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TIF Orders Types Explained: DAY, GTC, GTD, EXT, GTC-EXT, MOC, LOC

Posted on by Mike Martin

Last updated on February 18th, 2022 , 08:35 am

tif order types: stocks options

When trading stocks, options, and futures, brokers generally offer investors several different Time if Force (TIF) options to choose from. 

In addition to determining the order type (market, stop-loss, limit), traders must also specify to their broker the time and duration they want that order working. This is known as TIF order designation.

The most popular TIF order types are DAY orders (good for the day only) and GTC orders (good til cancelled). But there are so many more! EXT, MOC and LOC are a few.

Knowing the differences between these order types can be vital to get filled. Here’s what each one means. 

      TAKEAWAYS

 

  • The TIF order designation communicates to a broker the time and duration for an order to be working.

  • All orders default to “DAY”.

  • GTC (good til canceled) orders generally remain working for 90 days, or until the order is filled or canceled by the customer.

  • EXT (extended-market) orders ONLY work outside market hours.

  • Most brokers work EXT orders from 7 AM to 8 PM, though the formal NYSE Extended Market Hours extends these bounds.

  • When compared to MOC (market on close) orders, LOC (limit on close) orders can guarantee fill price, but not fill execution.

DAY Order Explained

day order tastyworks

DAY Order Definition: The TIF label DAY instructs a broker that a trade will only stay working during the current (or upcoming) market day. DAY orders are canceled after the market close.

  • DAY orders are only working during market hours.

  • If sent after the closing bell, a DAY order will be working for the following trading day.

  • All DAY orders are canceled at the closing bell. 

For just about all brokers, the “DAY” order is the default TIF order type. This simply means that the order is working for the day only.

If you send a day order before the market opens, that order will only be activated with the opening bell. Not before. If you want to work an order outside market hours, you’ll want to tag it EXT (Extended Market).

If you send a day order 5 minutes before the closing bell, that order will only be working for 5 minutes. 

Day orders apply to the current trading day. Not the day after. Therefore, if you submit a day order directly after the market closes, that order will be active for the next trading day. 

GTC (Good Til Cancelled) Order Explained

GTC order tastyworks

GTC (Good Til Cancelled) Order Definition: A GTC order is an order placed by an investor to either buy or sell a security that stays working until the order is filled or canceled by the customer (or broker).

  • GTC (Good Til Cancelled) orders remain working in the customer account until the customer cancels the order.

  • GTC orders do not work in the extended market.

  • Best practice is to periodically check and make sure the order is working, as brokers sometimes cancel GTC orders in error. Some brokers cancel these orders after 90 days.

  • Best for long-term traders who don’t monitor the market.

The GTC (Good Til Cancelled) order is the second most popular type of TIF order. This designation communicates to the broker that an order should stay working indefinitely, or until filled.

Sometimes, brokers cancel GTC orders without communicating this information to clients. This can happen either due to back-end issues, or simply because the GTC order was working for too long. 

For set-it-and-forget-it traders, it is wise to periodically check to make sure GTC orders are still working. 

GTD (Good Til Date) Order Explained

GTD order TIF type

GTD (Good Til Date) Order Definition: A GTD order type instructs a broker that a buy or sell order stays working until a specified date is reached. If the order is not filled by this date, it will be canceled.

  • GTD (Good Til Date) orders remain working in the customer account until the order is filled, canceled, or the pre-determined date is reached.

  • The GTD order type can help investors navigate volatile times (such as earnings) without having to monitor their accounts.

  • Best for long-term traders who don’t monitor the market closely.

The GTD (Good Til Date) is a great TIF order for investors who don’t have the ability to closely monitor their accounts. 

Let’s say you’re long FB stock, which is due to report earnings next week. If you’re not able to check your account on this day, you can tag a sell-stop order with the GTD tag to cancel your order on the day before earnings are released. This will allow you to stay in the stock during the volatile post-earning swings.

EXT (Extended-Market) Order Explained

EXT extended market order type

EXT (Extended Market) Order Definition: A EXT (Extended-Market) order instructs your broker that you want an order working in the extended market; this order will NOT be working during the normal trading hours. 

  • The EXT (extended market) tag designation instructs a broker that a buy or sell order is only to remain working in the extended market.

  • Many brokers allow EXT trading from 7 A.M. until 8 P.M. (not counting market hours). However, the NYSE extended market hours are technically between 4:00 A.M. TO 9:30 A.M. ET and 4:00 PM to 8:00 P.M. ET.

  • Trading in extended markets allows traders to capitalize on the large swings that exist in these markets.

  • Unless tagged GTC (Good Til Canceled), EXT TIF orders will only stay working for one session.

Extended markets are notorious for their illiquidity. Bid-ask spreads can widen enormously and stocks can fly. 

However, these swings can also provide investors with great opportunities.  

If you are long Amazon (AMZN) stock that pops $400 in the after-hours market post-earnings, you can sell your stock in the extended market by marking your order EXT. If you’re happy with the gains, why risk waiting another day? 

GTC - EXT (Good Til Cancelled - Extended Market) Order Explained

gtc ext order type

GTC_EXT (Good Til Cancelled Extended Market) Order Definition: A GTC-EXT order instructs a broker that a buy or sell order will remain working in the extended market until the order is filled or cancelled; this order will NOT be working during the normal trading hours. 

  • The GTC-EXT order combines both a GTC order and EXT order.

  • This order type works in the extended market until filled or canceled by the customer (or broker).

  • The GTC-EXT is NOT working during normal stock market hours.

The GTC-EXT order TIF allows a trader to work a stock order in the extended market indefinitely. As we said before, the formal NYSE extended market is between 4:00 A.M. TO 9:30 A.M. ET and 4:00 PM to 8:00 P.M. ET.

However, most brokers only allow trading from 7 A.M. until 8 P.M.

If you’re trading illiquid stocks that have huge market moves in the after-hours market, a GTC-EXT may allow you to take advantage of these moves without interrupting your dinner. 

MOC (Market On Close ) Order Explained

moc market on close order

MOC (Market On Close) Order Definition: A “Market-0n-Close” order is a buy or sell order placed with a broker to trade at the market close.

  • Market-On-Close (MOC) orders trade at the very end of the day.

  • These order types allow investors to trade out of positions at day end without having to monitor their accounts.

  • MOC orders in thin markets can result in poor fills.

The MOC (Market On Close) order TIF is a handy tool for day traders. This order type fills buy or sell orders on stocks, options, and futures at the very end of the trading day. 

The order fills as close as possible to a securities final daily trading price. 

The downside here is liquidity. If you’re trading options or thin stocks, try to avoid market orders at all costs!

But don’t worry – there is an alternative. Let’s read about the limit-on-close order next. 

LOC (Limit On Close ) Order Explained

LOC Limit on Close

LOC (Limit On Close) Order Definition: A buy or sell limit order placed with a broker with instructions to activate at the very end of the trading day.

  • Like MOC (Market On Close) orders, a LOC (Limit On Close) order goes live in the final seconds of trading.

  • Unlike MOC orders, the LOC order is not guaranteed to get filled.

  • LOC orders are great for liquid stocks.

A downside of MOC order types lies in the uncertainty of the fill price. 

Limit orders guarantee fill prices. If you’re trading option or thin stock, MOC orders can be dangerous. LOC orders hedge against poor fill prices. 

The downside of LOC orders (when compared to MOC orders) is that they are not guaranteed to get filled. If the order can’t be filled at your limit or better, you will not be filled.

Final Word

That wraps up our lesson on the 7 most popular TIF order types. 

There are indeed many more orders types, but these are rarely offered by brokers. 

When I worked with brokers in the SPX pit, we had AON (All or None) orders as well as FOK (Fill or Kill) orders. 

➥AON (All or None) orders communicate you want to either get filled on all of the order or none of it. 

➥FOK (Fill or Kill) orders communicate you want to get filled immediately, or not at all. What a nice acronym that is!

Order Type FAQs

Most GTC (good til cancelled) orders stay working for 90 days, though this varies by broker. 

The vast majority of DAY orders expire at the closing bell. Some options, however, trade until 4:15 PM.

GTC (good til cancelled) orders remain working in a customers account until 1.) the trade is filled or 2.) the customer or broker cancel the order.

DAY orders only remain working for ONE trading day. 

A LOC order activates a limit order at the very end of the trading day; a MOC order activates a market order at the end of the trading day. 

MOC guarantees a fill while LOC guarantees a fill price. 

Video: Option Order Types

Next Lesson

Leverage 101: Borrowing Money to Buy Assets

Posted on by Chris Butler

Last updated on March 27th, 2022 , 12:00 pm

Leverage

Investors sometimes borrow money to buy assets. Here’s how, why, and the pros/cons of each approach.

Buying a House With a Mortgage

The most mainstream example of borrowing money to buy an asset is taking out a mortgage to buy a home.

A mortgage is borrowing money from a bank to buy a home.

If you buy a $400,000 home with a 20% down payment, you’ll pay $80,000 upfront and borrow the remaining $320,000 to pay back over time (plus interest), commonly over 30 years.

According to the Bankrate mortgage calculator, a 30-year 3.5% interest rate mortgage would result in paying $197,000 in interest over the course of 30 years, which is the premium you’re paying the bank for lending you money.

Mortgage

Mortgages make expensive assets like homes affordable to many more people and also provide leveraged returns.

For instance, if you bought this $400K house with a 20% down payment, you’re leveraged 5:1.

$80,000 Down Payment / $400,000 Home Value = 20% Equity

$320,000 Loan / $400,000 Home Value = 80% Debt

Since you acquired the home while only paying for 1/5th of it, you’re leveraged 5:1.

Let’s say the home value appreciates 10% to $440K in a year and you decide to sell it.

If you sell the house for $440K, you’ll make $40K on the home appreciation. Since you paid $80K to acquire the house, your return is 50% (less interest payments/taxes/additional equity).

The home price appreciated 10%, but you’re leveraged 5:1 so your return is +10% x 5 = +50%.

You will pay interest on mortgage payments and add more equity to your home which will reduce your total return. The important thing to know is that buying a house with a mortgage (borrowing money to buy a house) provides you with leveraged returns.

Real Estate Crash Scenario

In a real estate crisis, if the home value falls 25% to $300K in a year and you need to sell the house, you’ll lose $100K.

Since you borrowed $320K to buy the home and you sold it for $300K, you’re now in debt $20K because the proceeds from the sale of the home do not pay off your mortgage. The mortgage is “underwater.”

Mortgage Scenarios

Fortunately, home prices have historically risen over the long-term, so if you maintain your ability to pay your mortgage payments you can hold onto the home through a short-term real estate crisis.

Buying Stocks on Margin

The second popular way investors borrow money to buy assets is “buying stocks on margin,” which means you’re borrowing money from your brokerage firm to buy stocks. You need a margin account to do this.

The process is usually automatic and simple: buy a portfolio of stocks valued at more than the equity in your account.

Usually, you can get 2:1 margin on stock purchases, meaning you can buy a portfolio of stocks that is 2x the value of your account equity (the portion of the account you own).

For example, if I deposit $13,000 into my margin account, I can buy $26,000 worth of stocks.

$13,000 is equity and $13,000 is debt.

If the stock portfolio increases 20%, my $26,000 portfolio will increase by $5,200 to $31,200.

