Investing Archives | Page 119 of 191

Aug

2023

How to Rebalance Your 401(k)

By Rebecca Lake | invest, Investing, Preparing for Retirement | Comments Off

Rebalancing is the process of buying and selling assets in a portfolio to bring your allocations back into line with your investment goals. If you’re new to rebalancing 401(k) savings, it helps to know how it works and how often you might want to do it.

Making 401(k) contributions can help you build retirement wealth while enjoying some tax advantages. Periodic 401(k) rebalancing can ensure that your asset allocation aligns with your risk tolerance and financial goals.

This article is part of SoFi’s Retirement Planning Guide, our coverage of all the steps you need to create a successful retirement plan.

What Is Rebalancing Your 401(k)?

When you’re talking about a 401(k) rebalance, you’re talking about buying or selling investments in your workplace retirement plan to bring them back into alignment with the original percentages you started with.

Example

If you started with 50% in equities (stocks) and 50% in bonds, over time that portfolio balance will drift as the value of those securities rises or falls. You can then rebalance your portfolio to restore the original 50-50 ratio. (Or you can adjust your allocation according to a new ratio that reflects what you’re comfortable with today.)

Rebalancing isn’t the same as changing your 401(k) contributions. That usually refers to increasing — or decreasing — the amount of your salary you defer into your plan. If you’re wondering can you change your 401(k) contribution at any time, the answer is usually yes, though it might depend on your plan administrator’s rules.

When you rebalance 401(k) assets, you’re changing where you invest the money you contribute. How you determine your retirement goals and your risk tolerance can shape your ideal asset allocation.

When to Rebalance Your 401(k)

How often should I rebalance my 401(k)? It’s a common question, but there’s no uniform answer, as every investor’s needs and goals are different. As a general rule of thumb, you might revisit your 401(k) allocation at least once a year. But rebalancing 401(k) savings could make sense at any time when your allocation no longer matches up with your investment goals.

Life changes might affect your decision of how often to rebalance 401(k) assets. For example, you might need to take a second look at your assets if you get married, have a child, or get divorced. Any of those situations can influence the way you approach investing, including how much risk you’re comfortable taking and how much you might need your 401(k) to grow to hit your retirement target.

Age is also a consideration for deciding when to rebalance a portfolio. When you’re younger with years ahead of you to ride out periodic ups and downs in the market, you might not be too concerned with rebalancing your 401(k) assets. You can afford to take greater risks at this stage to earn greater rewards with your investments.
As you get older, however, you might naturally begin to gravitate toward more conservative investments. If you find yourself growing less tolerant of risk, that’s a sign that it might be time for some 401(k) rebalancing.

Recommended: Average Retirement Savings by Age

Example of Rebalancing a 401(k)

Rebalancing 401(k) assets is a fairly straightforward process. First, you’d need to decide what you want your target asset allocation to look like. From there, you’d either buy or sell assets until your portfolio achieves the right balance.

Let’s say that you’re 35 years old and your target 401(k) portfolio allocation is 85% stocks and 15% bonds. Upon checking your latest statement, realize that your asset makeup is actually 75% stocks and 25% bonds. You could rebalance 401(k) investments by selling 10% of your bond holdings, then reinvesting the proceeds into stocks.

You can do that without any tax consequences as long as you’re not withdrawing money from your plan. Should you decide later that it makes more sense to move back to a 75%/25% split, you could sell off some of your stocks and purchase bonds instead.

💡 Quick Tip: Want to lower your taxable income? Start saving for retirement by opening an IRA online. The money you save each year is tax deductible (and you don’t owe any taxes until you withdraw the funds, usually in retirement).

Benefits of Rebalancing Your 401(k)

What is rebalancing meant to do for you? A few things, actually, and there are good reasons to consider regular 401(k) rebalancing.

Here are some of the main advantages of paying attention to your 401(k) allocation.

• Manage risk. Rebalancing your retirement savings can help ensure that you’re not taking more risk with your investments than you’re comfortable with. At the same time, it allows you to see if you’re taking enough risk in order to reach your goals.

In the example above, rebalancing the portfolio so it has a higher percentage invested in stocks will increase the portfolio’s risk/reward ratio. Stocks tend to be higher-risk investments, with a higher risk of loss and a higher potential for rewards.

• Maximize returns. If your 401(k) allocation becomes too conservative, you could miss out on opportunities to earn greater returns. Rebalancing can prevent that from happening so that you have a better chance of achieving the level of returns you’re looking for.

• Keep pace with changing goals. As mentioned, life changes and age can influence your asset allocation preferences. Should your goals or needs change, rebalancing can help you adjust your financial plan both for the short- and long-term.

Is there a downside to 401(k) rebalancing? There can be if the investments you’re buying underperform and don’t deliver the level of returns you’re expecting. Another unintended consequence centers on cost. If you’re swapping out lower-cost investments in your 401(k) for ones with higher fees, that could offset any benefits you might realize in the form of better returns.

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

¹Terms and conditions apply. Roll over a minimum of $20K to receive the 1% match offer. Matches on contributions are made up to the annual limits.

