Search results for: “index fund”

Forex trading is not for the faint of heart. This 24 hour-a-day market is the largest in the world yet most casual investors have not dabbled in it and for good reasons. The risks are high – even small currency moves can swing portfolio values up and down by large amounts – and the terminology is different to the general stock market.

But for the more adventurous investor who wants to add a speculative component to an existing portfolio, forex trading offers as many thrills as a rollercoaster ride and perhaps even more!

What Is Forex Trading?

Forex trading is different from stock market trading in many ways, including the hours the market is open, the trading counterparty, and the leverage involved.

You don’t need a huge amount of capital to get started in Forex trading. With a few hundred dollars, you can make a wager on whether a currency will rise or fall.

And while you don’t need a whole lot of cash to get started, FX trading is by no means a shortcut to riches.

The slow and steady path of buying the best index funds and dividend paying stocks, and not putting all your eggs in one basket are a better choice for most.

Nevertheless, the allure of forex trading is obvious. Small cash outlays can lead to quick wins (and losses). If you have come from the world of equities investing or options trading, you will need to know how forex differs.

HOW FOREX IS DIFFERENT FROM STOCK MARKET TRADING

Forex trading is different to stock trading in lots of ways:

	Stock Market	Forex Market
What Is Traded?	Shares of stock	Currency pairs
Trading Hours	9.30am – 4pm ET	24 Hours (from market open Sunday to market close Friday)
Traded With	Cash (& margin up to 4x)	Margin (up to 50x)
Where Are Trades Placed?	Central Stock Exchange	Trader To Trader

Perhaps the biggest difference between forex trading and stock trading is that currencies are traded in pairs.

This simply means that when you trade a currency, such as the U.S. dollar, you always exchange it for another currency, so trading takes place in pairs.

The major currency pairs are tied to the U.S. dollar:

Pair	Description	Label
EUR/USD	Euro/U.S. Dollar	Euro
USD/JPY	U.S. Dollar/Japanese Yen	Gopher
GBP/USD	British Pound/U.S. Dollar	Cable
USD/CHF	U.S. Dollar/Swiss Franc	Swissie

The “four majors” above make up the bulk of FX trading along with three lesser pairs below:

Pair	Description	Label
AUD/USD	Australian Dollar/U.S. Dollar	Aussie
USD/CAD	U.S. Dollar/Canadian Dollar	Loonie
NZD/USD	New Zealand Dollar/U.S. Dollar	Kiwi

How To Read Forex Quotes

Forex quotes are displayed as exchange rates. For example, Cable may be quoted as:

GBP/USD 1.30145

The currency listed first, GBP, is equal to one unit of the currency, so in this case it is one pound sterling.

The currency listed second, USD, represents how many units of that currency can be bought for one unit of the first currency.

In this example, one pound sterling buys 1.30145 U.S. dollars.

The first currency is called the “base” currency while the second currency listed is the quote currency, also called the counter.

Pair	Base	Quote or Counter
EUR/USD	Euro	U.S. Dollar
USD/JPY	U.S. Dollar	Japanese Yen
GBP/USD	Pound Sterling	U.S. Dollar
USD/CHF	U.S. Dollar	Swiss Franc
AUD/USD	Australian Dollar	U.S. Dollar
USD/CAD	U.S. Dollar	Canadian Dollar
NZD/USD	New Zealand Dollar	U.S. Dollar

When the quote rises, the base currency has gained in value. For example, if the quote changed from:

GBP/USD 1.30145  → GBP/USD 1.33157

It means that the Pound Sterling has strengthened because one pound sterling buys more U.S. dollars than it did before.

The order of the pairs is fixed, so “cable” is always listed with the pound sterling shown first as the base currency and the U.S. dollar always as the quote or counter: GBP/USD.

When you buy one currency, you are always selling another. So, if you want to buy the Pound Sterling and sell the U.S. dollar, you would buy GBP/USD.

And if you wanted to sell the Pound Sterling and buy the U.S. dollar, you would sell GBP/USD.

How To Read Forex Spreads, Bids and Asks

If you ever exchanged money at an airport, you can call yourself an FX trader. And if you are familiar with buying and selling stocks, you may have looked quizzically at the exchange rate board at the airport currency exchange kiosk. That’s because Forex quotes are displayed from the dealer’s perspective.

Bid Price	Equals how much of counter currency you can buy when selling a unit of base currency.
Ask Price	Equals how much of counter currency needed to sell one unit of base currency.
Spread	Equals difference between Ask price and Bid price

>> Travel Tip: If you ever spotted a “No commissions” sign at a foreign exchange desk at an airport, the “catch” is the exchange desk makes money from the “spread” which can be large.

Take our example above for cable and we’ll assume the following bid-ask prices.

Bid Price (GBP/USD)	Ask Price (GBP/USD)
1.30145	1.30157

So you could buy 1 pound sterling for $1.30157 (the Ask price) and you could sell 1 pound sterling for $1.30145.

You will often see Ask prices quoted as the last two digits only. For example, if you saw the following quote:

1.30145/57

It means that the Bid price is 1.30145 and the Ask price is 1.30157.

How Is Forex Traded?

