Jun
21
2023
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Pros & Cons of Global Investments

By | Growing Wealth, invest, Investing | Comments Off on Pros & Cons of Global Investments

Individual investors have access to a wide variety of investments in and outside of the US, which include international and domestic assets. Global investing involves investing in securities that originate all around the world.

According to Charles Schwab , global allocation provides diversification benefits and is the pillar of wealth management. It can also help investors position your portfolio for long-term growth.

Increased geographic diversification may also offer some downside risk mitigation, as the relative performance of US vs. international stocks has historically alternated, according to Morgan Stanley.

Essentially, the US markets may have a different rhythm than international markets. Therefore, investing in both has the potential to give investors the best of both worlds if one rises while the other falls, helping minimize return losses.

Investing in Global Investments

There are several ways investors can get started in the global market. But before an investment decision is made, it’s important to learn as much as possible about each investment option and understand the risks involved.

Mutual Funds

A mutual fund is a type of security that pools money collected from investors and invests in different assets such as stocks and bonds. The portfolio of a mutual fund is made up of the combination of holdings selected. US-registered mutual funds may invest in international securities. These types of mutual funds include:

•  Global funds that invest primarily in non-US companies, but can invest in domestic companies as well.
•  International funds that invest in non-US companies.
•  Regional or country funds that primarily invest in a specific country or region.
•  International index funds designed to track the returns of an international index or another foreign market.

US-registered mutual funds are composed of a variety of different international investments. As with any mutual fund, when an investor purchases a US-registered mutual fund, they’re buying a fraction of all of the securities, which increases diversification.

For investors to create this level of diversification on their own with individual stocks and bonds would be difficult, expensive, and time-consuming. Therefore, buying shares of US-registered mutual funds may give investors access to more diversification.

Exchange-Traded Funds (ETFs)

An ETF is an investment fund that pools different types of assets such as stocks and bonds and divides ownership into shares. Most ETFs track a particular index that measures some segment of the market.

This is important to understand—the ETF is simply the suitcase that packs investments together. When investing in an ETF, investors are exposed to the underlying investment.

ETFs that are US registered include foreign markets in their tracking but trade on US stock exchanges These types of investments may offer similar benefits as US-registered mutual funds.

Stocks

While many non-US companies use ADRs to trade their stock, other non-US companies may list stock directly on a US market, known as US Trade foreign stocks. For example, Candian stocks are listed on Canadian markets and are also listed on US markets instead of using ADRs.


💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.

Why Invest in Global Markets?

While some of these investments may seem confusing, there are a few reasons why investors might choose global investments.

Diversification

Again, choosing global investments can diversify an investor’s portfolio. It may be tempting for an investor to concentrate money in a few familiar sectors or in companies for which there is a personal affinity. But putting all their eggs in one basket could potentially lead to vulnerability.

There is no guarantee against the possibility of loss completely—after all, risk is inherent in investing. But spreading assets to international and domestic equities may reduce an investor’s vulnerability because their money is distributed across areas that aren’t likely to react in the same way to the same occurrence.

Global Growth

Another reason investors might choose to invest globally is because of the growth potential. The US is considered a mature market and may not have as much growth potential as other economies. Choosing global investments allows investors to potentially capitalize on profits from growing economies, particularly in emerging markets.

Greater Selection

If you choose not to invest outside of the US, you are narrowing your investment opportunity set. Even though investment information may be more challenging to obtain and analyze, there is the potential for a great deal of growth.

The Risks of Global Investments

As with any financial decision, careful consideration is required when selecting an investment. But, there are a few unique global investment risks and issues that need to be accounted for before investing in any global investment.

Currency and Liquidity Risk

Currency risk is also known as exchange-rate risk. It stems from the price differences when comparing one currency to another. When the exchange rate between the US dollar and a foreign currency fluctuates, the return on that foreign investment may fluctuate as well. It’s possible that a non-US investment might increase its value in its home market but may decrease in value in the US because of exchange rates.

In addition to the risk of exchange rates, some countries may restrict or limit the movement of money out of certain foreign investments. Conversely, some countries may limit the amount or type of international investment an investor can purchase. This could prevent investors from buying and selling these assets as desired.

