Cons of Using a Brokerage Firm?

Although it’s not true of every brokerage firm, some require you to keep a minimum amount of money in your account in order to use their services. These minimums might be $500 or more, which can be a barrier to entry for some beginner investors.

Investing Archives | Page 124 of 191

Q: What Is an Investment Broker?

Investment brokers are the companies that enable individuals to buy and sell securities, like stocks, on an exchange market.

Q: Pros of Using a Brokerage Firm?

Thanks to the magic of the internet, you can sign up for a brokerage account in minutes and start trading stocks as soon as your account is funded. That means employing a broker is one of the easiest ways to get started on an investment journey as soon as possible.

Aug

2023

Investment and Financial Brokers Explained

By Michael Flannelly | Growing Wealth, invest, Investing, Terminology | Comments Off

A number of investors trade stocks and bonds through an investment broker. What is a broker? A broker — or brokerage firm — is the middleman between the buyer and seller and can help make a transaction go smoothly.

But an investment broker is not strictly necessary. Some companies offer a direct stock plan, allowing investors to purchase shares straight from the company without a broker.

In order to decide if you need an investment broker, it’s essential to know how a broker works, what exactly they do, and how to shop around for one that fits your needs.

What Is an Investment Broker?

Investment brokers enable individuals to buy and sell financial securities, like stocks or bonds, on an exchange market.

What does a broker do? Reputable brokers act as a boon to both buyers and sellers: They ensure that each party actually has the money to buy assets or the assets to sell.

Brokers settle trades by delivering securities and payments to each party, while also taking care of all the bookkeeping and tax-related documentation required. In many cases, going through a brokerage firm is the easiest and most accessible way for individuals to get started with investing.

💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

Pros and Cons of Using an Investment Broker

As with any financial service, there are both benefits and drawbacks to using a brokerage firm to facilitate your trades.

Pros of Using a Broker

Accessibility

Thanks to the internet, you can open a brokerage account in minutes and start trading stocks as soon as your account is funded. That means employing a financial broker is one of the easiest ways to start an investment journey as quickly as possible.

Simplicity

When you buy and sell through a broker, a lot of the tedious footwork — like keeping tabs on your interest earnings for tax purposes — is taken care of for you. Depending on the type of brokerage firm you go with, you may also have access to professional financial advice and other advisory services that could help you make the most of your portfolio.

Cons of Using a Broker

Fees and Commissions

Although they’ll vary based on the specifics you choose and the type of account you open, some brokers charge maintenance fees and trade fees — also known as commissions — which can eat away at your nest egg. In fact, the average stock broker commission charged by brokerage firms is usually 1% to 2% of the value of the total transaction.

That said, you can minimize your investment fees, or even eliminate them, by shopping around for brokers with the lowest costs. For example, many online brokers offer no commission trading.

Required Portfolio Minimums

Although it’s not true of every brokerage firm, some require you to keep a minimum amount of money in your account to use their services. These minimums might be $1,000 or more, which can be a barrier to entry for some beginner investors.

Recommended: What Is Broker Call Rate?

Two Types of Brokerage Accounts

If you’re still asking yourself, what does a broker do?, it’s important to understand that not all brokers are created equal. There are many kinds of brokerage accounts to choose from. For instance, you may want to choose between a brokerage account vs. a cash management account, both of which are offered by brokerages.

The best product for you will depend on your individual financial goals and your budget. Here’s what you need to know to help make an informed decision.

1. Full-service Brokerage Accounts

Along with the ability to buy and sell assets, a full-service brokerage account might also include advice from human financial planners and portfolio management to help you make the best investment decisions possible.

However, these perks don’t come cheap. Full-service brokerage accounts and wealth-management companies usually calculate their charges as a percentage of your total portfolio, and may have account minimums as high as $250,000. They may also collect trade commissions and annual management fees.

2. Discount Brokerages

Discount brokers offer less consultation and guidance, allowing you to DIY your investment portfolio cheaply. Many have $0 account minimums and may charge less than $10 per trade — or even offer commission-free assets trading.

Both full-service and discount brokerages typically offer both cash and margin accounts. In a cash account, you’ll need the actual cash to buy your assets. In contrast, in a margin account, the broker will lend you some capital to make purchases, using the securities you already own as collateral.

