Investment fundamentals
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Whats a mutual fund?
A mutual fund, also referred to as an open-end fund, is an investment company that spreads its money
across a diversified portfolio of securities -- including stocks, bonds, or money market instruments.
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Shareholders who invest in a fund each own a representative portion of those investments, less any
expenses charged by the fund.
Mutual fund investors make money either by receiving dividends and interest from their investments, or by
the rise in value of the securities. Dividends, interest and profits from the sale of any securities (capital
gains) are passed on to the shareholders in the form of distributions. And shareholders generally are
allowed to sell (redeem) their shares at any time for the closing market price of the fund on that day.
Go to the CBS MarketWatch Mutual Funds page for news, commentary and data on funds.
Why invest in mutual funds?
There are a variety of reasons why investors might choose mutual funds over other investments, such as
individual stocks and bonds. The number one reason is diversity, which can both increase your potential
returns and decrease your overall risk.
Mutual funds allow an investor to spread out his or her money across as few as a handful to as many as
several thousand companies at one time.
Funds can be especially advantageous for small investors who would be forced to pay enormous
transaction fees if they bought the securities individually, and for investors who either dont have the time
to research their own investments or who dont trust their own investment expertise. (For more on asset
allocation, see Build Your Own Mutual Fund Portfolio tool).
That said, mutual funds arent necessarily low-cost investments. Many of them charge one-time load fees
to new purchasers that can exceed 5 percent of the investment, and all mutual funds take on average take
1. percent of assets a year for operating expenses, expressed as the expense ratio.
As a result, index funds (see below) have surged in popularity in recent years because, on average, they
provide a much lower expense ratio than managed funds. Also an index funds risk is limited to that of the
benchmark index that it tracks, such as the Standard & Poors 500.
Finally, the rapid emergence of 401(k) plans as the retirement vehicle of choice for millions of Americans
means that mutual funds are here to stay.
Professional management can be both a benefit and a liability of actively managed mutual funds. Several
studies show that, over time, the average, actively managed fund has underperformed the overall stock
market. Still, by picking funds with good long-term track records, managers you trust and low expenses,
investors can build a portfolio with the potential for steady, long-term returns that match their own
investment goals and tolerance for risk.
Liquidity -- the ability to readily access your money -- is another benefit of mutual funds. Funds can be sold
on any business day at that days closing price or at the following day's close if the sell order is placed
after the market closes.
The price per share at any given time is known as the net asset value, or NAV, which is the current market
value of all the funds assets, minus liabilities, divided by the total number of outstanding shares. As new
investors buy into a fund, the number of outstanding shares goes up, as does the market value of assets,
but the NAV remains the same.
Mutual fund educational links
Online classes are a fun way to learn mutual fund basics
Take The Vanguard Groups mutual fund quiz
The American Association of Individual Investors glossary of mutual fund terms
The Investment Company Institute's Web site for mutual fund facts and figures
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Types of funds
STOCK FUNDS
Also known as equity funds, these funds invest primarily in the shares of publicly traded companies. There
are numerous types of stock funds.
A blend fund, sometimes known as a core fund, invests across all levels of companies -- small, mid-size
and large -- and unless indicated otherwise, across both growth companies and value companies.
Small-cap, midcap and large-cap funds invest only in companies that fit those definitions, which are based
on the market capitalization, or total stock value, of the companies they invest in.
Growth funds stick to companies with potential for better-than-average profit growth, while value funds
stick to companies with a low stock price relative to their earnings or such measures.
Investors should note that each fund family and each fund manager has his or her own definition of a
value or growth stock, a small-cap stock and what is an acceptable level of ownership of a certain asset
class to meet a funds category.
Investors should check the funds prospectus and Fund Profiles found on CBS MarketWatch before
deciding on a fund.
BOND FUNDS
Bond funds invest primarily in the debt instruments of companies and governments. They make money
both by selling bonds at a profit and through income from the coupon payments of the bonds they hold.
These coupon payments also are distributed to shareholders, thus generating income in addition to
potential capital gains.
Bond funds tend to be less volatile than stock funds, though there are several types of bond funds, some
riskier than others. Junk bond funds, also known as high-yield bond funds, invest primarily in corporate
bonds rated below whats considered investment grade by the major ratings agencies, Moodys and
Standard & Poors.
GO DO IT!
To build your own table of top mutual funds--based on criteria you select--for any of these categories and
more, see our Fund Finder tool.
Municipal (or muni) bond funds invest in debt sold by U.S. cities, counties and states, while government
bond funds invest mostly in U.S. Treasury bonds. Likewise, international bond funds invest in non-U.S.
government and corporate debt. Investors should note that bond funds tend to go up in value when interest
rates decline, and vice-versa.
BALANCED FUNDS
Balanced funds, also called hybrid funds, hold a mixture of stocks and bonds, and typically also a small
amount of cash or money-market instruments.
MONEY MARKET FUNDS
Invest in short-term, interest-bearing securities. Money market funds are generally less risky than either
stock funds or bond funds. The fund industrys trade association, Investment Company Institute, says
money market funds are most appropriate for short-term investment and savings goals or in situations
where you seek to preserve the value of your investment while still earning income. Money market funds
are designed to trade at a constant $1 a share.
INDEX FUNDS
Index funds can be either bond funds or stock funds. They invest in companies that make up a given
index, such as the S&P 500 or the Nasdaq 100, in an attempt to mimic the returns of that index. Their
advantage to shareholders is that they usually have lower costs than managed mutual funds because
index funds do not have to hire staffs of research analysts and money managers to pick their stocks. Most
also come without load fees.
SECTOR FUNDS
Stock mutual funds that invest in a specific industry sector, such as technology, health care, or energy.
Sector funds are usually much more volatile than general equity funds, because sectors of the economy
tend to go in and out of favor among investors, often for reasons that confound the average investor.
However, they can also generate higher returns, such as the triple-digit performance of dozens of tech
funds during 1.
