The good news: The market’s most exotic tools are now available to everyday investors. And yes, that’s also the bad news.
Markets are complex to start with, much more so than slick trading apps can make them seem. The click of a “buy” button triggers a sequence of near-instantaneous algorithms, behind which billion-dollar intermediaries execute your trade then deliver shares into your account. Add, say, a derivative to that already complex equation, and it’s enough to make the mind reel.
Michael Resnick, a financial adviser at GCG Financial, traded options for 17 years at the Chicago Board Options Exchange (CBOE), then the Chicago Mercantile Exchange, before managing money for individuals. He’s seen even the most talented traders suffer astronomical losses for the chance at a tiny upside. “There were some incredibly talented options traders who, for trying to squeeze out a little bit of extra return, didn’t realize how much risk they were taking,” he says.
All this to say, investing is inherently risky, but it can become catastrophically risky for newcomers who aren’t sure what they’re doing.
Here’s a look at four of the more complicated parts of the market, how they work, and what’s at risk.
What are they? Cryptocurrencies likely don’t need much of an introduction at this point: They’re digital assets that can be bought or sold, like Bitcoin, Ether, or even Dogecoin. They can be treated as an investment or a commodity. They’re built on top of blockchain technology, which is decentralized, and they don’t rely upon a government or institutional authority to manage them.
Bitcoin was the first cryptocurrency, created in 2009. As the first digital asset, it’s also the most well-known and widely used. Ethereum, the blockchain behind cryptocurrency Ether, hosts a great deal of what’s called “decentralized finance,” or DeFi, which is where some of the most innovative changes are happening in the financial industry.
There are more than 6,500 different cryptocurrencies—quite a lot to choose from.
When are they appropriate to use? Some investors hold Bitcoin, Ether, or other digital assets as a way to diversify their portfolio and hedge against risk in the equity market—as crypto operates entirely independently from the rest of the market. Risk of inflation in traditional currencies, in particular, may spark interest in holding crypto as part of an asset allocation. Owing to their recent surge in value, digital currencies have also become known as a method to boost returns, especially when other parts of the market are offering slim yields as a result of low interest rates.
Phil Ratcliff, a financial adviser at Rebel Financial, says it may make sense for investors to allocate somewhere between 1% and 5% of the value of their portfolio in crypto, although it’s going to depend on risk tolerance, as well as every person’s individual financial situation.
What are the costs? Investing in crypto can be expensive, as it’s still early days in the space. Fees at crypto exchanges can reach upwards of 2% or 3% of invested assets. Grayscale Bitcoin Trust, a fund that offers exposure to Bitcoin, charges investors an expense ratio of 2%.
However, overall costs to hold crypto will likely go down in future, particularly as more companies start competing in the space, according to Amy Wu, partner at Lightspeed Venture Partners, which invests in crypto companies. “At some point, the retail investor is going to get wise to how many fees they’re paying, and they’re going to start going to the platform that [will] charge them way less because the product has become commoditized,” she says.
How to get started: Crypto can be difficult to understand at first—particularly because of its terminology, which is unfamiliar to the everyday person. “It is a very nerdy engineering-filled space full of technical jargon,” Wu says. The easiest way to understand it, according to Wu, is to start small and explore the market.
There are a host of different ways to buy cryptocurrency: You can purchase it from peers, for instance, or invest in a trust. (There aren’t any U.S. crypto mutual funds or ETFs yet.) Here is a Fortune guide on how to buy Bitcoin in particular.
You should pay attention to… The volatility. Cryptocurrencies deliver—by far—the bounciest ride of any asset class. In addition, it’s better to stick to currencies an investor is willing to research and understand, as many of them may not perform well in the long run, according to Ratcliff. “There’s over 6,000 of these things, growing every month,” he says. “I would say over 95% of them will fail.”