Since I only had $13,000 of equity in the account before the stock price increase, a $5,200 return on my $13,000 equity translates to a return of 40%.

I could then sell $13,000 worth of shares and relieve my debt portion of the position, leaving $18,200 in my account, 100% of which is mine (equity).

If I did not buy shares on margin, I would have only been able to afford $13,000 in shares. The 20% stock return would have only generated $2,600 in profits for me as opposed to $5,200.

So borrowing money to buy stocks, or buying stocks on margin, increases leverage and therefore returns.

In the worst-case scenario, if I bought $26,000 worth of stock with $13,000 of equity in my account, and the stock price went to zero overnight, I now owe the brokerage firm $13,000 since I lost all of my money and the money they lent me.

In that case, I lose 200% of my investment and am now $13,000 in debt. I’ll need to repay the brokerage firm over time just like any other debt.

Collateralized Loans

Buying a home with a mortgage and buying stocks on margin are examples of collateralized/secured loans.

The money lent to you is backed/secured by an asset you are pledging as collateral.

A home bought with a mortgage can be sold to pay back the mortgage, which means the home is collateral. If you stop making your mortgage payments, the bank you borrowed from can sell your house to get their money back.

Stocks bought on margin can be sold by the brokerage firm to recover their loan to you, which means the stock positions are collateral. If you buy stocks on margin and the value of the stock position falls, the brokerage firm can sell your stock position to recover their loan.

So a collateralized or “asset-backed” loan means the lender can sell your asset to get their money back if they need to.

The downside to these two popular borrowing approaches is that the money you’re borrowing can’t be used freely to buy whatever you want. You are borrowing money to buy those specific assets (a home or stocks).

There are other examples of collateralized or asset-backed loans where the proceeds can be used freely.

Crypto Collateralized Loans

Crypto-backed loans are becoming very popular because many crypto investors are sitting on massive capital gains. If they sell their crypto now, they’ll pay 20%+ in capital gains taxes and lose some/all of their exposure to their crypto asset.

If a profitable crypto investor wants to access the money they’ve made but doesn’t want to pay capital gains taxes and/or also wants to keep holding their crypto, they can take out crypto-backed loans.

Here’s a concrete example using BlockFi:

Let’s say I have 1 BTC that I bought for $5,000 and is now worth $50,000.

I want to take out $10,000 for some short-term expenses and also don’t want to sell my BTC because I think it will continue increasing long-term. Selling an appreciating asset to pay an expense isn’t ideal based on my outlook.

I can get $10,000 in cash by depositing some of my BTC at BlockFi as collateral.

If I take out a loan with a 50% loan-to-value ratio, that means I need to deposit $20,000 in BTC to take out $10,000 in cash.

Loan-to-Value (LTV) Ratio => Your outstanding loan balance / the value of your collateral.

$10,000 Loan Balance / $20,000 BTC collateral = 50% LTV.

This is an “over-collateralized” loan because I’m pledging an asset with a value higher than the loan I’m taking out, which lenders require due to bitcoin’s high volatility.

If you take out a $10,000 loan against $20,000 of bitcoin, your LTV is 50%. If the value of your BTC falls to $15,000, your new LTV is 66%.

A higher LTV is bad because it means a higher percentage of your collateral needs to be sold to repay the loan. If your LTV exceeds 100% then liquidating your entire collateral position will not fully repay your loan. Bad news.

A lower LTV is good because it means a small percentage of your collateral can be sold to repay the loan.

The $10K in cash can be used for whatever I want. I could deposit it into my brokerage account and buy stocks with it, or buy more bitcoin with it (which leverages my bitcoin position since I’m buying more BTC with borrowed money).

I could also use the money to pay for rent or other living expenses.

I’ll have to pay back this $10K loan over time with interest, but I’ll keep my entire bitcoin position and not pay 20%+ in capital gains taxes.

Using a bitcoin-backed loan like this is a sound strategy IF I believe bitcoin will appreciate in the future, but there are big risks associated with BTC-backed loans (or any asset-backed loan).

If the value of BTC falls after taking out a loan, the value of your collateral (bitcoin) falls relative to the value of your loan.

Example: if you take out a $10K loan against $20K of bitcoin, your LTV is 50%. But if bitcoin falls 50% after taking out the loan, now your bitcoin collateral is worth $10K and your loan is $10K. The LTV is now 100%.

You will need to either add more bitcoin as collateral or pay down your loan to reduce your LTV. For instance, paying $5K towards the loan reduces your outstanding loan to $5K vs. your $10K bitcoin collateral value, reducing your LTV to 50% once again.

Or, if you add another $5K in BTC to your collateral account, your BTC collateral value goes to $15K. Your $10K loan vs. the $15K collateral value means your LTV is now 66%, a better situation than a 100% LTV.

If you do not reduce your LTV by paying down your loan or adding more collateral, the lender will sell your bitcoin to pay down your loan.

In that scenario, you’ll lose your bitcoin position and have to deal with the tax consequences.

Bitcoin Loan: Worse-Case Scenario

The value of your collateral falls to zero abruptly, leaving you with your loan and no collateral to pay it down if needed. So you’re left with a $0 asset and a loan to pay off with ordinary earnings.

So if you took out a $10K loan against $20K BTC and BTC went to zero overnight, you’d be left with a $10K loan to pay off and no BTC. It wouldn’t be such a bad situation if you still had the $10K cash in your checking account, but if you spent the money then you’d need to come up with that money to repay the lender over time.

Because of this, it may be better to take out a bitcoin-backed loan during a BTC decline as opposed to new all-time highs (ATH) because if BTC corrects from ATH, your LTV will increase, bringing you closer to a margin call.

Example: BTC at $70K and you deposit 1.0 BTC to take out a $35K loan.

Beginning LTV: $35K Loan / $70K BTC collateral = 50% (Good).

BTC falls to $50K.

New LTV: $35K Loan / $50K BTC collateral = 70% (Risky – Close to margin call).

If you take out a BTC-backed loan during a big decline and the value of BTC begins to rise after you take out a loan, your LTV will fall, bringing you further away from a margin call.

Example: BTC at $50K and you deposit 1.0 BTC to take out a $25K loan.

Beginning LTV: $25K Loan / $50K BTC collateral = 50% (Good).

BTC increases to $75K.

New LTV: $25K Loan / $75K BTC collateral = 33% (Great – significant BTC decline required for margin call).

It’s also wise to take out small loan-to-value loans, such as borrowing $10K against $50K bitcoin, or a 20% LTV, because it would take a much larger BTC correction to bring you into margin call territory.

Stock Collateralized Loans

Like a BTC-backed loan, which is just an asset-backed loan, you can take out loans against your stock portfolio. Any asset can be used as collateral, especially a highly liquid holding like a stock portfolio.

So if you had $100K in the S&P 500, you can take out a loan against the value of your stock portfolio (which we’ll explore in a later section).

Again, the idea would be to avoid selling your stocks and realizing capital gains taxes, reducing your stock market exposure and giving you a large tax bill to pay.

Unsecured/Uncollateralized Loans

All of the borrowing methods discussed thus far have been tied to an asset that is pledged as collateral, meaning the asset will be sold to recover the loan in the worst-case scenarios.

These asset-backed loans are “secured” or “collateralized” loans because the loan is backed by a valuable asset.

There are “unsecured” loans you can get which are not backed by anything other than your income. There is no asset pledged as collateral to be sold to recover the loan, making it a riskier loan for the lender to make because they’re trusting that your income allows you to make debt payments.

Because of the increased risk to the lender compared to an asset-backed loan, you’ll pay a higher interest rate on these loans.

The benefit of an unsecured/personal loan is that as long as you can make the payments, you will never be forced to sell an asset you purchased with the loan proceeds.

Benefit of Using Unsecured Loans to Buy Assets

The obvious downside of taking out an asset-backed loan is the forced liquidation of your asset/collateral if the value of that asset plummets. If the value of the asset falls significantly, the lender can sell the asset to recover their loan.

Of course, this means you’ll be selling your asset during a downturn, which is likely when you’d want to be acquiring more of that asset.

So the benefit of taking out an unsecured personal loan to buy an asset like a portfolio of stocks or bitcoin is that you won’t be forced to sell those assets if their values fall.

So as long as you can keep the bank happy by continuing to make the loan payments, you’ll be just fine.

Example: Say an investor takes out a $50,000 personal loan to buy bitcoin @ $50,000, then bitcoin falls 80% to $10,000. As long as the investor continues to make their loan payments, they will keep their bitcoin and can hold it to see if it recovers back to $50,000 and beyond.

Compare this to an investor who has $100,000 worth of bitcoin and they take out a $50,000 bitcoin-backed loan to buy more bitcoin. Their loan-to-value ratio is 50%.

Then bitcoin falls 50%, cutting the value of their bitcoin position to $50K. Their LTV is now 100% because their loan is $50K and the value of their BTC position is $50K.

In this scenario, the borrower must reduce their LTV by either:

  1. Adding more bitcoin to the collateral account

  2. Paying down some of the loan from other cash sources.

Both options will reduce the value of the loan relative to the collateral.

If they cannot do either, the lender will sell their BTC for $50K to recover the money lent out.

This leaves the investor with $0 in debt and $0 in bitcoin. Full liquidation.

The investor will then deal with the tax consequences and also have zero exposure to bitcoin, which would be tough to stomach if bitcoin’s value surged after liquidation.

Buy, Borrow, Die

How do the wealthy use the above information?

“Buy, borrow, die.” is how.

What the saying means is that you buy assets with your earnings over time, borrow against them to avoid capital gains and continue holding appreciating assets, then die. It’s a cheeky way of saying you’ll never sell the assets you accumulate.

The idea is to avoid selling assets at all costs because holding assets long-term protects you from inflation, eliminates capital gains taxes, and prevents interrupting long-term compounding.

If you can borrow against your assets at an interest rate lower than the long-term annual growth rate of the assets, you come out ahead.

A WSJ article quoted a 3.2% interest rate on asset-backed loans from Merrill Lynch for those with $1M+ in assets, or 0.87% for those with $100M+ in assets:

  

I ran a basic simulation of a stock portfolio worth $1M compounding at 8% per year. I compared selling 25% of the portfolio to come up with $250K in cash vs. borrowing $250K at 3.2% interest for 10 years.

The BankRate Amortization Calculator showed a $2,450 monthly payment for that loan with a total interest cost of $42,500 over the 10 years:

Of course, this means you’ll be selling your asset during a downturn, which is likely when you’d want to be acquiring more of that asset.

So the benefit of taking out an unsecured personal loan to buy an asset like a portfolio of stocks or bitcoin is that you won’t be forced to sell those assets if their values fall.

So as long as you can keep the bank happy by continuing to make the loan payments, you’ll be just fine.

Example: Say an investor takes out a $50,000 personal loan to buy bitcoin @ $50,000, then bitcoin falls 80% to $10,000. As long as the investor continues to make their loan payments, they will keep their bitcoin and can hold it to see if it recovers back to $50,000 and beyond.

Compare this to an investor who has $100,000 worth of bitcoin and they take out a $50,000 bitcoin-backed loan to buy more bitcoin. Their loan-to-value ratio is 50%.