Unlike companies trading on stock market exchanges, such as the New York Stock Exchange or NASDAQ, currencies are traded globally on a decentralized market.

In the stock market, shares exchange hands whereas on the Forex market, lots exchange hands.

Lot Type	Units Of Currency
Micro	1,000
Mini	10,000
Standard	100,000

Risk and reward increase when you move from micro lots to standard lots. Beginner Forex traders should be cautious about trading standard lots because the portfolio swings can be enormous.

Another difference with stock trading is that Forex pairs move by amounts called pips. Where share prices go up by pennies or points, Forex pips are used to denote when a currency pair has changed value – it’s the smallest unit by which a currency pair changes value.

And here’s where it gets tricky, a pip means something different depending on whether you are trading micro, mini or standard lots!

Lot Type	Pip
Micro	$0.10
Mini	$1
Standard	$10

In our example, the difference between the Ask price of 1.30157 and the Bid price of 1.30145 is 0.00012.

The second last digit usually represents the smallest price movement, so the spread is 1.2 pips, or $0.12 on a micro lot, $1.20 on a mini lot and $12 on a standard lot.

>> More: How To Invest In The Stock Market For Beginners

Portfolio Margin Vs Forex Leverage

When you invest in the stock market, your broker may permit you to use portfolio margin.

For example, if you have $100,000 in a brokerage account at thinkorswim you may be able to purchase as much as $200,000 in stock.

Margin is a way for you to borrow funds to buy stock, thereby amplifying gains and losses.

If a stock rises 10% and you are using 100% of your portfolio margin, you will enjoy a 20% return on your cash minus the margin interest cost.

It works in reverse too, so if a stock declines by 10% and you are using 100% of the portfolio margin made available to you then you will lose 20% of your cash plus you still must pay margin interest.

If you think that’s scary, then Forex is downright frightening!

Forex brokers typically permit you to borrow 10x, 20x and even up to 50x the cash you have in your account. So very small swings in price can lead to very large gains and losses in your account.

>> Related: How To Diversify Your Portfolio

Forex Trading Example

Now let’s take the example where you want to buy GBP/USD at 1.30145/57.

Bid Price (GBP/USD)	Ask Price (GBP/USD)
1.30145	1.30157

A micro lot of 1,000 units would cost you $1,301.45 for 1,000 pounds sterling.

A mini lot would cost you $13,014.50 for 10,000 pounds sterling and a standard lot would cost you $130,145 for 100,000 pounds sterling.

The numbers become dazzlingly high in a hurry, so to lower your cash outlay, you could look to tap into the leverage your broker offers.

For the mini lot (of $13,014.50), 10:1 leverage would mean ponying up $1,301.45.

If you used 50:1 leverage, you would only need to come up with $260.29 out of pocket.

Currencies tend not to move by much on any given day so leverage allows you partake in FX trading with less cash.

But when currencies do move, watch out! When Brexit was announced, the pound sterling crashed overnight.

Due to the amplifying factor of leverage, large currency moves in the wrong direction can wipe out an account in no time.

Currency Pegs

As you become more familiar with FX trading, you will discover that some countries employ a fixed exchange rate, called a currency peg, whereby a currency’s value is fixed to the value of another currency or a basket of currencies, or even to gold.

The idea behind a currency peg is to stabilize a currency by fixing its value to a specific ratio. Currency pegs often succeed for long time periods but market forces often win in the end, breaking the peg.

During these periods, volatility spikes and currency traders are often subject to enormous swings in account balances.

While famous examples in history of currency traders winning, such as George Soros and Jim Rogers “breaking the Bank of England” in the 1980s, few casual traders are so lucky.

So, if you are keen to try Forex trading, start with a paper trading account or virtual trading demo account, and above all, be wary of using excess leverage.

Have you traded forex? What were the pros and cons. Share your trading stories with us, we would love to hear from you.

>> Discover How To Research Stocks

>> How Did Warren Buffett Get So Rich?

>> What Are The Top 5 Investing Lessons?

No doubt, you have heard the old saying:

“Don’t put all your eggs in one basket”

You know it is a high stakes game when you put all your eggs, meaning all your hard-earned savings, into a single basket, or asset class. And still the temptation to ignore the sage advice remains.

Financial news networks blast headlines about stocks to buy now, and the urge to make a trade increases as the feeling of missing out on a money-making opportunity grows.

But when stock markets crash, having all your eggs in one basket can lead to financial ruin. It’s one thing to get a little too greedy when the economic climate is rosy but when it is cloudy, it is best to have your eggs spread among many baskets.

Smart Asset Allocation:
Which Eggs Go Into Which Baskets?

Asset allocation is the process of choosing which eggs to place into which baskets.

But how much savings should you allocate to each category? Should you choose stocks or bonds? Commodities or money market funds?

Depending on your risk profile, time horizon to retirement and living expenses, your allocation will favor a higher percentage of equities or bonds.

EQUITIES ASSET CLASS

Generally, younger investors with longer time horizons put more eggs into the equities basket while retirees seeking income over growth favor a higher percentage of bonds and money market funds.