GLOBAL & INTERNATIONAL FUNDS
They sound like the same thing, but theyre not. International funds invest solely in companies based
outside the U.S., while global funds can invest in both U.S. and foreign companies. Its an important
distinction, because if youre picking such funds to diversify your U.S. portfolio, a global fund might have
some overlapping investments to your existing domestic funds.
CLOSED-END FUNDS
These are technically not mutual funds, although many investors consider them as such and they're often
compared with mutual funds as investment alternatives. Closed-end funds differ from open-end (mutual)
funds in that they issue a set number of shares and are usually listed on exchanges, like stocks.
Like mutual funds, they invest in the stock of a number of different companies, but unlike mutual funds they
do not issue and redeem new shares. Because the share prices are dictated by the market, they often
trade at discounts, and in some cases premiums, to their net asset value.
EXCHANGE TRADED FUNDS
These too are not mutual funds but are often compared with them for investment purposes.
Exchange-traded funds are, as their name suggests, traded on stock exchanges. Most represent shares in
the companies that make up a recognized index.
The first such fund, Standard & Poors Depository Receipts (SPY), commonly referred to as a SPiDeR,
launched in 16. At the end of April 001, the ETF industry had grown to nearly $76 billion in assets
spread across 114 funds.
Their increasing popularity among investors stems from certain advantages over mutual funds. Theyre
priced throughout the day, options can be written on them, they can be sold short, and they have no
minimum investment amount beyond the price of the individual share.
The ETF structure is also considered more tax-efficient than mutual funds because they limit the exposure
to capital gains distributions that can occur when fund managers are forced to sell securities to meet
redemptions.
Some of them also have lower expense ratios and better tax efficiency than comparable mutual funds.
However, unlike mutual funds, investors must pay transaction fees to brokers when they purchase
exchange-traded funds, which can be especially costly for investors looking to put a set amount of money
in them each month.
Currently, ETFs only mimic specific indexes. But plans are underway to introduce actively managed
exchange-traded products. The Securities and Exchange Commission plans to publish a concept release
on the subject this summer.
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Fees and expenses
Mutual fund fees fall into two general categories loads and operating expenses.
Fees and expenses are important because they reduce the total return that you, the investor, make on
your mutual fund investment.
For example, if one fund has an annual expense ratio of percent, it would have to post a return that was
at least two percentage points higher than a fund with a 1 percent expense ratio to match the return to the
investor.
OPERATING EXPENSES
Operating expenses are all the administrative, management, distribution and other costs that a fund
company incurs in running a mutual fund.
They are expressed as the "annual expense ratio" of the fund, a percentage figure which can be found on
fund prospectuses as well as the fund profiles on CBS MarketWatch. The largest portion of a fund's
operating expenses is the management fee, which a fund pays to the managers of the fund.
1B-1 FEE
Named for a rule in the Investment Company Act of 140, a 1b-1 fee is charged by some mutual funds to
cover marketing and distribution expenses, such as paying sales professionals. By law, this fee cannot
exceed 0.75 percent of a fund's average net assets per year, and funds are required to disclose the fee in
prospectuses.
A no-load fund can charge a 1b-1 fee of up to 0.5 percent of assets. A fund's annual expense ratio
includes 1b-1 fees.
LOADS
Loads, also called "shareholder fees," are separate from operating expenses and arent included in the
annual expense ratio. Loads are sales charges usually designed to compensate a financial professional
such as a broker for his or her services in selling the fund and in helping you select it.
The most common type of load is the "front-end load," a one-time fee charged at the time of purchase.
These fees can range as high as 8.5 percent, but funds that use them usually charge anywhere from
percent to 6 percent. A "back-end load," also called a "deferred sales charge," is levied when an investor
sells his or her shares. Some funds only charge back-end loads if an investor redeems the shares before a
certain period of time, for example one year.
CLASSES OF SHARES
Some funds offer different share classes, which basically represent different ways of charging investors for
the same mutual fund. While these classes differ from fund to fund, Class A shares usually have a
front-end load; Class B shares often have a 1b-1 fee and a back-end load, and Class C shares often
have a higher 1b-1 fee (and thus a higher expense ratio) but no load.
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Taxes
Mutual fund investors are taxed on their investments in three ways the sale of shares, capital-gains
distributions and dividend distributions.
When you sell your shares, you must pay capital-gains taxes on any profit that you made. Likewise, you
can declare a loss on the investment if the shares decreased in value. The amount of gain or loss is
determined by the difference between the sale price and the "cost basis" of the fund shares (generally the
purchase price).
DISTRIBUTIONS
Mutual fund investors are also taxed on the two types of distributions that mutual funds make to
shareholders during the year dividends and capital gains.
Dividend distributions are primarily from the interest and dividends earned from the investments in the
fund's portfolio. These must be reported as income on your 1040 federal tax form.
Capital-gains distributions represent any gains from the sale of shares held more than a year that the fund
itself made during the year. These are taxed as capital gains, often at lower rates than federal income
taxes.
Fund investors are often befuddled by a large drop in the share price of their fund when distributions are
paid out. In such cases, while the share price may have dropped sharply, the number of shares in the fund
-- and the number of shares you own increased proportionately, meaning the value of your investment
stayed the same.
TAX EFFICIENCY
Most mutual fund investors mistakenly overlook the issue of tax efficiency when purchasing mutual funds,
and yet it can have as large an impact on your total return as the fund's expenses or even its performance.
The factor which most drives the tax efficiency of any given fund is its turnover ratio how often the
investments within the portfolio are bought and sold during the year. Funds looking for conservative,
steady long-term returns are likely to have lower turnover ratios and as a result higher tax efficiency
than aggressive funds looking for sharp short-term gains. Funds usually report their tax efficiency ratios on
their prospectuses, and some fund companies have begun to report after-tax returns on their Web sites.
Keep in mind that, if you hold your funds in a 401(k) or other tax-deferred retirement account, the issue of
tax efficiency is mostly moot, as dividends and capital gains accrue tax-deferred until you draw from the
account.