Then bitcoin falls 50%, cutting the value of their bitcoin position to $50K. Their LTV is now 100% because their loan is $50K and the value of their BTC position is $50K.

In this scenario, the borrower must reduce their LTV by either:

  1. Adding more bitcoin to the collateral account

  2. Paying down some of the loan from other cash sources.

Both options will reduce the value of the loan relative to the collateral.

If they cannot do either, the lender will sell their BTC for $50K to recover the money lent out.

This leaves the investor with $0 in debt and $0 in bitcoin. Full liquidation.

The investor will then deal with the tax consequences and also have zero exposure to bitcoin, which would be tough to stomach if bitcoin’s value surged after liquidation.

It’s reasonable to assume an investor that has amassed $1M in assets would be able to easily afford this payment. If not, there is the option of slowly selling assets to meet the monthly payments, which will reduce the benefits below but will likely still be better than liquidating a huge chunk of the portfolio at the beginning.

Here are the outcomes of the two approaches:

  1. Borrow $250K against a $1M stock portfolio at 3.2% interest for 10 years

  2. Sell $250K of the portfolio

  

The investor who liquidated $250K at the beginning pays a 15% long-term capital gains tax (since I’m assuming accumulating a $1M stock portfolio took decades and most of the value of the portfolio is from capital gains).

To make things simple we’ll just use 15% of the entire $250K generated from the sale. If 50% of the $250K came from capital gains, then the capital gains tax would be $18,250 instead of $37,500. An insignificant difference in this comparison.

By borrowing $250K at 3.2% interest, the investor gets to hold the $1M in stocks for the entire 10-year period. Growing at 8% per year, the portfolio grows to $2,158,925. Total capital gains = $1,158,925. They pay $42,460 in loan interest.

The investor who liquidated $250K of their portfolio at the beginning experienced $869K in capital gains over the 10-year period. Their portfolio ended at $1,619,194.

So the investor who borrowed against their stock portfolio had a $2.16M portfolio vs. a $1.62M portfolio at the end of the 10-year period. The investor that borrowed against their assets to come up with cash experienced nearly $300K more in capital gains over the 10-year period compared to the investor who sold their stocks to come up with cash.

The simple way to interpret this is that investor #1 paid $42,500 in loan interest in exchange for increasing their 10-year capital gains by almost $300,000.

The key consideration here is each investor’s confidence in their ability to make loan payments. As long as the investor in scenario #1 can make the loan payments, they reap the benefits of holding onto their appreciating assets.

A big reason one might want to sell a portion of their assets vs. borrow against their assets is if they are not confident they’ll be able to make the debt payments or do not want any debt.

The point here is that debt isn’t always bad and can be used strategically to improve long-term financial outcomes, which is precisely what the wealthy do.

Disclaimer

I hope this post was informative and helped you understand the basics of borrowing money (asset-backed and unsecured).

I want to clarify that I’m not recommending or promoting taking out debt to buy assets, especially highly volatile assets like bitcoin. Debt is a risky thing because it increases leverage, which increases returns but increases losses as well. It also adds pressure to your finances because you increase your monthly payment obligations.

What you decide to do with your personal finances is your decision, but I hope this post broadened your awareness of what’s available to you.

The simple goal here is to increase financial literacy by making you more familiar with the tools available to you in the personal finance realm.

-Chris

Recommended Reading

Chris Butler portrait

Covered Call vs. Long Call: Here’s How They Differ

Posted on by Mike Martin

Last updated on February 11th, 2022 , 06:57 am

Long Call
Covered Call Graph

Covered calls (aka “buy-writes”) and long calls are very different types of options trading strategies. 

In a nutshell,  call options are speculative investments that profit when a stock rises substantially in value. Covered calls, on the other hand, are a combination of 100 shares of long stock and a short call. This latter strategy has less market risk (but greater principle risk), and a greater chance of profitability. Additionally, covered calls can profit in any market direction.

Let’s first take a look at the textbook definition of the two, then dive into a few examples. 

TAKEAWAYS

  • Long calls profit in very bullish markets.
  • The covered call strategy is ideal for market-neutral traders.
  • A long call consists of buying a single option; the covered call consists of selling one call option AND purchasing 100 shares of stock.
  • The maximum loss on a long call is the entire premium paid.
  • The maximum loss on a covered call resides on the stock side, and is calculated by stock purchase price – option premium collected.

What is a Long Call?

Long Call Definition: A long call gives the owner the right, but not the obligation, to purchase 100 shares of stock at a specified strike price on or before a specified expiration date. 

Long Call Components: Long call at strike price X.

Long call options provide very bullish investors with great upside potential. When compared to stocks, options are leveraged at a ratio of 100 shares per 1 option contract. This “multiplier effect” magnifies both risk and reward.

Long Call Example

Let’s say Apple is trading at $170/share. You believe that in two weeks, following their earnings report, AAPL will be trading at $185/share. 

Here are the details of the call option you purchase:

Initial Trade Details:

➥Stock Price: $170

➥Call Strike Price: $180

➥Call Cost (premium): $2 ($200)

➥Call Expiration: 14 Days Away

So lets say that 2 weeks have passed. Following earnings, the price of AAPL stock soared. How did our trade do? Let’s see.

Trade Details at Expiration:

➥Stock Price: $170 –> $185

➥Call Strike Price: $180

➥Call Value: $2 (200) –>$5 ($500)

➥Call Expiration: Today

As we can see, with the stock trading at $185 on expiration, our call option netted us a nice profit of $300! We purchased this option for $2 and on expiration, it is trading at $5. The difference between these two figures tells us our profit.  This value is all intrinsic value. 

If the stock was trading under our strike price of $180 on expiration, we would have lost the entire premium of $2 ($200) that we paid. 

What is a Covered Call?

Covered Call Definition: A covered call is an income generation options strategy that allows investors to profit from their long shares in a stagnating market. 

Covered Call Components: Long 100 Shares of Stock AND Short 1 Call Option

If an investor is either neutral, mildly bullish or mildly bearish on a stock they own, that investor could sell an out-of-the-money call option on that stock to generate income. 

As long as the stock price is trading under the strike price of the call sold on the option’s expiration, the investor will collect the entire premium of the option sold. 

Selling a call against stock does, however, limit upside potential. If the stock rallies beyond the strike price + value of premium collected, the short call will act as ballast on the long stock, preventing further gains. 

Covered Call Example

Lets re-visit our above AAPL trade, but this time, we don’t think AAPL is going to go anywhere.

Unlike our long call option strategy, the covered call must include a short call and 100 shares of long stock. So we will assume we have 100 long shares of AAPL in our account today. 

We believe AAPL will be trading under $180 in two weeks. It is currently trading at $170. To generate income from our stock, we will sell an out-of-the-money call. Here are the details of our trade:

Initial Trade Details:

➥Stock Price: $170

➥SHORT Call Strike Price: $180

➥Premium Collected: $2 ($200)

➥Call Expiration: 14 Days Away

So let’s say 14 days have passed. We were right this time – AAPL closed at $176 on the expiration day, below our short call strike price of $180. 

Unlike buying calls, when an investor sells a call, they want that call option to go down in value. Here is how our trade played out:

Trade Details at Expiration:

➥Stock Price: $170 –> $176

➥SHORT Call Strike Price: $180

➥Closing Option Value: $2 –> $0

➥Call Expiration: Today

This was an ideal outcome for us. We made $7 per share on the long stock AND collected the full premium of the option sold ($200).

Now, what if the stock rallied instead to $190 on expiration instead? In this scenario, our short call would prohibit additional stock profit at the strike price + premium sold level ($180 + $2 = $182). 

In this second outcome, the call option is in-the-money on expiration; an investor can choose to do nothing, and the short call will be exercised, forcing them to sell 100 shares at the strike price of $180/share. The result would be a flat position.  

Long Call vs Covered Call: Head-to-Head

Long Call

Covered Call

When to Trade?

The long call is best suited for traders who are extremely bullish on an underlying security. 

The covered call is a great way for investors to collect income on a stock that they believe will change little in the future.  

Maximum Profit Potential

Unlimited (there is no cap on how high a stock can go)

Short Call Strike Price - Stock Entry Price) + Option Premium Collected

Maximum Loss Potential

Entire Premium Paid

Stock Entry Price - Option Premium Collected

Breakeven

Strike Price + Premium Paid

Stock Price - Short Call Premium Collected

Time Decay Effect

As time passes, and both implied volatility and stock price stay the same, a long call option will persistently shed value. 

As time passes, and both the implied volatility and stock price stay the same, the short call portion of a covered call will shed value, which is desirable as a short option profits when its value falls. 

Ideal Market Direction

Bullish

Tips

In the long run, buying call options is usually a losing battle. For out-of-the-money calls, you need the stock to go up in value - by a lot. Time is NOT on your side here. 

The covered call is a great way for all investors to make a little extra money from their stock in a neutral market. Over the long run, however, owning the stock outright is usually more advantageous. 

Additional Resources

What Is a Long Call? | The Motley Fool

Covered call – Wikipedia

Call Options vs. Shares: 6 MAJOR Differences

Posted on by Mike Martin

Last updated on February 24th, 2022 , 09:05 am

Long Call vs Long Stock

There are some pretty significant differences between buying call options and buying stocks. Before we examine how these types of securities differ, it may first help to understand a few ways in which they are alike.

1.) Both long calls and long stock positions are bullish.

If you purchase a stock, you anticipate that stock will go up in value. If you purchase a call option on that same stock, you are also bullish. However, call option buyers are much more bullish than stock buyers. 

2.) A call option can “trade like” a certain amount of shares. 

In options trading, the “Greeks” are a series of calculations traders use to determine how an option will react to various market movements. The Greek “Delta” tells traders how an option will react to an immediate $1 move in the price of the underlying security. 

Delta also tells us how many shares of stock an option “trades like”. If a call option has a delta of .50, this tells us this option will trade like approximately 50 shares of stock. Unlike stock, however, the option Greeks are in constant flux with time and volatility.

Now that we understand the limited ways in which these types of securities are similar, let’s now explore how stocks differ from options. 

TAKEAWAYS

  • For long-term investors, stocks tend to out-perform call options.

  • Stock (or equity) comes with certain rights, such as the right to receive dividends. Call options have no such rights.

  • Options are usually leveraged at a ratio of 100:1, meaning one contract represents 100 shares of stock. 

  • If the price of a stock remains the same, a shareholder will not lose money. Call options shed value as time passes if the stock remains the same. 

  • All call options will expire at some future, pre-specified date (expiration date)

  • In theory, stocks have greater principle risk than options. 

1) Stock Represents Ownership

When you buy a share of a company’s stock, you are buying a piece of that company. This is known as “equity”. 

Having “equity” in a company comes with certain benefits:

  • Right to inspect company records and books
  • Right to vote on major corporate events
  • Right to transfer your stock to another party
  • Right to receive dividends

Options contracts are “derivative” instruments. This means their value is derived from the underlying security. Though the owner of a long call does indeed have the right to convert their contract to 100 long shares at any time, until this “exercise” happens, they have none of the rights that stock owners have. In the eyes of the company, they do not exist. 

In fact, call options actually go down in value when a stock goes “ex-dividend”.

2) Call Options Offer Leverage

As explained by FINRA, options are standardized contracts. This standardization allows for greater market liquidity and regulation. 

