Investing Archives | Page 157 of 191

May

2023

Understanding Inverse ETFs

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

An inverse ETF — or short ETF — is a portfolio of securities that allows investors to make a bet that either the broader markets or a particular asset class or market sector will go down in the short term.

There are a wide range of inverse ETFs to choose from — there are currently 89 traded in U.S. markets. They allow investors to make short-term investments in the likelihood that the price of a given asset will go down. Investors can use inverse ETFs to find returns when there are price dips in equities, fixed-income securities, and certain commodities.

How Does an Inverse ETF Work?

To understand inverse ETFs, an investor first needs to know about Exchange Traded Funds (ETFs). An ETF is a portfolio of stocks, or bonds or other securities that trades on an exchange, like a stock. Its share price fluctuates throughout the day, as investors buy and sell shares of the fund.

As with regular ETFs, investors can buy and sell inverse ETFs throughout the day. Unlike the way ETFs work, however, inverse ETFs are designed not to invest in a given index, but to deliver the opposite result. If the index goes down, the ETF is meant to go up, and vice versa.

What Do Inverse ETFs Invest In?

Inverse ETFs — or short ETFs — use complex trading strategies, involving a heavy use of futures contracts, to deliver the opposite result of the markets. Futures contracts are essentially agreements to buy or sell a given asset at a given date and price, regardless of the market price at the time. Using futures contracts, an investor can bet that a given asset, like a stock, will go up or down, without actually owning that asset.

Put simply, investors who think the price of a given stock will go down may buy a futures contract that allows them to sell a stock at a higher price than they think it will trade at by the expiration of the contract. If the price of that stock does go down, they can buy it on the open market cheaply and sell it to the other person or institution at the agreed-upon higher price, and pocket the difference.

An inverse ETF does that with a group of stocks, every trading day. The largest inverse ETFs aim to deliver the opposite returns of major stock indexes, like the Nasdaq or the S&P 500. For example, if the S&P 500 goes down 1% on a given day, then a corresponding inverse ETF could be designed to go up 1% that day.

Leveraged Inverse ETFs

There are other inverse ETFs that take the formula one step further, using leverage. That means they buy the futures contracts in their portfolios partially with borrowed money. That gives them the ability to offer outsized returns — two and three times the opposite of the day’s return — but it also exposes them to sizable single-day losses, and larger losses over time.

For example, on that same hypothetical day when the S&P 500 goes down 1%, the corresponding inverse ETF could be designed to go up by 2%.

Who Invests in Inverse ETFs?

An inverse ETF might seem like a good choice for an investor who is generally pessimistic about the prospects for the broader markets over the next few months or years. But that’s not necessarily the case.

Inverse ETFs only invest in one-day futures contracts. The futures contracts they invest in expire at the end of the trading day, locking in the ETFs’ gains and losses.

With an inverse ETF, it’s not enough to be right about the general direction of a given market, asset class or sector. The performance of inverse ETFs isn’t the exact opposite of the index it tracks over longer periods of time. So, the investor has to be correct on the right days, as well.

Inverse ETFs get a lot of attention in the media during market swoons, when they post eye-popping returns. But most financial professionals probably don’t recommend them as long-term investments. They’re generally best for sophisticated investors with a high tolerance for risk.

What Are the Risks of Inverse ETFs?

Investors who purchase inverse ETFs take on risks that are common to all investors, and also some that are unique to this specific investment vehicle.

• Loss: If an investor buys an inverse ETF and the index that it shadows goes up, then the investor will lose money. If the given index goes up by 1% that day, then the fund offering the inverse of that index will go down by 1%; with a leveraged ETF, it could even go down by 2% or 3%.

• Fees: While most ETFs have very low management fees, inverse ETFs may have higher fees, which may take a bite out of returns over time. (It’s worth noting that the management fee can be typically lower than the time and expense of shorting the stocks directly.)

The risks are significant enough that in 2019, the Securities and Exchange Commission proposed new regulations about inverse ETFs, requiring companies that manage leveraged and inverse ETFs to specifically make sure customers understood those risks. The regulation was not approved, which means the onus is still very much on investors to understand the risk.

The Takeaway

Inverse ETFs are designed as tools to allow investors to bet against the market, or specific asset classes. While they come with unique risks, inverse ETFs can help investors find returns during market dips — giving them the chance to short the market with one trade. These ETFs go up as the index goes down, offering opportunity when it might otherwise seem there is none.