A rule of thumb is to have at least a 50:50 split of bonds and stocks when approaching retirement. You want to avoid a situation where you are heavily invested in equities and retiring just when the market has peaked and may be on the verge of a big fall.

As tempting as it may be to find the next Facebook or Twitter, keeping some powder dry  by allocating to income-generating investments, such as bonds, is prudent.

Within the equities basket, consider diversifying your stock holdings by purchasing the best index funds rather than holding a concentrated portfolio of just a handful of stocks.

The odd gamble from time to time with a small amount of disposable money may not break the bank, but it would certainly be a mistake as a long term strategy.

If you are tempted to trade a concentrated portfolio of fewer stocks, explore ways to generate income from covered calls and limit risk by applying married put options strategies.

>> Related: Find Out How To Invest In The Market For Beginners

BONDS ASSET CLASS

When you buy stocks, your portfolio will rise and fall based on the combined performance of the stocks you hold, which in turn is related to the profitability of the companies in your portfolio.

Bonds are an attractive way to generate a predictable income because they pay a predictable yield at regular intervals. For retirees depending on a fixed income to pay the bills day-to-day, this feature makes bonds more attractive than stocks.

Within the bonds asset class, you can select among three categories:

• Government bonds
• Municipal bonds
• Corporate bonds

Government bonds are widely believed to be the safest asset class because the likelihood of the U.S. government defaulting on its debt is perceived to be low.

Still, bond investing is not without risks. Some countries have defaulted on their debt – Argentina is the poster child for frequent sovereign debt defaults.

Municipal bonds are the next least risky bet and are attractive because interest earned on munis are often exempt from state taxes when you live in the state that issues them.

Municipals are not without some risk either so, before diving in, make sure the state’s finances are in good shape and no pension crisis is looming as has been the case with states like Illinois.

It is best to diversify your bond holdings also by spreading risk among government, municipal and corporate bonds.

You can often find corporate bonds paying reasonable yields that have low default risk, like those issued by solid companies such as Apple.

>> Investing Tip: How Does A Fed Rate Hike Affect Your Bond Investments?

CASH ASSET CLASS

Money market funds fall under the umbrella of the Cash asset class. Along with savings accounts and certificates of deposit, these are among the most conservative places to store your money, but equally they tend to pay the lowest yields.

Cash is useful to have on hand when you need to put a downpayment on a home or you need to pay for life events, such as weddings, as well as college tuition costs and so on. But keeping all your eggs in a cash basket won’t do you favors over the long-term to grow your wealth.

The rate of interest you can earn is so low that inflation often exceeds your savings rate, meaning your purchasing power diminishes over time.

Just think back to the cost of a bag of chips from your childhood and compare its cost today. Inflation creeps up slowly but steadily and is a powerful force that impacts nominal wealth.

The rule of thumb is that every 20 years or so, purchasing power is cut in half. So, the dollars you need to live a good life now will need to double to enjoy a similar lifestyle then.

>> Related: Retirement Planning For Dummies

COMMODITIES ASSET CLASS

Commodities are well known as a volatile asset class, so they generally form only a small portion of most investors’ portfolios. Historically, the price of oil, gold, precious metals and other commodities have been known to soar and plummet quickly as the winds of economic fortune change direction.

How Should You Allocate
Savings Across Asset Classes?

The first step in figuring out how to allocate your savings to various asset classes is to calculate how much you need to save.

Once you have an idea of how much you need to save each month to reach retirement, you can start to think about how to invest your savings across asset classes. Which eggs should you put in which baskets? And how many eggs should go into each basket?

HANDS OFF INVESTING

The simplest way of allocating your money is to sign up with a robo advisor who will ask you some questions relating to your age, risk tolerance, financial goals, and lifestyle expenditures.

Leading robo advisors, such as Betterment and Wealthfront, automatically invest your money across various asset classes in alignment with your risk and reward objectives. You don’t have to lift a finger.

They automatically perform tax loss harvesting on your portfolio to minimize the tax impact from capital gains. And many have financial tools and calculators to help you reach retirement comfortably.

>> Find Low Fee Robo Advisors

HANDS ON INVESTING

If you choose to take charge of your own investing in a brokerage account or retirement account, the first step will be to set a time horizon.

When do you realistically believe retirement is possible?

Does retirement mean owning a nice home, having a family, and living off of a sizeable nest-egg? If you don’t yet own a home, take a candid look at how long it will take to buy one.

A study by ApartmentList showed how expectations and reality are starkly different among Millennials with respect to how much savings are needed to buy a home.

When you take an honest look at the numbers, the length of time needed to save for a new home is often longer than expected.

Many millennials will need more than a decade to save the 20% needed for a home downpayment.

If you already own a home, and are supporting a family, squirreling away a monthly amount for retirement is crucial to realizing your financial goals.

If you have time on your side, you can ride out the market swings and can look to a higher percentage of equities.

If you’re in your early twenties, thirties, forties, fifties or beyond how much should you invest in equities?

This simple formula is just a rule of thumb but it’s a helpful one.

100 – Your Age = How Much To Invest In Equities

The balance you should invest in bonds.

So if you are 25, then an allocation of 75% equities and 25% bonds would be appropriate.

A 65 year old retiree should look to a balance of 35% equities and 65% bonds.

