Other Types of Securities: ETFs, Bonds, and Derivatives

In the previous two posts, we've exclusively covered stocks and how those can fit into your investment portfolio. However, there are so many other types of instruments, more formally called "securities", that you can trade. In this post, we'll cover three of the most common: ETFs, Bonds, and Derivatives!

So, what is an ETF? An ETF (Exchange-Traded Fund) is a fund that acts like a basket of stocks and is traded on the open market. What makes an ETF and an individual stock different is that when you invest in an ETF, you're essentially getting exposure to every single company within that ETF. For example, let's say we have an ETF that contains Microsoft, Google, and Apple. When you buy that ETF, you are investing in a combination of Microsoft, Google, and Apple, and you're doing so by just investing in one asset: that ETF.

The whole point of an ETF is that you're getting more diversification in one investment. If you were to invest in Apple's stock and on any given day, it lost value, that investment would surely lose value too. But, if you invested in the ETF above that contains Microsoft and Google as well, and they were positive on this day, the ETF's value could have increased on that day. Therefore, your investment can still increase in value even if some stocks lose value.

ETFs generally contain hundreds if not thousands of different stocks, so the example above is not super common, but the concept remains the same. Some of the most popularly-traded ETFs have the tickers SPY and QQQ: they replicate the returns of the S&P 500 and Nasdaq indices, respectively. They provide direct exposure to investing in index funds, which is why many investors put a lot of money in them.

Next, what is a bond? A bond is a loan that you give to a government or corporation where the debtor pays you back a fraction of the principal amount (your initial investment/loan) plus some interest over time. It can be thought of as a bank giving a person a loan, except now, you're the bank. Generally, bonds don't produce very high returns (3 - 4% annually), but their returns are almost guaranteed. For the government to not pay back the debt on a bond, there would need to be a gigantic financial crisis, if not a government collapse.

Bonds are often bought alongside stocks, as they are considered a good way to reduce risk during a market downturn. In previous years, bonds often move in an inverse way to stocks, so during periods of strong market negativity, the losses from stock investments can be partially offset by bonds. However, in more recent years, bonds have been found to not perform consistently inversely to stocks and there may be better ways to reduce your risk than simply buying bonds. We'll get into that more in future blog posts.

Finally, what are derivatives? The literal definition is that it's some kind of financial contract/asset that is dependent on an underlying financial contract. That might not make much sense at first, which is completely okay, but let's go over a few examples.

First, there are multiple different types of derivatives. The two most commonly known are options and futures. Let's start with futures.

Futures are contracts in which you bet on the future price of something. Some common examples are of commodities, like oil. If I believed that the price of crude oil was going to reach $70/barrel by the end of 2026, and the price of the futures contract for that time is $68/barrel, I would buy that futures contract. The reason is because at that time, I believe the price is going to be $2 higher than the current cost of the futures contract is. Therefore, I can bag $2 per barrel in profit. A different way to think about a futures contract is that if you were to buy that $68/barrel contract for end of 2026, you are making an agreement to buy a barrel of oil for $68 on that precise date, regardless of what the actual market price of oil is at the end of 2026. If the market price of oil is above the price you agreed to buy it for by the end of 2026, say $75/barrel, you just made a profit!

Options are a similar concept, but work a bit differently. Unlike futures in which you are obligated to buy something at a certain price on a given day, options give you the right to do so but not the obligation. However, this comes at the cost of a premium that you pay when buying an options contract.

One extremely important note is that derivatives like futures and options are incredibly risky. With certain types of options, you could triple your initial investment in a matter of hours, or lose all of it. Or, anything in between. They are easily the most risky type of asset to trade, and you need to have a clear plan before ever trading derivatives. Furthermore, you certainly don't need to trade derivatives to have a profitable long-term portfolio. Simpler can be better, and some of the greatest investors of our era never even dabble in derivatives. You can create a strong portfolio off of just stocks.

I hope this brief summary of ETFs, bonds, and derivatives was informative! In future posts, we'll take a deeper look into each one of these types of assets.