Steps for Rebalancing Your 401(k)

Ready to rebalance your 401(k)? The process itself isn’t that difficult, though you may want to spend some time researching the different investment options offered through your plan.

Calculate Current Asset Allocations

The first step in 401(k) rebalancing is figuring out what kind of asset split you currently have. In other words, what percentage of your account is dedicated to stocks, bonds, or other assets.

You may be able to do that by logging in to your 401(k) plan and checking your asset allocation. Many plan administrators offer online investment portfolio tracking so you can see at a glance how much you have invested in stocks, bonds, or other securities.

If your plan doesn’t automatically calculate your allocation, you can figure it out yourself by identifying the amount of money assigned to each investment, dividing it by the total value of your account, then multiplying by 100.

For example, say that you have $120,000 in your 401(k) and $72,000 of that is in stocks. If you divide $72,000 by $120,000, then multiply by 100, you get 60%. That means 60% of your 401(k) portfolio is stocks. You can perform the same calculation for each type of investment in your plan.

Compare to Target Asset Allocations

Once you know how your 401(k) assets break down, you can compare those percentages to your target percentages. For example, if you’ve got 60% of your 401(k) in stocks and your goal is 80% stocks, then you know you’ve got a 20% gap to close.

How you set your target allocations is entirely up to you and, again, it can depend on things like:

• Your age

• Risk tolerance

• Investment goals

• Time frame for investing

You might try using a basic rule of thumb like the rule of 100 or rule of 120 to find a starting point for allocating assets. These rules suggest subtracting your age from 100 or 120, then using that number as a guide for allocating your portfolio to stocks.

For example, if you’re 35, then based on the rule of 120, stocks should account for 85% of your portfolio. You could also look at how much you have saved versus what you need to save. This kind of retirement gap analysis can tell you how close or how far away you are to your goals and where you might need to adjust your savings strategy.

Sell Overweight Assets

Now that you know what your target allocation should be, you can take the next step and sell off overweight assets. These are the ones that are causing your asset allocation to skew away from your ideal alignment.

If you need more stocks, for example, then you’d sell off bonds. And if you want a more conservative allocation, you’d sell some of your stocks so you can use the money to buy more bonds.

Buy Underweight Assets

The last step is to buy underweight assets in order to bring your 401(k) portfolio back in line with where you want it to be. There are a couple of ways you can do this.

First, you could make a large, one-time purchase using the proceeds from the overweight assets that you sold. That might be easiest if you don’t want to make any changes to future allocations of your 401(k) contributions.

The other option is to change your allocations to direct future 401(k) contributions to underweight assets. What you have to keep in mind here is that once you reach your target allocation, you may need to change your future allocation preferences again so that you don’t accidentally end up overweight in one asset class.

One more possibility when considering how to manage 401(k) asset allocation is to check with your plan administrator to see if automatic rebalancing is an option. An automatic rebalance 401(k) feature could make keeping your allocation easier so you don’t have to spend as much time worrying about your assets.

Consider a Target Date Fund

If you want to skip rebalancing altogether, you might consider investing in a target date fund in your 401(k). Target date funds have an asset allocation that shifts automatically over time as you get closer to retirement.

You choose a target date fund based on your expected retirement date and the fund does the rest. Target date funds offer convenience since you don’t have to actively rebalance, but they might not be right for everyone. If the fund’s allocation doesn’t adjust in a way that’s consistent with your goals, you might be overexposed or underexposed to risk.

The Takeaway

When can I retire? It’s a big question, and if you’re contributing to a 401(k), it helps to know how to make the most of it. Rebalancing your 401(k) can help you stick to an asset allocation that makes the most sense for you. You also have the option of changing your allocation if your risk tolerance changes or your goals shift.

Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

Easily manage your retirement savings with a SoFi IRA.

FAQ

Is it good to rebalance your 401(k)?

It’s a good idea to rebalance your 401(k) if you’re concerned about taking too much risk — or not enough — with your investments. Rebalancing 401(k) assets is usually recommended when you experience life changes that affect your retirement goals and as you get older.

Should I rebalance my 401(k) before a recession?

Whether it makes sense to rebalance a 401(k) before a recession can depend on your current asset allocation and what you perceive the biggest threat to be should a recession occur. If you’re heavily invested in securities that are typically recession-proof or tend to fare well in economic downturns, then rebalancing might not be necessary. On the other hand, you might need to make some shifts in your 401(k) assets if you think a recession could expose you to more risk than you’re comfortable with.

Does it cost money to rebalance 401(k)?

It shouldn’t cost you any money to rebalance a 401(k), since you’re buying and selling assets in the same plan. You may want to ask your plan administrator whether any transaction fees will apply before you move ahead with 401(k) rebalancing. Keep in mind that taking money out of your plan to buy investments could cost you, since early withdrawals are subject to tax penalties.

Should I rebalance my 401(k) in a bear market?

Whether you should rebalance your 401(k) in a bear market can depend on the type of assets you’re holding and where you think stocks might be headed next. Bear markets can be opportunities for investors who are comfortable taking more risk, as you might be able to find investments at bargain prices when the market is down. Once the market recovers, those discounted investments might pay you back in the form of substantial gains as prices rise again.