💡 Quick Tip: If you’re opening a brokerage account for the first time, consider starting with an amount of money you’re prepared to lose. Investing always includes the risk of loss, and until you’ve gained some experience, it’s probably wise to start small.

Regulations for Investment Brokers

Investment brokers are regulated by the Financial Industry Regulatory Authority (FINRA). Brokers must register with FINRA, and they are required to follow a standard of conduct known as the suitability rule. Under this rule, brokers need to have suitable grounds for recommending particular investments to clients.

The rule also encompasses something called “know your customer,” which spells out the various steps brokers need to use to identify clients and their goals for savings, including making a reasonable effort to ascertain a client’s financial and tax situation when recommending investments.

Different Types of Investment Accounts

Aside from deciding what type of brokerage you’d like to do business with (and how much you’re willing to pay for financial services), you’ll also need to decide what type of investment account works best for your goals.

Maybe you’re investing for a shorter-term objective, like purchasing a house — or perhaps you’re trying to ensure you’ll have a comfortable retirement. Either way, specific investment account types, or “vehicles,” are designed to help you get there.

Taxable Brokerage Account

Think of this as a default investment vehicle. It may be a good choice if you’re looking to grow wealth and want to be able to add or withdraw funds on your own terms without waiting to reach a certain age or life circumstance. However, you pay taxes on earnings, so there are no tax advantages to this type of account. If you don’t make any specific investment vehicle choices when you open your brokerage account, this is most likely the one you’re getting.

Individual Retirement Account (IRA)

An individual retirement account, or IRA, is a type of investment account designed specifically for retirement goals and is available to self-employed people and those working for a company. IRAs carry specific tax incentives; for example, contributions to traditional IRAs are deductible, while Roth IRAs allow for tax-free distributions. However, you can’t access the funds without paying a penalty until you reach age 59 ½ or meet certain circumstantial requirements, such as purchasing your first home.

A broker may offer other savings or investment vehicles, such as a 529 college savings plan, a tax-incentivized plan to help people save for educational costs. For full details on the type of accounts available, it makes sense to check with your broker directly.

Alternatives to Investing With a Broker

Although using a broker to invest in the stock market might be a smart money move for some, there are other ways to get started with investing, including the following options.

Recommended: Buying Stocks Without a Broker

Automated Investing

Automated investment products, or robo-advisors, are platforms that utilize a combination of computer algorithms and human financial planners to create and manage diversified portfolios at low costs to users.

Your funds will be invested in a diversified portfolio, and the platform typically offers goal-planning tools and rebalancing services to help keep your funds moving in the right direction.

If you don’t want to pay the high prices for a full-service broker, but self-managing your portfolio makes you more than a little nervous, a robo-advisor may be right for you.

Buying Stocks and Fractional Shares Directly

Depending on whose stocks you’re interested in purchasing, you may be able to buy them directly from the issuer without needing to go through a brokerage firm.

It pays to read the fine print, however: Buying stocks directly may save you money on trade commissions, but you may also be subject to proprietary fees from the company or minimum purchase amounts. And if you’re buying fractional shares (fractions of shares of stock), you need to have an investment account, such as one with an online broker or robo-adviser.

Diversifying your assets can still be helpful for investors who buy stocks directly. If all of your investments are tied up in a single company, you may not be in a great position if that company begins to falter. In contrast, if you’ve invested in several different firms and other asset classes, you will likely have a wider margin for error.

Choosing Alternative Investments

Although the stock market is one of the most popular and generally low-effort ways to invest, there are plenty of other ways to try turning your money into more money.

You might consider exploring alternative investments. For example, you could invest in real estate and sell the property at a profit or turn a condo into a passive income source by putting it up for rent. Or you might invest in art; the value of paintings is not necessarily correlated with the behavior of the stock market, giving it the potential to rise even during a stock market crash.

That said, many alternative investments require significantly more time, work, and know-how than crafting a diversified portfolio of stock market assets. And as always, every investment involves risk. There’s no such thing as a sure thing.

Controlling Your Investments With SoFi

If you’ve decided stock market investments are the right move for you and your money, going through a broker can be a relatively simple and low-cost way to gain access to the market. However, if you’d rather avoid potential downsides, like fees or required account minimums, you may want to consider the option to invest directly. The choice is yours.

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).

Invest with as little as $5 with a SoFi Active Investing account.

FAQ

What is the role of a stock broker?

A stock broker is a financial professional who buys and sells stocks on behalf of clients. A broker generally earns a fee or commission for their services.