What is it? Investors can borrow money from their brokerage in order to boost their equity buying power, and potentially boost returns. An investor could purchase $5,000 worth of shares, then borrow another $5,000 from their brokerage—to purchase a total of $10,000 worth of shares. Investors can generally hold the margin loan as long as they like, but they must continue to pay the interest required. When an investor sells shares in a margin account, those earnings will first go toward paying back the broker.
The amount of money investors can borrow is directly correlated to the value in their overall portfolio, meaning that investors will lose buying power as the value of their investments decreases.
When is it appropriate to use? Margin can be used by investors who feel confident in a trade and want to boost their return. Although, put another way, it can also amplify losses, and investors can lose their entire investment, and then some. “However much you leverage out, you can double your gains or double your losses,” says Steve Sanders, executive vice president of marketing and product development at Interactive Brokers.
What are the costs? Brokerages charge interest for the securities or assets they loan out. That rate may vary based on the assets you have held with them, but may range from somewhere around 1% to 9%.
How to get started: Because of the risks, brokers put restrictions in place as to who is permitted to borrow on margin. These can include account minimums and also may require applications or filling out account agreements to do so.
You should pay attention to… Regulatory rules require investors to have at least 50% of the securities’ purchase price in cash in order to borrow funds from the broker. After the trade is made, they need to maintain equity in their account equal to that of 25% of the market value of those securities at all times. If, at one point, the equity in their account falls below that rate, it triggers what is known as a “margin call,” in which case investors may need to either quickly deposit more money or sell shares in their account to reach the required minimum. Failure to do so could lead to the broker liquidating securities in their account, thus forcing investors into serious losses.
Here’s an overly simplistic example of how things can go wrong: Tesla (TSLA) is trading at around $800 as I write this (rounding up for clarity). Let’s say an investor has $800 to invest in his account, but is very bullish on how Tesla will perform over the next three months and wants to buy two shares instead of one. He could borrow up to $800 from his broker for that trade, to invest $1,600. The investor will need to maintain equity from his own cash of at least 25% of that investment—or $400. After about two months, let’s say Tesla has a sudden, disastrous day: Its share price drops to $350, triggering a margin call. The investor would need to either immediately deposit another $50 into the account or sell positions in Tesla or other stocks to free up capital. In this case, let’s say the investor holds only Tesla in the margin account, and the broker ends up liquidating the two shares after the margin call. That means the investor has lost $450 of his original investment. On top of that, he still needs to pay back the broker: He will need to hand over that remaining $350—then come up with another $450 to repay the loan, plus whatever interest has accumulated in those two months.
What are they? Options are contracts linked to underlying assets, like stocks. They give you the choice to purchase or sell that asset over a set time period, or at a specific point of time, which can range from days to months to years.
There are two primary types of options: a call and a put. A call means you want the opportunity to buy an asset. (This could be lucrative if you think shares of a company will go up in price before the expiration date.) A put option is purchased if you want to sell an asset. (That’s if you think the price of an asset is going to go down before the expiration date.)
Let’s say you think Amazon (AMZN), currently trading at almost $3,300, will spike in price during the holiday season given Christmas shopping—but you want to wait and see before you buy. In this case, you could purchase a call option with a strike price of $3,300 that expires Jan. 1, giving you the option of purchasing 100 shares of Amazon at that price for two months. If you’re wrong, and the price drops to $3,200, you’re under no obligation to purchase the shares. Alternatively, let’s say you already own AMZN, and you think the stock price will dip during the holiday season. In this case, you could purchase a put option with a strike price of $3,300 that expires Jan. 1, giving you the option of selling your shares at that price for two months. If you’re right, and the price drops to $3,200, you can sell your shares at a $100 premium to their market value, minus the premium you paid. Important to note: There is someone on the other side of both these trades. In both scenarios, there are options sellers, who intend to profit off the premium that the investor is paying. Being wrong can be quite costly.