Photo credit: iStock/miniseries

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Aug

2023

How to Trade the Bullish Harami Candlestick Pattern

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

The bullish harami pattern consists of two candlesticks and is a sign of a potential bullish turn on a stock. When a downtrend has been in place, a harami can offer traders clues that an upward trend is forming.

Other technical analysis tools should be used alongside observation of the bullish harami pattern for better confirmation. The pattern is useful when analyzing assets other than stocks, for example, the bullish harami pattern is also applicable to cryptocurrency charts.

Period 1 of a bullish harami is a long bearish candle, often after a series of down days. Period 2’s candlestick has a smaller body, sometimes even a doji (a candle with little to no body due to opening and closing prices being very close.

What Is a Bullish Harami Pattern?

A bullish harami candlestick pattern indicates a bottom may be forming. This two-day candlestick pattern is a signal that a bullish reversal might be taking shape.

You can learn more about candlestick charts on SoFi Invest.

Period 1’s candle is a large red body (or black depending on your candlestick chart settings) which is bearish. It might be a bearish marubozu, a candle with no wicks — that means the opening price is the high of the day and the closing price is the low of the day. Period 1’s candle could also have small wicks.

An upper wick is price action above the opening price and closing price. A lower wick is trading activity below the opening and closing price.

Period 2 features a small green (or white) body. This candle is contained within period 1’s candle. This is also known as an inside day pattern. Period 2’s trading action includes a gap higher at the open and a closing price that is slightly higher than the opening price. The upper and lower wicks should be within the body of the first day’s candle.

Day 2 is often a minor increase in price that might seem unimportant, but the pause in the prior downtrend is taken as a signal of bearish exhaustion. Some traders further limit the size of period 2’s candle such that the candle body is no larger than 25% of period 1’s candle.

As with most candlestick patterns, it is important to know the context of the larger trend. With a bullish harami candlestick pattern, the existing trend is bearish.

A bullish harami is just one of many bullish technical indicators.

On the flip side, a bearish harami candlestick pattern happens after a bullish trend, and can indicate the start of a new bearish trend.

What Does a Bullish Harami Pattern Tell Traders?

A bullish harami pattern tells traders to be on guard against a quick change in trend. For bears, that means it might be prudent to cover short positions. For bulls, this type of harami candlestick pattern can be a signal to get long.

Before putting on big positions, the wise trader reviews other technical indicators for confirmation of a change in trend. Momentum tools such as oscillators, moving average crossovers, and subsequent bullish candlestick patterns can help confirm the predicted bullish reversal.

The crucial aspect of a bullish harami pattern is period 2’s gap up in price and higher close. A small body, sometimes a doji, shows indecision on a price chart. It indicates that bearish momentum could be slowing and perhaps the bulls are ready to take charge.

If period 2’s candle is a doji, traders refer to the pattern as a bullish harami cross. The “cross” refers to the doji candlestick.

Example of a Bullish Harami Pattern

It can be helpful to use an example of a stock’s price action to show how a bullish harami pattern works.

While the harami candlestick formation is frequently used and offers a favorable reward/risk ratio, it does not guarantee profits. It’s important to know the existing price trend and use other trading tools for better results.

Initially, you want to identify that a downtrend was in place before the harami pattern appeared. Let’s say a stock was trading at $100 one year ago, and it closed at $30 on the most recent trading day. You can use other technical tools like moving averages to help confirm the bearish price trend.

Next, look for clues that the bears are losing their stranglehold on the security — that could be seen with a bullish hammer or other candlestick patterns. This is not a requirement, but it can be a telltale signal that a reversal is not far off. What’s important is that a bearish trend is in place before day 1’s candle.

In our example, let’s say day 1’s candle opens with a small gap down to $29. Intraday price action is bearish. The stock closes at $26, near the low of the day. Bears are excited as a downward price trend seems to be continuing. The stock’s sentiment is likely very bearish.

Day 2 opens with a minor gap higher to $27. The low of the day and high of the day are tight — between $26.50 and $27.50. The stock settles up on the day at $27.20. That is also slightly above the opening price.

The entire session’s trading activity is within day 1’s range.

While other candlestick patterns require a third day to help confirm a reversal in trend, a bullish harami pattern does not. Traders use the two-day candlestick pattern to identify a bullish price reversal.

Other technical indicators, like the relative strength index, can be used to show that the market is in an oversold condition.

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Does the Bullish Harami Pattern Work?

When researching stocks, technical analysis is used to help traders improve their chances of making profits over time. One indicator is never a sure thing, though.

It is helpful to analyze price action around the harami and to use other tools to spot key areas of support and resistance.

A bullish harami pattern has advantages and disadvantages. Let’s describe those.

Benefits of the Bullish Harami Pattern

An upshot to the bullish harami is that it can offer early long entry points when a bullish trend begins. That means the risk to reward ratio can be very favorable.

Moreover, it is an easy pattern to identify on a price chart.

Drawbacks of the Bullish Harami Pattern

There are some limitations, however.

You should not use the harami in isolation. You also must know the prevailing price trend when looking for a bullish harami pattern.

Finally, you should have a grasp of momentum indicators to help support the case for a bullish reversal.