More aggressive investors may prefer to use a modified version of the formula, so that:

110 – Your Age = How Much To Invest In Equities

A 35 year old would then invest 75% in equities and 25% in bonds.

With your equity and bond percentage allocation selected, you might be wondering how much to allocate to cash.

A good rule of thumb is to have at least six months of cash on hand. So, if your monthly expenses are $4,000 then you probably want around $50,000 on hand to dip into in case of emergency.

How have you spread your money across asset classes? Are you on track to hit your retirement goals? Share your investing experiences with us, we would love to hear from you in the comments below.

>> Find Out Why Retiring Baby Boomers Are A Big Deal

>> Discover How To Pick The Best Robo Advisor

>> Who Are The Top 5 Best Robo Advisor CEOs

When you invest with a traditional financial advisor or a robo advisor, your money will generally be allocated to a combination of stocks and bonds to form a balanced portfolio.

The division of stocks versus bonds depends on all sorts of factors including your time horizon to retirement, how much you spend, your risk profile and so on. The younger you are and the more money you have, the higher your allocation to bonds generally.

The idea behind putting more of your nest egg into bonds than stocks as you close in on retirement is that bonds are regarded as a safer investment than stocks.

But bond investing is not without risks and you should know what you are buying before investing your hard earned savings.

How Bond Investing Works

For most of your life, you have probably been on the side of the fence where you borrow money to pay for a car, a home, or perhaps your tuition expenses. With each loan you may have taken out, you committed to a repayment period at a certain interest rate, whether variable or fixed.

When you buy bonds, you are on the other side of the fence. Instead of paying back interest to a lender, you now become the lender and earn interest. It is the responsibility of the borrower to fulfill their obligations to you over a specific time period and pay your principal back at an agreed upon interest rate.

When you step into the shoes of the lender, your mindset flips from wanting the interest rate to be as low as possible to wanting it to be as high as possible while keeping the risk low. So, you want your borrower to be creditworthy and the risk of default to be minimal.

If you were to think about the safest borrower to whom you could lend, the U.S. government would probably come top of your list. U.S. government debt is considered to be as safe as it gets.

The ranking of the safest bonds in order are generally regarded to be as follows:

1. Government bonds
2. Municipal bonds
3. Corporate bonds

GOVERNMENT BONDS

Government bonds fall into three categories:

Bond Type	Maturity
Short-term Treasury Bills	Up to 1 Year
Intermediate-term Treasury Notes	2-10 Years
Long-term Treasury Bonds	10+ Years

When your goal is to save for the short-term, Treasury bills may be appropriate but the interest earned on them is generally low. For example, if you needed to park money that you had slated for the down payment of a home into an interest-earning account for a short time period before completing escrow, Treasury bills may be a good option.

If you have a longer term time horizon, Treasury notes and bonds with longer maturities may be a better fit for your portfolio, and will pay a higher yield.

MUNICIPAL BONDS

Municipal bonds are issued by city and state governments. If you live in a state that issues bonds, interest payments earned are often exempt from state taxes.

These bonds are used to finance city and state project spending, such as the construction of schools, roads, dams, and bridges.

CORPORATE BONDS

Corporate bonds generally pay the highest yields but also have higher risk than government bonds and munis.

There are exceptions to the rule from time to time. Very large companies, such as Apple, with large amounts of cash reserves and highly successful business models can often issue debt at very low interest rates because the likelihood that they will default is low.

In rare cases, corporate bond yields can be so low that the interest payments owed by sovereign nations are higher!

>> More: View Stocks To Buy Now

PRIMARY RISKS OF BOND INVESTING

Default Risk: The primary risk when investing in bonds is default risk. When the borrower fails to meet or honor its obligations to pay back the principal it received when the bond was issued plus interest payments, the lender risks not receiving their loaned money and interest due.

Interest Rate Risk: When interest rates rise, bond prices fall. The reason for the decline is that new bonds issued on the market pay higher interest rates so the old bonds are less attractive to bond investors.

Rising interest rates are bad when you own bonds because their prices fall, but falling interest rates have their own drawbacks. If you own a bond paying a high interest rate and the Federal Reserve lowers interest rates then when the bond comes to maturity, you will be unable to earn the same high interest rate you had been enjoying because market yields for equivalent bonds are lower.

For this reason, when interest rates are very high as they were in the 1980s, locking in a high long-term government bond interest payment is a smart investment strategy. Imagine locking in a 15% yield for 30 years – guaranteed by the full faith and credit of the U.S. government!

Be Wary Of High Yield Bonds

The risks of bond investing are not confined to default risk and interest rate risk. Sometimes, the most attractive bond on the surface is the one to shy away from. Novice bond investors often swoon when they come across a high yield bond that pays a high interest rate.

But these bonds often have high yields for a reason – and it’s not usually a good one! Remember higher interest payments reflect higher risk. So, when yields are high, it means that risks to investors are commensurately high.

If in doubt, look to the ratings assigned to bonds by major ratings agencies, such as Moody’s or Standard and Poor’s.

Bonds rated by Standard and Poor’s above BBB or those rated by Moody’s above Baa are generally regarded as appropriate for consideration by casual investors.