Part of an options standardized terms pertains to the “multiplier effect”.

Option Contract Multiplier Definition: Standard call and put options have a multiplier of 100, meaning that one contract represents 100 units or shares of the underlying stock, exchange-traded fund (ETF), or index. 

To better understand how option leverage works, let’s look at an example from the tastyworks trading platform:

Buying 100 Shares of AMZN

AMZN 100 Shares

The above image shows an order to buy 100 shares of Amazon (AMZN) stock. The cost of this trade? Over 340k.

Now, let’s take a look at an at-the-money call on AMZN expiring in a few days. 

At-The-Money AMZN Call

AMZN Call

The above shows an order ready to buy a call option on AMZN. 

We said earlier that a call option delta shows us “how many” shares of stock a contract mimicks. This call option has a delta of about 50. If we were to buy two of these calls, our delta would match that of 100 shares of stock!

  • Cost of 100 AMZN Shares: $341,000
  • Cost of 2 ATM Call Options: $7,330 ($3,665 x 2)

As you can see, by using options we can get the same exposure to AMZN for a significantly reduced price when compared to buying the stock.

Sound too good to be true? That’s because it is! Options come with significant risks. One of these risks is “time decay“. Let’s explore the detrimental effect of time decay next.  

3.) Call Options Experience Time Decay

If you were to purchase 100 shares of AMZN at $3,405 per share, and if in one week AMZN was still trading at $3,405, you would neither have made nor lost money. 

However, if you purchased an at-the-money 3,405 strike price call on AMZN last week, and the stock was unchanged when the option expired, you would lose 100% of the premium you paid. For us, that would mean a total loss of $7,330. Though options trading does offer leverage, you indeed pay for this privilege!

I prefer trading vertical spreads to hedge some of this risk. 

Time decay is also known as “theta”, which is another option Greek (we already know delta!).

The below table shows the theta for options on AAPL:

AAPL Options Chain

Type Strike Price Theta

Call

147

3.25

-.52

Call

148

2.63

-.56

Call

149

2.11

-.54

Where AAPL is trading at $148.20 and expiration 2 days away.

The above theta value shows us how much the each corresponding AAPL call option will decline in value with every passing day. This assumes an environment of constant implied volatility and stock price. 

To go in-depth on theta, check out our video below!

4) All Call Options Expire

One of the standardized terms of an options contract is its expiration date.  All options expire. Some options expire in hours, other expire years into the future (these are known as Long-Term Equity Anticipation Securities (LEAPS)).

Stocks never expire. Eventually, most companies will become defunct either through bankruptcies or mergers, but the stock itself does not have a prearranged expiration date. 

Options are decaying assets. In a constant environment, they are persistently shedding value (as we learned above).

The below image shows how the value of an option slowly sheds as the stock remains the same and expiration approaches. 

Option Pricing

5) Call Options vs. Stock: Principal Risk

Long Call vs Long Stock

From a total risk perspective, call options have less principle risk than stock. 

Now, this can indeed be misleading We are looking at this through a theoretical lens; or a “worse case scenario” perspective. 

Let’s revisit our AMZN example above. Remember, we spent $7,330 to buy 2 call options that gave us the same exposure to AMZN as 100 shares of stock. This stock cost us $341k.

  • Shares Maximum Loss: $341,000
  • 2 ATM Call Options: Maximum Loss $7,330 ($3,665 x 2)

If AMZN were to plummet to $0 in value overnight, we would lose A LOT more on the stock than the options. 

However, AMZN will most assuredly not be trading at $0 in the next few days. Therefore, this perspective is not very reasonable. But it is possible!

6) Call Options vs. Stock: Liquidity

Stock Market Liquidity Definition: The ease in which a security can either be entered or converted into cash.

Generally speaking, equities have better liquidity than options. When trading stocks, we are usually only concerned with two aspects of liquidity: daily volume and the bid/ask spread.

The below image (taken from the tastyworks trading platform) shows the current market for Tesla (TSLA) stock. 

TSLA Stock

The above image shows we can purchase TSLA stock for $1,189.23 and immediately sell it for 1,188.42.

Considering the stock is trading 1k+, that is a pretty tight market. 

What about options on TSLA?

 

TSLA Call Options Liquidity

TSLA Liquidity

When we are looking at options, we need to add a few more liquidity variables:

 

The 1175 call option on TSLA is bid at $92.10 and offered at $95.15.

This means that if we were to immediately buy and sell this option, we would lose $3.05.

When compared to the stock, the liquidity on options is almost always worse. 

It is therefore important to always try and get filled at the mid-price when placing an options trade. Never use market orders on options. Slowly work call (and put) option orders in nickel increments, until you are filled. 

If the open interest and volume on a particular option series is low, it is best to avoid those options altogether. 

Final Word

Perhaps the greatest distinction between call options and stocks is the risk: options have inherently more risk than stocks. 

Stocks are generally held as long-term investments; options are short-term “trades” that require diligence and maintenance. 

Let’s conclude our article by going over a recap of what we learned. 

  • Stocks pay dividends; options don’t
  • Call options offer a 100:1 ratio
  • As time passes, call options decay in value
  • All call options will expire
  • Options have less principle risk than stocks
  • Stock have better liquidity

Next Lesson

Additional Resources

Call options basics – Fidelity Investments

Options Trading: Investopedia

SWAR: 2X Leveraged Software ETF Explained

Posted on by Mike Martin

Last updated on February 11th, 2022 , 07:07 am

Rocket Ship Taking Off

Direxion has just released yet another leveraged ETF. The SWAR ETF is a rather niche tech fund, focusing exclusively on the “software” segment of tech. 

The aim of the fund is to track the S&P North American Expanded Technology Software Index at a leveraged ratio of 2:1 (200%).

Like all leveraged ETFs, it is important to note that SWAR is best suited for short-term traders. The financial instruments used to achieve leverage (futures and derivatives), often result in long-term underperformance when compared to the underlying index.

TAKEAWAYS

  • Direxion’s SWAR ETF is a bullish fund that seeks a return that is 200%  the return of its software benchmark index.

  • Direxion aims to provide this leverage on a daily basis; not in the long-run.

  • SWAR charges a very high fee of 1.07%

  • The vast majority of stocks in this fund fall within the IT sector, while the rest are in communication stocks. 

  • Over the long-run, SWAR will likely underperform its benchmark (leverage aside).

  • “Swaps” are used in this fund to achieve a leverage ratio of 2×1 (200%).

SWAR ETF Factsheet

  • Expense Ratio: 1.07%
  • Market Direction: Bullish
  • Index: S&P North American Expanded Technology Software Index
  • Number of Holdings: 130
  • Leverage: 200% (2×1)
  • Average Spread: $0.05
  • Average Market Cap: 78.07 Bil

Before we dig too much into Direxion’s SWAR ETF, it may first help to have a better understanding of the index which the fund aims to track (at a 2×1 ratio).

S&P N. American Expanded Tech Software Index

Chat from https://www.spglobal.com/

The S&P North American Expanded Technology Software Index is a product of S&P Dow Jones Indices.

What sets this index apart from other tech funds is its software focus. The aim of this index is to:

SWAR: Fees

  • Expense Ratio: 1.07%

Like most leveraged exchange-traded funds (ETFs), the net expense-ratio for SWAR is quite high. When comparing SWAR’s fees to the average ETF fee of 0.40%, 1.07% is quite high indeed. 

In fact, SWAR exceeds even the average leveraged ETF fee of 0.95%. These types of funds do require considerably more management, but perhaps not enough to justify a fee of over 1%.  

SWAR: Fund Sectors

In order to understand the sectors that comprise the SWAR ETF we only need to look to its benchmark: The S&P North American Expanded Technology Software Index.

SWAR Sectors by Percentage

SWAR Sectors

Image from https://www.spglobal.com/

As suspected, SWAR is dominated by stocks within the Information Technology sector. Additionally, a small portion of the portfolio has exposure to the Communication Services sector. The stocks within this sector do indeed have exposure to software, but in a more oblique fashion than those in the IT sector.

SWAR also has some minor exposure to Canadian stocks. The stocks within this ETF are divided across North America in the following manner:

  • United States: 98.8%
  • Canada: 1.2%

SWAR: Top Stocks

SWAR’s underlying index (S&P North American Expanded Technology Software Index), is a “modified market cap weighted index”. The value of the index is a summation of the aggregate value of the individual share weights. 

Like many tech ETFs, the top ten holdings dominate market share. For SWAR, the top ten stocks represent 45% of the funds value:

SWAR: Top Ten Stocks and Weight

  • Microsoft: 7.74%
  • Salesforce: 7.34%
  • Adobe: 6.86%
  • Intuit: 6.34%
  • Oracle: 4.94%
  • ServiceNow: 4.53%
  • Autodesk: 2.16%
  • Synopsys: 1.97%
  • Palo Alto Networks: 1.92%
  • Workaday: 1.84%

SWAR: Leverage Utilization

Like most leveraged ETFs, the ways in which SWAR uses leverage to achieve its ideal 2×1 ratio is quite nebulae. 

In the fund’s prospectus, I was able to locate one derivative position the fund employs to achieve its leverage: 

So the fund does not use options, nor stock futures, but a swap to gain leveraged exposure. 

Swaps are unlike options in that they are private, non-standardized, and widely unregulated agreements between two parties, generally large financial institutions. 

Swaps do indeed have counter-party risk, but it is unknown the degree to which this risk exists in the SWAR ETF. Many times, funds can mitigate this risk through additional measures.

Final Word

For incredibly bullish investors looking for very short-term exposure to the IT software sector, SWAR appears to be a great option. 

However, this is not a set-it-and-forget-it ETF. When you factor in both the cost of rolling derivatives and the very high fees, SWAR will almost certainly underperform the index in the long-run (not considering leverage).

Leveraged ETFs tend to lose their most value in very bearish markets. On a particularly volatile day when the underlying index is down 1%, it will not be uncommon for 2x leveraged products to fall more than 2%.

The problem here is that when/if the market rallies again, these types of funds rarely make up for that decay lost during the downturns.

However, when compared to 3x leveraged products, 2x wins the vast majority of the time in the long run. 

We’ll conclude our article by taking a look at the results of a study by Tony Cooper comparing the performance of various leveraged indices over a long period of time. 

Long Term Leveraged ETF Performance

Leveraged ETF Study

Leveraged ETFS In-Depth

Next Lesson

Additional Resources

Direxion Launches New 2X  Software ETF – PRENWSWIRE

SWAR ETF Overview -USNEWS

SWAR ETF Report: Ratings, Analysis, Quotes, Holdings

VGT vs QQQ vs XLK: Performance and Holdings

Posted on by Mike Martin

Last updated on February 11th, 2022 , 08:48 am

Information Technology ETF Comparison

VGT QQQ XLK
Issuer:
Vanguard
Invesco
State Street Global Advisors

Index:
MSCI US Investable Market IT 25/50 Index
Nasdaq-100 Index
S&P Technology Select Sector Index
Category:
Small Cap, Mid Cap,& Large Cap
Large Cap
Large Cap
Dividend Yield:
0.63%
0.45%
0.65%
Expense Ratio (fees):
0.10%
0.20%.
0.12%
Number of Stocks:
340
104
77
5 Year Return:
30.87%
29.85%
28.47%
Top Holding (And Weight)
AAPL (19.35%)
AAPL (11.70%)
AAPL (22.79%)

Over the past twenty years, technology stocks have vastly outperformed the broader market. As technology tends to advance exponentially, this trend will probably only continue (if not advance) over the next twenty years.

