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It’s a shame, really, that much of what is offered here – at no charge – is not taught in the public schools. Why is it that you can graduate in the top of your high school class and know next to nothing about credit card debt, adjustable-rate mortgages, or 401(k)s? Founded in 1999, the goal of... More
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  • Leveraged ETFs: Avoid These 40 Funds At All Costs
    Source Leveraged ETFs: Avoid These 40 Funds At All Costs

    by Louis Basenese, Small Cap and Special Situations Expert

    You see that ugly 268-point Dow sell off on Tuesday, followed by the 96-point drop yesterday?

    Whatever you do, don't panic and run for cover in triple-leveraged inverse ETFs.

    They may promise big returns, should the market really falter. But I'm here to tell you that they'll do anything but.

    You see, triple-leveraged ETFs (whether long or short) pack a nasty surprise. It's almost unbelievable, actually. And in this volatile market, they're hardwired for losses.

    Here's what I mean...

    The Nuts and Bolts of Leveraged ETFs

    Leveraged ETFs have been around about as long as Hannah Montana (only since 2006).

    Given such newness, let's first make sure we're all on the same page about the general mechanics of how they work...
    • Exchange-traded funds are constructed to mirror the movement of some underlying index. If the index rises 5%, the ETF tracking it is supposed to rise 5% (before expenses).
    • An inverse ETF simply moves in the opposite direction of the index it's tracking. So if the index drops 5%, the inverse ETF should rise 5%.
    • Apply leverage, however, and the movements are magnified. So if the ETF uses three-times leverage and the index falls 5%, the ETF should rise 15%.
    Sounds simple enough in theory, right?

    Too bad the reality doesn't measure up.

    Leverage? What Leverage?

    Exhibit A: From January to May 15, 2009, the Russell 1000 Financial Services Index fell by 5.9%.
    • A long ETF using three-times leverage should have dropped by 17.7% (minus 5.9 multiplied by 3 = minus 17.7%). But it didn't. It plummeted by 65.6%.
    • An inverse ETF using three-times leverage should have been up 17.7%. But it sank by 83.4%.
    Talk about not getting what you paid for.

    Pick any other period and I promise it will yield similarly confounding results. And the worst offenders will always be the ETFs using three-times leverage.

    The question is: Why?

    Two Fatal Flaws of Leveraged ETFs

    To be clear, I don't detest all ETFs.

    Their advantages include...
    • A low-cost way to achieve instant diversification and/or access markets otherwise not readily available.
    • Unlike traditional mutual funds, they also provide intraday liquidity.
    But when it comes to leveraged ETFs, those benefits are completely nullified by two fatal flaws in the set up...
    • Daily Rebalancing: Leveraged ETFs don't actually buy individual stocks. Instead, they invest in derivatives. And these derivatives require daily rebalancing in order to match the rise or fall in the index. Otherwise, the leverage ratio for the ETF will be off-kilter. As a result, leveraged ETFs can only be counted on to perform as promised for a single day.
    • Compounding Hurts: For years, we've been wooed by the power of compounding returns. If you're 18 years old and invest $2,000 per year for three years (and not a penny more after that), they say you'll end up a millionaire if you simply leave it invested and let compounding work its magic.
    But when it comes to leveraged ETFs, compounding often works against us.

    Consider an index that drops by 10% on Day 1, then rises by 10% on Day 2.

    If you started with $100, the index would be at $90 after Day 1 and $99 after Day 2. Total return: minus 1%.

    Now let's take a look at what happens with an ETF that seeks double the return of the index - i.e. uses two-times leverage. Again, we'll assume a starting value of $100...
    • Day 1: The ETF would be down 20% to $80.
    • Day 2: The value of the ETF would rise by 20% to reach an ending value of $96.
    • Total return: minus 4% when it should actually only be down by 2%.
    If we ratchet up the leverage to three times and extend the holding period, it magnifies the negative impact of compounding. Toss in some market volatility and this tracking gets even worse.

    Stocks Are Down... But Don't Try to Take Advantage With These Leveraged ETFs

    In case you didn't notice, volatility is back. The average daily change of the S&P 500 is above 1% - roughly double the historical average.

    So ignore the headlines pegging leveraged ETFs as "the ultimate hedge for individual investors." The truth is, there's never been a worse time to own them, particularly the 40 triple-leveraged ETFs currently available.

    You see, beneath a simple exterior - and the allure of a novel hedging strategy - there are considerable complexities and risks. And unless you think you can predict each of the market's upward and downward moves every day, you'll never get what you bargained for with leveraged ETFs. Heck, even if you could pull off such a feat, the transaction costs would eat your portfolio alive.

    I recommend you avoid triple-leveraged ETFs at all costs.

    Good investing,

    Louis Basenese

    Disclosure: No Position
    Jul 01 1:28 PM | Link | Comment!
  • Options Market Myths DeBunked: How to Handle Risk and Brokerages
    Source Options Market Myths DeBunked: How to Handle Risk and Brokerages

    by Karim Rahemtulla, Options Expert

    Alright, let's try to clear a few things up here...