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Stocks
Introduction
Everything is now working in favor of individual investors to learn about stocks and trade them. The
Internet has opened up a new world to everyone.
Online trading has changed the average investors involvement in trading their own stocks. The availability
of company information has become so widespread and easily attainable that researching and finding
stocks to buy and sell is as easy as logging onto your computer.
Buying a stock for the long term means that you want to own part of a company and you think that in the
future the company will be profitable. If you buy stock in a company and the company performs well, the
stocks price should rise. If the company fails, then the stock should fail you, too and go down.
Companies list their stocks on the various stock exchanges located throughout the U.S. The stock
exchanges actually compete with each other for these listings, since companies that attract more trading
make more money for the stock exchange that listed it.
Company stocks are assigned a ticker, or trading symbol by the listing exchange. You may notice some
well-chosen tickers that are easy to remember, like DNA for the company Genentech, a biotechnology
firm. Or some companies ticker is the same as its name, Nike for example.
You need to know the ticker of a stock in order to access information about the stock and eventually trade
it.
The various stock exchanges are a very good place to start getting information on stock trading and
general investing. We suggest you visit the following web sites
The American Stock Exchange (www.amex.com)
The Nasdaq Stock Market (www.nasdaq.com)
The New York Stock Exchange (www.nyse.com)
The Pacific Exchange (www.pacificex.com)
The Philadelphia Exchange (www.phlx.com)
Besides being a great online source, some of the exchanges listed above give free seminars about
investing.
The Securities and Exchange Commission, which is the watch dog and regulator of the securities industry,
also has an investor education program and you can get more information at its web site at
www.sec.gov/oiea1.htm.
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Stocks
Bulls and Bears
All this talk about bull and bear markets means that it's a zoo out there, when it comes to investing. And,
like any zoo, there are quite a few species to be found down on Wall Street.
Most investors' favorite animal is clearly the bull. The term is used in several ways. Referring to the stock
market, it describes a period in which prices rise for a lengthy period of time. When it comes to people,
bullish describes one who is optimistic.
How this usage came about is not entirely clear. A bullish investor is one who buys a stock in the
expectation that its price will rise. This could be compared with bulls charging ahead, stampeding prices
higher. Or it could simply reflect the fact that bulls habitually toss their heads upward.
To be considered a bull market, prices need not rise continuously. There can be days, weeks and even
months in which prices fall. What matters is the long-term trend.
Bears
The Street's least favorite animal is the bear. This term is used to describe downers both stock prices
and individuals. It originated from the old days, when traders used to sell bearskins before the bears were
actually caught. In the stock market, it applies to people who expect prices to decline.
As for how much of a price decline constitutes a bear market, the rule of thumb seems to be at least 0
percent. However, a lot depends on how long the drop lasts. The quicker the rebound, the less likely that
investor psychology will turn from optimism to the pessimism that usually accompanies a bear market.
You can find other animals down on Wall Street. For example, there are dogs, as in Dogs of the Dow. This
is an investment strategy that calls for buying the 10 stocks with the highest yield among the Dow, altering
the portfolio annually as needed.
In the feline family, remember CATS (Certificates of Accrual on Treasury Securities), LYONS (Liquid Yield
Option Notes) and TIGRS (Treasury Interest Growth Receipts)?
Arachnids
A recent addition to the Street's menagerie is SPDRS (pronounced spiders), which enable investors to
participate in the price performance and dividend yield of the Standard & Poors 500 Index by purchasing
shares at a price equal to roughly 10 percent of the value of this index.
While buying and selling stock, investors must be on the lookout for donkeys and elephants, representing,
of course, the two major political parties. The government certainly plays a big role in Wall Streeters' lives.
Sometimes Washington even makes monkeys out of traders by changing the rules in the middle of the
game.
There are two other animals to keep watch for. Ostriches are investors who stick to their old strategies,
oblivious to changes in the world around them. And then there are the hogs as in the expression, bulls
can make money, bears can make money, but hogs, investors who are too greedy, usually get
slaughtered.
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Before buying
If you have decided to go ahead and buy and sell your own stocks, but where do you begin? Thanks to in
Internet you can find out a lot by just logging on.
It is suggested by many financial experts that before you lay down any hard-earned money, you need to
first research a few stocks to see if they are sound companies that have the potential to earn money and
grow over time.
One of the best sources of information about a public company is in its financial reports, like an annual
report, a quarterly report, or a special filing with the Securities and Exchange Commission. And luckily for
everyone, these reports are usually available online at each companys web site, or at the SEC's EDGAR
database online (which is also free).
Perusing the annual report or looking at a company's earnings report can tell you a lot about how the
company is doing and, in some cases, what they have in the pipeline that will help it in the future.
And there is some quick math you can do to test a company's health. You may have heard of "earnings per
share" or "profit margins" or "price-to-earnings ratios"--and you should familiarize yourself with a few of
these terms. Visit the glossary to find out more about those terms.
Another good source to find out more about a company are Wall Street analysts and stock brokers.
Analysts and brokers are usually employed by a bank to give their opinions on a stock. Some say you
should buy, or hold, accumulate a particular stock, but if you look beyond the opinion there is sometimes
hard numbers and much research to read up on.
A good strategy is to use analysts and brokers to get information about a stock and then to check some of
the numbers for yourself before investing.
Keep abreast of what analysts are saying and how it affects a stock. Some analysts carry a lot of weight
and what they say can move a stock significantly, within minutes of giving an opinion. And others are just
dead wrong about a stock again and again.
Also, if you are investing for the first time, look for a company that has been out for a while and is paying
dividends and has a low price-to-earnings ratio. Older, more solid companies tend to have some history of
excellent earnings and you can learn a lot by studying a company that has a good track record.
And although history shouldn't be heavily-weighed when making a stock pick, looking at what a company
has done in the past can help you see how it might react to changes in the future.
Risks
You will also want to learn what risks are involved when investing in stocks especially if you plan on buying
and selling them often. Although some people trade stocks for a living, it is not for everyone and can really
be a dangerous endeavor that will eat up your savings in a jiffy. And there are arguments as to who makes
more money over time--the active trader or the buy-and-hold types.