There are three juggernaut funds that rule the ETF space within the information technology sector. Which one is best for you? Let’s get started with the comparisons right away!

TAKEAWAYS

  • VGT, QQQ & XLK represent the most popular ETFs in the tech space
  • Vanguard’s VGT has the lowest fees at 0.10%; QQQ has the highest fees at 0.20%
  • All ETFs have significant exposure to AAPL, with XLKs weightage coming in at 22.79% for this equity
  • VGT is the most diverse ETF as this fund includes small, mid & large cap stocks
  • Over the long-term (five years), VGT has performed the best; over the short-term (one year) XLK has performed the best 

VGT vs QQQ vs XLK: Comparing Benchmarks

Let’s start with the most important comparison; differentiating what these three ETFs actually attempt (quite successfully) to track.

VGT: MSCI US Investable Market Information Technology 25/50 Index

So that’s a rather confusing name for an index! What exactly does this index track? Let’s head over to the MSCI website to see what the founders of this index have to say. 

So this exchange-traded fund (ETF) includes stocks in all three of the capitalization categories (small, mid, and large). When compared to the other ETFs on our list (which only include large cap companies), VGT is the best diversified because of this.

QQQ: Nasdaq-100 Index

Invesco’s QQQ ETF is by far the most popular fund on our list. However, because of its relatively high fee nature, VGT and XLK are fast catching up! (if you’d like to check out some top tech Nasdaq 100 ETFs, read our article: Differences Between Invesco’s QQQ, QQQM, and QQQJ!)

So what index does the QQQ’s track? The Nasdaq 100. The below excerpt is taken from nasdaq.com, the founders of this index:

The Nasdaq-100 is a modified capitalization-weighted index. This means that the largest companies (AMZN, GOOGL, AAPL, etc.) have a larger weight than smaller companies. “Modifications” were put into place to assure a few companies did not dominate the index. The below lists two re-balancing contingencies put into place to assure this:

  1. A single company is worth > 24% of the entire index
  2. 48% of the companies have a weighting of at least 4.5%

XLK: S&P Technology Select Sector Index

Unlike the QQQ’s, State Street’s XLK ETF takes its stocks from the S&P 500. This popular index can be broken down into seven unique sub-sectors. One of these sectors is technology, which is formally called The S&P Technology Select Sector Index, which the XLK ETF tracks.

So how many stocks in the S&P 500 fall under the information technology sector? 77. 

The S&P Technology Select Sector Index is a weighted index. When compared to other tech indices, this index places a disproportionately large emphasis on larger corporations (which we will get into soon). If you love mega-cap tech companies, this index/ETF is for you.

VGT vs QQQ vs XLK: Comparing Fees

The average ETF fee is about 0.40%. When taking that into account, every ETF on our list charges a very low fee, or “Expense-Ratio”.

  • VGT Expense Ratio: 0.10%
  • QQQ Expense Ratio: 0.20%
  • XLK Expense Ratio: 0.12%

We can see that Invesco’s QQQ charges a fee that is 100% higher than Vanguard’s VGT. Should this relatively marginal difference in fee structure steer you away from the QQQs?

Maybe, but let’s first take a look at the historical performance of these ETFs. If the QQQs return an extra 1% per year, I’ll gladly pay that tiny difference in fees.

VGT vs QQQ vs XLK: Comparing Performance

The below table shows how our various ETFs have performed over different spans of time. 

Rank VGT QQQ XLK
1-year
34.71%
34.39%
37.14%
3-year
37.33%
34.48%
37.89%
5-year
30.87%
28.47%
29.85%

The winner here, of course, will depend upon the time frame we are looking at. VGT appears to be the long-term winner (5 years), while State Street’s XLK has performed the best short-term (1 year).

VGT vs QQQ vs XLK: Comparing Sectors

Though all of our ETFs are tech rooted, some of the sub-sectors within their compositions deviate a little outside of tech. The below images (taken from etf.com) show the top 5 sectors that every ETF on our list invests in (click to enlarge).

VGT Sectors

VGT ETF Sectors

QQQ Sectors

XLK Sectors

XLK ETF Sectors

VGT vs QQQ vs XLK: Top Stock Holdings

Next up, let’s examine what stocks these ETFs actually invest in. Of particular interest here is the weight that these different ETFs place on particular stocks.

Rank VGT QQQ XLK
1.
Apple Inc. (19.35%)
Apple Inc. (11.70%)
Apple Inc. (22.79%)

2.
Microsoft Corp. (18.36%)
Microsoft Corp. (10.64%)
Microsoft Corp. (21.81%)
3.
NVIDIA (4.93%)
Microsoft (10.64%)
NVIDIA (7.15%)
4.
Visa (2.60%)
Tesla (6.08%).
Visa (2.87%)
5.
Adobe (2.14%)
NVIDIA (5.32%)
Adobe (2.80%)

We can see that Apple (AAPL) dominates these portfolios. However, the XLK ETF has almost twice as much exposure to AAPL as the QQQs. If you’re not very bullish on AAPL, XLK probably isn’t for you.

Final Word

So what’s the best ETF for you? From the various historical performances listed above, there does not appear to be a clear winner. All three ETFs have outperformed the S&P 500. 

Additionally, it is worth noting that tech stocks tend to have more risk than a benchmark like the S&P 500. 

The best hedge against risk is usually diversification. Out of the three ETFs on our list, Vanguard’s VGT ETF is the most diverse. This fund has over 300 stocks within it (QQQ has 104; XLK has 77). VGT also spans numerous market caps (small, medium, and large) while QQQ and XLK stay in the large-cap category. 

But you aren’t limited to one tech fund. With most brokerage houses charging no money for commissions, why not invest in all three?

Worth noting here is the low dividends on almost all of our ETFs. Many tech companies fall into the growth category. Growth stocks tend to invest any extra income back into the company rather than pass it on to shareholders in the form of dividends.

Next Lesson

Additional Resources

VGT Vs. QQQ:  Seeking Alpha

VGT vs. XLK: Head-To-Head – ETFDB

Best Tech ETFs for Q1 2022 – Investopedia

PSDN: AdvisorShares Poseidon Cannabis ETF Explained

Posted on by Mike Martin

Last updated on February 11th, 2022 , 09:22 am

Cannabis Leaf Caution

The investment firm Poseidon recently teamed up with AdvisorShares to launch a new leveraged cannabis ETF: the AdvisorShares Poseidon Dynamic Cannabis ETF (PSDN).

What makes this ETF stand out in comparison to other cannabis funds is its leverage. By using swaps and derivatives, PSDN aims to apply moderate levels of leverage on up to 150% of the portfolio’s assets. This leverage will inevitably lead to more volatility. Therefore, PSDN is better suited for very bullish investors with higher risk tolerance. 

Should this leveraged ETF find a home in your portfolio? For your review, projectfinance has dissected the fund’s prospectus.

TAKEAWAYS

  • PSDN invests in the cannabis and hemp industry
  • The fund is actively managed, making it more agile to market changes
  • Because of its active management style, PSDN charges a high expense ratio of 0.92%
  • PSDN is well diversified, investing in cannabis sub-sectors which include software tech, biotechnology, pharma, internet enabled devices and agriculture
  • PSDN will also seek opportunities from both IPOs and mergers in the cannabis space
  • PSDN leverages its portfolio by trading derivatives, including “swaps”

PSDN: Expense Ratio

The first thing I look at before investing in a fund is the expense ratio. Over the past few years, the fees that exchange-traded funds (ETFs) charge have been drastically decreasing.

So what does AdvisorShares/Poseidon’s PSDN charge? I found it tucked away in the bottom corner of the fund’s information page.

  • Management Fee: 0.80%
  • Other Expenses: 0.12%
  • Net Expense Ratio: 0.92%

The net expense ratio for PSDN is 0.92%, twice as high as the average ETF fee of 0.40%. Why do they charge so much?

Leveraged ETFs require more maintenance than passively managed funds. Because of this work that must be performed, the expense ratios on such funds are generally high. PSDN’s net fee of 0.92%, however, is extremely high.

As this ETF is brand new, we must allow some time to see if the funds performance merits such a high fee. 

 

PSDN: Investment Strategy

The “fund objective” of PSDN is rather generic, stating they simply wish to seek, “long-term capital appreciation”. 

The fund’s investment strategy, however, gives us a better idea of its unique approach. 

PSDN is not, therefore, a pure cannabis play. The companies in which they invest must make half of their money from marijuana and hemp. Where does the other half come from?

What will make this fund attractive to most investors is the second part of their investment strategy: investing in derivatives. Let’s take a closer look at that next. 

PSDN: Leverage Utilized

What differentiates PSDN from other popular cannabis ETFs (like CNBS and YOLO) is their proposed use of leverage. 

There is little information on what derivative instruments, exactly, the fund plans on utilizing to gain this leveraged exposure. PSDN’s prospectus states that “total return swaps” will be included.

Swaps are like options contracts and futures in that they are both derivatives, but that’s where their similarities end. 

 

  • Swaps are customized derivatives that trade in the over-the-counter (OTC) market
  • Options and futures are standardized securities that trade on public exchanges

Unlike options, swaps are private agreements between parties. Though many types of swaps are indeed regulated by the government, counterparty risk is still present. The risk with swaps is that one party may not follow through on the prearranged agreement.

PSDN: Market Sectors

The PSDN ETF includes a large range of sectors within the cannabis industry. Below are a few of the sectors on the radar of Poseidon/AdvisorShares’ fund:

  • 1. Agriculture
  • 2. Biotechnology
  • 3. Pharmaceuticals
  • 4. Real Estate
  • 5. Finance

PSDN: Top Ten Stocks

Poseidon’s PSDN fund currently owns around 30 stocks. This is not a very well-diversified ETF.

Additionally, the top-ten holdings comprise more than 70% of the fund’s value. Note the first security on the list: GREEN THUMB INDUSTRIES SWAP REC.

If you’re able to find out what, exactly, this represents, please let me know!

PSDN: Top 10 Holdings

Company/Security Portfolio Weight
GREEN THUMB INDUSTRIES SWAP REC
12.19%
REC AYR WELLNESS INC
8.51%
VERANO HOLDINGS CORP SWAP REC
8.31%
TRULIEVE CANNABIS SWAP REC
8.09%
ASCEND WELLNESS HOLDINGS SWAP REC
8.08%
CRESCO LABS INC SWAP REC
6.86%
WM TECHNOLOGY INC
5.92%
CURALEAF HOLDINGS INC SWAP REC
5%
JUSHI HOLDINGS INC SWAP REC
5.40%
PLANET 13 HOLDINGS SWAP REC
5.02%

data from advisorshares

Cannabis Stocks vs S&P 500

So how does the cannabis industry stack up to the S&P 500? 

If you’re going to be investing in an ETF, you’d hope that ETF has been outperforming the market -particularly when there is leverage involved.  

The below image compares the one-year performance of AdvisorShares’s YOLO Cannabis ETF (blue) with the SPDR S&P 500 Trust ETF (gold).