There are no guarantees however that ratings agencies will hit the nail on the head when it comes to evaluating bonds properly. During the 2007-09 stock market crash, securitized loans were notoriously difficult to analyze and even major ratings agencies found it difficult to properly ascertain creditworthiness and default risk of bond issuers.

So, the takeaway is: if in doubt, steer clear. Better to stick with a lower yield bond than a high yield bond that keeps you awake at night.

>> More: Retirement Planning For Dummies

How To Buy Bonds In
A Retirement Portfolio

When you buy stocks and bonds, you don’t need to pour over research reports to pick the very best ones. Exchange-traded funds and index funds offer a way for stock and bond investors to diversify risk across stock and bond holdings.

If you work for an employer who has a 401(k) plan set up, you will be restricted in the choices of funds available. The bond funds made available to you will generally include a diverse group of bonds of varying maturities.

If you are curious how bond funds in your retirement accounts stack up, Blooom offers you an easy way to evaluate your 401(k) holdings and even offers to manage your allocation automatically so it is optimized.

HIGH INTEREST RATE ENVIRONMENTS

If you are selecting bond investments by yourself in a brokerage or IRA account when interest rates are high, purchasing longer maturity bonds is a smart move. You get to lock in a high yield for a long duration even if interest rates decline.

LOW INTEREST RATE ENVIRONMENTS

Conversely, when interest rates are low, it is better to choose short-term and intermediate-term bonds because rising interest rates will cause bond prices to fall, which could hurt your portfolio value.

Regardless of the maturity of the bond you purchase, you don’t need to hold it all the way through to maturity. So, if interest rates are low but you expect them to rise, you can exit your bond position on the secondary market and find another bond paying a higher yield when rates rise.

If you are buying individual bonds but new to the market, err on the side of caution. You may wish to consider government Treasury bills and notes before buying municipal bonds unless you are confident your city and state are not in financial distress as Illinois has been with its pension crisis.

What Taxes Do Bond Investors Pay?

When it comes to investing, what matters most is not your gross portfolio return but your after-tax return – the amount you actually get to keep after paying Uncle Sam.

Smart bond investing allocates tax-efficient bonds to taxable accounts and tax-inefficient bonds to tax-deferred accounts.

The golden rule for new bond investors is: do not buy municipal bonds in a tax-deferred account, such as IRA or 401(k). Tax-deferred accounts are by definition not taxed, so there is no reason to buy munis, which are generally exempt from state tax if you live in the state.

Conversely, tax-inefficient bonds are bonds that require you to pay taxes on interest earned. Corporate bonds fall into this category and so, to maximize your after-tax returns, it is best to buy these bonds in a tax-deferred account, such as an IRA.

Bond Type	Tax Status	Best Account
Municipal Bonds	Tax-efficient	Taxable
Corporate Bonds	Tax-inefficient	Tax-deferred

High net worth individuals may also favor municipal bonds because of their tax-exempt status.

>> More: Retirement Planning For Dummies

Your Bond Investing Takeaway

When you buy bonds, examine the key factors that can affect your returns:

• Taxes
• Interest rates
• Creditworthiness
• Maturities

As you get closer to retirement, a higher portion of your portfolio should generally be allocated to bonds over stocks.

The combination of equities and bonds forms a balanced portfolio that reduces the volatility of holding equities alone so you can sleep more peacefully at night without worrying so much about the effects of a stock market crash on your portfolio.

What bonds have you found to be good investments? Share your investment experiences in the comments below, we love hearing from you.

>> Read The 7 Deadly Causes Of The Illinois Pension Crisis

>> What Are The Best Index Funds?

>> Discover Ways To Make Money Trading Options

When you borrow money to buy a home, a car, or to pay for tuition expenses, your monthly repayment amount may be affected when interest rates go up.

Even if you have no loans but simply own a portfolio of stocks and bonds, interest rate hikes can affect your net worth.

And if you have banks savings accounts or certificates of deposit, rate hikes may positively affect the interest you earn monthly.

What Is A Fed Rate Hike?

When interest rates rise or fall, it is the Federal Reserve, the central bank of the U.S., that controls their level.

The idea behind the Federal Reserve System when it was established in 1913 was to create central control of the monetary system in order to avoid future crises following the panic of 1907.

When the economy is weak, the Fed will lower rates and when the economy is strong, the Fed hikes rates to slow it down.

When interest rates are low, companies borrow more because they believe they can generate higher returns on capital from investing borrowed money in their businesses than they pay in interest costs.

Low interest rates generally stimulate individuals to borrow more too, which results in spikes in purchases of homes, autos, and other consumer goods.

The investment by companies and spending by consumers when interest rates are low stimulates economic growth and expansion, which the Federal Reserve board of governors monitors carefully.

If the economy is perceived to be overheating, the Fed will look to cool it down by increasing borrowing costs through a Fed rate hike, which increases the federal funds rate – the interest rate that banks and credit unions lend reserve balances to each other overnight.

Source: Board of Governors of The Federal Reserve System

>> Related: How To Invest In The Stock Market For Beginners

How Does A Fed Rate Hike
Affect Your Portfolio?