Instability

Countries in the midst of transition, war, or economic uncertainty may also be experiencing adverse economic effects, and companies within those countries may be impacted. These days, news can change by the minute, and it might be difficult to keep on top of what’s happening when so much news is happening all at once.

Cost

Sometimes it can be more expensive to invest in non-US investments than investing domestically. This is due to possible foreign taxes on dividends earned outside the US, as well as transaction costs, brokers’ commissions, and currency conversions.

Limited Access to Information

Different countries may have various jurisdictions that require foreign businesses to provide different information than the information required of US companies. Also, the frequency of disclosures required, standards, and the nature of the information may vary from what you would see in the US.

For example, the Securities and Exchange Commission or SEC is responsible for protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation in the US. The SEC does this by requiring public companies to disclose “meaningful financial and other information to the public.” This allows investors to make informed investment decisions about particular securities.

Whereas in other countries they may have different organizations and guidelines for monitoring and regulating capital markets.

Additionally, analyzing individual investments is challenging enough with all the information available. But when investing internationally, the analysis adds another layer of complexity, since investors need to figure out different issues such as account, language, customs, and currency.


💡 Quick Tip: How to manage potential risk factors in a self directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

Consider Investment Risk When Building Your Portfolio

Risks are a part of life. It’s difficult to grow, change, or improve without taking chances. What’s safe isn’t always what’s best, so getting the best of something typically involves some risk.

When creating an investment portfolio, determining risk tolerance, which ranges from conservative investments (low risk) to aggressive investments (high risk), is a typical first place to begin.

Higher-risk investments may have the potential for higher returns, but they also have greater potential for losses. Therefore, by assessing your risk tolerance, you won’t take risks that you can’t afford to take.

Just like in life, there are no guarantees when taking an investment risk, but considering informed risks—based on research and experience—may put financial goals within reach.

Becoming a Global Investor

Even though the world’s political, economic, and sociological landscape is ever changing, considering investments in global markets may help minimize risk exposure.

To become an international investor, a good place to start might be by adding certain mutual funds and ETFs to an investment portfolio. Newer investors might be more comfortable starting with US stocks.

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.
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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.


Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
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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Jun
21
2023
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What Is Interest Rate Risk?

By | Growing Wealth, invest, Investing | Comments Off on What Is Interest Rate Risk?

Interest rate risk is the possibility that instead of going up in value, an investment asset can go down in value due to fluctuations in interest rates. It’s a type of opportunity risk: When someone pursues one type of investment opportunity, they may be giving up the opportunity to invest in another asset.

This term is usually made in connection with bond purchases. When market interest rates go up, the prices of fixed-rate bonds go down. Conversely, lower market interest rates equal higher fixed-rate bond prices. This is an inverse relationship that goes in both directions.

How Does a Bond Work?

Bonds are a type of loan, with funds going from the investor to the issuer. The issuer could be the federal government, a state or local government, or a company. In return for the bond purchase loan, the investor is promised that they will be repaid the full amount of the bond—plus a predetermined amount of interest—on a specific date.

Traditionally, bonds have paid a fixed rate, although there are some with a variable or “floating” interest rate.

The predetermined rate is called the coupon rate, with interest paid on coupon dates. Bonds come with an expiration or “maturity” date, when the value of the bond must be paid back in full.

An investor can sell a bond before it reaches its full maturity. If the bond issuer is doing well and the bond is in high demand, the investor could see a capital gain. If not, the sale might be made at a loss.

While there’s no such thing as a safe investment, investors typically consider bonds to be lower-risk than stocks and some other investments.


💡 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.

Interest Rate Risk and Timing

When investors buy fixed rate bonds, they’re taking the risk that the interest rate may go up after they’ve already made their purchase.

If interest rates do increase, then new bonds are issued with higher return rates, which means that the existing bonds with lower returns are in lower demand.

In general, long-term bonds come with more interest rate risk than ones with shorter terms. The more that interest rates rise after the bond was purchased, the more of an impact that has on the investor’s return on investment.

The Office of Investor Education and Advocacy of the US Securities and Exchange Commission (SEC) offers a helpful resource on this subject. In it, they provide two contrasting examples to illustrate the concept.

In the first example, they assume that a Treasury bond has a 3% interest rate. A year later, market interest rates drop to 2%. But investors who bought their bonds at 3% continue to receive that interest rate, making it a more valuable investment than new bonds paying just 2%.