SPY vs YOLO

SPX vs YOLO

Chart from Google Finance

Although cannabis stocks began the past year with a roar, they have since quieted down. A lot. The S&P 500 has easily outperformed the cannabis industry as a whole in 2021. And in 2022? Who knows what will happen. 

However, I’m not sure I would want to own a non-leveraged cannabis ETF in this presently under-performing sector! 

Final Word

Getting involved with leveraged securities can be a dangerous game. If you don’t understand completely what comprises a product, it is probably best to stay away. Swaps and derivatives can blow up fast. I’ve learned the hard way!

I’ll leave you with this advice. 

Years ago, I was thinking about buying a cafe (I know nothing about restaurants).

I asked a restaurateur friend what his thoughts were.

“If you have to ask what you’re getting involved with,” he replied, “the restaurant business isn’t for you.”

With that being said, if you truly want to learn more about leveraged ETFs, check out our video below!

Recomended Articles

Additional Resources

AdvisorShares Poseidon Dynamic Cannabis ETF Overview – Marketwatch

5 Ways Stocks Differ From Options

Posted on by Mike Martin

Last updated on February 11th, 2022 , 09:34 am

Stocks vs Options Comparison

Comparing stocks to options is like comparing apples to oranges. They are completely different types of securities.

If you own a share of a company’s stock, you own a portion of that company. This comes with added benefits and rights, such as dividends and voting rights. Stock ownership is referred to as “equity“. 

Options are “derivatives“, meaning their value is derived from that of an underlying stock (or ETF, or any asset, for that matter). They have nothing to do with the company – think of them as “side-bets”.

Let’s take a look at a few key options characteristics before we move on.

  1. One options contract typically represents 100 shares of stock. This is known as “leverage” and has the potential to magnify both profits and losses quickly. 

  2. All options are either calls or puts. A long call position is bullish, while a long put position is bearish. In both types of these options contracts, a “strike price” and an “expiration date” are set.

  3. Unlike stock, all options will eventually expire.

  4. An options “moneyness“, (which tells us where the options strike price is in relation to the stock price) at expiration will determine whether a contract has value or not. 

  5. Stock is generally a longer-term investment. Options are shorter-term trades.

TAKEAWAYS

  • For long-term investors, stocks are almost always the better option.
  • Like stocks, options contracts can be bought or sold. The holder (owner) of an option contract has the right to either purchase stock (calls) or sell stock (puts) at the contract’s strike price.
  • Options are usually leveraged at a ratio of 100:1, meaning one contract represents 100 shares of stock. This leverage increases risks. 
  • Most (not all) stocks pay dividends. Options do not pay dividends. 
  • Both options and stocks are considered high risk. However, certain options trading strategies have considerably more risk than stocks. 

Options vs Stocks

STOCKS OPTIONS

Ownership

Represent direct ownership in a company; can vote and receive dividends

No direct rights, but long options holders have the right to convert their contract to either long stock (calls) or short stock (puts) 

Multiplier Effect

One share represents one indivisible unit of capital

One options contract typically represents 100 shares of stock

Expiry

Shares of stock (equity) never expire

ALL options contracts have an expiration date, ranging from one day to years away

Security Style

Stocks are generally long term investments 

Options are generally short-term trades

Risk

Medium to High Risk

Generally high risk, but this depends upon the options trading strategy utilized

This article looks at the main differences between stocks and options.  In order to truly understand these differences, you must understand the mechanics of options trading, which can take some time.

The good news? projectfinance has created perhaps the most intuitive guide out there to aid you in this process. Check out our, “Options Trading for Beginners” guide here.

For those ready to move forward with the comparison between stocks and options, let’s get right to it!

1. Ownership: Stocks vs Options

Let’s start off with one of the major differences between stocks and options: Ownership.

Ownership Rights in Stock

When you own shares of a company’s stock, you own part of that company. Being an owner comes with its benefits. Here are a few perks that come with owning equity in a company:

  • Right to inspect company records and books
  • Right to vote on directors and major corporate decisions (mergers, etc)
  • Right to Transfer your stock ownership
  • Right to receive dividends declared by the board

Perhaps the most important right on this list is the ability to receive dividends. You may not want to spend your weekends digging through the payrolls of a company of which you own 10 shares of stock, but you’ll probably want to receive that dividend. 

Though dividends may seem small on paper, they really add up over time! In fact, over the past 20 years dividends have accounted for 43% of the S&P 500s historic return! Take a look at the below image from BNY Mellon.

S&P 500 Dividend Growth Chart

Data from BNY Mellon Investment Management

IMPORTANT! Not all companies pay dividends! Up-and-coming growth companies tend to invest superfluous income back into the company rather than distribute it to shareholders.

Ownership Rights in Options

Options Contract Definition: An options contract gives the owner the right  to purchase (call) or sell (put) 100 shares of a company’s stock at a specified price (strike price) by a predetermined date (expiration date).

Traders’ long options contracts have none of the four rights listed above for stock investors. In a company’s eye, options traders do not exist.

Why? 

Options contracts are “derivatives.” These contracts are exchanged between market participants who are not involved with the company. As we saw in the definition, options contracts give the holder the right to either buy (for call options) or sell (for put options) shares of the underlying stock at a specific price by a specific date. When this happens, it is called “exercising” your option. 

When a long call is exercised, it is typically transferred into 100 shares of long stock. When that happens, you have all of the rights listed above. But before this transformation occurs, you will have zero rights.

Put options, however, are transferred into short stock. Short stock (like options) has no rights. 

2. Multiplier Effect: Stocks vs Options

We mentioned in the above paragraph that an option contract represents 100 shares of stock. Let’s take a closer look at that now.

Multiplier Effect in Stock

One share of stock represents one divisible unit of capital. If you want to determine what percent ownership a single share of stock represents in a company, simply divide one share of stock by the total share of stock that the company has outstanding.

Multiplier Effect in Options

One options contract almost always represents 100 shares of stock. This produces a ratio of 100:1.

You may have heard that options trading is a risky business, and you’d be right. Because of this multiplier effect, options contracts have profound leverage. 

If a stock is trading at $50/share, it will cost you $50 to purchase one share. 

If an options contract is trading at $2, it will cost you $200 to purchase one contract. Why is this? Because of the multiplier effect of 100! Therefore, in order to determine the true cost of an options contract, you simply need to move the decimal point of the quoted price two places to the right.

3. Lifespan of Stocks vs Options

Time and Money

Next up, let’s take a look at the different lifespans of stock and options.

Stock Lifespan: Potentially Infinite

Stocks have no listed expiration date. Over time, most companies will eventually go bankrupt, merge, or get bought out, but these events are often unseen. Some companies have been around for a very long time. State Street Corporation, for example, has been around since 1792! 

Options Lifespan: Finite and Predetermined

Unlike stock, every single options contract has a predetermined expiration date. If by this date your long call or put option is “out-of-the-money”, it will expire worthless and you will have lost the entire premium paid. 

As time passes and the underlying stock price drifts away from the strike price of an options contract, time decay will set in. This is known as “theta”, and is the reason why most beginner options traders are unsuccessful. Theta is one of the option “Greeks” which traders use to help manage risk. 

It is true some options contracts are more long-term, with Long-Term Equity Anticipation Securities (LEAPS) having lifespans of more than two years. However, no option contract spans centuries, like many stocks do,

4. Investment Style: Stocks vs Options

Stock traders and options traders frequently have different investment philosophies. 

Stocks Are Investments

Generally speaking, the mindset of stock investors and options traders is vastly different. Most people who purchase stock do so with the intent of holding the position long-term, riding the ups and downs of the company’s profits and losses, hoping, somewhere down the road (maybe years), to sell that stock for a profit. 

Stock inventors generally utilize the “set it and forget it” method. After purchasing a stock, they don’t have to check the position every day, nor do they have to manage it. They just sit back, collect dividends (sometimes), and hope the price appreciates. 

Option Are Trades

This is different for options traders. Why? 

We mentioned before that all options have a strike price and an expiration date. If the underlying price moves away from an options strike price, a trader will need to take maintenance action to 1.) avoid further losses or 2.) avoid being “assigned” (for short options positions). 

Over the long run, stock investors tend to outperform options traders. However, this isn’t always the case. The success of an options trader depends dually upon that trader’s savviness as well as a certain amount of luck.

Why luck? 

Generally speaking, we have a better idea about what is going to happen to the price of a security over the long term. If you believe in Apple, buying shares of AAPL may very well pay off in the long-term. But what’s going to happen tomorrow at AAPL headquarters? Nobody can foresee this. 

Because stocks don’t expire, they have the ability to ride out short-term volatility. Options? Not so much.

5. Risk: Stocks vs Options

Jumping over risk

Last up, let’s take a look at the fundamental risk profiles of both stocks and options.

Stocks Are High Risk Investments

When compared to treasuries, bonds, and money markets, stocks are considered risky assets. 

So stocks are indeed risky. When you diversify your stock positions across numerous companies, however, this risk can be mitigated. Exchange-traded funds (ETFs) offer a great way for investors to diversify. 

However, everything is relative. When comparing stock investing to popular options trading strategies, the former is indeed less risky in nature. 

Options Are VERY High Risk

Options trading is an intricate and complicated world. There are indeed options trading strategies that you can put together that lower your overall risk when compared to stock. But this article is focused on the more popular strategies such as buying calls and puts. 

When compared to buying stock, buying options is riskier. 

This is a wide assumption and made from an “overall” viewpoint. 

In theory, however, options typically have less principal risk than stocks. 

Why?

A call option on AAPL is going to cost you a lot less than buying 100 shares of AAPL stock (which is the amount one options contract represents).  Therefore, your total principal risk when trading options is less than that of stock! Check out the graph below, which shows how the max loss on stock is greater than a call option (where you will only ever lose the premium paid).

Long Call vs Long Stock

However, over time, time decay (AKA “theta“) sets in, and long options often lose money. AAPL stock probably won’t go to zero; an out-of-the-money call bought on AAPL, on the other hand, probably will go to zero.  

Additionally, notice in the graph how the stock needs to move up quite a bit for a long call to breakeven (yellow dot). Breakeven here is determined by strike price + premium paid.

With stock, breakeven occurs the moment you purchase (or sell) the security. 

Final Word

Buying a share of stock is one of the simplest ways to invest. You click a mouse button, and voila, you’re filled. All you need to do is (hopefully) collect dividends, and wait for the price to appreciate. 

Options trading can get extremely complicated. Huge sums of money are made and lost every day in the options markets. If you’d like to learn more about options trading, check out our guides below!

Next Lesson

Additional Resources

Difference Between Options and Stocks – Fool.com

Getting Acquainted With Options – Investopedia

Options vs. Stocks | Ally

The Great Resignation, Entrepreneurship and Stocks

Posted on by Mike Martin

Last updated on February 11th, 2022 , 09:50 am

The pandemic has changed the way American’s view the workplace, and mostly for the worse. A mass exodus of employees known as “the Great Resignation” is putting many employers on edge. Understanding this shift in talent is vital for investors: a company is only as successful as the employees that constitute it. 

In this article, projectfinance will take a closer look at the reasons for these departures, as well as the rise of entrepreneurship. Additionally, we will examine a few companies/industries which may benefit/lose from this unparalleled shift of labor.