The trick: choosing the right inverse ETF on the right day, in order to gain rather than lose. The funds are risky, but can be popular among investors who want to hedge their exposure to a given asset class or market sector, and investors who believe that a given market is due for a big drop.

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May

2023

Coattail Investing Basics

By Brian Nibley | Growing Wealth, invest, Investing | Comments Off

Coattail investing, also known as copycat investing, is one of many popular investment strategies and one that involves investors trying to replicate the results of investors that already have a proven track record of success. In effect, investors look at what other successful investors are doing, and replicate it.

For newer investors, this method has some obvious advantages, and can help ease the learning curve a bit. But, of course, there are both benefits and drawbacks, and it’s helpful to know who you can or perhaps should try to replicate before choosing some coattails to ride at random.

How To Be a Coattail Investor

For the most part, coattail investing incorporates a buy and hold strategy, where an investor buys stocks and holds them for the long term — a period of several years or several decades. Publicly available information from the financial press and the Securities Exchange Commission (SEC) website can give copycat investors information on how investors (those managing more than $100 million) have invested their money.

Coattail investing begins with choosing what person or group to watch. Then, based on their investment choices, a copycat investor can choose to replicate those investing strategies either in whole or in part.

In most cases, the average investor probably doesn’t have enough capital to keep up with big money managers and institutions in an exact 1:1 ratio. But watching what they buy and sell (and when), and acting accordingly to some degree, is the heart of coattail investing.

While investors used to have to manually follow their favorite investors by searching the SEC website or elsewhere, today, certain online services exist that help to automate the process.

Some brokerages may even offer “mirror investing” services that allow investors to set their own portfolios to make the same exact trades that their favorite investors make, with customized asset allocations.

Who Do Coattail Investors Follow?

When attempting coattail investing, following those who adopt a “buy and hold” strategy could prove beneficial. Because markets move fast, by the time a trade is executed, the most profitable opportunity may have already passed. Buying and holding takes a long-term time horizon or perspective, meaning it could take some of the timing and guesswork out of the equation, making it easier to realize profits.

A copycat investor could choose to copy just about anyone. That said, there are a few choices most commonly used by those who are successful at copycat investing. These include financial professionals and other investors who can influence markets simply by announcing their positions.

Activist Investors

Activist investors are known for causing stocks to rise when they reveal their own investments. These influencers may be ahead of the curve on investment trends, and financial news media reports on the actions of these investors regularly. Activist investors also often publicize their own moves through blog posts or press releases as well. This tends to make it easy for coattail investors to keep up and act accordingly.

Money Managers

People and institutions that manage over $100 million are required to report their holdings to the SEC. The SEC then publishes this information, making it public. Rather than hire a money manager, some copycat investors simply search for investments that large money managers have made and then choose those they think would be best for their own portfolios.

Large Corporations and CEOs

Successful companies that have accumulated cash reserves are challenged with figuring out where to put that money — and coattail investors sometimes follow suit.

For many years, holding cash and bonds was probably the safest option for investors. But bonds and cash have their risks, too, such as interest rate fluctuations and inflation. This has led some companies to look elsewhere for returns, often in the form of alternative investments.

Unlikely Visionaries

Following more nontraditional investors — people outside the financial world who have made successful investments — might not be as profitable as activist investors or proven money managers, but there can still be insight to be gained.

That may include professional athletes or social media influencers. There are numerous examples of both who have made what turned out to be successful investments of various types. Of course, even if you start to mirror an athlete’s or influencer’s portfolio activity, there’s no guarantee that they’ll continue to make wise choices.

While watching athletes or celebrities for investment advice might not be something anyone would recommend, it can bring a unique perspective from outside the echo chamber and herd mentality of those within the financial world. People who come from outside that world tend to have a different outlook and could see something that others miss.

That said, an investor who looks to popular culture icons for investment advice does run the risk of racking up significant losses. It might not be realistic to establish an entire portfolio around this idea. It’s widely believed that in coattail investing, investors should follow only the most esteemed professional money managers.

What Are the Risks of Coattail Investing?

The main risk of copycat investing is that one might end up following an investor who loses, rather than gains. There could also be psychological risks, such as thinking that because one is copying a successful investor’s moves, all personal responsibility has been taken out of the equation.

In reality, investing always comes with risk, and always requires investors to conduct their own due diligence. Unless a copycat investor is using an automated program that buys and sells as soon as a big investor announces their trade, like a robo advisor of one type or another, they will still have to stay on top of their own investments, even if the decisions of what/when to buy/sell are all recommended by someone else.