The general consensus is that rising interest rates are bad for your portfolio. A common stock market saying is:

“Don’t fight the Fed”

It is widely believed that this means when a Fed rate hike occurs, it is best to adopt a cautious economic outlook because the Fed is trying to slow the economy down.

Federal Funds Rate History and Recessions

Source: St. Louis Fed

The general rule of thumb is that the stock market rises when interest rates fall and the stock market falls when interest rates rise.

But research studies have shown that many exceptions to this rule have occurred over the course of history. Sometimes, the stock market has fallen when interest rates have fallen and sometimes the stock market has risen when interest rates have risen.

In the short-term, the generally accepted belief that rising interest rates is bad for the stock market often causes jitters. But over the intermediate term, different sectors react differently.

For example, foreign stocks will react not only to interest rate hikes but also to currency exchange rate swings. Dividend paying stocks may react differently to small cap stocks, and blue chips may react differently to index funds.

>> View Stocks To Buy Now

Should I Change My Asset Allocation After A Fed Rate Hike?

History is filled with examples of the market moving in one direction short-term only to reverse the opposite way in the intermediate term, so it is generally wise not to react impulsively to any immediate stock market movements after a Fed rate hike.

Keep Focused On The Long Term

Stock market volatility can trigger investors to react irrationally short-term. Fear of loss causes many investors to panic and sell their holdings when staying the course and holding for the long-term has historically may be a more profitable path.

To highlight the power of a buy-and-hold strategy, think about two portfolios that are growing at 15% annually for 60 years. Both portfolios are subject to taxation of 30% for short-term gains and 20% for long-term capital gains.

At the end of the 60 year period, a buy-and-hold investor who doesn’t sell along the way makes over 6x more than an investor who sells every year to “bank” the 15% annual gains.

That 6x differential may not sound like a big difference until you perform the calculations and discover that the investor selling annually to lock in gains turns $1,000 into $615,757 whereas the buy-and-hold investor, who only sells at the end of the 60 year period, turns the same $1,000 into $3,812,172.

Take Advantage When The Stock Market Is Cheap

If you have a longer time horizon, and stock market volatility is not a concern, a stock market crash could be an opportunity to buy stocks at a discount.

As billionaire investor Warren Buffett has said in the past, if you were to walk into a department store and see Sale signs posted, you would view them positively as an opportunity to buy goods for less.

When the stock market goes “on sale”, investors tend to react oppositely and often panic. But a patient investor with a long time horizon can use the opportunity to buy value stocks at even better prices for even greater long term gains.

Change Bonds Vs Equities vs Cash Allocation

The “sleep test” is an anecdotal personal benchmark you can use if you are concerned about stock market volatility.

If you are finding it hard to sleep peacefully because you are concerned about losing value in your retirement accounts, such as 401(k)s or Roth IRAs, then switching your allocation up to favor more bonds is a way to reduce your overall portfolio’s fluctuations.

Bonds generally decline in price when interest rates rise but bonds are generally regarded as a less volatile asset class than equities, so even if bond prices decline the amount may be less than the amount equities fall by.

If you need the money to pay for living expenses in the next 5-10 years, and the swings in bond prices also feel scary, then allocating to cash is not a bad idea. The returns will be lower than equities or bonds, but so too will the risks be lower.

>> What Are The Best Stocks To Buy?

How Does A Fed Rate Hike Affect My Mortgage?

FIXED RATE MORTGAGE

If you have a fixed rate mortgage, you don’t have to worry about a Fed rate hike because your mortgage payment and rate won’t change.

VARIABLE RATE MORTGAGE

A nice feature of variable rate mortgages is that the interest rate initially offered to home buyers is lower than it is for fixed rate mortgages, but the downside is when interest rates rise, monthly payments goes up and could exceed the original fixed rate level offered.

It may not seem like something to be concerned about if the interest you were charged increases by 1% from say 4% to 5%, but that corresponds to a 25% increase!

Variable rate mortgage holders often enjoy teaser rates for fixed periods of time, but when they expire, the new payment can come as a shock – especially if interest rates have increased in the intervening period.

If you expect rates to increase and you have a variable rate mortgage, consider switching to a fixed rate mortgage.

HOME EQUITY LINE OF CREDIT

Any increases in short-term interest rates are passed on directly to borrowers who have home equity lines of credit.

Like variable rate mortgage holders, home equity lines of credit borrowers should evaluate the costs and benefits of converting mortgage balances to fixed rate home equity loans when Fed rate hikes are expected.

>> How Much Does The Top 1% Make?

How Does A Fed Rate Hike Affect My Bank Savings Accounts?

When a Fed rate hike occurs, bank savings accounts and certificates of deposit generally pay more interest.

Unlike a home equity line of credit which is affected right away by a Fed rate hike, a savings account doesn’t necessarily pay out more to depositors when interest rates rise.

Banks will happily charge you higher rates right away when you borrow from them but they won’t pay you right away when you deposit savings with them.

Eventually marketplace competition forces banks to pay depositors more when rivals increase rates on depositor savings accounts, but don’t hold your breath waiting for bigger monthly payouts.