Make realistic goals about how much you may make on a stock over time. Some think that since they have
been making 0 percent gains or more in the past couple of years, that this will always be the case. That is
not very realistic if the market slows down and it is more difficult for companies to make profits. Do not take
on more risk than you are comfortable with just to hope for above-average returns.
Diversifying your stock portfolio, or investing in different stocks with different revenue streams is really key.
Make sure you spend a lot of time looking at the forest as well as the trees. And stock splits and other
factors can really effect how your stock portfolio is weighed so set aside time to revisit your goals.
And remember that everyone is in it for the money--not just you. Brokers, exchanges, fund mangers, etc.
Use your broker or fund manager to find out exactly what you are getting into. Really find out how a broker
or fund manager makes money off of you and what fees are involved. Go to the various stock exchange
web sites or SECs web site and read up on regulations and risks.
This is especially true when it comes to margin accounts--or an account that is set up by a broker who lets
you borrow money, pay interest on that money, and trade it as well. Margin accounts can be very risky, so
know the risks before signing up.
The key to successful stock picking is that you must do your homework and find out as much as you can
about the company behind the stock. Really dig and dont give up. Theres tons of free information out
there and the more you know the more you will be rewarded.
Its a big job, which is why many rely of mutual fund managers, brokers and others to do the stock picking
for them. But if you have the knack, the time and the money, nothing is standing in your way to do it
yourself.
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Corporate filings with the SEC
One of the best ways to begin researching a company's financial health and history is through corporate
filings with the Securities and Exchange Commission.
Reports filed most frequently by companies with the SEC include, annual and quarterly reports, insider
transaction documents, IPO- related documents and other registration statements.
The following provides a brief description of the most frequently filed documents with the SEC (for a full
description visit the agency's description of SEC forms )
Typical information provided in an annual or quarterly report includes, financial data, results from
continuing operations, market segment information, new product plans, subsidiary activities and research
and development activities on future programs.
Insider transactions are among the most common corporate filings with the SEC. Every director officer or
owner of more than a 10 percent stake in a company must disclose their holdings with the SEC. These
filings are made on Forms , 4 and 5.
Registration statements filed most often by companies include S-1 and S- documents. An S-1 is a basic
registration form filed when a company's planning an IPO. After a company has been publicly traded for a
year, any subsequent plan to offer securities, which may include common stock, preferred shares or debt
securities, must be filed through an S- registration statement.
Visit CBS.MarketWatch.com's column, which provides daily coverage of the latest in SEC Filings. Also,
visit the SEC's free online database of filings, EDGAR.
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Bonds
Introduction
Many investors decide to have a portion of their money in bonds or bond funds, and some experts say as
much as 0 percent of your money should be invested in bonds.
Why? Bonds are very liquid -- easily sold -- and can be less risky than stocks, to start. They are
fixed-income investments that pay interest, which means safer and more dependable income than many
other investment choices.
A bond is very similar to an I.O.U. with interest. When you buy a bond you are giving money to a
government, a corporation or a municipalityand it in turn issues an "I.O.U." for the money you provided.
Until that money (called the face value of the bond) is paid back to you on a specified date, you are paid
interest on it.
Here are the types of bonds you can choose from U.S. government securities, municipal bonds, corporate
bonds, mortgage and asset-backed securities, federal agency securities and foreign government bonds.
It used to be hard to find information on the Web about bonds, but that's not so anymore.
A good place to look may be The Bond Market Association site. This site has a great deal of information on
bond basics as well as free bond price information on corporates, municipals and treasurys. It also has
bond news and research information, and a list of bond dealers.
Bonds Online is another good source to knowit's run by Twenty-First Century Municipals Inc., an online
information- services company based in Mercer Island, Washington. It has various news sections on the
fixed income market and a bond market commentary updated everyday. Price quotes and research reports
can be found there, too.
You can also go to the official site for Treasury bond information, which is the Bureau of Public Debt
Online. Ever wonder what that savings bond is worth? The site has a calculator to help you figure it out and
will even let you buy savings bonds online. But there's a ton of more bond information there for you to
peruse.
Also, visit the mutual fund types page to find out more about bond funds.
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Municipal bonds
Interested in municipal bonds? Youre not alone. While a $5,000 minimum limits muni bond investments
to mature, wealthy individuals, there are numerous muni-bond mutual funds carrying much lower initial
investments.
Internet resources for researching, pricing and buying these securities are booming. The result? A market
that once resembled an invitation-only country club party is turning into one that offers the variety and
accessibility of an all-you-can-eat buffet.
The $1.5 trillion-plus muni bond market doesnt necessarily allow the simple point-and-click satisfaction
investors enjoy with stocks and mutual funds. Among the daunting investment considerations youll
encounter are arcane credit ratings, varying durations and yields, and sometimes-complicated tax
compliance issues.
Still, many investors -- especially those in search of tax shelters -- will find that the learning process is
worth the effort.
Municipal bonds have two principal qualities that make them attractive to investors They're free from
federal and sometimes state and local taxes, and their proceeds go toward projects that benefit the public
-- new roads, schools, hospitals and even sports stadiums.
Even if you rely on a finance professional for investment advice, youll find plenty of useful background on
muni bonds on the Web.
Where to start research
Investors might begin their research on The Bond Market Association's Web site,
www.investinginbonds.com, suggests Arthur Sinkler, president of MuniDirect.com, a novel online
brokerage firm that allows individual investors to purchase bonds directly via the Web.
A click on MuniDirect.com gives investors two paths to follow, explains Sinkler. Experienced visitors can
find bonds by typing in specific qualities of the security theyre looking for through Detailed Search. Those
just getting their feet wet can experiment with Muni Wizard.
How muni-market commissions and pricing work had long been one of Wall Streets biggest secrets,
though the barriers started to come down even before brokers began Internet postings.