When are they appropriate to use? Some sophisticated investors use options to offset risk. Protected put strategies—where investors buy a put option to cap or hedge their risk—can allow investors to make a bullish bet on a stock, but also protect themselves from potential loss. These options “might mitigate your risk, but they’re also going to dampen your return,” says Resnick.
Call options can help investors avoid staying in a trade longer than they originally intended, just because it’s starting to go their way, according to Ryan Z. Farley, assistant clinical professor of finance at the University of Tennessee Knoxville. If an investor thinks a stock is worth $100, and it’s trading at $90, she can sell a call option with a strike price at $100. This could help eliminate the temptation investors may have to hold out, in case the price keeps rising.
“The problem with options is that some people simply will take more risk than they know they’re taking,” says Resnick. Short call options, for example, can lead to unlimited losses (the value of any stock or index may, theoretically, keep rising forever); long calls or long puts only risk what an investor paid for that option, he says.
What are the costs? To buy an option, there will typically be a premium, which is its per-share cost. If a premium is, say, $2 per share, and you buy $100 shares, then the premium will be $200 for that option—and that will be paid whether you ultimately decide to purchase the shares or not. Most brokerages also charge commissions for options trading. In addition, there are regulatory trading fees on options, called TAFs, which are usually a fraction of a cent per contract.
How to get started: Options and all the various strategies can get complicated. Resnick recommends investors watch tutorial videos on sites like Tastytrade and take online courses to fully understand how they work before attempting an options trade.
You should pay attention to… Your intended purpose for a trade. Investors might be aiming for a specific price increase, or hoping to set a cap on how much they are willing to lose. Once a stock or index hits these predetermined indicators, investors need to be ready to get out of the trade, rather than get greedy. “Always have an exit point,” Resnick says.
What is it? Investing in real estate has historically been a popular way for people to generate predictable cash flow. But it can also be complicated and dangerous, as the value of property can quickly change in response to adjustments in zoning laws, tax policies, or demographic shifts—“things most of us won’t know about until after everyone knows about them,” says Farley.
Many investors choose to use vehicles like real estate investment trusts, or REITs, which are mutual fund–like pools of investor assets, so that they can diversify their holdings and limit their risk. These portfolios may home in on specific sectors of the real estate market, such as health care or data centers, or they may invest in a wide range of properties.
When are they appropriate to use? Real estate can be a popular means to hedge against inflation, as landlords are able to increase rent on properties based on inflation levels. In addition, REITs can also deliver steady dividend income to an investor.
What are the costs? Many REITs are publicly traded, meaning that investors will be able to trade in and out of them as they do a standard stock or ETF. However, there are many non-traded REITs, which tend to be sold by brokers and financial advisers. These investments can have high upfront fees of up to 10% of the investment. High fees can reduce the value of the overall investment significantly.
How to get started: Most investors likely won’t want to (or won’t be able to afford to) purchase individual properties, so REITs may be a good way to get broader and more diversified exposure to the real estate market. Investors can purchase shares of individual REITs, such as American Tower (AMT) or Prologis (PLD), on the public exchanges. They can also buy REIT mutual funds or ETFs, which also offer exposure. The Vanguard Real Estate ETF (VNQ) and iShares U.S. Real Estate ETF (IYR) are two of the most popular. There are also online trading platforms, such as CrowdStreet, where you can invest in real estate, although some may be restricted to accredited investors.
You should pay attention to… The level of involvement you want in a real estate investment. If you’re opting to purchase an individual piece of property, such as a rental building, that can require plenty of management—and that’s best to decide well in advance of a purchase.
Questions investors may want to ask themselves when an investment seems complicated:
—How exactly does this work? What happens in the worst-case scenario?
—How much am I prepared to lose?
—How much will this cost? What’s the potential upside versus downside? What’s the likelihood the cost will make up for that?
—How liquid is this investment? If I decide I need to sell it, will I be able to?
—How much could I receive in a more basic, safe investment strategy? Is it better to invest this money there instead?