If you have squirreled away some of your nest-egg in certificates of deposit (CDs), you will have a similar experience as to the one you have in your savings account – rates will generally rise over time but not by a lot.

>> Money Tip: Online banks with lower fixed costs generally pay higher CD rates than brick-and-mortar banks do.

How Does A Fed Rate Hike Affect My Credit Card Payments?

Credit card rates will almost certainly increase when a Fed rate hike takes place. The Fed controls the prime rate, which is the benchmark rate that credit card issuers use to set their rates.

Credit card companies will inform you when your credit card APR is due to increase, and typically provide you with about 6 weeks notice.

>> Watch out: Credit card debt can increase quickly because of the power of compounding interest, so where possible try to lower it by switching to a 0% interest credit card.

The business of charging interest on credit card debt is so lucrative that billionaire investors, such as Warren Buffett, hold shares in established credit card companies, including American Express.

 

 

As shareholders of credit card companies, they benefit from consumer repayments of credit card debt, and you can too.

If you own shares of companies like Visa or Mastercard in your investment portfolio, you get to stake a claim of ownership that enables you to benefit – as opposed to suffer from – interest rate hikes passed on to consumers.

While credit card companies are directly affected by rising interest rates, other companies, such as Facebook and Twitter, may only be indirectly affected.

If you are worried about holding shares in a company when a Fed rate hike is expected, you can look to protect your downside risk by hedging your portfolio with a married put options strategy.

Options trading platforms, such as TastyWorks and thinkorswim, make it easy to execute orders to buy married puts that protect stock you own. Plus, if you expect share prices will decline much further, you can even look to short stock.

Have you made any changes to your savings, investment or credit card accounts when interest rates changed? Share your financial tips with us below. We would love to hear from you.

>> How To Rollover A 401(k) To An IRA

>> How To Diversify Intelligently

>> How To Invest Money Wisely

If you ever had the sinking feeling of betting the market would go up only to see it fall soon after you place your trade then the straddle options strategy might be what you need.

A straddle is designed to make money no matter which way the market moves. If it rises, you can earn a profit. And if it falls, you can make money too.

The key to making money with the options straddle is for the security you are betting on to move by a big amount in a small time frame.

When volatility does occur, the options straddle can be highly lucrative. But if the underlying security you place a straddle on doesn’t move much, your options position can fall underwater.

How To Capitalize On Volatility:
The Options Straddle

Many casual investors make money when markets rise by passively investing in index funds over the long term.

But how do you trade when you know a company is reporting earnings soon and you expect the share price could be volatile?

How do you profit when a pharmaceutical company is due announce whether a new blockbuster drug has been approved or denied by the FDA?

Are there ways to make money when you expect significant share price movement in a stock based on a new product release, a change in management or some other fundamental reason?

Markets move up and down so why limit yourself to making money only when stocks rise?

While some options trading strategies, such as the covered call, make money regularly for shareholders, others limit risk, such as the married put. But the options straddle is different because it can make money whether share prices rise or fall.

The secret to making money with the straddle is for the share price to rise or fall by a large amount. If it doesn’t, the straddle can lose money in a hurry.

>> Related: How To Trade Options

Options Straddle Basics

When you place a straddle, you will be buying both call and put options.

Buying call options is a bullish strategy, betting on share prices rising. While buying put options is a bearish bet that prices will fall.

Type	Buy	Sell
Call	Bullish	Bearish
Put	Bearish	Bullish

By purchasing both call and put options, you can make money when the underlying share price rises or falls.

Seems like an easy way to make money? After all, share prices go up or down, so it seems like you can make money no matter which way they go?

Well, not so fast.

It is true that you can make money if the stock price rises or falls, but a better way to think about this options strategy is that the stock price needs to soar or plummet.

To profit from an options straddle, volatility is needed. It is generally not sufficient for the share price of the stock you place the straddle on to meander higher or lower. It needs to move higher with some gusto or collapse lower in a hurry.

The reason sharp price movement needs to happen fast is that looming up ahead is expiration, the date when the call and put options cease trading.

And each day the options lose a little bit of value due to time-decay (which you can learn more about in this options trading basics article).

When you sell options, you can make money from this slow decay in options value due to time decay. But when you buy options, time decay becomes your enemy as it erodes value a little every day until options expiration.

How To Buy An Options Straddle

The way to structure an options straddle is to buy both call and put options at the same strike price for the same expiration month.

Imagine a stock was trading at $100 per share, you would buy the strike 100 call and strike 100 put options for the same expiration month.

When you buy both call and put options to form a straddle, the options strategy is called a long straddle.

(It is possible to sell both call and put options at the same strike price for the same expiration month to create a short straddle. The risk in a short straddle is high so we won’t explore it further).

The cost of the long straddle is the risk in the trade. It is the most you can lose, no matter which way the underlying stock moves.

So, if you paid $3 for the call option and $3 for the put option, the most you could lose is $6 per share.

Options are traded in contracts so if you purchase 1 call contract and 1 put contract whereby a contract corresponds to 100 shares, then the total cost would be $300 to buy the call and $300 to buy the put, for a total cost of $600.

When you place the trade, you will pay commissions so the total cost would be $600 plus commissions costs.