    In response to my article last week about selling put options, I received plenty of feedback and questions - most of which brought up options risk and the ability to actually trade options and sell puts in different accounts.

    I want to tackle those issues in a public forum, shedding some light on the element of risk, plus the rules and regulations surrounding options trading and brokerages...

    How to Handle the "Options Risk Myth"

    Since options trading was introduced, the myths and misconceptions about them have been as common as the sunrise.

    But let's play some "point/counter-point..."
    • Point: Many people believe options are risky. Riskier than stocks anyway. One of the chief reasons given for that risk is that options are time-sensitive. They have expiration dates. And that's often cited as a reason not to trade them.
    • Counter-Point: Sure, stocks don't expire. But they can still decline and lose you a lot more money than options. And when you consider that most people don't hold stocks for more than a few months at a time these days, you've just made the case for trading LEAPS (long-term options). LEAPS expire in one, two, or three years - a much longer period of time than most people hold stocks.
    And after all, why tie up 100% of your capital and put it all at risk when you can achieve the same or better results with just 10% to 15% of your money at risk?

    In truth, you're always going to have some risk when investing. So no matter whether you're trading options or any other investment, if you're doing so without a specific strategy or just for pure speculation, then of course it's going to be riskier.

    When the Going Gets Tough... the Tough Get a New Broker

    Now let's deal with how you actually go about trading options. This one is simple...
    • Point: You cannot make certain options trades in your account. Your broker won't let you.
    • Counter-Point: You can trade just about any type of options strategy in any account - be it a regular brokerage account or retirement. It depends on your level of options experience and the rules that the broker sets. Yep, the broker. Not Congress or the IRS.
    There are brokers who will allow you to sell put options in your retirement account... execute covered call trades... spread trades, in addition to buying and normal options.

    It's up to you to ask your broker for permission to make these trades in your account. Brokers like Interactive Corp, Think or Swim, Scotttrade, Ameritrade and Fidelity allow some or all of the trades that I recommend in retirement and non-retirement accounts.

    The bottom-line is this: It's up to you to find the right broker for your needs. And if you don't ask your broker to allow you to trade options in your account, then you're hurting yourself. And if your broker says no, then get another broker.

    Okay, so what about good and bad trades? And would I trade BP right now? Answers below...

    The Pick of the Put-Sell Candidates

    Investment U reader Sam R. sent in this question last week:

    "I enjoy your comments. I'd appreciate if you could give examples of recent successes and failures of trades you've exercised. Will you use BP as a case for the put-sell strategy now?"
    • My answer: Sam, I trade a lot of options, for sure. Recently, when the market headed south for a few weeks, I executed a lot of put-sell trades. The companies I traded were e-Bay (Nasdaq: EBAY), Microsoft (Nasdaq: MSFT), Intel (Nasdaq: INTC), iShares FTSE/Xinhua China 25 Index (NYSE: FXI), Wal-Mart (NYSE: WMT), General Electric (NYSE: GE), JP Morgan (NYSE: JPM), Berkshire Hathaway (NYSE: BRK-B)... and BP (NYSE: BP).
    In all but one case, I sold put options on these stocks at strike prices that were 40% to 50% below the share price at the time. I don't think I'll get "put" on any of the trades (i.e. be obligated to buy the shares)... but if I do, I'll be a very happy camper.

    With regard to BP, I sold put options on the stock there, too. Specifically, I sold the October $7.50 puts for $0.50 per contract. As you know from last week's put-selling article, this allows me to buy BP at $7.50 at options expiration in October.

    Now, I don't think the shares will get there, but there's always a chance. And the only reason I was able to get $0.50 a contract at the $7.50 strike price (the latter of which was almost 70% below the share price at the time that I sold) was because of the huge uncertainty and volatility in BP shares. But I didn't sell a lot of contracts because I'm not interested in potentially owning a few thousand shares of a company like BP at that price. But I think that the odds are in my favor or I wouldn't have made the trade.

    As for losers, they occur, too. I sold some Citigroup (NYSE: C) January 2011 $5 puts, which put my cost around $4.20 at expiration. Citi is currently trading around $4, but there's plenty of time to go on the trade yet.

    For much more on the options market and how to execute the various strategies, take a look through our Investment U archives. I'm confident that you'll find they're not quite as scary, complex, or risky as some people would like you to believe.

    Good investing,

    Karim Rahemtulla

    Disclosure: No Position
    Jun 30 9:34 AM | Link | Comment!
  • This is One Tax We Need to Raise
    Source This is One Tax We Need to Raise

    by David Fessler, Energy and Infrastructure Expert

    Thursday, June 24, 2010: Issue #1288

    It's a good thing I'm not running for government office... because I'm about to propose higher taxes.

    But hear me out before you vote "no" to my article below.

    I'm not talking about taxation in general. Like every other American, I'm not in favor of higher taxes. But the type of taxes that I am in favor of are on specific things that...
    1. we think are undesirable/harmful.
    2. people use heavily.
    For example...