If that bond is sold before it reaches its maturity date, the price would likely be higher than it was in the previous year. The bond’s yield to maturity, though, will be down for investors purchasing it at the higher price.

In the second example, instead of rates going down from the original 3%, rates go up to 4%. In that scenario, investors looking to sell their bonds would be competing with new bonds that offer a 4% rate. So the price of the bond that pays 3% may well fall, with the maturity yield going up.

Interest Rate Risk Management

One way to handle investment risk is with diversification. This means building an diversified portfolio that includes a variety of different asset classes, such as stocks, mutual funds, and real estate or other alternative investments, along with different types of bonds, some with staggered maturity dates. Diversified investment portfolios may offer some risk insulation so that if one area takes a financial hit, possible growth in another area could balance out that risk.

Another form of interest rate risk management is participation in hedge funds. With a hedge fund, money from multiple investors is collectively invested, with the goal of receiving a positive return on investment.

That said, because there are relatively higher fees involved with hedge funds, this is a strategy that the SEC calls “limited to wealthier investors” as well as “institutional investors, including pension funds.”

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Interest Rate Risk and High-Yield Bonds

There are pros and cons to high-yield bonds. These types of bonds—corporate bonds that were issued by companies looking to raise capital, or by “fallen angel” companies whose credit rating has dropped—might sound attractive to investors because the notion of receiving a relatively high rate of interest is appealing. But along with the high yield is the potential for a higher degree of risk.

Bonds receive ratings on their creditworthiness, with S&P Global Ratings and Moody’s serving as the two main credit-rating agencies. Bonds with quality ratings are less likely to go into default. When a bond goes into default, interest is less likely to be paid on time, if at all, and investors may also lose their initial investment. Bonds with high ratings include Treasury bonds issued by the federal government and those issued by large companies considered to be stable.

Bonds with lower ratings tend to need to offer higher coupon rates to entice investors. In other words, they often need to offer high-yield bonds.

When deciding whether to include high-yield bonds in their portfolio, investors may want to consider the pros and cons of doing so.

Pros of High-Yield Bonds

•  Consistent yields. Bonds typically come with an agreed-upon and consistent yield, which makes the amount owed to the investor predictable as long as the company doesn’t go into default (and many don’t). Stocks, on the other hand, don’t need to pay dividends at all and they don’t come with a guaranteed return on investment.
•  Priority payment if the company fails. If assets of a failed company will be liquidated, bondholders would be first in line for payouts, ahead of stockholders.
•  Possible price appreciation. If the credit rating score of the company issuing the bond improves, it’s possible that the bond’s price will go up. This isn’t possible for AAA bonds from companies with good credit ratings.
•  Potentially less sensitive to interest rate changes. When this is the case, it may be because high-yield bonds tend to have shorter terms than investment-grade bonds, which may be why they often have less sensitivity to fluctuations in interest rates.

Cons of High-Yield Bonds

•  Higher default rates. Because of the higher risk involved, more of these bonds default. When this happens, the investor can lose all funds, including the original principal they invested.
•  Harder to sell. There can be lower demand for this type of bonds, which can make it harder to sell them at a desired price (or at all).
•  Possible price depreciation. If a company’s credit rating drops further, then the price can further depreciate.
•  Sensitivity to interest rate changes. All bonds, including high-yield ones, are subject to interest rate risk.

The Takeaway

Bonds are a popular investment choice because they are less volatile than stocks, but they are not without risks. Interest rate risk is the potential for a bond value to drop as market interest rate rises (the opposite is also true). High-yield bonds are just as susceptible to interest rate risk as corporate or municipal bonds.

Investors can work to mitigate that risk through portfolio diversification, and some may choose to look into hedge fund investing.

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.


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.


Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

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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Jun
21
2023
Understanding The Stock Market Index

Understanding The Stock Market Index

By | Growing Wealth, invest, Investing | Comments Off on Understanding The Stock Market Index

A stock market index measures the performance of a particular “basket” of stocks, representing a specific industry or region. Investors use these market indexes in many ways—to analyze current market conditions, identify industry trends, and invest in index funds.

To help you better understand how market indexes work and how investors use them to their advantage, here’s a deep dive into the inner workings of stock market indexes.