How to Trade a Bullish Harami Pattern

You trade the bullish harami pattern by spotting a small bullish candlestick after a long bearish candle within an existing downtrend. You can use momentum oscillators and other technical indicators to help confirm a bullish reversal is taking shape.

A buy order can be executed after period 2’s candlestick. A trader might place a stop loss order below the low price over the 2-day harami pattern.

Since a new bullish trend pattern may be developing, look for multiple upside price targets to take profits based on prior support and resistance levels.

Bullish Harami Pattern in Crypto

Bullish harami candlestick patterns can be found on several timeframes and across many assets. It is a popular indicator among cryptocurrency traders. The tight risk range can lead to attractive risk-to-reward ratios.

A downside with crypto markets, since they trade 24/7, is that it is rare to see a price gap, so that is a limiting factor, but it can make the pattern even more important when it does appear on a crypto chart. Some traders also make allowances for no gap in price between periods, with all other factors in place.

The Takeaway

The bullish harami is a two-day candlestick pattern indicating a prior bearish trend could be reversing. A bullish harami candlestick pattern could signal that a bottom may be close, and that a bullish trend might be taking shape.

Period 1 of the pattern features a large bearish session with downward price action.

Period 2’s candle has a small body often with minor upper and lower wicks. The bullish harami candlestick pattern is used to spot signs of bearish exhaustion.

An upshot to the bullish harami is that it can offer early long entry points when a bullish trend begins. That means the risk to reward ratio can be very favorable, but this does have its limitations, and is best used by experienced investors when considering their goals.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Aug

2023

Dividend Discount Model (DDM): Formula & Examples

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

The Dividend Discount Model (DDM) is a fundamental quantitative valuation tool used to help determine the intrinsic value of a stock. There are several variations of the model based on future cash flow assumptions of owning a stock.

The goal is to determine a stock’s fair value, then compare it to the market price. If a stock is found to be undervalued via the DDM, then an investor might buy shares. If the formula finds a stock is overvalued compared to the market price, it could be a candidate for a short sale.

The DDM has some shortcomings, and other valuation tools can be used in conjunction with it to help improve the accuracy of your fundamental analysis.

Additionally, traders can combine this fundamental analysis with technical analysis tools to determine optimal entry and exit points when buying and selling shares.

What Is the Dividend Discount Model (DDM)

The DDM uses a discounted cash flow approach to valuing a stock. The idea is that a stock’s value is simply the present value of future dividends when discounted back to the present. This equity valuation technique looks closely at the cash flows of a stock including future dividend payments and the sale of the stock itself at some future date.

You can think of it as a bottom-up investing approach. The dividend discount model is used to find stocks that are either under- or overvalued compared to the market price. Thus, it is used to find long and short ideas using fundamental analysis and equity valuation.

To better understand the DDM, it’s helpful to know how business fundamentals, and fundamental stock analysis, works.

When a firm earns profits, it can either retain those earnings or pay them out as dividends. The DDM can work best with companies that pay out a large proportion of its profits as dividends. The DDM does not work as well on firms that do not distribute dividends or on companies that pay very little out to shareholders.

The dividend discount model formula is also based on the notion of the time value of money, which says that a dollar today is worth more than a dollar in the future. For this reason, firms that have big dividends today are generally thought to be worth more than those that defer them to the future (per the calculation).

💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

Dividend Discount Model vs Discounted Cash Flow Model

The Dividend Discount Model (DDM) is closely related to the Discounted Cash Flow Model (DCF) but has distinct differences.

The DDM focuses on the cash flows associated with holding a stock, including dividends and cash received upon a stock sale.

The DCF model examines the cash flows in a company and determines the overall market value of the company. Cash flows include profits, depreciation, changes in accounts receivable, changes in accounts payable, etc. As you might imagine a DCF calculation is extremely detailed and requires some financial and accounting acumen to perform accurately.

Both models require determining future cash flows and forecasting the future requires a mix of art and science to develop accurate valuations.

Dividend Discount Model Formulas

There are several dividend discount model formulas. Each is based on the nature of future dividend distributions from the company to shareholders.

Gordon Growth Model

The Gordon Growth Model (GGM) is one of the most popular versions of the DDM. It is named after American economist Myron Gordon, who first developed the valuation technique. The GGM is also a rather straightforward spin on the DDM since it assumes a stock will pay dividends at a constant rate into perpetuity.

You might use the GGM when analyzing very stable businesses that have steady cash flows and a track record of consistent dividend payouts. Big, blue-chip companies and utility stocks are good examples. The GGM is expressed as:

Where:

• V₀ = The current stock price

• D₁ = The dividend payment one period from now

• r = The required rate of return on the stock

• g = The constant growth rate of the company’s dividends into perpetuity

Be aware that the model is extraordinarily sensitive to the dividend growth rate used.

One-Period Dividend Discount Model

The one-period DDM is used less frequently than the popular Gordon Growth Model. It is useful when an investor wants to calculate a stock’s fair value in order to trade it after one period (often one year). Since it is a one-period look, a single dividend is used along with the proceeds of the sale of the stock. Those are the only two cash inflows.