MuniDirect charges no more than a $5 commission on a typical bond with a face value of $1,000 -- but
remember youll have to start with a $5,000 order -- and sometimes charges less. Typically, bond brokers
may pocket $10 to $0 per bond, or up to $70 on lower-quality, higher yielding bonds.
Still, critics of a MuniDirect system say lower commissions come at the expense of a large inventory of
bonds. While MuniDirects database is growing, some states, cities, and municipalities still opt to issue
through mainstream brokers because they provide underwriting and other services. And, in exchange for
higher commissions, traditional bond brokers sometimes shoulder some of the losses a bond may incur.
Customer base
Statistics are proving that the age and income level of the average muni investor fit the demographics of
individuals most likely to invest online, noted Sinkler, who said his average customer is about 55 years old.
A group of Wall Street heavy hitters -- including Goldman Sachs Group Inc., BondDesk.com LLC,
Susquehanna Partners GP, Paine Webber Group Inc., and Bear Stearns & Co. Inc. -- joined to create an
online, industry-wide, muni-bond marketplace, MuniGroup.com LLC. The site is pending Securities and
Exchange Commission approval.
Sinkler said about 40 Internet sites sell bonds, though he claims his is the first to sell munis directly to
individuals.
MuniGroup, for example, will sell bonds to brokerage houses, which then sell the bonds to individual
investors.
Still, a migration online is indicative of the evolution taking shape in a marketplace once dominated by a
select group of brokers able to keep price information essentially under wraps and institutions such as life
insurance companies that needed municipal bonds. Now, households directly hold 0 percent of munis
and when tax-free mutual funds, money market funds and closed-end funds are included, that figure climbs
to 7 percent.
Consider bond funds
An investor ready to take a nibble of the market rather than a bite might consider a tax-exempt bond or
money market fund, says Reno J. Martini, chief investment officer with the Bethesda, Md.-based Calvert
Group. His firm manages $4.8 billion in tax-free and taxable bond funds that recently earned top billing
from Barrons.
A fund manager can conduct daily credit research, keep closer tabs than busy investors on the debt
market and offer a variety of bonds to maximize return and weather ups and downs. Martini, whose
tax-exempt funds carry a smaller $,000 cover charge to get in, says his average investor is 40 to 60
years old.
The data we are seeing (shows) that more individuals are seeking financial help with their investments,
he says.
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Convertible bonds
Sleepless because of market volatility? You may want to consider convertible securities.
Convertible securities are hybrid investment instruments, the most common of which are convertible bonds
and preferred stocks. As their names imply, they can be converted at the users choice into other
investments, most often shares of common stock.
As a mixed breed, convertibles share the relative safety of fixed-income investments (bonds), while also
being exposed to the underlying stocks potential gains. They move in sync with the stocks into which they
can be converted, yet their hybrid nature makes them less volatile.
Like fixed-income investments, convertibles pay interest and principal payments as well as dividends. If its
a bond -- essentially a loan -- the company has to pay back the money with interest. If its a preferred
stock, which blends the characteristics of a bond and common share, it pays dividends and gives the
investor a leg up over common stock in making claims on a companys assets in the event of a liquidation
or sale.
Why convertible bonds?
A convertible bond is superior to convertible preferred stock because its safer and the interest is paid
before any stock dividends. In addition, if the company goes under, a convertible bond holder still has
priority over stockholders when it comes to settling financial claims.
Investors can make money two ways Sell the convertible when its price goes up in the market, or convert
to common stock and sell the shares.
Funds even better
Convertible securities have their place in a well-diversified portfolio, said William Harding, an analyst at
Morningstar, a mutual-fund rating and information company. But the exact percentage that convertibles
should take up in ones portfolio depends on personal investment goals and needs.
Its suggested that the best way for individual investors to participate in convertibles is to buy into a mutual
fund. Convertibles are complex securities and information about them isnt as readily available to small
investors as common stocks.
For example, when buying a convertible bond, the investor has to look at several things The bonds
interest rate and yield, how many years remain before maturity, the common stock price applicable upon
conversion, how it compares to a regular bond, downside risk and possible rewards in converting to a
stock.
Since a bond, whether convertible or straight is still a loan, the investor also has to investigate the quality
of the business issuing the bond to determine whether the company can pay back what it owes. Throw in
the idea that the company may choose to repay the loan before maturity and youve got more homework to
do than youd probably want.
The upshot? Researching a convertible carries an extra level of complexity because you have to
investigate the dual nature of this hybrid security. So stick with mutual funds, experts say.
The risks
Bonds, whether convertible or not, are only as good as the strength of the company behind it. In the past
year or so, the credit quality of convertible bonds has dropped off.
Indeed, half of the convertible market comprises issues in technology and telecommunications, both of
which can be volatile sectors.
Convertible funds also tend to be more expensive than domestic stock funds because most carry loads, or
sales charges.
And just because a fund invests in convertible securities doesnt mean it will always be less risky than a
regular stock fund.
Look at a funds investment policy carefully. Some managers are allowed to invest a large percentage of
the funds assets in regular stocks, and, if they are chasing performance, they most likely will have
investments in technology companies.
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Options
Introduction
You may have heard of options and seen that you can trade them in your online account, but what is a
stock option and why would you even care if one exists?
Lets start first with a very basic question What is a stock option?
A stock option is not a physical thing like holding shares in a company. Instead it is a contract between two
parties.
When you own stock (or shares) you actually own part of a physical entity--a piece of a company. An
option is an agreement, or contract, where one party agrees to deliver something to another party within a
specific time period and for a specific price.
This distinction is important because with options you are not borrowing anything. For example, in the case
of stock, you must first borrow the stock to short it--but with options there is nothing to borrow so you can
short options without the worry of borrowing first.
Options are popular because they can help you get more bang for your buck. Instead of buying a stock
outright, you can enter into an options contract which can be much cheaper but have the same--or even
better--results.
Options can also be less risky than holding stocks, but that is not always the case. If you plan on trading
options at some point make sure you understand fully the risk and downside of each trade. Also, options
take more attention and can amplify the movement of a stock in your favor or out of your favor very quickly.