What is a Market Index?

A stock market index tracks a specific group of stocks in a market segment, like a specific industry or region. Indexes can tell investors and financial institutions a lot about specific investments, the sector as a whole, even the overall economy. Here are a few insights investors look to indexes for:

•  To understand how the economy is performing
•  To help with trend forecasting
•  To create benchmarks to evaluate a particular investments’ profitability

Take, for example, the S&P 500, which tracks the 500 largest publicly-traded U.S. companies in the stocks market. Each company is carefully selected to embody every primary industry, thus creating a replication of the market as a whole. Conceptually, an investor might look at the past performance of the S&P 500 to assess whether the stock market is emerging or receding.

How Stock Market Indexes Work

Indexes are made up of hundreds and sometimes thousands of stocks. However, the index doesn’t evenly assess each stock. Depending on what stocks have higher weight in an index, their performance may have more or less influence on how the index performs overall.

There are a few ways indexes are typically weighted:

•  Price weighted: In price-weighted indexes, the stocks with the higher price will have a greater influence on overall performance than those with lower prices.
•  Capitalization weighted: These indexes look at the total value (or market capitalization) of each stock’s outstanding share to determine its weighted value, giving smaller market caps a lower percentage weighting, and higher market caps a larger one.
•  Value weighted: A light math formula is employed in this type of index, where the price of the stock is multiplied by the number of outstanding shares.
•  Equal weighted: In this index type, all stocks are given equal weight, regardless of market cap, value, or price.

Types of Stock Market Indexes

While there are many indexes investors and financial professionals can follow, here are a few examples of stock market indexes.

•  S&P 500. The S&P 500 measures the largest publicly-traded U.S. stocks. Financial professionals use the performance of the S&P 500 as a basis to compare other investment options.
•  NASDAQ Composite Index. The NASDAQ Composite Index measures over 3,000 global and U.S. stocks registered on the NASDAQ stock market. Because it covers so many stocks, it is one of the most followed and quoted indexes. Some of the types of stocks include common stock and real estate trusts (REITs).
•  Dow Jones Industrial Average. The Dow Jones Industrial Average, commonly known as the DJIA, measures 30 US-based blue-chip stocks that are often referred to as the foundation of the U.S. economy. These stocks usually include companies in market segments of the economy, with the exception of transportation and utilities (the Dow Jones has separate indexes for those two sectors).
•  Russell 2000 Index. In contrast to the S&P 500, which follows large-cap stocks, the Russell 2000 follows 2000 of the smallest companies in the U.S. market (or small-cap stocks), making it a good benchmark for small, publicly-traded companies.

How to Invest in a Stock Market Index

Although it’s possible to purchase all stocks within a particular index, this method might be too time-consuming, complicated, and potentially expensive. Another option is to invest in ETFs or index funds or that attempt to replicate indexes’ performance, known as an index fund. This investment strategy is often referred to as index investing.

With index investing, investors can effortlessly access index funds. By investing in index funds, they can also follow some common investing pillars, such as diversification. For example, investing in an index fund helps investors exercise a diversification strategy instead of a strategy centered around stock-picking and market timing.

Advantages of Investing in a Stock Market Index

As an investment strategy, index investing has certain benefits that may attract investors. These are the big ones.

Index Advantage: Simple Investment Management

By investing in a stock market index, investors may earn better returns with minimal effort, making index investing an easier way to manage their investments.

Investing in a stock market index is typically considered a passive investing strategy, where investors buy and hold securities to hopefully capitalize on long-term gains. Conversely, active investors buy and sell securities with the intent to beat the market or some form of index returns.

Because active investors are more hands-on, it’s easy to assume that they may reap higher returns than what the average index investor would see. But that’s not necessarily so. In fact, according to the SPIVA Report , over the past five years, 77.97% of actively managed large-cap funds underperformed the S& P 500.

In addition to most actively managed funds underperforming their passive investing counterparts, active investing requires a lot of time, analysis and is often very challenging.

Index Advantage: Diversification

Diversification is considered by some to be one of the vital building blocks of a thorough investment strategy. With diversification, investors spread their investment across various assets instead of putting all of their money into a single security.

Since investments may perform differently in dissimilar economic environments, diversification may help investors minimize their risk exposure. In other words, if one investment drops in value, investors still have other investments to potentially make up for the loss.