Where:

• V₀ = The current stock price

• D₁ = The dividend payment one period from now

• P₁ = The stock price one period from now

• r = The required rate of return on the stock

Multi-Period Dividend Discount Model

In contrast to the one-period DDM, the multi-period formula assumes that an investor plans to hold a stock over a period that features many dividend payments.

What makes this variation of the DDM tough is that you forecast several future dividends. There is no guarantee that a firm’s payout policy will match your forecast. Like other DDM models, a final return of capital is assumed — the sale price of the stock at the end of the holding period.

Each future dividend is discounted back to the present using a discount rate that is typically the firm’s estimated cost of equity.

Variable Growth DDM or Non-Constant Growth

You can get even more complex with the variable growth version of the dividend discount model formula. With this approach, you can divide growth into several stages.

Perhaps a firm will grow rapidly over the first year, slow down in year two, then finally transition into a steady grower into perpetuity. Some argue this is a more realistic way to value a stock versus other models. The variable growth DDM assumes non-constant growth by commonly using a two-stage or three-stage approach. Of course, even more stages can be applied.

Zero Growth DDM

A final approach is the zero growth dividend discount model. This is actually the simplest of all DDM variations. It is the same calculation you would use when valuing a perpetuity or preferred stock. It’s simply:

Dividend Discount Model Example

Let’s perform an example using the most common DDM method: the Gordon Growth Model.

Suppose a company pays a current annual dividend of $5 (D0) and will grow it at a steady rate of 3% per year into perpetuity. Shares currently trade at $60. We will also assume we used the Capital Asset Pricing Model to find the firm’s 10% estimated cost of equity. Here’s how the DDM would look:

Since we found the stock’s intrinsic value to be significantly higher than the market price, we might buy shares with the thought that eventually the market will realize how valuable the stock is and the price will move towards our valuation.

Interpreting DDM Results

Interpreting the results from the dividend discount model is straightforward, but it is getting to the output that can be tricky. The inputs to the calculation are often subjective and can change over time, so any interpretation should be taken with a grain of salt.

Dividends can be hard to forecast accurately, and valuations are sensitive to the growth and discount rates chosen. The analyst must also be open to the possibility that market forces can cause an over- or under-valued stock to further drift from intrinsic value.

How Investors Can Use DDM

The dividend discount model, and all its variations, can be used to calculate a stock’s fair value. In practice, that fair value is then compared to the market price.

Investors can choose to go long shares when they determine that a company’s intrinsic value is above the market price. They can also short shares if the DDM valuation method determines that a stock is overvalued compared to the market price.

The dividend discount model can be used to value stocks in different sectors to see which might be the best investment.

The use of the DDM is based on fundamental analysis and the notion that stock values ultimately revert to their intrinsic worth based on the present value of future cash flows.

Investors can use the DDM along with other valuation techniques to help form a better mosaic of a company’s value. Moreover, technical analysis indicators could be used for more precise buy and sell price points.

The Takeaway

The dividend discount model formula is one of the most widely used equity valuation techniques. Its premise is that firms pay out a large proportion of their profits as dividends to equity holders, thus an intrinsic value can be calculated using those predictable future cash flows.

There are several variations of the DDM based on the profile of a firm’s future dividends. There are drawbacks to the DDM, and using other valuation methods can help an analyst determine if a stock is over- or under-valued.

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

Photo credit: iStock/svetikd

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

SOIN0221052

Aug

2023

The Heston Model: Defined & Explained with Calculations

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

The Heston model is an options pricing model developed to address some of the shortcomings in the Black-Scholes model when pricing European options. In contrast to the Black-Scholes model, the Heston model uses stochastic, not constant, volatility as a key variable to determine option prices.

Developed by mathematician Steve Heston in 1993, this model is thought to be more real-world in nature since implied volatility percentages change during an option’s life. However, the Heston model is just one of many option valuation techniques to consider.

What Is the Heston Model?

The Heston model is used to gauge the value of options. The main difference between this and other models is how volatility is treated. The Heston model for option pricing assumes that volatility is stochastic, or random. That simply means that volatility is treated as a variable, in contrast to other models that assume constant or local volatility.

Option prices are made up of several variables — often referred to as the Greeks. It is important to understand price inputs in order to know how to trade options. Volatility is a major piece of the price of an option. The higher the implied volatility, the more valuable the option is. The Heston approach accounts for this by assuming there is a relationship between a stock’s price and its volatility.

💡 Quick Tip: In order to profit from purchasing a stock, the price has to rise. But an options trading account offers more flexibility, and an options trader might gain if the price rises or falls. This is a high-risk strategy, and investors can lose money if the trade moves in the wrong direction.

How Does the Heston Model Work?

By assuming that volatility is random, many traders believe the Heston option pricing model works better than the Black-Scholes model since it captures the true nature of volatility. The Heston approach is considered a superior model to the Black-Scholes, too. The downside is that it can be more complicated to calculate. Moreover, it can only be used on European options — those that can be exercised only at expiration.

Like other option pricing models, the Heston method attempts to determine the time value piece of an option’s total value. Intrinsic value is straightforward to figure out since it is just the difference between the stock price and strike price. Intrinsic value and time value comprise an option’s total worth.

