Section-2
Kushanu B & Aedan L
Other Investing Practices
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Intro
This section will explore other various investing options in today’s stock market, including short-selling, ETFs, leveraged ETFs, and an intro to Option Trading. The goal is to provide you with a more comprehensive view of different types of trading approaches. Option trading will be getting its own seperate section
Why?
There are many reasons why one would want to use a different trading approach, rather than buying and selling a stock.
Some approaches offer more stability and less risk, while others can offer higher risk and higher reward.
Exchange Traded Funds (ETFs)
One popular investing strategy is investing in ETFs.
ETFs are securities that can be bought and sold like stocks. They are funds that measure the movement of a collection of stocks or an index.
An Stock ETF is an ETF that acts as a basket of stocks, and the ETF takes the average performance of each stock, combining them to determine the overall movement of the individual ETF.
Take the ETF: (CIBR). This ETF measures the average performance of several cybersecurity companies.
(CIBR) is composed of percentages from each public company in the cybersecurity sector, making it a Stock ETF.
An Index ETF is an ETF that monitors the movement of a certain index.
Index ETFs are a relatively low risk investment choice, as indexes tend to be less volatile.
An example of an Index ETF is the Vanguard S&P 500 ETF (VOO). This ETF, (you can probably guess), mimics the movement of the S&P 500 index.
Stock and Index ETFs are popular choices for medium and long term investors.
This is because the prominent indexes, such as the NASDAQ, GSPC (S&P 500), and DOW, tend to rise upwards at a steady pace, therefore supporting ETFs.
Leveraged ETFs
Moving away from conventional ETFs, Leveraged ETFs, or (LETFs) are higher risk, higher reward scenario choices.
While conventional ETFs track a security at a steady 1:1 ratio, Leveraged ETFs (LETFs) aim for a higher yield ratio.
Many leveraged ETFs move at a 2:1 or even 3:1 ratio, this means either 2x or even 3x volatility.
For example, take a 3:1 leveraged ETF that specifically tracked the stock of NVIDIA (NVDA).
If on this specific day, NVDA increased by 3%, the leveraged ETF would increase by 9%, as 3% at a 3:1 ratio would become 9%.
This aspect highlights the high-risk nature of many leveraged ETFs.
LETF Decay
We have just highlighted the risk behind leveraged ETFs, ( LETFs).
Despite that, leveraged ETFs carry another concern.
Diverging from LETFs for a moment:
“When you lose money, it becomes harder to make that money back”.
A vivid example of this fact can be demonstrated:
- You start with $100
- You lose 10%, bringing the total to $90
- You then regain 10%, but 10% of $90 is only $9
- This means after a 10% loss, then a following 10% gain, you’re at $99
We started with $100, but now we’re a dollar short? This is called decay.
Coming back to leveraged ETF scenario with a 3:1 LETF:
- You start with $100
- The stock loses 10%, meaning the LETF loses 30%
- You now have $70
- The stock regains 10%, meaning the LETF gains 30%
- $70 multiplied by 1.30 = $91
Here, we started with $100, but now have $91 left, meaning a 9% loss!
We then start to see the significantly higher decay possible when trading leveraged ETFs.
Short Selling
Moving on, let’s discuss short-selling and covering.
NOTE: Short-selling is not the same thing as selling, (not even remotely accurate).
Short-selling will be referred to as “shorting” for the rest of this section.
We already know that when buying shares, you aim for the stock price to rise.
However, with shorting, you instead are betting that the stock price will decline.
Example:
Let’s say you see JP Morgan Chase (JPM) at $210/share.
They then release a negative earnings report with shrinking revenue. (earnings reports etc. be covered in Fundamental Analysis).
Their stock would immediately decrease as a result, but you think they will continue to decline in the medium-term.
In this case, you would short JPM, as you believe their stock price will continue to decrease.
Covering the Short
A month later, JPM is now $150. The net-change is negative $60 from the original $210/share.
This means you made a $60 profit for each share shorted.
However, now, you want to end your shorting position on JPM, and take the profit.
To eliminate a shorting position, you would cover you short.
Covering terminates your sell-short, and you pocket the net-change.
The Internal Workings
The behind-the-scenes workings of short-selling can be explained relatively easily, however, they aren’t very important. For that reason, it won’t be listed here.
However, if you’re interested in reading about it, an article explaining it is here.
The Bottom Is The Ceiling
Shorting additionally has a ceiling on the amount of returns you can achieve.
This contrasts from buying & selling, where the returns have an infinite potential to rise, as share price can theoretically go to infinity.
This is because, in short-selling, you’re betting the stock price will go down. But stock price can never go below zero, therefore limiting the returns possible from short-selling.
Shorting stocks is a risky trading approach, as the losses are theoretically infinite, but the gains are limited and finite.
— Conclusion —
You’ve finished reading the section for “Other Investing Practices”.
This section has covered several other trading approaches that are used in today’s stock market. Understanding different approaches and their risk factors is vital towards building a successful portfolio.
Originally Published: 7/7/2024
Last Revised: 9/2/2024
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