How do brokers make money?

Brokers typically work on commission. The average stock broker commission is usually 1% to 2% of the value of the total transaction.

Why do people use brokers?

People use brokers to help them buy and sell stocks and bonds. Brokers also handle the necessary bookkeeping and tax-related documentation. For many individuals, using a broker is the easiest way to start investing.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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.

SoFi Invest®

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

Aug

2023

How to Buy Bonds: A Guide for Beginners

By Austin Kilham | Growing Wealth, invest, Investing | Comments Off

Investing in bonds is a method of lending money to a company or government. Governments, municipalities, and companies issue bonds to investors who are willing to lend them money for a set period of time. In exchange, the issuer pays interest over the life of the loan and returns the principal when the bond “matures” at the end of a predetermined period known as the bond term.

For diversification, many investors want to include a mix of equities (stocks) and fixed income (bonds), since the two securities have different attributes and often behave differently throughout the economic cycle.

Why Invest in Bonds

As investors choose between the different types of investments, there are several reasons they might opt for bonds. Bonds pay interest at regular intervals, such as twice a year, which provides investors with a predictable stream of income. Also, if investors hold the bond to maturity, they get back their entire principal. In this way, investors can preserve their savings while investing.

Bonds are also an important tool for building a diversified portfolio. Compared with stocks, bonds are less volatile, so they can offset some of the risk inherent to stock investing.

While investors typically consider bonds a less risky investment, it’s still possible to lose money when investing in bonds if the issuer is unable to fulfill its obligation. In addition, inflation can eat away at bond returns, since fixed returns are worth less during periods of high inflation.

Where Can You Buy Bonds?

The best way to purchase bonds will depend on the type of bond and the bond market exposure that you want.

The Government

If you’re 18 or older, you can buy government bonds directly from the federal government through the TreasuryDirect website. The site is available at all times and gives investors access to Treasury bills, notes, bonds, Floating Rate Notes, Treasury Inflation-Protected Securities and savings bonds.

A Brokerage

Investors can buy a variety of bonds, including corporate, municipal, and government bonds, through their brokerage account. Bond prices vary depending on transaction fees and markups.

An ETF or Mutual Fund

Investors who don’t want to buy bonds directly can gain access to the asset class by buying shares of exchange-traded funds (ETFs) or mutual funds that invest in bonds.

Diversification is the main reason for investing in funds. Because issuers typically sell individual bonds in large units (a single bond might cost $1,000) the average investor may only be able to purchase a few of them on their own, making it tricky to put together a diversified bond portfolio.

Meanwhile, funds typically hold a diversified basket of bonds that tracks a bond index or a certain sector of the bond market, making it much easier for individuals to diversify. It’s important to note that while the yield of individual bonds is fixed, the yield on bond mutual funds or ETFs can fluctuate over time.

What Type of Bonds Can You Buy?

There are a few basic types of bonds you may consider buying:

Corporate Bonds

Corporate bonds are a type of debt security issued by public and private corporations. Investment banks typically underwrite the debt and issue it on the entity’s behalf. Companies use the money they raise through bond sales for a variety of purposes, such as investing in new equipment, research and development, paying investor dividends, and stock buybacks.

Municipal Bonds

States, cities, and counties issue municipal bonds, sometimes called “munis”, to finance capital expenditures like the building of new roads or bridges. There are three general types of municipal bonds:

• General obligation bonds aren’t backed by assets, but rather the “full faith and credit” of the issuer. Governments have the power to tax residents to pay bondholders back.

• Revenue bonds are backed by revenue from a specific source, such as highway tolls. That said, some revenue bonds are “non-recourse” meaning that if the revenue source disappears, bondholders have no claim to it.

• Conduit bonds are issued on behalf of private entities like hospitals.

US Treasuries

The Department of the Treasury issues U.S. Treasury bonds for the federal government. Investors typically consider Treasuries one of the safest investments, since they have the full faith and credit of the U.S. government backing them.

• Treasury bills are short-term debt obligations that mature within one year or less.

• Treasury notes are longer-term debt securities that mature within 10 years.

• Treasury bonds mature in 30 years and pay bondholders interest every six months.

• Treasury Inflation-Protected Securities, or TIPS, are notes or bonds that adjust payments to match inflation. Investors can buy tips with maturities of five, 10 and 30 years, and they pay interest every six months.