Heston Model Pros and Cons

The Heston option pricing model has several advantages and disadvantages. By incorporating variable volatility characteristics, an options trader can have more confidence in the Heston model’s output reflecting observed market behavior versus other valuation techniques. The Heston model achieves increased accuracy by considering correlations between the price of a stock and its volatility. It also assumes that volatility exhibits mean reversion.

Additionally, Heston’s approach yields a closed-form solution that can simplify what is a complex mathematical equation.

The Heston model has its limitations. For one thing, the output is only as good as the variables you assume. This model is also thought to be ill-equipped to price options close to expiration due to instances when implied volatility might be extremely high.

Perhaps the biggest downside is its complexity versus Black Scholes and the binomial options pricing model.

Pros	Cons
Incorporates more realistic market conditions such as changing volatility levels	Only useful on European-style options
Prices options considering the price and maturity variables on volatility	Only as good as the inputs used
Yields a closed-form solution that can be used to compare an option’s value to its market price	Considered not an accurate gauge to price short-term options with high volatility

Heston vs Black-Scholes Model

Understanding the differences between the Heston model and the Black-Scholes model can help you determine which might work best when you trade options.

Heston Model	Black-Scholes Model
Assumes that volatility is random	Assumes that volatility is constant
Incorporates a relationship between a stock’s price and its volatility	Does not incorporate correlations between a stock’s price and volatility
Can be used in a variety of market conditions	Prices options under one set of volatility parameters

Finally, user-friendly options trading is here.^*

Trade options with SoFi Invest on an easy-to-use, intuitively designed online platform.

*Check out the OCC Options Disclosure Document.

Heston Model Formula Explained

The Heston volatility model includes several mathematical inputs. Knowing these can help you find the right strategies for trading options. Understanding the model inside and out can arm you with the quantitative armor other traders might not possess.

Here is the full Heston model formula:

Where:

• S_t = specific asset price at time t

• r = the risk-free interest rate, often a short-term Treasury rate

• √V_t = volatility (standard deviation) of the asset

• σ = volatility of volatility

• θ = long-run price variance

• k = reversion rate to the long-term price variance

• dt = indefinitely small positive time increment

• W_1t = Brownian motion of the asset price

• W_2t = Brownian motion of the asset’s price variance

Note that the two Brownian motions are negatively correlated. For example, a drop in the asset price will see an increase in volatility. The two Brownians are related by the following equation:

Where ρ is the correlation.

In his original paper describing this model, Heston provided default parameters for the equations above which include:

• S_t = 100

• r = 0

• V_t = 0.01

• σ = 0.1

• θ = 0.01

• k = 2

• ρ = 0

• Option maturity = 0.5 year

Further calibration of the model requires advanced mathematical analysis.

Other Option Pricing Models

The Heston option pricing is just one of many approaches to consider. Let’s outline several of the most common methods you might use to price options.

Binomial Model

The binomial model uses an iterative approach using several periods to value American-style options. It follows a binomial pricing tree, which can be useful in illustrating how option prices change from one period to another. This method is considered intuitive and is used more often than Black-Sholes.

Risk-Neutral Probability

The risk-neutral approach to option pricing assumes that risk is not considered. This method can help a trader assess the true value of an option outside of market risk conditions.

Monte Carlo Simulation

Monte Carlo simulations are sometimes used to gauge the value of options. This method utilizes computer simulations to create thousands of potential outcomes. Option values can be calculated based on the probability-weighted computer output.

Monte Carlo simulation is used to generate realistic market conditions which can be useful for options traders as they attempt to assess how an option value will fluctuate over time. However, it can be time-consuming and costly to run these complex programmatic scenarios.

The Takeaway

The Heston model prices options using stochastic (random) volatility to more accurately model options pricing behavior. The more well-known Black-Scholes option pricing model assumes that implied volatility remains constant.

Some traders believe that the Heston model approach works better to incorporate practical, real-world conditions. Still, there are many techniques to price options for you to consider when you trade.

Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.

Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.

With SoFi, user-friendly options trading is finally here.

FAQ

What is the Heston model used for?

The Heston Model is used for pricing European options. It uses stochastic volatility to arrive at pricing outcomes, helping traders value options. If a trader determines that an option is over- or under-valued, they might sell or buy the option, then hold it through expiration or trade out of the position before expiration. It is important to remember that European options, unlike American options, cannot be exercised early.

Is the Heston model better than Black-Scholes?

It’s hard to conclude that the Heston stochastic volatility model is better than the more widely known Black-Scholes model. In contrast to Black-Scholes, the Heston model assumes that volatility can change. The Heston model can be more useful to traders since it assumes implied volatility, an important variable for options pricing, increases as options become more in-the-money or out-of-the-money. While the Heston model is considered to be more accurate, it comes with increased computational complexity or in layman’s terms…it’s slower.

What does stochastic local volatility mean?

Local volatility is a basic application of the Black-Scholes model. It accounts for the requirement to price-in skewness into option values. Stochastic volatility contrasts local volatility in that the former can produce a more real-world forward volatility profile. It’s thought that stochastic volatility can overprice options while local volatility and the Black-Scholes method might underprice options.