 Highlights

  • 95% of employees are considering changing their jobs.
  • Many of those quitting their jobs are becoming entrepreneurs.
  • The Great Resignation may provide investors with numerous opportunities. 

Employees Aren’t Happy

Monster.com recently released shocking results from a poll they took. The results are almost impossible for investors to ignore and present a nightmare scenario for HR professionals:

  • 95% of employees are currently considering changing jobs
  • 92% of employees plan to change industries
  • 63% of employees have been searching for a new job for the past 1-3 months

This search has been fueled by a historically unparalleled job-seekers market.

Why the Unhappiness?

Tired Employee

According to Monster, burnout and a lack of growth opportunities accounted for 61% of the discontent. 

Adding to this stress, many more employees are being forced to return to the workplace. 

Teleworking has fallen quite dramatically from its height of 35.5% in May 2020 to its current level of 14.4% (July 2021).

But this alone can’t possibly make up for such discontent in the labor force.

When I think about the mass exodus of American workers I first begin to wonder why. How is it possible so many Americans are throwing away lucrative careers?

The American Way Redux

The security and stability a job offers can make it difficult to walk away from. It gets in our blood and changes who we are. This dependency runs parallel to the pillars of American thought, as written about beautifully in Ralph Waldo Emerson’s “Self-Reliance”.

I began my career 15 years ago at a small company where quite literally every employee loved their job. That little company has since been bought three times, and on my last day, I didn’t know a single employee who was happy. 

If I could change the words of Tolstoy a little bit, I could say, “All happy companies are all alike; every unhappy company is unhappy in its own way.”

Perhaps we, as a nation, were not able to see our unhappiness until we were able to step back.

The 800-Pound Gorilla From a Distance

In this great step back, Americans have gained perspective. Americans look back at their old workstation, train, and managers through a telescopic lens. Through that lens some are seeing Goliath, or that “800-pound gorilla”, flapping its arms in a desperate, ostensibly caring gesture (insurance reasons), to get us back. 

Many Americans are saying, “No thanks, Mr. Gorilla.” 

In April, a record 4-million employees shook their heads together. Take a look at the center line on the below chart from the Economic Policy Institute.

Economic Policy Institute Quits

So where are all of the people that constitute this sharp rise going? What are their plans?

Entrepreneurship on the Rise

A lot of people are following in the footsteps of their parents and grandparents by starting their own businesses. According to NPR:

It will be a long and arduous journey for these ambitious souls. Barriers to entry are high in many sectors. Sheer luck will play a large contribution to their success. The Chamber of Commerce shows us just how hard:

  • 80% of small businesses survive their first year 
  • 70% of businesses survive only 2 years
  • 50% of businesses make it to the five-year mark

There will be the inevitable “return to thy master”, with millions of employees returning to their old employers with their tails between their legs. 

But a few will indeed make it, and they will require more employees, and soon they will capture the gorilla’s attention.

American isn’t the only country whose citizens are rolling up their sleeves and going their own way; Forbes reported that the number of individuals filing to start their own company has been skyrocketing around the globe.

Great Resignation Winners

If the Great Resignation stays the course, it will have a material impact on stocks and industries. Here are a few ideas as to which industries and companies may benefit from the great shift in labor.

Nasdaq Growth

Thomas Edison once said that “Discontent is the first necessity of progress.”

The most discontent of workers in today’s labor market is relatively young, most of whom are in their early and mid-career. They have a lot of time in front of them. So what is it young people know?

Technology. An extraordinarily successful company I used to work for had a tech department that was run almost exclusively by ex-Starbuck employees. I can’t help but wonder where all these kids quitting their dead-end retail jobs will take our economy in ten years. 

In addition to retail workers leaving their jobs, “high-tech” employees were also at the top of the resignation list. High-tech typically employs some of the brightest minds in the country. What will they create when given complete liberty?

An exchange-traded fund well suited for up-and-coming tech companies is Invesco’s NASDAQ Next Gen 100 ETF (QJJJ).

Small-Caps

But the tech industry will not alone benefit from the Great Resignation. A predicted low-interest-rate environment for the foreseeable future should help to be a catalyst to the success of all new businesses. With talent shifting from large-caps to smaller capitalized companies, indexes such as the Russell 2000 can’t be ignored. 

Though small-caps are currently priced at very high levels, getting some exposure in the next dip could prove lucrative.

A broad-based ETF, such as Vanguard’s Small-Cap ETF (VB) could pay off well in the future.

Artificial Intelligence

Remember when artificial intelligence (A.I.) used to be the predominant fear of the US workforce? Well, post-pandemic, it’s still there. 

Back in 2018, Elon Musk actually said of A.I., “Mark my words — A.I. is far more dangerous than nukes.”

The Great Resignation will only precipitate the evolution of A.I. in the workplace. Companies are beginning to recognize that they no longer require “someone” to fill a role, but “something”.

Exchange-traded funds like The ROBO Global Robotics & Automation ETF (ROBO) are positioning themselves to capitalize on this shift to robotics and automation-enabled products.

Top Reviewed Companies

Not all employees looking for new careers are hoping to start a new business. Many simply want to be treated better. 

So what companies treat their employees the best? According to Glassdoor, a few of the best publicly-traded companies to work for, as rated by present and past employees are:

responsive winners
Company
Glassdoor Rating (out of 5)
Bain & Company (BCSF)
4.5
NVIDIA Corporation (NVDA)
4.7
HubSpot Inc (HUBS)
4.6
Alphabet Inc (GOOGL) Glassdoor Rating: 4.5
4.5

Great Resignation Losers

Just as the Great Resignation will have its winners, there will be losers as well. 

Retail

No industry is losing more employees in the Great Resignation faster than the retail industry. 

According to Kate Morgan at the  BBC, 

Why? Many retail and service workers (deemed “essential” during the pandemic) feel themselves to be overworked and underappreciated. As a result, many of these employees are beginning to think long-term. They are willing to make short-term monetary sacrifices to obtain upward mobility.

Opportunities in Retail

With that being said, there are some retail companies that are very well-positioned.

Amazon (AMZN), Wal-Mart (WMT), and Costco (COST)  all have very promising futures. The pandemic’s long-term impact on these companies can’t be ignored, and they should weather the storm just fine.

Healthcare

Perhaps the most critical sector in the country, healthcare, has been losing a lot of talent. From March 2020 to March 2021, Forbes reported that this industry had an increase in resignations of 3.61%. For the future of this country’s health, that number is very scary.

Worst Reviewed Companies

Nearly all job candidates will check their potential future employers out on review sites like Glassdoor.

Not all reviews are positive. The Great Resignation shows us that salary is not everything anymore; people care how they are treated. 

Here are a few companies that could be hemorrhaging talent due to their low ratings.

Company
Glassdoor Rating (out of 5)
Union Pacific (UNP)
2.1
Frontier Communications (FYBR)
2.7
Regus (IWG)
2.8
OfficeMax (ODP)
3.1

Final Word

As of right now, many believe the Great Resignation will not have a material impact on the economy. Just like inflation, many experts are calling the phase “temporary”. 

However, you will never regret being prepared for the day if/when they are proved wrong.

Recommended Readins

Additional Resources

3 Stocks to Buy as ‘The Great Resignation’ Steams Ahead” fool.com

7 Stocks to Buy to Combat the Great Resignation

ETFs Explained: Investing Basics

Posted on by Mike Martin

Last updated on April 8th, 2022 , 08:48 am

The popularity of exchange-traded funds (ETFs) has been skyrocketing in recent years. In 2003, there were only about 100 ETFs. Today, there are over 2,000.

Although mutual funds still contain a greater amount of assets when compared to ETFs (your 401k is probably all in mutual funds), ETFs are rapidly catching up. 

In this article, projectfinance is going to explain why investors are flocking to ETFs and leaving traditional mutual funds in the dust. We will cover topics such as how ETFs are formed, what to look at specifically before purchasing an ETF (fund objective and fees), how an ETF maintains price stability, and why ETFs are superior to mutual funds. 

First off, we are going to learn what exactly an ETF is. Although you probably know the broad strokes of how ETFs work, let’s paint the whole picture of an ETF with the painting analogy.

   Highlights

  • Exchange-traded funds (ETFs) pool together investors money to invest in baskets of securities.
  • Unlike mutual funds, ETFs are traded on exchanges, allowing for greater liquidity.
  • An ETFs prospective informs investors about important information such as the fund objective, expense ratio, relative price performance, and net asset value. 
  • “Authorized Participants” help to keep the fund’s NAV in line with the price of the underlying securities that compose it.
  • Mutual funds have minimum investments; ETFs don’t. Mutual funds are illiquid; ETFs are generally very liquid; mutual funds often have two fees; ETFs have one.

What is an ETF?

ETF is an acronym for “exchange-traded fund”. An ETF falls under the ETP (exchange-traded product) umbrella .

Here is the textbook definition of an ETF.

Exchange-Traded Fund (ETF) Definition:  An exchange-traded security that tracks one (or more) asset types, including indexes, sector’s and commodities.

Pretty simple, right? ETFs represent a bundle of securities that typically trade within an asset class on an exchange.

If you’re fortunate enough to have a 401k plan, you are probably familiar with mutual funds. If you were to look up the definition of a mutual fund, you would find a very similar definition with one very important exception: mutual funds are NOT traded on exchanges in the open market. 

Having the ability to trade your security on exchanges is a huge bonus to investors. Just like shares of stock (AAPL or AMZN), you can purchase and sell ETFs in real-time and get filled at prices that you determine. Mutual funds? Not so much. 

In order to understand the mechanics of ETFs, let’s start off with an analogy comparing an ETF to an investment in the art world.

Simple ETF Example: Painting Analogy

Painting

Since I’m writing this article in Figueres, Spain, I thought the art of Salvador Dali would be appropriate. 

Let’s say that you were part of that small crowd that adores Dali. The above work (we’ll call it a painting) goes up for auction and sells for the insanely high price of 100 million dollars. You were at the auction, but you had only $500 to invest. Wouldn’t it be great if you could buy a piece of the painting (perhaps a tiny blotch of paint) for only $500? 

That way, if, in 10 years, the painting were to double in value, you will make a profit of $500. 

This “pooling” of funds is essentially what an ETF is. By combining your money with others, you can create enough wealth to buy complete artworks (or asset categories). So how would it work here?

“Creating” an ETF Fund

The creator (or seller) of the painting would create a “fund” and hold said painting in this fund. Next, the creator will issue 20 million shares to make up the whole 100 million dollar value of the fund. 

Since the fund’s assets are worth 100 million, and the creator issued 20 million shares, then each share must be worth (100/20) $5/share. 

This setup allows us to buy a share of this fund for only $5. We can then partake in the increase and decrease of the painting’s value over time.

But where do we do the buying and selling of our shares? 

How about if we had a central location with brokers and traders that could help facilitate these transactions?

“Listing” an ETF Fund

Lastly, the fund’s creator would publicly list these $5 shares on a stock exchange. 

After this step is complete, investors from around the world can buy shares of this fund, therefore giving everyone exposure to our 100 million dollar painting. 

Since we wanted to invest $500 in the painting, how many shares were we able to buy?

Simply dividing our total investment ($500) by the per-share price ($5) gives us exactly 100 shares of the painting. 