The Takeaway

Coattail or copycat investing is a strategy that involves mirroring another investor’s market moves. Copycat investing could be pursued in almost any fashion imaginable. It’s possible to follow anyone for investment advice, using their trades as a game plan.

Investors with an interest in pursuing coattail investing would do well to consider sticking to tracking these types of people and their portfolios. But watching others with more experience and preferring to match their actions more often than not can bring a sense of security to some investors. It can also reduce some of the personal responsibility involved in researching investments and trying to decide when to buy or sell.

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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May

2023

Trade vs Settlement Date: What’s the Difference?

By Inyoung Hwang | Growing Wealth, invest, Investing, Terminology | Comments Off

The day that an investor or trader’s buy or sell order for a security is confirmed is called the trade date. But the day that the security actually changes hands is called the settlement date.

Both the trade date and the settlement critical to understand for investors who may not realize that there are things taking place behind the scenes when they’re buying or selling investments.

What Is a Settlement Date in Investing?

As mentioned, the settlement date in investing refers to the date that a security which is purchased or sold exchanges hands between the buyer and seller. It’s the day that a transaction or trade is final, in other words. It’s like buying a car or house — the transaction process may take some time, but it’s not really final until the keys are handed over.

Generally, the settlement date for a transaction is two business days after the trade date. So, if you make a trade, you should anticipate that it won’t be settled for at least a couple of business days.

Types of Settlement Dates

Depending on the specific security involved in a trade or transaction, settlement dates may vary. You can read further below for more detail, but typically you can expect a settlement date to be two business days following the sale or purchase of a stock, bond, or exchange-traded fund (ETF). This is sometimes referred to as “T+2,” meaning “trade date, plus two days” to settle.

Further, some types of securities, like government securities or options, may only require one business day to settle (T+1). Others, like mutual funds, may require between one and three business days.

Trade and Settlement Dates Explained

To recap, the trade date is the day that an investor actually executes a trade from their brokerage account — they decide to buy or sell a security, and go through the necessary steps to make the transaction. That day, say it’s a Tuesday, is the trade date.

The settlement date comes after that. Again, if you’re buying stock, it’ll take two business days for everything to settle, and if you made the trade on Tuesday, the settlement date will probably be on Thursday (two business days later).

These built-in delays between the trade date and settlement date aren’t due to you doing anything wrong, and there’s not much you can do to speed it up — it’s more or less how stock exchanges work.

Why Is There a Delay Between Trade and Settlement Dates?

Given modern technology, it seems reasonable to assume that everything should happen instantaneously. But the current settlement rules go back decades, way back to the creation of the Securities and Exchange Commission (SEC) in 1934, when all trading happened in person, and on paper.

Back then, a piece of paper representing shares of a security had to be in the possession of traders in order to prove they actually owned the shares of stock. Moving this paper around sometimes took as long as five business days after the trade date, or T+5.

💡 Recommended: A Brief History of the Stock Market

What Is the T+2 Rule?

As discussed, the T+2 rule refers to the fact that it takes two days beyond a trade date for a trade to settle. For example, if a trade is executed on Tuesday, the settlement date will be Thursday, which is the trade date plus two business days.

Note that weekends and holidays are excluded from the T+2 rule. That’s because in the U.S., stock exchanges are open from 9:30am to 4:00pm Eastern time Monday through Friday.

The T+2 rule has been enforced by the SEC since 2017. Before then, the T+3 rule was in place.

What Investors Need to Know About T+2

This delay in settling applies to trading of almost all securities. An exception is Treasury bills, which can settle on the same day they are transacted.

Investors who plan on engaging in cash account trading need to know about trade vs. settlement date. Cash accounts are those in which investors trade stocks and exchange-traded funds (ETFs) only with money they actually have today. Meanwhile, margin trading accounts allow investors to trade using borrowed money or trade “on margin.”

An investor may notice two different numbers describing the cash balance in his or her brokerage account: the “settled” balance, and the “unsettled” balance. Settled cash refers to cash that currently sits in an account. Unsettled refers to cash that an investor is owed but won’t be available for a few days.

Are T+1, T+0, or Real-Time Settlement Possible?

Market observers have called for the T+2 rule to be reevaluated, as the settlement process may be able to be sped up and improve trading conditions.