Recommended: How to Buy Treasury Bills, Bonds, and Notes

Bond Mutual Funds

A mutual fund is a pool of money that’s invested by an investment firm according to a set of stated objectives. A bond mutual fund focuses specifically on bonds. They may focus on one type, such as corporate bonds, or they may contain all types. Unlike traditional bonds, investors don’t get their principal returned with bond mutual funds, and there may be ongoing fees and expenses associated with owning shares of the mutual fund.

Bond ETFs

Like bond mutual funds, bond ETFs represent a way for investors to pool their money and spread it across many different investments. While investors can only trade mutual funds once a day, they can trade ETFs throughout the day. ETFs may have lower fees than mutual funds.

How to Invest in Bonds

As investors decide which bonds to buy, they may want to consider the following factors:

Credit Ratings

Credit ratings are a way to gauge the creditworthiness of companies or governments that issue bonds. The ratings give investors an idea of how likely the bond issuer is to default. Standard & Poor’s, Moody’s and Fitch are the three private companies that control most bond ratings. The rating system is slightly different at each company, but generally speaking, a mark of AAA represents the highest rated and least likely to default issuers, while C or D denotes the riskiest issuers.

Duration

A bond’s duration is not the same at its term, or maturity. Rather it is a measure of how sensitive a bond’s price will be to changing interest rates. The longer a bond’s duration, the more likely its value will fall as interest rates rise. However, you can avoid duration issues by holding the bond to its maturity date.

Fees

If you buy bonds through a broker, you should expect to pay transaction fees. Brokers typically markup the price of a bond when they sell it to you in lieu of charging a commission. Markups may be anywhere from 1% to 5% of the bond’s original value. Look for brokerages that have low fees and markups.

Risk Level

Before buying a bond, investors should understand the associated risks, including:

• Credit risk: The risk that issuers may fail to make interest payments and default on the bond.

• Interest rate risk: The possibility that changes in interest rate will raise or lower a bond’s value if sold before maturity.

• Inflation risk: The risk that inflation will decrease the value of bond returns.

• Liquidity risk: The risk an investor won’t be able to sell their bond when they want to due to low or no demand.

Recommended: Investment Risks and Ways to Manage

Timing

You might consider matching the maturity date to your investment timeline. For example, if you need your principal in five years to make a down payment on a house, you may not want to buy a 10-year bond. While you could sell the 10-year bond after five years, market conditions could make it less valuable than if you waited until maturity.

The Takeaway

Whether purchased individually or accessed through mutual funds and ETFs, bonds provide a way for investors to diversify their portfolios. They can also typically help investors develop a reliable stream of income, which can become increasingly important as they move toward retirement.

Before buying a bond, you should research issuers and credit ratings to be sure you aren’t taking on undue risk. And above all, you should be sure that whatever you buy fits into your long-term investment plan.

Invest with as little as $5 with a SoFi Active Investing account.

🛈 While SoFi does not offer direct purchases of bonds, you can gain exposure to the bond market by purchasing bond funds through our online investment platform.

Photo credit: iStock/ILIA KALINKIN

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.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

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.

SOIN0723024

Aug

2023

What is a Futures Contract? Definition & How Futures Work

Futures Contracts: What They Are and How They Work

By Colin Dodds | Growing Wealth, invest, Investing | Comments Off

Futures contracts are a type of financial derivative that investors use to speculate on the price of a security at a forthcoming date. These typically trade on separate futures exchanges, which allow for higher volumes of trading.

Futures are a type of derivative, and trading futures and other options contracts requires an advanced level of trading and market knowledge. That said, investors would do well to know the basics of futures contracts, so that they can determine whether they have a place in their investing strategy.

What Is a Futures Contract?

Futures contracts, or futures, are legal agreements to either buy or sell a given security, commodity, or asset at a specific time in the future, for a previously agreed-upon price. For investors, they offer access to commodities and other markets they might not be able to access otherwise. They can also act as a way to protect against volatility.

One important feature of a future contract is that both buyers and sellers can execute the contract regardless of the current market price of the underlying asset when the contract expires.

Investors use futures contracts when they believe that the underlying security will go up or down by a certain amount of time over a fixed period of time. The futures contract buyer enters a legal agreement to buy the underlying asset at the contract’s expiration date. On the other side of the trade, the futures contract seller agrees to deliver the underlying security at the agreed-upon price, when the contract expires.