    ~ Federal & State Tobacco Taxes: I'm not a smoker, but there's fairly sound medical data that says smoking is detrimental to your well-being.

    Cigarette taxes vary by state. For instance, if you smoke in Missouri, you pay its government just $0.17 per pack in taxes. But Rhode Island smokers pay a hefty $3.46 per pack.

    The nationwide average tax for all states is $1.18. Add in the $1.01 the feds charge smokers to inhale and you're talking some serious money.

    ~ Alcohol: Many people enjoy beer, a decent glass of wine, or single-malt from time to time. But the feds and states tax you every time you do.

    However, there's a tax on something that we use frequently... but one that hasn't caught up with the times...

    This Road Fund is Running on Empty

    With governments scrambling for dollars and unemployment hovering near 10%, new sources of revenue are hard to come by.

    So it's more than a little surprising that the federal gasoline tax is still where it was back in 1993: 18.4 cents a gallon.

    And it's this tax that helps pay for the building and repairing of roads in the United States. Revenue from the tax is deposited into the highway trust fund.

    However, the fund took a huge dive when the recession hit. And the domino effect of the downturn hit the fund, too. Americans started driving less, as many people got laid off from their jobs and/or were generally more strapped for cash.

    As a result, current revenue from the federal gasoline tax is much too small to cover existing projects, let alone new ones. In fact, the only way the fund hasn't gone bankrupt is thanks to annual cash infusions from the government's general fund.

    In 2010, of the nearly $40 billion earmarked for spending from the highway trust fund, 50% of it will come from general fund transfers and 50% of it from the federal gasoline tax.

    And with Congress and the President reluctant to raise the gasoline tax, the funding deficit is destined to continue.

    And that's a problem, given the significant cost to build and repair roads and bridges...

    You Use It... You Pay for It

    The cost to build an interstate varies depending on a number of factors. Most fall between $1 million to $2 million per mile, but Boston is home to the most expensive road in U.S. history, at over $1 billion per mile.

    The problem with forking out such huge amounts of money isn't so much the cost itself... but who's footing the bill.

    Everyone is paying to build and fix the roads... even if they don't use them.

    However, there's a simple solution to the problem: tolls.

    Road tolls aren't a revolutionary idea. They're implemented all over the United States. Many major roads and bridges already have tolls - and most of the money collected is used to maintain them.

    In my home state, for example, we have the Pennsylvania Turnpike. People who drive on it pay for its maintenance via tolls - and it's a relatively well-maintained road.

    But last year, when the state attempted to pass legislation that would put tolls on Interstate 80 - a major east-west route through Pennsylvania - the Federal Highway Administration shot it down.

    It cited a rule, dictating that revenue from tolls can only be used to maintain that particular road. And Pennsylvania was going to use it for maintenance funds on some of its other roads - roads that I can personally say are some of the worst in the country.

    So should we increase the federal gasoline tax to help pay for new roads and improvements to existing ones? Well, it would serve two purposes...
    1. It would close the widening budget gap in the federal highway trust fund.
    2. It would make gasoline more costly. However, given that the average person won't change their routine unless a cheaper alternative appears, installing tolls on roads and bridges that don't have them would also generate essential revenue for state coffers. And people who don't drive wouldn't pay.
    Investing in Private Infrastructure

    A number of states have thrown in the towel and sold off or leased portions of roads, airports and bridges to private companies. In doing so, they receive much needed revenue and get rid of the maintenance.

    There are also a number of public companies that own and invest in infrastructure...
    • Macquarie Infrastructure Company (NYSE: MIC)
    The firm owns, operates and invests in various infrastructure businesses in the United States and is one of the larger firms in the business.

    Its energy-related division includes bulk liquid storage terminals and gas production and distribution. It also owns the largest cooling system in the United States, Thermal Chicago, which provides water to over 100 buildings to keep them cool during the summertime.
    • Macquarie Global Infrastructure Total Return Fund Inc. (NYSE: MGU)
    This is a broader way to invest in the infrastructure sector. The firm's infrastructure investments include pipelines, toll roads, electric utilities, airports, water, seaports and electric transmission lines.

    So if you wish to gain direct exposure to the infrastructure sector, consider adding a few shares of either of the Macquaries to your portfolio.

    Good investing,

    David Fessler

    Investment U... Extra Innings: Remember when President Obama was campaigning for the presidency and he talked about all the money he was going to spend on improving the U.S. infrastructure?

    After 18 months in office, his promises are ringing a little hollow. His stimulus program originally earmarked $30 billion for roads and bridges and $8 billion for high-speed rail. But talk is cheap.

    First of all, a high-speed rail network linking major metropolitan areas would cost way more than what he's set aside. It's moot anyway, since a national rail plan doesn't even exist at this point.

    Not only that, America's new infrastructure bank has had its $60 billion budget hacked down to a mere $4 billion.

    And more importantly, we've seen no new legislation to replace the transport funding law, which expired at the end of 2009. All the White House is doing is prodding Congress to extend it until the end of this year.

    Disclosure: No Positions
    Jun 24 11:52 AM | Link | Comment!
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