Many investments sound like a good idea at first, but they can be hazardous for most investors. To name a few, out-of-the-money options, leveraged ETFs, and penny stocks can all be disastrous to your portfolio.
Here's why it's so important to avoid investment "traps" like these and what you should be doing with your money instead.
1. Out-of-the-money options
The basic concept of options is easy to understand. By purchasing a "call option," you are buying the right to purchase a stock at a certain price (known as the strike price) at any time before the option contract expires. And by purchasing a "put option," you are buying the right to sell a stock at a certain price any time before expiration. Each options contract is valid for 100 shares of stock. Here is a more thorough introduction to options for those who may be interested.
And while options certainly have their practical uses, out-of-the-money (OTM) options should generally be avoided. An OTM option is one whose strike price is higher (for a call option) or lower (for a put option) than the current market price of a stock. These options are used to bet on future movements in a stock's price. Let's look at an example.
Let's say I'm bullish on Citigroup, which is trading for about $53 as of this writing, so I buy a call option with a $55 strike price expiring on June 19. I have the right to buy 100 shares of Citigroup for $55 at any time before the expiration date. This is almost the same thing as buying a lottery ticket. If Citigroup has a fantastic run and is worth $60 per share at expiration, my investment will be worth $500 -- a gain of more than 600%. On the other hand, even if Citigroup delivers "OK" performance and rises to $54, my contract will expire worthless, and I'll lose 100% of my investment.
Buying OTM options is usually a gamble and does not fit into a long-term investment strategy. There are some good uses of OTM options, such as hedging positions in your portfolio, but that's best left to the experts.
2. Leveraged ETFs
These ETFs may sound like a good idea at first. If you're bullish on the technology sector, for example, why not invest in a fund that uses leverage to amplify your exposure (and thus your potential returns)?
The problem with leveraged ETFs is that they aren't designed to be long-term investments. Most are designed to follow the daily performance of a certain sector or index, and they rebalance each day in order to maintain a constant leverage ratio.
When a leveraged ETF's holdings decline, this can result in higher losses that are tough to overcome. Consider a hypothetical example in which a certain index declines by 5% per day for four consecutive days and then rebounds on the fifth day, making back all of its losses. Even though the index would be worth 100% of its starting value, a leveraged ETF that exaggerated the index's movements by a factor of two would be worth less than 96% of its original value.
|Day||Index Performance||Open||Close||Leveraged ETF Performance||Open||Close|
So leveraged ETFs are good if the market keeps going up day after day. Unfortunately, this doesn't happen in the real world, and the amplified losses of leveraged ETFs can be too great to overcome.
3. Penny stocks
Many investors mistakenly think that the best way to find the next Microsoft or Apple is to buy "penny stocks." Unfortunately, this rarely works out well. In fact, neither of these companies were ever actually penny stocks.
For our purposes, we'll consider a penny stock to be any stock with a market cap of less than $300 million that trades on the over-the-counter bulletin board (OTCBB) or on the "pink sheets."
The fact of the matter is that many penny stocks are extremely risky. The OTCBB and pink sheets have no minimum standards for stocks to trade on the exchange, and stocks on the pink sheets don't even have to file any documents with the SEC. Many of these companies are brand new and don't have any real business, and others are companies that are in such bad shape that they were de-listed from one of the major exchanges.
Because of their low standards and lack of liquidity, the penny stock markets are full of scams and frauds. As in the movie The Wolf of Wall Street, many of these companies artificially hype their stock and/or sell shares to brokerages that use "boiler room" tactics to sell shares to investors. Once the shares reach a certain point, the scam's insiders unload their positions and the price comes crashing down. This is known as a "pump-and-dump" scam.
Stick to the basics
There's a reason that most successful investors have portfolios full of the stocks of solid, reputable companies, as well as bonds, mutual funds, and real estate. These may not be the most exciting investments in the world, but they tend to deliver consistent performance over long periods of time, with little risk of losing substantial amounts of money.
The best way to get rich is by being patient and sticking to time-tested investments.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple and Citigroup Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.