The majority of futures contracts on a futures exchange are standardized by date and price, to allow for higher trading volumes and simpler transactions.

Investors can buy futures contracts to make money — or to hedge against losses — resulting from the price increases or decreases in stocks and commodities like oil, as well as other financial instruments.

💡 Quick Tip: In order to profit from purchasing a stock, the price has to rise. But an options 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 Do Futures Contracts Work?

In a futures contract, the purchaser gets to buy a given asset at a predetermined price. That can help protect against big price swings up or down, making them popular not only with investors, but with companies that rely on commodities that experience sudden price changes.

Example of a Futures Contract

An airline, for example, might buy an oil futures contract to lock in the price of the oil that it will need to buy in order to get its jets off the ground in the coming months. Purchasing the futures contract allows the airline to guard against the financial harm of a sudden rise in the price of fuel. The risk to the airline, however, is that oil prices will go down – in which case, it will miss out on those lower prices.

On the other side of this hypothetical transaction is a fuel distributor, which has millions of gallons of oil in its inventory. It would sell the oil futures contract as a way of maintaining a steady market for its oil in the coming months. That’s because the airline buying the futures contract must buy the fuel at the agreed-upon price on the dates specified in the contract. That removes some risk for the oil distributor, but it also creates a risk if oil prices climb before the futures contract expires. Should that happen, the oil distributor will still have to sell the oil at the lower price specified in the futures contract.

To stay with this example, in the futures contract, the airline and the oil distributor will set and agree upon the terms, specifically the price of the oil and the expiration date upon which the contract expires. In this contract, the distributor agrees to sell 1,000 barrels of oil at $50 per barrel, in exactly 90 days. If the price of oil in 90 days is $75 per barrel, then the airline will have gotten a good deal. If a barrel of oil falls to $35, then the oil supplier will have protected itself against the price declines.

What’s the Difference Between Futures and Options?

Futures and options are both derivative contracts. However, futures contracts oblige the buyer or seller to complete the deal at the contract’s expiration, while options contracts give traders the right but not always the obligation to execute the contract when it expires.

Recommended: 10 Important Options Trading Strategies

Both futures and options share some of the same trading terminology. For example, both investors in both types of derivatives will need to consider its bid-ask price. The bid price is the highest price a buyer will pay for the contract, while the ask price is what the seller will accept.

Investors can also purchase options on future contracts. In a call option on a future, the buyer has the right to buy a futures contract at a specific price at a specific future date. In a put option, the buyer has the right to sell the futures contract at a specific price at a specific date.

Futures Contracts Pros & Cons

Futures trading can be a profitable strategy, but it also has some drawbacks that investors should consider.

Benefits of Futures Contracts

• Futures contracts act as a hedge against the risks related to price volatility.

• Most futures markets are highly liquid, allowing traders to buy and sell when they want.

• Futures may give investors access to commodities, and other markets not normally accessible to everyday investors.

• Futures contract pricing is determined by adding the cost of carrying the underlying asset to its spot price.

Downsides of Futures Contracts

• Futures contracts can be a high risk investment. In some cases, a futures contract can lose all of its value and trade at $0 when it expires.

• Futures contracts can reduce or eliminate potential gains from price swings in the underlying securities or assets.

• Futures contracts themselves are often highly volatile, with their prices fluctuating wildly.

• You may have to pay high commission charges on high-volume trades.

How Investors Use Futures Contracts

But not everyone who buys an oil futures contract plans to take delivery of the oil it represents. Retail investors also use futures as a way to protect their investments against volatility. Those futures investors who buy and sell the contracts to make money off the price changes that the contracts themselves undergo.

To go back to the example of an oil futures contract, an investor owns a contract, and the price of oil rises, allowing the contract owner to buy oil for less than the market price. The investor will be able to sell that contract for more than they purchased it for. The investor will then sell the contract on the futures market.

Other investors use futures contracts related to other commodities, including corn, soybeans and wheat. But there are also futures markets where investors can buy futures contracts that offer them the ability to bet on the future of currencies, individual stocks or stock indices like the S&P 500 or 10-year Treasury bills. Investors may choose to buy futures, rather than the securities themselves, to reduce their volatility exposure.

How to Trade Futures Contracts

There are several steps to trading futures contracts.