Photo credit: iStock/FG Trade

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
SOIN0322020

Aug

2023

Guide to Barrier Options

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

Barrier options are complex derivative products that have payoffs based on whether an underlying asset crosses a pre-specified price threshold.

There are several types of barrier options, and they are used to hedge a portfolio or simply to speculate on an underlying asset’s price change, much like regular call and put options. But due to the restriction of the barrier, premiums tend to be lower when initiating the trade.

What Is a Barrier Option?

Barrier options are just like regular options with the inclusion of an additional barrier to the regular option payoff.

Beginners start trading options with purchases of simple puts and calls. Options trading quickly turns complex as you dive into writing options, combination strategies, and exotic options.

In contrast to barrier options, plain-vanilla options typically have some value as the asset approaches and then crosses the strike price. Before an option is in the money, the value is known as time or extrinsic value.

Once an option is in the money, the option price is a combination of intrinsic value and extrinsic value.

A barrier option’s payoff (or lack thereof) is predicated by the underlying asset crossing some barrier price determined upon option initiation. Once the barrier is crossed, the nature of the option changes.

In some cases, the option is “normal” but after crossing the barrier it becomes worthless forever, simply by crossing the barrier. Other barrier options begin as worthless (or close to it), but revert to a normal option once they cross the barrier, even if they later cross the barrier again.

These products can be used to develop simple or complex strategies in options trading.

💡 Quick Tip: If you’re an experienced investor and bullish about a stock, purchasing call options (rather than the stock itself) can allow you to take the same position, with less cash outlay. It is possible to lose money trading options, if the price moves against you.

How Barrier Options Work

First, recognize that a barrier option is an exotic option — it comes with added rules and features compared to the more common American-style and European-style flavors. A barrier option is also path-dependent, much like non-exotic options, in that its value is determined by changes in the underlying asset’s market price.

A key feature of a barrier option is when it can be exercised. Depending on the barrier option pricing terms, its value activates or becomes worthless at that crossover price.

Pros and Cons of Barrier Options

Barrier options work like puts and calls, but they feature more restrictions than standard American or European options. That leads to advantages and disadvantages for both the holder and seller of a barrier option.

Barrier options’ pricing terms often dictate how and when traders of these derivatives might use them in their trading strategies.

In general, there is less risk for the barrier option seller and more restrictions put on the owner. Both parties, however, should be aware that there is less liquidity in barrier option markets compared to more actively traded standard options markets.

Pros	Cons
Lower option premiums means a cheaper way to trade for option buyers	Less chance to exercise due to restrictive terms (for the holder)
Reduced risk to the option writer	Poor liquidity versus plain vanilla puts and calls
Can be more customized than standard options	Added complexity makes barrier options tougher to understand for new traders

Finally, user-friendly options trading is here.^*

Trade options with SoFi Invest on an easy-to-use, intuitively designed online platform.

*Check out the OCC Options Disclosure Document.

Knock-In and Knock-Out Barrier Options

Knock-in and knock-out barrier options are the two common types of barrier options. Knock-in options are unable to be exercised until the underlying security crosses a trigger point, deemed the barrier price.

Knock-out options can be exercised immediately, but they turn inactive (worthless) at the time of breaching the barrier price. It can be helpful to see how these products work via barrier options examples.

Knock-In

Knock-In Option Example

Let’s say you buy a knock-in barrier call option featuring a strike price of $100 and a barrier of $110 while the underlying security trades at $90. The option is not exercisable until the underlying asset’s price climbs above the $110 barrier.

The option owner pays a premium but that premium is lower than for a regular call. Why?

Two reasons:

1. The barrier option won’t be immediately exercisable and is worth close to zero until the underlying asset crosses the barrier price.

2. The barrier price typically exceeds the strike price for calls and is below the strike price for puts. That means the likelihood to have any intrinsic value is lower because the option must first breach the barrier. A regular option has intrinsic value once it exceeds the strike price.

However, after the barrier is breached the barrier option will trade like any other standard call option with a strike of $100, no matter what the price does subsequent to breaching the barrier. If the barrier is not broken, the seller keeps the premium.

Knock-in barrier options are broken down further into up-and-in or down-and-in options.

The call above is an up-and-in barrier option example, the asset price must move up for the option to be exercisable. Down-and-in means the price must move down to the barrier before it is exercisable and typically is used for barrier put options.

Knock-Out

Knock-Out Option Example

For a knock-out barrier option, we’ll assume you bought an up-and-out call option with a barrier of $50 and a strike of $40 while the underlying asset trades at $35. If the asset rallies to $50, the option will cease to exist and be worth nothing.

A knock-out option is worthless even if the underlying asset’s price touches the barrier price for only a moment before falling back.

The call above is immediately exercisable and will always trade at a lower price than a regular call. Why?

Reasons include:

1. If the underlying asset is far from the barrier, the option will be cheaper than a regular option as it is still at some small risk of breaching the barrier and being worthless.

2. As the underlying asset moves closer to the barrier the option will move towards zero as the risk of crossing the barrier increases dramatically.

Knock-out barrier options are broken down further into up-and-out or down-and-out options. The difference is which way the price must move to breach the barrier and become worthless.

As you can see, barrier options pricing puts a spin on the usual calls and puts you might be familiar with.