Clearinghouses — which serve as middlemen in financial markets that ensure the transfer of a security goes through — have previously said that the settlement process should be changed from two days to one. But in recent years, market volatility has actually prompted greater scrutiny and interest in regulations surrounding clearing and settlement. That included a lot of trading during the “meme stock” frenzies in 2020 and 2021.

Moving to T+1, T+0 or real-time settlement would need the approval of the SEC and collaboration of dozens of stakeholders across Wall Street. But the real-time transactions made possible in the cryptocurrency market by blockchain technology have escalated chatter for modernizing securities markets.

Potential Violations of the Trade Date vs Settlement Date

Knowing the difference between trade date vs. settlement date can allow investors to avoid costly potential trading violations.

The consequences of these violations could differ according to which brokerage an investor uses, but the general concept still applies. Violations all have one thing in common: They involve the attempted use of cash or shares that have yet to come under ownership in an investor’s account.

Cash Liquidation Violation

To buy a security, most brokerages require investors to have enough settled cash in an account to cover the cost. Trying to buy securities with unsettled cash can lead to a cash liquidation violation, as liquidating a security to pay for another requires settlement of the first transaction before the other can happen.

Let’s look at a hypothetical example: Say Sally wants to buy $1,000 worth of ABC stock. Sally doesn’t have any settled cash in her account, so she raises more than enough by selling $1,200 worth of XYZ stock she has. The next day, she buys the $1,000 worth of ABC she had wanted.

Because the sale of XYZ stock hadn’t settled yet and Sally didn’t have the cash to cover the buy for ABC stock, a cash liquidation violation occurred. Investors who face this kind of violation three times in one year can have their accounts restricted for up to 90 days.

Free Riding Violation

Free riding violations occur when an investor buys stock using funds from a sale of the same stock.

For example, say Sally buys $1,000 of ABC stock on Tuesday. Sally doesn’t pay her brokerage the required amount to cover this order within the two-day settlement period. But then, on Friday, after the trade should have settled, she tries to sell her shares of ABC stock, since they are now worth $1,100.

This would be a free riding violation — Sally can’t sell shares she doesn’t yet own in order to purchase those same shares.

Incurring just one free riding violation in a 12-month period can lead to an investor’s account being restricted.

Good-Faith Violation

Good-faith violations happen when an investor buys a security and sells it before the initial purchase has been paid for with settled funds. Only cash or proceeds from the sale of fully paid-for securities can be called “settled funds.”

Selling a position before having paid for it is called a “good-faith violation” because no good-faith effort was made on the part of the investor to deposit funds into the account before the settlement date.

For example, if Sally sells $1,000 worth of ABC stock on Tuesday morning, then buys $1,000 worth of XYZ stock on Tuesday afternoon, she would incur a good-faith violation (unless she had an additional $1,000 in her account that did not come from the unsettled sale of ABC).

With these examples in mind, it’s not hard for active traders to run into problems if they don’t understand cash account trading rules, all of which derive from trade date vs. settlement date. Having adequate settled cash in an account can help avoid issues like these.

Settlement Date Risks

Given that a lag exists between the trade date and settlement date, there are risks for traders and investors to be aware of — namely, settlement risk, and credit risk.

Settlement Risk

Settlement risk has to do with one of the two parties in a transaction failing to come through on their end of the deal. For example, if someone agrees to buy a stock, but then does not pay for it after ownership has been transferred. In this case, the seller assumes the risk of losing their property and not receiving payment.

This tends to happen when trading on foreign exchanges, where time zones and differing regulations can come into play.

Credit Risk

Credit risk involves potential losses suffered due to a buyer failing to hold up their end of a deal. If a transaction is executed and the buyer’s funds are not transferred before the settlement date, there could be an interruption in the transaction, or it could be canceled altogether.

History of Settlement Dates

The SEC makes the rules regarding how stock markets operate, including trades, and even what a broker does in regard to retail investing. As such, the SEC is tasked with creating the clearance and settlement system — a power it was granted back in the mid-1970s.

Prior to the SEC’s involvement, exchanges and transfers of security ownership were left up to participants, with sellers delivering stock certificates through the mail or even by hand in exchange for payment. That could take a long time, and prices could move a lot, so the SEC came in and set the settlement date at five business days following the trade date.

But as technology has progressed, transactions have been able to execute much faster. In 1993, the SEC changed the settlement date to three business days, and in 2017, it was changed to two days.

