many ways to form a foundation of a trading plan. One could be a trend following day trader of ETFs, or long term trader using fundamental analysis to select individual stocks (very time consuming) or select Value mutual funds, then use the "worst performer out" strategy to replace the worst performing fund every year.

You really need to ask yourself how these constraints (time to study markets, starting capital, emotional reactions to market events, personality) interact. Based on that reflection, it will be a lot easier to select strategies and vehicles well suited to your own personality - and this will greatly increases likelihood of your trading success.

Next week, we will list more strategies, and more details of the various approaches to trading.

 

 


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