So options trading is not for everyone, especially if you are not comfortable taking on risk or managing
positions.
Learning about options isnt difficult anymore. There are a few web sites that have popped up recently to
help you keep track of options news. And there have been plenty of books written recently that can really
help individual investors understand how using options can be a worthwhile endeavor, depending on your
financial needs.
Many of the various options exchanges have web sites geared towards individual investors looking for
information on options.
Probably the best prepared to reach investors is the Chicago Board Options Exchange, which has a terrific
web site set up to educate you. Visit its education page. The CBOE also holds seminars and sells books
about options and how to trade them.
Your broker also can give you much guidance if you are prepared to trade options online or through a
proprietary service.
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Bull strategies
If you are trying to make money on a stock that you think will go up, you may adopt a bull spread strategy
(hence the name).
This trading strategy can be accomplished with either puts or calls.
Remember a call is the right (not obligation) to purchase a security (stock, index, or bond) at a specific
price on or by a specific date. A put is the right (not obligation) to sell a security (stock, index, or bond) at a
specific price on or by a specific date. See Options terms.
NAKED LONG CALL
The simplest bullish strategy is the naked long call (see chart below). This is simply buying the call without
any type of hedge and the strategy is used when you think that a security is going to make a large move
upward.
Let us assume that a stock is trading $50. You may purchase a call with a strike price of 50 and about 0
days until that option expires. This call may costs $4, for example.
If the stock closes $50 or less on expiration then the call will expire worthless. This represents your
maximum risk. There is no way to lose more than you paid for the call. If the stock closes at some price
higher you will begin to recoup some of your investment and possibly make money.
If the stock closes at $54 on expiration, you will exercise your right to purchase the stock at $50 and
immediately turn around and sell the stock for $54 yielding $4. Since this profit covers your initial
investment, however, the outcome is a net wash.
This point is important since it is your breakeven point. It is always important to know your breakeven point
PRIOR to making any options trade. By knowing this point you also know where you are loosing money but
more importantly where you are making money.
Now comes the good part. If the stock closes above $54 you will be making a net profit. Let us say the
stock closes $60 on expiration. There are two ways to take profits The first is to exercise the right to
purchase the stock at $50 and then turn around and sell it for $60 yielding a $6 profit. But you have to have
enough money in your account to take delivery of the stock.
Another way to take a profit, and the better way of doing it, is to sell the option the Friday of expiration for
$10. This $10 is referred to as the par value of the option. Math is $10 minus the $4 you paid for it yields
$6 in profit. (Note that you may actually be able to sell it for 10 1/8 or have to sell it for 7/8 depending on
how volatile the stock is, or how liquid those particular options are that day.)
$5 BULL SPREAD
Lets talk about bull spreads. Bull spreads also take advantage of an upward movement of a stock, but they
are less risky. And unfortunately if the stock makes a very large movement to the upside, then you are also
limiting your reward by using this strategy
But lets assume that a stock is trading for $50. If you are bullish, you may choose to buy the 50-55 call
spread.
What does this mean? This means that you are purchasing the 50 level calls and selling the 55 level calls.
Since the 50 level calls are more expensive than the 55 level calls, this spread is done for a net debit.
Remember our previous example. The 50 level calls were trading for $4. Let us say that the 55 level calls
are trading for $. This means that you can buy the 50-55 call spread for $ ($4-$).
This call spread is a $5 call spread since the strikes of the two options involved are $5 apart. This means
that at expiration (when the options expire) the most the call spread can be worth is $5 and the least the
spread can be worth is $0.
Let us take a look at two extreme examples.
First lets assume that the stock goes to $100. The 50 level call that you own will be worth $50 however,
you will have to pay out $45 on the 55 level call that you are short ($50 - $45 = $5). This means that your
profit is $5 minus the $ that you paid for the spread that is $.
Another example is what would happen if the stock dropped to $5. Both of the calls will be worthless since
they will both be out of the money. Therefore your loss is $, the amount that you paid for the spread.
Remember, if you paid $ for the spread the most that you could hope to make is $. Heres the math $5
is the most that the spread can be worth, minus $ which is what you probably paid for it.
It is also possible to do $10 call spreads or $15 call spread, but those spreads will cost more to do since
the possible reward is greater however, they work pretty much the same way.
BULL SPREADS WITH PUTS
Bull spreads can also be done with puts.
If you sell the 50 55 put spread the result is identical to the example above. Lets say that the 55 put is
trading for $7 and the 50 level put is trading for $4. (Notice that the 50 level put and call are the same
price, this is true close to expiration with the stock trading at the strike.) If you sell the 55 level put and you
buy the 50 level put then you have sold the put spread for a net credit of $ to you.
Let's once again use the same extreme examples of stock movement. First with the stock trading $100
both of the puts are worthless and therefore your profit is the $ you got for selling the spread. If the stock
goes all the way down to $5 the 55 level puts are worth $50 and the 50 level puts are worth $45, meaning
the spread is worth $5.
Since you are short the spread you must pay out the $5 but since you sold the spread for $ you are really
only out $.
STRADDLES
Straddles are a fun to look, but are complicated and difficult to take advantage of. They are kind of like
chess… a day to learn but a lifetime to master. But lets discuss it nonetheless
Straddles are when you buy both the put and call of the same strike of the same month. They work when
you think that a stock is going to make a very large move EITHER to the upside or to the downside.
Let's keep using the same options that we have been talking about in the previous examples. To put on a
straddle we would have to buy the 50 level call for $4 and the 50 level put for $4. This means that we have
just paid an $8 debit for the straddle.
As you can see from the chart and as you have probably guessed, your maximum loss occurs at $50
where you loose all $8.
The breakeven points are at $58 and $4. At $58 the put is worthless and the call is worth $8. At $4, the
call is worthless and the put is worth $8. Therefore, you do not make anything unless the stock makes a 16
percent move ($8). This is a huge move. To make $8 the stock must move either to $66 or down to $4 a
percent move.
