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Stocks, Mutual Funds, Exchange-Traded Funds, and Fixed Income

Stocks (Corporate Equities)

Many companies raise capital through the sale of corporate stock to the public. When the stock is first sold to the public, it is known as an Initial Public Offering, or IPO. More frequently, common stock is bought and sold each day on secondary markets around the world, including the New York Stock Exchange (NYSE), the NASDAQ, various Electronic Communication Networks (ECNs), or one of the many foreign exchanges.

Profitable companies often distribute a portion of their earnings to their shareholders in the form of dividends. The potential receipt of dividends is a common motivation for purchasing a particular stock. Perhaps more importantly, stock ownership permits investors the freedom to choose the companies they believe will be successful and to become an owner, to the extent of the shares they purchase, of those companies. Stock ownership can therefore be both exciting and liberating, but it should be pursued with caution, discipline and professional guidance.

Mutual Funds

Mutual Funds enable investors to participate in the risks and rewards of publicly-traded companies worldwide by pooling together the investment dollars of all the funds' shareholders for the purchase of securities.

Mutual Funds allow investors to:

  • Manage risk through diversification
  • Benefit from the expertise of professional money managers
  • Allocate their assets to provide income or growth
  • Transfer assets between funds within a mutual fund family in order to address changing investment needs.

Exchange-Traded Funds

Exchange-traded funds, or ETFs, are very much like mutual funds. That is, they are baskets of stock that are bought and sold. They differ from mutual funds in that shares of ETFs can be traded at any time while the host stock market is open. Also, they do not have a professional money manager; therefore, there are typically less expenses incurred.

Covered Calls

A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. If the trader buys the underlying instrument at the same time as he sells the call, the strategy is often called a "buy-write" strategy. The long position in the underlying instrument is said to provide the "cover" as the shares can be delivered to the buyer of the call if he decides to exercise.

Writing a call generates income in the form of the premium paid by the option buyer. And if the stock price remains stable of increases, then the writer will be able to keep this income as a profit, even though the profit may have been higher if no call were written. The risk of stock ownership is not eliminated. If the stock price declines, then the net position will likely lose money.

For example:

An investor has 500 shares of XYZ stock, valued at $10,000. He sells 5 call option contracts for $1500, thus covering a certain amount of decrease in the XYZ stock (i.e. only after the stock value has declined by more than $1500 would the investor lose money overall). Losses cannot be prevented, but merely reduced in a covered call position. If the stock price drops, it will not make sense for the option buyer to exercise the option at the higher strike price since the stock can now be purchased cheaper at the market price, and the seller (writer) will keep the money paid on the higher premium of the option, thus reducing his loss from a maximum of $10,000 to $10,000 – (premium), or $8500.

This "protection" has its potential disadvantage in that the investor (option writer) may be forced to sell his stock below market price at expiration, or must buy back the calls at a price higher than he sold them for. If, before expiration, the spot price does not reach the strike price, the investor might repeat the same process again if he/she believes that stock will either fall or be neutral.

Bonds

At Marcheso and Associates, one of our goals is to provide income for our clients. We believe bonds are an excellent way of doing this, and should be part of any balanced portfolio, whether you own a corporate, municipal or government bond. The advantage of using high credit quality corporate bonds is that they allow for a slow and steady return with rates that can generally beat the banks.  How it works is the investor loans money to an entity (corporate or governmental) and they borrow the funds for a defined period of time, generally at a fixed interest rate. As with any investment strategy, diversification is the key. Therefore we use multiple issues from several different companies.  Because most bonds pay interest every 6 months, we like to establish a bond ladder portfolio which sets up our clients for a monthly income stream with various maturity dates.  If you find yourself paying too much in taxes municipal bonds can be a great way to lower your tax liabilities.

Bonds (Fixed-Income Securities)

Bonds provide a guarantee, backed by the issuing entity (usually a government agency, municipality, or corporation), to return your original investment principal plus a fixed interest rate if the bond or bill is held to maturity. There is usually a correlation between creditworthiness of an issuing entity and the interest rate that is paid to the bondholder. Bonds can also be traded through secondary markets allowing the investment to be sold at the market rate rather than held to maturity, thereby providing liquidity[1].

Fixed income securities provide:

  • A guarantee of the principal and interest rate, backed by the issuing entity, if held to maturity;
  • The flexibility of various maturities to fit your investment needs.

Tax-Exempt Municipal Bonds

Most municipalities raise money through the sale of bonds (i.e. they borrow from investors). Because there is a civic purpose for the money raised through these bond issues, they often receive special tax treatment from the state and federal authorities.

Tax-Exempt Municipal Bonds offer:

  • An exemption from state and federal taxes, allowing for a potentially higher rate of return;
  • Guaranteed returns, backed by the borrowing institution or municipality, if held to maturity;
  • The opportunity to sell currently held bonds, before maturity, at the market rate in the secondary markets[2].

[1] & [2] Selling price may be more or less than the price paid for the security.

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