4 Things Every Investor Should Know
There are a lot of nuances to investing, especially with new products popping up every year. Stocks, bonds, mutual funds, options, and ETFs are just a few of the options available to investors, but there are nuances that still escape many.
In the spirit of The Motley Fool's mission to educate investors, I've outlined four things I have learned about investing in recent years that every investor should know.
Shorting pays -- sometimes
Did you know that you can actually get paid to short stocks? When you short a stock, you borrow it from your broker (who is really borrowing it from another customer) and sell it on the market, leaving cash in your account. Hypothetically, this cash will earn you interest. So, if you bought and then sold a stock at the same price (for a $0 gain/loss) you would actually be left with less money than if you shorted and then bought back the same stock at the same price.
This is one of the advantages of shorting that few investors are aware of. The payout may not be high today, given the record-low interest rates, but shorting can potentially earn you some interest.
Here's the rub, though: This advantage to shorting is available to the big players, but it may not be to you and me. Most brokerage houses won't pay small retail investors on the cash from shorting, and with interest rates as low as they are, even the big guys don't get much back. For two examples, I know that Scottrade does not pay interest (or charge to borrow stock), but if you have more than $100,000, Interactive Brokers will pay interest on short balances if rates allow it. Clearly that asset level isn't in the cards for everyone, so check with your broker if this is something you want specific information about.
Leveraged ETFs head toward zero -- eventually
ETFs have become a popular investing instrument for retail investors, but leveraged ETFs come with dangers for investors who don't know how they work.
A leveraged ETF doesn't follow the long-term performance of an underlying index; it is built to follow the daily performance of an underlying index. This means that when you do the math, the leveraged ETF will eventually deteriorate in value as long as the underlying index moves up and down over time.
Don't believe me? Take a look at the graph below of two reference indexes and two leveraged ETFs that provide leveraged returns of the referenced index. The first pair is the S&P 500 and ProShares Ultra S&P 500 (NYS: SSO) , which "seeks a return that is 2x the return of an index or other benchmark (target) for a single day," according to the fund's overview. The second pair is the Nasdaq 100 index and ProShares Ultra QQQ (NYS: QLD) , which seeks the same result.
Notice that the Nasdaq 100 rose over the last five years, while the S&P 500 fell, but both leveraged ETFs underperformed their indexes. This shows that whether an index is going up or down, the leveraged ETF will underperform over the long term due to the math behind following daily returns, which I explain in more detail here. Given enough time, as long as an index doesn't head straight up or down forever, leveraged ETFs will head toward zero.
Special dividends are just that: special
At The Motley Fool, we love our dividend stocks. But some investors may not be aware that not all dividends are created equal. Regular dividends are given on a regular basis by a company and are generally expected to stay consistent by investors; these are the dividends we usually talk about. Special dividends, on the other hand, are one-time events that affect options and stock prices in ways you may not expect.
A special dividend comes with three very important dates for investors: the payment date, the date of record, and the ex-dividend date. For example, Microsoft (NAS: MSFT) paid a $3-per-share special dividend on Dec. 2, 2004, but the date of record was actually Nov. 17. So the ex-dividend date, or the first day of trading that the stock trades without the dividend, was Nov. 15. Investors needed to own shares on Nov. 12 (a Friday) to get paid the dividend.
It is also interesting to note that Microsoft's stock didn't fall $3 when it traded ex-dividend, either.
Closing Stock Price Before Special Dividend
Opening Stock Price Ex-Special Dividend
Source: Yahoo! Finance.
The same pricing phenomenon happened when Wynn Resorts (NAS: WYNN) paid an $8-per-share dividend in 2010. This may be because investors have to pay taxes on dividends, and in theory, this is already priced into the stock. If there weren't any taxes, the price drop should be equal to the special dividend.
Finally, if you trade options, they will adjust their strike price when a big enough special dividend is paid so that options traders have no advantage or disadvantage over other investors.
To boil all of this down to two simple points: Know when the ex-dividend date is and remember that the strike price of options will change after the special dividend.
In options trading, time is money
Some investors think options are a good way to hedge their bets in the market. But options have time value, something investors must consider when hedging. This time value can be a costly hedge and can quickly eat away at returns.
Let's take an oil company that may be hedged like Kodiak Oil & Gas (NYS: KOG) . This company is highly dependent on the price of oil, because its operations may become unprofitable if oil falls too far. I'd be worried that oil would drop -- and the stock along with it. With shares trading at $8.53 as I'm writing this, I could choose to protect myself with an $8 put option that will expire in August. In theory, this protection sounds smart, because I would be protected if the stock fell below $8.
But look at what you'd pay for this protection. The option itself is selling for $0.45 right now, a price I wouldn't recoup unless the stock fell 12% to $7.55. If the stock ends anywhere over this price, the option will produce a loss for me.
Using longer-dated options only makes the problem worse. If we go out to September, a $7.50 strike price put is even more expensive than the $8 August put at $0.55, even though the stock would have to fall an additional $0.50 to be in the money.
The bottom line here is that options are an expensive way to bet on stocks or hedge your bets. You're paying a lot for the time value of the options, especially in volatile stocks.
Foolish bottom line
Shorting, leveraged ETFs, special dividends, and options may not be a part of your everyday investing, but they're important to understand when they affect you.
As I highlighted above, some ETFs aren't for long-term investors. But our analysts have found three ETFs that will benefit from an economic recovery -- and they're revealed in a free report that you can access by clicking here.
The article 4 Things Every Investor Should Know originally appeared on Fool.com.Fool contributorTravis Hoiummanages an account that owns shares of Microsoft and Wynn Resorts. You can follow Travis on Twitter at@FlushDrawFool, check out hispersonal stock holdingsor follow his CAPS picks atTMFFlushDraw.The Motley Fool owns shares of Microsoft.Motley Fool newsletter serviceshave recommended buying shares of Interactive Brokers and Microsoft, as well as creating a bull call spread position in Microsoft. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.
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