Here's the problem If the stock goes up to $66 and closes at expiration at $58 then all you do is break
even. The same is true if the stock goes to $4 and closes $4.
Let's say the stock goes to $66 and you sell the call out for $17 ($1 for premium). And then the stock goes
back down, you have locked in your profit of $ ($17-$8) and still own a free put till expiration. This is also
possible to the downside.
However, this requires that you are constantly paying attention to your stock and you will also incur
additional commissions. Diligence and patience can pay off though.
____________________________________________________________________________________
Bear strategies
If you are trying to make money on a stock that you think will go down, you may adopt a bear spread
strategy (hence the name).
This trading strategy can be accomplished with either puts or calls.
Remember a call is the right (but not the obligation) to purchase a security (stock, index, or bond) at a
specific price on or by a specific date. A put is the right (not obligation) to sell a security (stock, index, or
bond) at a specific price on or by a specific date. See Options terms.
NAKED LONG PUT
The simplest bear strategy is the naked long put. This is done by simply buying the put without any type of
hedge. This strategy is used when you think that a security is going to make a large move downward.
Let us assume that a stock is trading for $50. You may purchase a put with a strike price of 50 and about
0 days till expiration. Let us say that this put costs you $4. If the stock closes at $50 or more on expiration
then the put will expire worthless.
This represents your maximum risk. There is no way to lose more than you paid for the put. If the stock
closes at some price lower you will begin to recoup some of your investment and possibly make money.
If the stock closes $46 at expiration, you will exercise you right to sell the stock at $50 and immediately
turn around and buy the stock for $46 yielding $4. But since this profit covers your initial investment the
outcome is a net wash.
This point is important since it is your breakeven point. It is always important to know your breakeven point
PRIOR to making any options trade. By knowing this point you also know where you are loosing money but
more importantly where you are making money.
Now comes the good part. If the stock closes below $46 you will be making a net profit. Let us say the
stock closes $40 on expiration. There are two ways to take profits. The first is to exercise the right to sell
the stock at $50 and then turn around and buy it for $40 yielding a $6 profit.
But taking profits this way means you must have enough money in your account to cover the stock.
Another way to take profits is to sell the option the Friday of expiration for $10. This $10 is referred to as
the par value of the option. Math is $10 minus the $4 you paid for it yields $6 in profit. (You may actually
have to sell it for 10 1/8 or have to sell it for 7/8 depending on how volatile the stock is, or how liquid
those particular options are that day.)
$5 BEAR SPREAD
Lets talk about bear spreads. Bear spreads also take advantage of an downward movement of a stock but
are less risky than the naked long put. However, if the stock makes a very large movement to the
downside then you are also limiting your reward.
Lets assume that a stock is trading for $50. If you are bearish, you may choose to buy the 50-45 put
spread. What does this mean? This means that you are purchasing the 50 level puts and selling the 45
level puts.
Since the 50 level puts are more expensive than the 45 level puts, this spread is done for a net debit.
Remember our previous example? The 50 level puts were trading for $4. Let us say that the 45 level puts
are trading for $. This means that you can buy the 50-45 put spread for $ ($4-$).
This put spread is called a $5 put spread since the strikes of the two options involved are $5 apart. This
means that at expiration (when the options expire) the most the put spread can be worth is $5 and the
least the spread can be worth is $0.
Let us take a look at two extreme examples. First lets assume that the stock goes to $1. In this case, the
50 level put that you own will be worth $4 however, you will have to pay out $44 on the 55 level put that
you are short ($4 - $44 = $5).
This means that your profit is $5 minus the $ that you paid for the spread or $.
Our second example is if the stock is trading at $100. Both of the puts will be worthless since they will both
be out-of-the-money (see options terms). Therefore your loss is $, or the amount that you paid for the
spread.
BEAR SPREADS WITH CALLS
Bear spreads can also be done with calls.
If you sell the 4550 call spread the result is identical. Lets say that the 45 call is trading for $7 and the 50
level call is trading for $4. (Notice that the 50 level put and call are the same price, this is true close to
expiration with the stock trading at the strike.) If you sell the 45 level call and you buy the 50 level call, then
you have sold the put spread for a net credit of $ to you.
Let's once again use the same extreme examples of stock movement.
First with the stock trading $1 both of the calls are worthless and therefore your profit is the $ you got for
selling the spread. If the stock goes to $100 the 45 level calls are worth $55 and the 50 level calls are
worth $50 meaning the spread is worth $5.
Since you are short the spread you must pay out the $5 but since you sold the spread for $ you are really
only out $.
STRADDLES
Straddles are a fun to look, but are complicated and difficult to take advantage of. They are kind of like
chess… a day to learn but a lifetime to master. But lets discuss it nonetheless.
Straddles are when you buy both the put and call of the same strike of the same month. They work when
you think that a stock is going to make a very large move EITHER to the upside or to the downside.
Let's keep using the same options that we have been talking about in the previous examples. To put on a
straddle we would have to buy the 50 level call for $4 and the 50 level put for $4. This means that we have
just paid an $8 debit for the straddle.
As you can see from the chart and as you have probably guessed, your maximum loss occurs at $50
where you lose all $8.
The breakeven points are at $58 and $4. At $58 the put is worthless and the call is worth $8. At $4, the
call is worthless and the put is worth $8. Therefore, you do not make anything unless the stock makes a 16
percent move ($8). This is a huge move. To make $8 the stock must move either to $66 or down to $4 a
percent move.
Here's the problem If the stock goes up to $66 and closes at expiration at $58 then all you do is break
even. The same is true if the stock goes to $4 and closes $4.
Let's say the stock goes to $66 and you sell the call out for $17 ($1 for premium). And then the stock goes
back down, you have locked in your profit of $ ($17-$8) and still own a free put till expiration. This is also
possible to the downside.
However, this requires that you are constantly paying attention to your stock and you will also incur
additional commissions. Diligence and patience can pay off though.
