A bit of swap, a dabble of ETF

Due to some recent stuff going on at work, I’ve been learning a little bit more about some non-traditional types of investments – index traded funds, ETFs, options, futures, and swaps. Since I’m getting the knowledge (and knowledge is power?), I thought I’d pass it all along to you.

Most of what I know is involved with the differences between these types of funds, but I will try to give a short summary, and end with why you might care – especially if you are looking to invest a bit yourself.

Let’s start with options first. Stock options are exactly what they sound like – they are a contract giving the right, within a certain period, to buy or sell a specific number of shares of a specific stock. However, there is no obligation to buy/sell at all, and the contract can be fulfilled at any time during the agreed-upon period. There’s a formula for calculating whether or not the option risk is worth it, but I don’t really understand how this works. There are also exchange-traded options which are options on a range of funds, mimicking an ETF.

So – futures.  Basically, they’re the same as options, except you make an agreement to trade stock (or a group of stocks) on a certain day.  There’s no backing out or choosing which day to trade.   You’re making a best-guess as to what will be happening in the future market, and through this prediction and the associated risk analysis, you’re speculating that one stock or group of stocks will do well.  There’s more to it having to do with marking-to-market, which I don’t really understand, but hopefully I will sometime soon.  At the moment, I really don’t know why people would buy futures, other as a sort of balance to risk in other areas (i.e., hedging) using the sale (or short) of the future to protect and counterbalance an investment in the same industry.  Forwards are a similar exchange that are traded between individuals rather than through an exchange, increasing risk for both parties, and they are not marked to the market daily, meaning that drastic market changes don’t get calculated until the end of the agreement.

Swaps are kinda like futures and options, but they are a little different – and I’m talking strictly about equity swaps here.  The key difference is that swaps, like forwards, are traded between individuals rather than on an exchange.  This means that there is less security for the parties involved.  Also, different brokers tend to offer extremely different swaps due to their own investments.  Maybe they are looking to offload a particular index for awhile either as a hedge for themselves or to manipulate their own portfolio in some way – then they’d be much more likely to swap the rate of that index at a deep discount.  Swaps usually deal with cash flows, rather than actual trading of stocks or indices – instead, they seem to refer to the pricing of an index and a comparative interest rate over a certain period.  Again, not really sure the advantage of one of these, unless you know things I don’t.

So, lastly, indexed funds and ETFs.  I’m lumping these together since they’re basically only different in their  tradablility.  ETFs can be traded throughout the day, where indexed funds use the closing price of the previous day.  basically they are groups of funds in a range of flavor, allowing you to invest in an index or across a broad spectrum of funds.  They are similar to a mutual fund, but more flexible and more liquid (and cheaper).  You don’t pay as many fees on them, but they are also not heavily managed.  If you want to invest in barrels of apples across the board, you’re getting the bad apples as well as the rest of the bunch.  However, if a specific commodity or area starts doing really well or really badly, you can get in and out of these types of funds fast.

To conclude – indexed funds and ETFs, yay!  They rock the personal investor, especially if you are espousing a specific area of investment.   The others, pretty much stay away, until you (or I) do a little more studying up on how to use them as balances and counters to other things you might want to do.

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