A stock market index fund packages many different stocks in an individual investment, providing nearly instant diversification, vs. investing in just one stock.

Index Advantage: Minimal Barriers to Entry

For investors on a strict budget, it might be challenging to invest in more than just a few companies. However, by investing in a stock market index, they have exposure to a large assortment of stocks using the same amount of cash.

What’s more, investors don’t need the assistance of a money manager or financial advisor to invest in an index. That said, it’s still essential to review any related fees and costs. While indexes tend to have lower taxes and fees, it’s generally a good idea to review all costs involved in any investment before moving forward.

Disadvantages of Investing in Stock Market Indexes

Few things in life are perfect, and that includes investments. Here are some common disadvantages of investing in stock market indexes.

Index Disadvantage: Not a Short-Term Investment Strategy

Because indexes follow the market, their value increases incrementally, making them a better long-term investment strategy than short-term. Investors may also see fluctuations in returns, since they’ll go through various business cycles—Which means that at times, investors may see very small, if any, increases to their portfolios.

Index Disadvantage: They Don’t Fully Follow a Certain Index

Stock market indexes may closely chart the index they track, but they may not perform exactly how the entire index performs. This is because indexes typically don’t include all of the stocks within a particular index; they only include a snapshot of the index as a whole. Thus, the index fund can’t wholly mimic the performance of the entire index.

However, while the index doesn’t directly mimic a stock market’s performance, it tends to have similar price fluctuations. So, if the market increases, typically the index will as well.

The Takeaway

The stock market index is a useful way for investors and analysts to get a sense of how a certain segment of the market is performing—whether that’s the top 500 publicly-traded large-cap US companies or the bottom 2000 small-cap ones. It’s also a way for investors to diversify their portfolios in one move, by investing in an index fund or ETF.

For investors who are interested, the government recommends reviewing all of the information available on a particular index, including the fund’s prospectus and most recent shareholder report. You may also want to identify the fees, your investment goals, and the investment risk of investing in a particular index.

Using the SoFi Invest® online investing platform can help you easily monitor your investments, and invest in low-cost ETFs with no SoFi management fees. ETFs give you exposure to a wide variety of stocks for a fraction of the cost of investing in each stock individually.

Find out how SoFi Invest can help you reach your investment goals.

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.


Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

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.

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.

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21
2023
What is a Gamma Squeeze?

What Is a Gamma Squeeze?

By | Financial Independence, Growing Wealth, invest, Investing | Comments Off on What Is a Gamma Squeeze?

The finance world is chock full of strange terminology. “Gamma squeeze” is a perfect example.

In general, when there’s a “squeeze” in the market, that usually describes an event when investors feel pressure to make a move that they otherwise would not have made. For instance, in “short squeezes,” investors who made bearish bets on a stock–known as short sellers–are forced to buy shares of the stock they’ve actually bet against.

This piece will dig into what a gamma squeeze is, what it has to do with options trading, and what it means for investors.

Overview of Options Trading

It’ll be helpful if we quickly recap how options trading works. Options can be bought and sold, just like stocks. In short, they’re contracts that give purchasers the right (but not the obligation) to buy or sell an asset—i.e., the option to transact.

Options can be used to speculate on price changes. For example, if an investor thinks the price of a stock is going to increase, they can purchase an options contract to put themselves in a position to profit if their prediction were to come true.

There are call and put options to take into account. A call gives purchasers the right to buy an asset at a certain time or price, whereas a put gives them the right to sell it. Buying these types of options allows them to effectively bet on a stock, without outright owning it. Purchasers typically pay a small “premium,” or the price of the contract.

Generally, if an investor thinks a stock’s price will increase, they buy calls. If they think it will decrease, they buy puts.

Recommended: Options Trading Terminology

Gamma Squeeze Definition

A gamma squeeze has to do with buying call options. Remember, purchasers buy calls when they think the price of a stock is going to increase. And as the price of that stock increases, so does the value of the call option. Now, when a stock’s price starts to increase, that can lead to more investors buying calls contracts. There’s a whole lot of call-buying going on.

But on the other side of those calls are the traders or institutions that sold them—remember that options are a contract between two parties, so for an investor betting on a stock price’s increase, there’s another that’s betting that it’ll fall. They’re taking a “short” position, in other words.