Now let’s say five years pass and that painting is now worth $200 million dollars. How much will our initial investment of $500 be worth?

Bingo. $1,000. We can then sell our shares back in the open market to lock in our profit. 

An ETF operates just like this painting example; it is a method of dividing a portfolio of assets into numerous shares. By doing so, we allow investors of all different sizes to participate in the ownership of the fund’s assets. 

Again, buying an ETF is very similar to buying shares of a company. If you were to buy shares of Apple (AAPL), you would have a small piece of ownership of the company. Instead of having ownership in a single company, an ETF allows us to own numerous companies (or any asset class type, like energy) through a single fund. 

ETFs are therefore a great tool to democratize investing.

Real World ETF Example: S&P 500 ETF Trust (SPY)

If you understand the above painting analogy, you should have no problem with understanding how a real-world ETF works, such as State Street’s SPDR S&P 500 ETF Trust, or simply SPY.

The SPY ETF is the most popular ETF in the world. It trades more than any single company’s stock does in the world over a given day. Why?

Because of what it attempts to track- the S&P 500 index. This weighted index tracks the market capitalization of the 500 largest companies listed on stock exchanges in the United States.

In order to track this index, SPY, therefore, purchases ALL of the component stocks that make up the S&P 500 on a weighted basis.

So we can see why people would want to buy SPY now. Currently, you can purchase one share of SPY for $450. That means for $450, you get exposure to ALL companies within the S&P 500. That sounds like a great idea! But there are many ETFs that track the S&P 500; why is SPY so popular?

Let’s take a closer look at the details of SPY to find out why this particular fund is so popular.

What is the ETF “Fund Objective”?

The fund objective of an ETF is simply what the fund is trying to accomplish. Some examples would be a growth in investor value, income generation, or even a combination of both. In short, a fund wants to make us money; the fund objective tells us how they plan to go about this. 

So in order to determine what SPY is trying to accomplish, where do we go? To the source of course!

All companies that list ETFs have a website dedicated to informing the public of important fund information, such as the fund objective, holdings, and relative performance. This is generally known as the fund “prospectus”. A prospectus informs investors about key fund details. You can find State Street’s SPY fund information here. 

Let’s take a closer look at the details on this page next. 

SPY Fund Objective

Below, you will find the fund objective of State Street’s SPY fund, listed here under “Key Features”.

SPY Fund Objective

SPY Fund Objective: The SPDR® S&P 500® ETF Trust seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the S&P 500® Index (the “Index”).

Pretty straightforward, right? 

Also listed on this page is a VERY important feature that all ETFs have: a fee.

SPY Expense Ratio

ETFs are not free. Some are incredibly cheap (like SPY), but they ALL must charge something. This isn’t, after all, charity. If somebody is going to not only purchase all 500 stocks within the S&P 500 but make sure the price continues to match that of the holdings, work must be performed. 

For SPY, this fee is very low, coming in at around 0.09%.

What does this mean for us?

This means that if we invest 10k in SPY, we will pay only $9 in management fees for holding SPY over the course of the year. 

A fee of about 0.09% (or 9 basis points) is incredibly low. 

But what about the ETF’s relative performance? Its objective is to trace the S&P 500, but is it actually doing this? This brings us to our next point. 

SPY ETF Price Performance

Also included on the fund’s information page is its relative performance.

SPY Fund Performance

We can see from the above image that SPY is doing a pretty darn good job of achieving its objective of tracking the S&P 500. The fund’s Net Asset Value (NAV) from inception has gained 10.47% per year compared to the S&P 500 Index NAV of 10.60%. Considering the work and money required to purchase the individual stocks composing the S&P on your own, that’s quite good indeed. 

So what exactly does NAV mean? Let’s dive into that next. 

Fund Net Asset Value (NAV) Explained

The below image shows us the NAV of SPY. Additionally, you will see the total number of shares outstanding and the funds assets under management (AUM).

SPY NAV

So what exactly is NAV? Let’s look at the formula first. 

Net Asset Value = Fund’s Assets – Liabilities / Total Number of Shares.

In the SPY example, since there are no liabilities, we simply divide the fund’s assets by the total number of shares. This gives us a per-share price of about $450.

Now if you were to forgo the ETF option and buy every one of the stocks within the S&P 500 individually, you would need A LOT more than $445. Amazon (AMZN) alone would cost you over 3k!

Not All ETFs Are Created Equally

Before we move on, it is important to note that not all ETFs act as SPY. Many (if not most) ETFs underperform their benchmark and charge very high fees to do so. 

The average ETF fee is 0.53%. Compared to SPY, this average annual fee is quite high; but when compared to the average annual mutual fund fee of 1.42%, this number is quite small indeed. 

Take a look at a few of the high fee fund’s ETFDB lists below. These fees are ridiculously high and should be avoided in just about every single circumstance.

High ETF Fees

Let’s take a look at a few more examples of ETFs you should probably avoid. 

Fear of Missing Out ETF (FOMO)

One ETF in particular that stands out for its exorbitantly high fees is the Fear of Missing Out (FOMO) ETF. This ETF tries to provide investors exposure to popular stocks, such as “meme” stocks. For exposure to only 76 stocks, a management fee of 0.90% seems quite high to me!

Leveraged ETFs: ProShares UltraPro Short QQQ (SQQQ)

Proshares SQQQ ETF is another fund that got our attention for its high fees. This ETF is known as a leveraged inverse ETF. SQQQ tracks the QQQ ETF inversely, at a ratio of 3:1. This means that, in a perfect world, this fund will increase in value by 3% on a day that the QQQ ETF decreases in value by 1%. On the contrary, if QQQ increases by 1% on a given day, SQQQ should decrease in value by 3%. 

This ETF, therefore, requires a lot of manpower and trading. The result of this work performed is reflected in SQQQ’s expense ratio of 0.95%. This means that over the course of a year, this ETF is already down 1% in a constant market. 

Though leveraged ETFs are used quite effectively by investment professionals for short-turn hedging, the general retail investor should probably avoid them. They are not designed for long-term investors. Why? Their ratio (whether it be 2:1 or 3:1) usually does not last in the long run. Volatile markets chip away at the NAV of leveraged ETFs. 

If you’d like to learn more about the mechanics of leveraged ETFs, please check out our video below.

Leveraged ETFs for Beginners

To conclude this section, you should always go through the below checklist before investing in an ETF.

  1. Check the fund’s expense ratio.
  2. Make sure the fund actually tracks its benchmark.
  3. Make sure the funds NAV trades in line with its representative underlying products. 

So you may have been wondering how it is possible that ETFs are able to correspond their price to match the holdings within. There is indeed a feature of ETFs that allows for their prices to correspond to their holdings. Let’s look at that next!

ETF Price Stability Explained

The Net Asset Value (NAV) is essentially the true share price that represents how much the value of the fund’s assets is divided by the number of shares. Because ETFs trade on public markets, the share price of ETFs can fluctuate with supply and demand. Shares of ETFs therefore can sometimes trade at a discount, or premium, to the actual value of the fund’s holdings.

So what keeps the ETF shares in line with the NAV?

Authorized Participants

Traders called “authorized participants” are called upon to help level out the price of an ETF when its share price deviates from its NAV. Here’s the definition of an AP.

Authorized Participant Definition: An organization that has the ability to change the supply of ETF shares, thus providing liquidity for their representative fund. 

APs, therefore, have a relationship with an ETF issuer. APs are chosen at an ETFs launch. Their job is to keep the share price in line with the NAV. Whenever a premium or discount is present, they step in and correct it.

Authorized Participant Example: SPDR S&P 500 ETF (SPY)

Let’s say SPY shares are trading at a premium to their Net Asset Value (NAV). Can you guess how the Authorized Participant (AP) would correct this?

An AP would go out into the market and purchase all stocks that SPY holds (the S&P 500). By doing so, the AP increases the price of their ETF. Sounds like a lot of work! 

In return for providing this service, the AP receives shares of the ETF (SPY in this case) from the issuer. The AP will then sell these shares in the open market. These two actions combined help to chip away at the premium and bring the NAV in line. 

If the ETF is trading at a discount, the AP will sell shares of the underlying and buy up the ETF: just the opposite as above.

So, in short, the AP battles price imbalance by:

  1. Buying/selling the underlying shares
  2. Buying/selling the ETF itself.

These actions combined are often enough to stabilize an ETF price. APs aren’t the only ones to profit from price imbalances; if traders see an imbalance in price, they too can take advantage by participating in arbitrage.

Why You Should Avoid Mutual Funds

So hopefully by now, you’ll have a good idea of why investing in ETFs makes more financial sense than investing in mutual funds. Let’s really drive this home now.

1. Mutual Funds Typically Have Minimum Investments

For most mutual funds, there is a minimum initial investment. This often ranges between $500 and $5,000.

ETFs have no minimums. Ever. You’ll only ever need to pay the share price. And with fractional shares, you can even avoid this.

2. Mutual Funds Are Illiquid

Liquidity allows us to quickly buy and sell a security with minimal loss. Think of trading Apple (AAPL) stock. You can buy it and sell it on an exchange through your broker immediately for almost the same exact price. You also have no idea as to the bid-ask spread.

Mutual funds do NOT TRADE on public stock exchanges. You can’t buy and sell them whenever you want. Usually, you can only trade them once per day. You will have no idea at what price you will get filled. Typically, the price is the last trading price of the day. This doesn’t help you much if you want to sell a fund first thing in the morning before the market tanks 2%!

Additionally, some mutual funds have a “lock-in” period. This means you can’t sell the funds until a certain amount of time has passed.

In addition to being traded on exchanges, ETFs have no lock-in periods. 

3. Mutual Funds Have Higher Fees

Mutual funds actually have 2 fees!

1.) Expense Ratio

Like ETFs, mutual funds have an expense ratio. However, on a whole, mutual fund fees are much higher than ETF fees.

2.) “Load” Fees

Mutual Funds have “load” fees; ETFs don’t. 

There can be both “front-end” and “back-end” fees for mutual funds. This means you have to pay a flat percentage to sometimes both enter and exit a mutual fund.

ETFs have no load fees. Ever. 

Hopefully, you now realize there is seldom a case when a mutual fund beats an ETF. 

So what are some of the more popular ETFs? Let’s take a look at a few next.

Popular ETFs in Each Asset Class

Below you will find a chart illustrating the ETFs that have had the most inflows of funds over the past year. 

Popular ETFs in 2021
Chart from projectfinance; data from www.etf.com

ETFs are not limited to only stocks; they cover a wide array of asset classes. Here are some of the more popular ETFs across various asset classes:

  • Commodity ETFs

XLE: The Energy Select Sector SPDR® Fund

DBO: Invesco DB Oil Fund 

  • Stock ETFs

VTI: Vanguard Total Stock Market Index Fund ETF

IWM: iShares Russell 2000 ETF

VO: Vanguard Mid-Cap ETF 

  • Bond ETFs

TIPS: iShares TIPS Bond ETF

BND: Vanguard Total Bond 

More on ETFs

If you’d like to read more on specific ETFs, please check out our articles below!

Next Lesson

Additional Resources

Exchange-Traded Fund (ETF) Definition – Investopedia

What Is An ETF? – Fidelity – Fidelity Investments