Monday, September 14, 2009

Derivatives aren't practical for most investors

On Mondays, we answer a question in this space from a reader. Today's question comes to us from Twitter, specifically from @CFMcG. (Thanks for the question!). The answer is from Dan Danford of the Family Investment Center. Please send us your questions - we are always happy to answer reader questions.

Question: What are some income generating strategies for a sideways market? Covered calls, cash secured equity puts?

Answer from Dan Danford: Well, looking for income is a very common pastime today. With treasuries, money market funds, and banks paying almost nothing, investors are scratching to find any return at all. But it's a tough environment for that.

The tools you mention have a place in the investment world. And there are folks on Wall Street and elsewhere who specialize in derivatives (so-called because the price is derived from an underlying stock or security). Puts and calls are actually dated options to buy or sell a particular security for a specified price. Their value rises or falls with the stock's price, and they finally expire at a specified date. Holders can exercise the option (by buying or selling the security) for profit, or let it expire worthless.

For most of us, these aren't a practical way to make much money. First, it takes a lot of volume to offset the costs. Second, most of us are amateurs and the market's Big Money investors are pros. Translation? The other side of each trade you place is likely a professional with far more research and resources than you have. And, last, there's a big element of speculation (gambling) in the decisions you make. Gambling - in my estimation - has no place in family finance.

Is this an indictment of all derivatives? No. For many large investors, they offer a type of "insurance" for their portfolio. Much like a farmer who sells his crop months in advance, the portfolio can lock in certain gains or protect against certain losses. And some professionals are willing to speculate on the other side to generate a potential profit. As I said earlier, these are sophisticated tools in the marketplace, and they play an important role. They just aren't very practical for the typical investor.

Don't try to create something from nothing. Today's rate environment is bad and that's a disaster for income investing. But, sometimes you have to take what the market give you. Most of the big mistakes I see is when investors - frustrated by dismal returns - accidentally increase their risks. People dismayed by government bonds jump to "hi-yield" corporate bonds to get a bigger coupon. But that junk only pays a higher coupon because it's riskier. In some cases, the risk is more by a huge margin. Believe me, you'll be happier to accept lower rates today than suffering the consequences of reaching for yield.

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