1. Open a brokerage account

To trade futures contracts, the first thing you’ll need is a brokerage account. You may also need your broker to give approval for margin and options privileges in your account.

2. Set a trading strategy

Before jumping into the futures market, develop a strategy. That strategy could involve technical analysis based on market data, or fundamental analysis based on the investment’s underlying economic and financial trends.

Some investors even try out their strategy using hypothetical trades before they start trading with real money. This allows you to understand the risks of potential trades without actually losing money.

3. Research trades that make sense for your investment strategy

Most brokerages that offer futures trading have an online platform you can use to research specific securities and see futures contracts available to buy or sell.

4. Double-check the terms

Make sure that the contracts will do what you think. That means confirming the selling and purchase price of the contract, the expiration, and the fees.

5. Develop your skills

Whether doing it on paper, or with real money, you’ll want to refine your strategy over time. You may find that you make more profitable trades in a specific sector, for example, or need to work on staying calm as security prices rise and fall. Practice will allow you to improve, and get more out of the futures strategy you’ve developed.

💡 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.

The Takeaway

Futures contracts are a type of investment that can offer access to commodities markets, as well as a way to protect against volatility. They can be a helpful tool to some investors, but they’re also risky and can be an expensive way to invest.

Futures trading can be fun and profitable, but is incredibly risky. It’s also a high-level trading strategy, and one that may not be suited for beginning investors. If you’re curious about it, though, you may want to speak with a financial professional for guidance.

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/fizkes

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.

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.
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.

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Aug

2023

What Are Exotic Options? 11 Types of Exotic Options

By Colin Dodds | Growing Wealth, invest, Investing | Comments Off

An option is a financial instrument that gives the buyer the right to purchase or sell an underlying security, such as a stock, during a set time period for an agreed-upon price. They are popular with investors because they allow the investor to bet on the price increase or decrease of a stock, without owning the stock itself.

Exotic options are a class of options that allow investors to take advantage of some features of options contracts to pursue other strategies. Exotic options pricing tends to be higher than that of traditional options.

What Is an Exotic Option?

Exotic options are hybrid securities that offer unique and often customizable payment structures, expiration dates, and strike prices. For those features, they typically charge a higher price than traditional options. University of California Berkeley professor Mark Rubenstein coined the term “Exotic Options” in a 1990 paper about contracts.

The asset that underlies these options also includes non-traditional assets and securities. Exotic options can be either covered or naked call, meaning that the seller has not set aside shares or cash to meet the obligation when it expires.

To understand what makes an exotic option exotic, let’s review a traditional, plain-vanilla options contract and how it works. With a traditional option, the owner can buy or sell the underlying security for an agreed-upon price either before or at the option’s predetermined expiration date. The holder is not, however, obligated to exercise the option, hence the name.

An exotic option typically has all of those features, but with complex variations in the times when the option can be exercised, as well as in the ways investors calculate the payoff.

Investors typically buy and sell options in the over-the-counter (OTC) market, a smaller dealer-broker network. An exotic option may have underlying assets that differ from those offered by traditional options. Those underlying assets can include commodities like oil, corn and natural gas, in addition to stocks, bonds, and foreign currencies.

There are even exotic derivatives that allow traders to bet on things like the weather. Both institutional and sophisticated retail investors use customized exotic options to match their own unique risk-management needs.

💡 Quick Tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, options trading can be risky, and best done by those who are not entirely new to investing.

11 Types of Exotic Options

There are many types of exotic options that investors can purchase for exotic options trading. Here’s a look at some of them:

1. Asian Options

One of the most common forms of exotic options contract, the Asian option is a contract whose payoff to the holder reflects on the security’s average price over one or several agreed-upon periods of time. This makes it different from a U.S. option, whose return reflects the price of the underlying asset when the holder chooses to exercise it, and different from a European option, whose payoff reflects the price of the security at the time of the option’s expiration.

2. Barrier Options

These options remain effectively dormant until activated, usually by the price of the underlying asset reaching a certain level.

3. Basket Options

Unlike traditional options, which typically have a single underlying asset, basket options contracts depend on the price movements of more than one underlying asset. For holders, the payout on a basket option reflects the weighted average of the assets underlying the contract.

4. Bermuda Options

The main differentiator of Bermuda options is when the holder can exercise them. An investor can exercise a Bermuda option at its expiration date, and at a handful of set dates before then. This makes them different from U.S. options, which holders can exercise at any point during the contract, and European options, which can only be exercised at expiration.