“Market makers”–the trading firms that are selling the call options–are typically the party on the other side of the trade. They’re essentially “short” those call options that investors in the market are buying. These market makers face a good amount of risk if the price of the underlying stock rises, so they will buy some shares of the stock to hedge some of that risk.

Buying the shares also helps to ensure that they will be able to deliver the stock if they become “due,” or the investor exercises their call options.

However, if investors keep buying more and more calls, and the stock’s price increases, market makers need to buy more and more stock—increasing its price even further, and thus, creating a “squeeze.” The gains in share value cause the market makers to be more exposed, hence they need to hedge even more.

Part of this is also because the stock’s gains brings the options closer to the prices at which calls can be exercised.

Basically, the short positions held by some investors allows a gamma squeeze to happen. And if a stock’s price rises instead of falls, the shorters’ need to start buying the stock, further increasing its price, creating the feedback loop mentioned earlier.

Recommended: Shorting a Stock Explained

What’s Gamma in Options?

Okay, so you may have a grasp on how a gamma squeeze can occur. But we still need to talk about what gamma is, and how it fits into the picture.

Gamma is actually just one of a handful of Greek letters (gamma, delta, theta, and vega) that options traders use to refer to their positions. In a nutshell, “the Greeks” help traders determine if they’re in a good position or not.

For now, we’ll just focus on delta and gamma. Gamma is actually determined by delta. Delta measures the change of an option’s price relative to the change in the underlying stock’s price. For instance, a delta of 0.3 would mean that the option’s price would go up $0.30 for every $1 increase in the underlying stock’s price.

Gamma measures how delta changes based on a stock price’s change. It’s sort of a delta of deltas. In other words, gamma can tell you how much an option’s delta will change when the underlying stock’s price changes. Another way to think of it: If an option is a car, its delta is its speed. Its gamma, then, is its rate of acceleration.

When a gamma squeeze occurs, delta and gamma on options are in a state of flux, creating stock volatility and ultimately, squeezing some market players.

The Takeaway

When investors are making bullish bets on a stock, sometimes they use call options–contracts that allow them to buy a stock at a certain date in the future.

When brokers or market makers sell those call options to the investors, they buy shares of the underlying stock itself in order to try to offset the risk they’re exposing themselves to. This also helps them ensure they can deliver the shares if the options get exercised by the investor holding the call options.

Gamma squeezes occur when there’s rapid buying by the market makers of the stock, causing a dramatic surge in the share price. The sudden increase, in turn, causes greater exposure for the market makers, causing them to hedge themselves more by purchasing additional shares.

Options trading is complex and may not be for everyone. But if you want a simpler investing experience, then an online investing account with SoFi may be a good choice. SoFi Invest allows investors to buy and sell stocks, ETFs and fractional shares without commissions. Users can also start building a portfolio with as little as $5 on the Active Investing platform.

Check out SoFi Invest today.

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.
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Jun
21
2023

What Is a Market Maker?

By | Financial Topics, Growing Wealth, invest, Investing, Terminology | Comments Off on What Is a Market Maker?

Market makers are trading firms that continuously provide prices at which they will buy or sell assets.

Market makers are typically banks, brokerage firms or proprietary trading firms. Unlike traditional investors, they’re not in the business of betting whether the price of an asset will go up or down. They also don’t tend to hang on to securities for very long. Instead, market makers profit off the tiny price spreads that come from buying and selling securities rapidly.

Because they stand ready to do both sides of a trade, market makers are considered to be liquidity providers. Liquidity is the ease with which an asset can be bought or sold without affecting its price.

How Market Makers Work

In both stock and equity options trading, there are at least a dozen different exchanges. In order to provide prices across multiple exchanges, market makers rely on algorithms and ultra-fast computer systems to make sure their price quotes reflect the supply and demand for a security in the market.

Because of their use of such technology, market makers are sometimes called high-frequency traders. Here’s a closer look at the role market makers play in financial markets today.


💡 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.

How Market Makers Earn Money

Market makers seek to profit off the difference in the bid-ask spread, or the difference between the price at which an asset can be bought and the price at which it can be sold.