At most brokers, you will also need to pay commissions when you exit the trade, or sell the call and put options. But as competition has increased among brokers, so too have commissions costs declined. And these days, you can close out long options without paying a dime in commissions costs at TastyWorks.

What Is The Risk and Reward
Trading Options Straddles?

OPTIONS STRADDLE RISK

The cost of buying a straddle is also equal to the risk, or the most you can lose.

Cost Basis = Purchase Price of Call Option + Purchase Price of Put Option

Cost Basis = $3 + $3 = $6 = Maximum Risk

But what are the conditions that can lead to a trading loss when you own a long straddle?

The short answer is when volatility doesn’t materialize, you can end up underwater in a hurry trading options straddles.

Both call and put options will have no value if the stock stays at $100 through to the expiration date.

So you would end up losing $3 on the call option and $3 on the put option for a maximum loss of $6.

This is the worst case scenario.

If the stock ended up at $101 on the expiration date, the call would have $1 of value so it would show a $2 loss, and the put would lose all $3.

Similarly, if the stock declined to $98 by expiration, the put would have $2 of value while the call would expire worthless.

OPTIONS STRADDLE PROFIT

You can quickly see that no matter which way the stock moves, one of the options will be worth zero at expiration – guaranteed!

As a result, the share price must move a lot either up or down for the straddle to profit.

In this example, you paid $6 to buy the straddle so you need the stock to move $6 above the call strike price of $100 or $6 below the put strike price of $100 in order to end up at breakeven.

Any share price movement greater than $6 will result in a profit.

A $6 share price movement corresponds to a 6% movement in the share price of the $100 stock.

It is common for stocks to move by 6% over the course of a few months or a year but it is not an insignificant movement. And remember, the share price must move by at least 6% to begin profiting.

Once the share price moves by more than 6%, each additional $1 is gravy when it comes to making money.

If the share price rose to $115, the call would be worth $15 at expiration, so the profit would be $15 minus the cost of the straddle, $6, which is $9 per share.

Buying 1 call option and 1 put option for $600 would then lead to a $1,500 payout, and $900 of profit – a 150% return!

It is these high percentage payouts that make straddles so alluring to options traders.

The higher the stock goes, the more money you can make – with theoretically no limits.

You can see visually how the straddle performs in this risk graph.

Image Credit: Wikipedia

If the stock were to fall, a limit does exist to your profit potential because the stock cannot fall below zero. Still, you can make money on the put option with each dollar the share price declines all the way to zero.

When Should You Trade
A Long Straddle?

A long straddle is inherently a speculative bet on future volatility.

The share price will need to move a lot in order to make money but the uncertainty is high that it will do so.

As a result, the straddle is not part of a core investment strategy for most casual traders but should be thought of more akin to a gamble that could pay off in a big way or lose out in a big way.

If you cannot afford to lose the money it costs you to enter the straddle, then think twice about entering it. It is best to consult with a financial advisor or pass on the trade if you have any doubts at all.

If the prospect of losing all your money on such a speculative options trading strategy seems perilously concerning, a passive investing approach might be a better fit for your risk tolerance and financial goals.

Many robo advisors offer a hands off, automated investing approach so you don’t have to “get your hands dirty” so to speak.

For example, one of the larger robo advisors, Betterment, will automatically invest your money on your behalf, conduct tax loss harvesting to minimize your tax liability, and help you set financial goals to reach retirement.

Which Stocks Work Best For Straddles?

Stocks that work best for straddles are ones that tend to move a lot after big news events.

But how do you know when a big news event is occurring or whether it will lead to substantial share price movement?

Perhaps the most predictable news event that leads to volatility is a company’s quarterly earnings announcement.

If a stock has a history of moving up or down a lot over time when quarterly earnings are announced, you could reasonably assume that volatility will continue in the future.

But there are no guarantees. It is possible a share price that historically has displayed lots of volatility after earnings announcements displays almost no volatility after you place a straddle.

It is a speculative options strategy after all, so you must be prepared for lots of price movement or no movement at all.

After earnings, the implied volatility will seep away from the options and they will lose value quickly, especially if the stock doesn’t move by much.

Certain stocks like Twitter, Autozone and Facebook have historically been volatile but there are no guarantees they will remain so.

And there’s another factor to consider…

How To Decide Whether
To Buy A Straddle

It is not enough to simply buy a straddle on a volatile stock and hope for the best.

The key to making money with a straddle is not only that the share price moves a lot but also that it moves by more than the cost of the straddle.

So if our $100 stock historically had a history of moving $10 after earnings, and it cost us $6 to buy the straddle, then another $10 movement would lead to a profitable outcome.

But if the stock historically moves by 5%, which is still a big move following a single news announcement, the size of the move is still not enough to justify buying the straddle – because it costs $6 to buy the straddle, which requires a 6% movement in the share price to break-even in the example above.

So you need to look not only at how volatile the stock tends to be but also make sure the amount of volatility exceeds the cost of the straddle.

How do you trade stock market volatility? Share your trading stories with us below. We would love to hear from you.

>> Get Started With Options Trading For Dummies

>> Is Facebook Stock A Buy Or Sell?

>> Discover The Best Online Options Trading Brokers