5. Binary Options

Sometimes called digital options, binary options are unique because they only guarantee a payout to the holder if a predetermined event occurs. This all-or-nothing investment typically delivers a predetermined payout or asset if the agreed-upon event occurs.

6. Chooser Options

With ordinary options contracts, the investor must decide upfront if they’re buying a call (right to buy the underlying security) or put (right to sell the underlying security) option. But with a chooser option, the holder can decide whether they want the option to be a put or call option at a predetermined date between when they buy the chooser option and when the contract expires.

7. Compound Options

These options, often called split-fee options, allow investors to buy an option on an option. Whether or not a compound option pays off depends on whether or not another option pays off. Investors in compound options have to make their decisions based on the expiration dates and strike prices of both the underlying option, as well as the compound option itself.

8. Extendible Options

The main advantage that extendible options offer is that they give an investor the ability to postpone the expiration date of the contract for an agreed-upon period of time. This can mean adding the extra time for an out-of-the-money option to get into the money, a feature that’s priced into the original option contract.

Extendible options can be holder-extendible, meaning the purchaser can choose to extend their options. They can also be writer-extendible, meaning that the issuer has the right to extend the expiration date of the options contracts, if they so choose.

9. Lookback Options

Lookback options differ from most options because they do not come with a specified exercise price. Instead, an owner of a lookback option can choose the most favorable strike price from the prices at which the underlying asset has traded at throughout the duration of the option contract.

10. Spread Options

Unlike a traditional option, where the payoff depends on the difference between the contract’s strike price and the spot price of the underlying asset when the investor exercises the contract, a spread option pays an investor based on the price difference between multiple assets. The butterfly spread, which involves four separate options, is one example of a spread option.

11. Range Options

For highly volatile assets, some investors choose to use range options, because their payout is based on the size of the difference between the highest and lowest prices at which the underlying asset trades during the life of the range options contract.

Pros and Cons of Exotic Options

There are benefits and drawbacks to using exotic options.

Pros

• Some exotic options have lower premiums than more flexible American options contracts.

• Investors can select and customize exotic options to fit very complex and precise strategies.

• With exotic options, investors can fine-tune the risk exposure of their portfolio.

• Investors can use exotic options to find opportunities in unique market conditions.

Cons

• Many exotic options come with higher costs, and less flexibility than traditional contracts.

• There are no exotic options that guarantee a profit.

• Because of their unique structures, exotic options sometimes react to market moves in unexpected ways.

• The complex rules mean that exotic options have a higher risk of ultimately becoming worthless.

💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.

The Takeaway

Exotic options are complex financial instruments that allow investors to make bets on the price of an asset without owning that asset itself. Unlike traditional options, exotic options include customizable features that investors can use to pursue a specific options trading strategy.

As many investors know, trading options — of all types — is relatively advanced, and requires a good amount of background knowledge and understanding of intricate financial assets. For that reason, it may be a good idea to speak with a financial professional before diving into options trading.

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/Pekic

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.

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.
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.

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Aug

2023

Contango vs Backwardation: What’s the Difference?

By Colin Dodds | Growing Wealth, invest, Investing | Comments Off

Contango and backwardation are two ways to characterize and understand the state of the commodities or cryptocurrency futures markets, based on the relationship between spot and future prices.

In short, contango is a market in which futures trade at spot prices that are higher than the expected future spot price. But a contango market is not the same thing as a normal futures curve, though it is often mistaken for one. Normal backwardation, on the other hand, is a market where futures trade at a price that’s lower than the expected future spot price.

Futures and Derivatives

It’s important to have an understanding of both futures and derivatives to fully understand the difference between contango and backwardation.

Futures, Explained

Futures contracts, or futures, consist of legal agreements to buy or sell a security, commodity or asset at a set time in the future, for a predetermined price. One feature for both buyers and sellers of futures is that they can execute the contract no matter what current market price of the underlying asset when the contract expires.

Companies use futures contracts to hedge their risk of massive shifts in commodities prices, and investors who believe that the underlying security will go up or go down by a certain amount of time over a fixed period of time. The buyer of a futures contract enters a legal agreement to buy the underlying asset at the contract’s expiration date. The seller, on the other hand, agrees to deliver the underlying security at the agreed-upon price, when the contract expires.

💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.