Overview of Bid-Ask Spreads

Here’s a hypothetical example of how market making works. Let’s say a firm provides a quote for $10-$10.05, 100×200. That means they’re willing to buy 100 shares for $10, while simultaneously offering to sell 200 shares at the price of $10.05. The first part of the offer is known as the bid, while the latter is known as the ask. The prices that market makers set are determined by supply and demand in the market.

This means an investor or broker executing on behalf of a client can buy shares from the market maker at $10.05. And another investor looking to sell shares, can do so at $10 to this market maker. The difference of 5 cents is how the market maker locks in a profit. While making pennies on each trade sounds miniscule, it can be massively profitable at huge volumes.

Bid-ask stock spreads tend to narrow when markets are more liquid and widen when markets are less liquid. This is because during periods of volatility, sellers are more inclined to sell while buyers are more likely to stay put, anticipating lower prices in the near future. Because bid-ask spreads tend to widen during periods of stock volatility, it also means market makers are able to capture bigger profits when markets are turbulent.

Because of the risk of holding onto securities while making markets on them, market makers often hedge their bets by getting exposure to other assets or shorting securities in separate trades.

Overview of Payment for Order Flow

Another way some market makers earn revenue is through a practice known as payment for order flow. This is when retail brokerage firms send retail client orders to market makers who then execute the orders.

So let’s say for example, a mom-and-pop investor at home puts in a buy or sell trade via their brokerage account. The broker then bundles that order with other client orders and sends them to an electronic market making firm, which then fulfills the orders.

Recommended: Brokerage Accounts Explained

Market makers pay fees to brokerage firms for sending those orders, and this is how brokerage firms have been able to offer zero-commission trading to retail clients in recent years.

Payment for order is common and legal, but it’s come under controversy over the years with some critics saying the practice incentivizes brokers to boost revenue, rather than find the best prices for their customers. Market makers are required by regulatory rules to execute client orders with “best execution, “ but execution quality can be defined by price, speed or liquidity.

Defenders of PFOF argue that retail investors get “price improvement,” when customers get a better price than they would on a public stock exchange. A Bloomberg Intelligence report estimated that retail investors in 2020 benefited from price improvement by $3.7 billion. Separately, brokers are required by Securities and Exchange Commission regulation to make available statistics on execution quality, in what’s known as 605 and 606 disclosures.

What Are Designated Market Makers (DMMs)?

Designated market makers are trading firms on the New York Stock Exchange who are in charge of ensuring orderly trading of stocks listed on the New York Stock Exchange. Each company that chooses to list on the Big Board picks a DMM for its shares.

DMMs are supposed to add a human touch to stock exchange trading in today’s electronic markets. In contrast, the Nasdaq Stock Exchange, the second-biggest venue for U.S. equities, doesn’t have DMMs for its listed companies and trading is instead completely electronic.

Famous for wearing distinctive blue-colored jackets on the floor of the NYSE, DMMs used to be known as “specialists” back in the day. There used to be dozens of specialist firms in the 1980s, but these days there are just a handful of DMMs active on the NYSE floor.

The Takeaway

Market makers are intermediaries who provide prices all day in two-sided markets, where both bids to buy and offers to sell are quoted. Instead of making long-term bets on whether an asset will rise or fall, they make money from holding on to assets for short periods and profiting off their tiny bid-ask spreads. Market makers rely on high volumes in order to generate significant revenue.

Market makers are also sometimes called high-frequency traders because they use ultra-fast technology and algorithms to connect to multiple exchanges and quote numerous prices continuously. They’re considered important participants in modern financial markets because they speed up the pace at which transactions take place, particularly in stock and equity options trading.

On the SoFi Invest® online brokerage app, users can buy and sell stocks, exchange-traded funds (ETFs) or fractional shares. SoFi Securities LLC (Active Investing) earns a small amount of money from market makers–a process that allows users to trade without commission fees. For users who choose the Automated Investing service, SoFi will build and manage their portfolios for them and charge no management fees.

Check out SoFi Invest today.


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.

Stock Bits
Stock Bits is a brand name of the fractional trading program offered by SoFi Securities LLC. When making a fractional trade, you are granting SoFi Securities discretion to determine the time and price of the trade. Fractional trades will be executed in our next trading window, which may be several hours or days after placing an order. The execution price may be higher or lower than it was at the time the order was placed.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.

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