Types of Barrier Options

Beyond knock-in and knock-out options, there are a few other barrier option types to learn about.

Rebate Barrier Options

Rebate barrier options have provisions that allow the holder to retain some value of the option contract even if the barrier price is not reached. It might be a percentage of the premium paid from the execution of the trade.

This might be seen as a less risky version of barrier options as it is not an all-or-nothing approach.

Turbo Warrant Barrier Options

Turbo warrant barrier options are traded more actively in overseas markets. They are a category of down-and-out options and feature high leverage.

While they can be risky, turbo warranty barrier options are also less volatile than other types.

Parisian Option

Both time and price are key variables with Parisian barrier options. They work similarly to Asian options. They are different in that the underlying security’s price must not only cross the barrier but stay above that price for a predetermined time period before the contract is in effect.

The Takeaway

Barrier options offer traders another means to hedge a portfolio or speculate on an underlying asset. This type of option is exotic, meaning it is more complex than plain vanilla puts and calls.

With barrier “in” options, the call or put does not go into effect until a barrier price level is hit while “out” options are active until the barrier price is touched.

Barrier options give investors more flexibility and customization at a cheaper price, but they can be more restrictive and less liquid than other options.

With SoFi, user-friendly options trading is finally here.

FAQ

Are barrier options American or European?

Barrier options are complex exotic options different from the two common styles of options: American and European. While American-style options can be exercised at any time, before and at expiration, and while European-style options can be exercised only at expiration, barrier options are exercisable only after the barrier price is reached.

How are barrier options valued?

Barrier options have a path-dependent value since their worth is based on the underlying asset’s price movements. It is only when the underlying price crosses the barrier price that the option has value and can be exercised. If that predetermined barrier option price is never reached, then the option is worthless with a typical knock-out option. Knock-in options are non-exercisable until they reach the barrier price.

Can you replicate barrier options?

Some strategies can replicate the structure and payoff profile of barrier options. Many of these analyses were performed by academics over recent decades. The goal is often to produce sound portfolio hedging techniques.

Photo credit: iStock/nensuria

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SOIN0422029

How to Rebalance Your 401(k)

What Is Rebalancing Your 401(k)?

When to Rebalance Your 401(k)

Example of Rebalancing a 401(k)

Benefits of Rebalancing Your 401(k)

Get a 1% IRA match on rollovers and contributions.

Double down on your retirement goals with a 1% match on every dollar you roll over and contribute to a SoFi IRA.1

Steps for Rebalancing Your 401(k)

Calculate Current Asset Allocations

Compare to Target Asset Allocations

Sell Overweight Assets

Buy Underweight Assets

Consider a Target Date Fund

The Takeaway

FAQ

Is it good to rebalance your 401(k)?

Should I rebalance my 401(k) before a recession?

Does it cost money to rebalance 401(k)?

Should I rebalance my 401(k) in a bear market?

How to Trade the Bullish Harami Candlestick Pattern

What Is a Bullish Harami Pattern?

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What Does a Bullish Harami Pattern Tell Traders?

Example of a Bullish Harami Pattern

Does the Bullish Harami Pattern Work?

Benefits of the Bullish Harami Pattern

Drawbacks of the Bullish Harami Pattern

How to Trade a Bullish Harami Pattern

Bullish Harami Pattern in Crypto

The Takeaway

Dividend Discount Model (DDM): Formula & Examples

What Is the Dividend Discount Model (DDM)

Dividend Discount Model vs Discounted Cash Flow Model

Dividend Discount Model Formulas

Gordon Growth Model

One-Period Dividend Discount Model

Multi-Period Dividend Discount Model

Variable Growth DDM or Non-Constant Growth

Zero Growth DDM

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Access stock trading, options, alternative investments, IRAs, and more. Get started in just a few minutes.

Dividend Discount Model Example

Interpreting DDM Results

How Investors Can Use DDM

The Takeaway

The Heston Model: Defined & Explained with Calculations

What Is the Heston Model?

How Does the Heston Model Work?

Heston Model Pros and Cons

Heston vs Black-Scholes Model

Finally, user-friendly options trading is here.*

Trade options with SoFi Invest on an easy-to-use, intuitively designed online platform.

Heston Model Formula Explained

Other Option Pricing Models

Binomial Model

Risk-Neutral Probability

Monte Carlo Simulation

The Takeaway

FAQ

What is the Heston model used for?

Is the Heston model better than Black-Scholes?

What does stochastic local volatility mean?

Guide to Barrier Options

What Is a Barrier Option?

How Barrier Options Work

Pros and Cons of Barrier Options

Finally, user-friendly options trading is here.*

Trade options with SoFi Invest on an easy-to-use, intuitively designed online platform.

Knock-In and Knock-Out Barrier Options

Knock-In

Knock-Out

Types of Barrier Options

Rebate Barrier Options

Turbo Warrant Barrier Options

Parisian Option

The Takeaway

FAQ

Are barrier options American or European?

How are barrier options valued?

Double down on your retirement goals with a 1% match on every dollar you roll over and contribute to a SoFi IRA.¹

Finally, user-friendly options trading is here.^*

Finally, user-friendly options trading is here.^*

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