Derivatives, Explained

A derivative refers to any financial security whose value rises and falls based on the value of another underlying asset, such as a security or commodity. That includes securities such as futures, options, and swaps. The most common assets upon which derivatives are based include securities like stocks and bonds, commodities like oil or other raw materials, but they may also reflect currencies and interest rates.

The Futures Curve

When writing futures contracts for a given asset, the futures seller will place different prices on that commodity at different points in the future. While the base price of a futures contract is determined by adding the cost of carrying the underlying asset to its spot price, it also includes an element of prediction. People buy more oil in the winter to buy their homes, for example, so oil investors may predict that oil will be in higher demand — and thus cost more — in January than it will in May.

By comparing the prices within futures contracts for the same underlying asset at different points in the future, the dollar amounts form a curve.

Normal Futures Curve vs Inverted Futures Curve

In a normal futures curve, the prices assigned to the underlying asset of futures contracts goes up over time. In the example of oil, a normal futures curve will be one in which a barrel of oil is priced at $50 for a contract expiring in 30 days; $55 for a contract expiring in 60 days; $60 for a contract expiring in 90 days, and $65 for a contract expiring in 120 days.

A normal futures curve embodies an expectation that the price of the asset underlying the futures contracts — such as oil, soybeans, a stock, or a bond — will rise over time. An inverted futures curve assumes just the opposite.

To go back to the example of oil, in an inverted futures curve, a barrel of oil is priced at $50 for a contract expiring in 30 days; $45 for a contract expiring in 60 days; $40 for a contract expiring in 90 days, and $35 for a contract expiring in 120 days.

The futures curve is used by investors, policymakers and corporate treasurers as an indicator of popular sentiment toward the underlying asset. And the prices of those futures contracts can represent the market’s combined best guess about the prices of those assets.

The spot price of the asset, on the other hand, the price at which it’s currently trading. It’s the relationship between the spot price and the prices on the futures curve that determine if the futures market is in a state of backwardation or contango.

What Is Backwardation?

When an asset is trading at spot prices that are higher than the prices of that asset as reflected in the futures contracts maturing in the coming months, it’s called backwardation.

It can happen for a number of reasons, but most commonly occurs because of an unexpectedly higher demand for the underlying asset, especially in cases of a shortage in the spot market. Sometimes backwardation is caused by a manipulation of a commodity’s supply by a country or organization. Decisions by the Organization of Petroleum Exporting Countries (OPEC), for example, could create oil backwardation.

When backwardation occurs in futures markets, traders may try to make a profit by short-selling the underlying asset, while buying futures contracts that promise delivery at the lower prices. That trading drives the spot price down, until it matches the futures price.

What Is Contango?

Contango, on the other hand, is a situation where the spot price of an asset is lower than those offered in the futures contracts. In an oil contango market, for example, the spot price of the oil would rise to match that of the futures contracts at expiration. In contango, often associated with a normal futures curve, investors agree to pay more for a commodity in the future.

Backwardation vs Contango for Investors

Contango and backwardation can occur in any commodities market, including oil, precious metals, or agricultural products. Investors can find different opportunities and investment risks when investing in commodities in both backwardation and contango.

Recommended: Investing in Precious Metals

In backwardation, short-term traders who practice arbitrage can make money by short-selling the underlying assets, while buying futures contracts until the difference between the spot and futures prices disappears.

But investors can also lose money from backwardation in situations where the futures prices keep falling while the expected spot price remains the same. And investors hoping to benefit from backwardation caused by commodity shortage may wind up on the wrong side of their trades if new suppliers appear.

For investors, contango mostly poses a risk for investors who own commodity exchange-traded funds (ETFs) that invest in futures contracts. During periods of contango, investors can, however, avoid those losses by purchasing ETFs that hold the actual commodities themselves, rather than futures contracts.

💡 Quick Tip: If you’re an experienced investor and bullish about a stock, buying 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.

The Takeaway

Contango and backwardation are two terms that describe the direction futures markets are headed. Knowing the difference between these two terms can help institutional and retail investors make the strategic choices when investing in a wide range of derivatives markets.

These are fairly high-level terms, and may be used as a part of an advanced trading strategy. If investors don’t feel comfortable investing in derivatives or futures contracts – or similar securities — it may be best to consult with a financial professional to get a better sense of if they fit into your strategy.

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/LumiNola

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.

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.
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.

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