____________________________________________________________________________________
Options terms
Expiration The final day of the contract that the option must be either exercised or expire worthless. For
standard listed options this is the Saturday following the third Friday of the month of expirations. Brokerage
firms require that you let them know by 0pm PST the Friday before. Most of the time in-the-money
options are automatically exercised.
In-the-money For calls this means that the strike price of the option is less than the price of the stock. For
puts this means that the strike price is greater than the price of the stock. All in-the-money options are
usually exercised on expiration automatically. Check with your brokerage firm to be sure.
Out-of-the-money For calls this means that the strike price is greater than the price of the stock. For puts
this means that the strike price is less than the price of the stock. Out-of-the-money options are almost
never exercised.
At-the-money For both puts and calls, the strike price is the same or close to the price of the stock. i.e. if
the stock is trading 56 1/, the 55 level puts and calls are referred to as the at-the-money-options.
Premium The value of the option that is not intrinsic. Out-of-the-money options are all premium. Premium
is sometimes referred to as time value. Premium generally goes down as expiration approaches. Also
referred to as juice.
Juice see Premium.
Time Value see Premium.
Theta The daily amount of decrease of options value due to advancement of time. Also referred to as
decay.
Decay See Theta.
Vertical Spread Any spread strategy that employs multiple options (all puts or all calls) in the same month.
i.e. Butterflys, bull, bear, Christmas tree, condor.
Time Spread When you buy an option in one month and sell an option to hedge in another month.
Straddle When you either by or sell a put and a call of the same strike and same month.
Strangle When you either buy or sell a put and call of different strike and the same month
American options Options that may be executed any time until expiration. This is the most common type of
option.
European options Options that may only be executed at expiration.
Types of orders
GTC Good till cancelled. The order is valid until it is either executed or it is cancelled.
Day The order is valid until the end of the trading day or it is cancelled.
AON All or none-- The entire order must be executed at once or it is not valid.
OCO One cancels the other-- When two orders are entered at the same time, only one of the orders may
be executed. As soon as one of the two is executed the other is cancelled.
IOC Immediate or cancel-- The order must be executed immediately or it is cancelled.
Limit The maximum a customer will pay to execute the order.
Market The customer will pay the best offer to execute the order irregardless of the price.
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Futures
Ever wonder how the coffee you drink in the morning actually got there? Or where the wheat that went into
your toast came from? Or what sultanate pumped the oil that was turned into the gas in your car that got
you to work so that you could make the money to buy the coffee in the first place?
Probably not, but you may want to. Some very nervy people make a lot of money every day betting
whether theres going to be more or less of those things available.
All of these things -- coffee, wheat, oil and dozens more -- are called commodities. They are the raw
materials of life. They dont have brand names, they havent been turned into anything. Theyre just the
stuff from which fortunes are made.
The way those fortunes are made is by people who buy and sell contracts to deliver a set amount of a
commodity, say cocoa from West Africa, on a set date for a set price. Those contracts are called futures.
A futures contract is a legally binding obligation for the holder of the contract to buy or sell a particular
commodity at a specific price and location at a specific date. They can change value very fast because of
changes in the weather, or politics, or peoples expectations about whats going to happen.
People who trade futures pay a lot of attention to the weather because a lot of commodities are things that
grow, such as wheat, oranges, cocoa and cotton. They also pay a lot of attention to politics because things
like wars and revolutions can affect the price of oil and natural gas and gold.
Because so many commodities are agricultural products, the Commodity Research Bureau Futures Price
Index is among the most closely watched indicators of future futures activity.
A futures contract is valuable because it lets the owner control a lot of something. One cotton contract
represents 100 bales, or 50,000 pounds of cotton, for example.
There are at least a couple of reasons why people might want to buy a futures contract.
One reason is to protect your business against fluctuations in the price of the things that you need to make
your products.
For instance If youre a baker and you need to have wheat to bake your special walnut wheat sourdough
bread next summer, and youre not sure that theres going to be enough wheat available then, you can buy
a futures contract to guarantee that youll have it.
Whether the price of wheat goes up or down, you know youll have your wheat and you know how much it
will cost. If wheat goes up between now and when the contract expires, you save money. If wheat goes
down, you lose money. But either way, you know youll have the wheat.
On the other hand, if you grew the wheat, and youre worried that all your brother and sister farmers
around the world are growing wheat too, you might buy a contract giving you the right to sell your wheat at
the current price. That way, even if prices fall, youll still get the higher price agreed to in the futures
contract.
Another reason to trade futures is to make money. The people who do this, called speculators, dont have
bakeries, or chocolate factories or anything that they need the commodities for. They just want to bet on
which way the futures contracts are going to go. Of course, if theyre wrong, they may wind up having to
figure out what to do with 50,000 bushels of cotton.
Futures contracts, like stocks, are traded on exchanges, found mostly in New York and Chicago.
They can be pretty lively places because the prices are usually set by people shouting at each other at the
top of their lungs and using hand signals to show how much they are willing to buy and sell for because its
too hard to hear.
The top ten U.S. futures exchanges are
Chicago Board of Trade grains, precious metals, financial indexes
Chicago Mercantile Exchange - livestock, currency
New York Mercantile Exchange - precious metals, natural gas, energy futures
Commodity Exchange division of the New York Mercantile Exchange - precious metals, copper, financial
indexes
Coffee, Sugar and Cocoa Exchange - food
New York Cotton Exchange - cotton, orange juice
Kansas City Board of Trade - grains, livestock, food and fiber, stock indexes
Mid America Commodity Exchange - financial futures, currency, agriculture
Minneapolis Grain Exchange - grains
Philadelphia Board of Trade - foreign currency
Naturally the trading of futures is completely above board and honest. But just in case someone like
Nelson Bunker Hunt tries to corner the market for silver, as he did, the trading at these exchanges is
monitored by the Commodity Futures Trading Commission (CFTC).
If you want to find out the latest commodity prices, check out Futures Contracts. And to get a handle on
which way the markets are moving you can look at Futures Movers every day.
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