The Takeaway

The trade date is the day an investor or trader books an order to buy or sell a security, and the settlement date is when the exchange of ownership actually happens. For many securities in financial markets, the T+2 rule applies, meaning the settlement date is usually two business days after the trade date — so, not including weekends or holidays. An investor therefore will not legally own the security until the settlement date.

While there’s been chatter that the settlement process needs to speed up to either T+1 or real-time settlement, it’s still important for investors and traders to know these rules so they don’t make violations that lead to restricted trading or other penalties, and so they can properly gauge the risks of trading.

While you can’t make trades settle faster, you can start trading online using SoFi Invest®. You can invest in stocks, exchange-traded funds (ETFs), 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.

FAQ

What’s the difference between trade date and settlement date?

The trade date is when an investor initiates a buy or sell order, and the settlement date is when ownership of the underlying security is actually transferred. That generally happens two business days after the trade date (also called T+2).

Is the settlement date the issue date?

Typically, the settlement date and issue date are the same, as the settlement date is when a security actually exchanges hands. But there are times when the two can be different, concerning specific types of securities.

Why does it take two days to settle a trade?

The two-day lag between the trade date and settlement is designed to give a security’s seller time to gather and transfer documentation , and to give a buyer time to clear funds needed for settlement.

SoFi Invest®

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

May

2023

Guide to Options Sweeps

By Kenny Zhu | Growing Wealth, invest, Investing | Comments Off

What Are Options Sweeps?

Options sweeps are large options trades executed by well-capitalized, typically institutional investors, quickly and across the best available order prices. When an option sweep is placed, the executing broker will hit all available counterparties, by order of best outstanding prices, until the investor-specified order size is filled.

The typical retail investor typically will not execute options sweep trades, given the massive amount of funding and leverage they entail. Instead, options sweep trades can serve as an indicator of underlying interest around a certain security. As they typically reflect institutional investor actions, option sweep trades are indicators of what the “smart money” is doing.

What an options sweep implies is up to interpretation and depends on the order size, type of option, and average price at which the options sweep was executed. We cover how options sweeps work and how retail investors should interpret them.

How Do Options Sweeps Work?

When options sweeps are executed, the trade will be visible to market participants. The details around the trade, namely its size, the type of option traded, and the approximate price of the trade, are viewable by traders with the capability to scan for them. However, the specific entity entering the trade and the order type (whether it’s a buy or sell) will not be disclosed.

Option sweeps aren’t really considered one of the strategies for trading options. But given the massive amount of capital needed to properly transact an options sweep, and the fact that these are typically entered as block trades, entities that use option sweeps are likely to be well-capitalized institutional investors.

Consequently, options sweeps are viewed as indicators of aggressive bets made by “smart money,” and can stir up investor interest due to the perceived informational advantage that professional money managers have over retail investors learning to trade options.

Under the right circumstances, they can provide useful insight into implied short-term price swings that large institutional investors might be hedging against. This makes it a popular tool for short-term traders.

How to Interpret Options Sweeps

Options sweeps serve as indicators of unusual options activity surrounding the underlying investment.

Options trades may imply aggressive actions by institutional investors, and traders who detect options sweeps may use them to inform their actions.

How an options sweep should be interpreted depends on the type of option being traded, its expiration date (American- and European-style options are different), and the price near where the options sweep was executed.

Regardless of what an options sweep may suggest, investors should bear in mind that institutional investors are fallible like retail investors. In other words, sometimes the “smart money” isn’t so smart. Despite the informational asymmetry, option sweeps should be interpreted with a grain of salt. Make sure to conduct your own due diligence before trading, looking at bearish or bullish stock indicators and so on.

Option Type

When a trader buys to open a call option, this generally implies a bullish bet on the price of a security, as call options offer upside potential beyond the stated strike price.

Conversely, when a trader buys to open a put option, this implies a bearish bet on the direction of the underlying security, as put options offer downside protection beyond the stated strike price.

Price

While it’s evident that a trade was made when an options sweep occurs, the trade won’t explicitly disclose whether the options were bought or sold by the institutional investor.

To gauge whether or not an options sweep was a buy or sell order, and to better understand options pricing, traders can contextualize based on whether the average execution price was traded “near the bid,” or “near the ask.”

Trades made near the bid are typically sell orders, while near the ask trades are typically buy orders. This follows the traditional trading logic of “sell at the bid” and “buy at the ask.”

Combination Trades

Not all option trades are simply buy calls or buy puts. Combination trade strategies using multiple options are very common. It might be very difficult to interpret the strategy of the option sweep investor, and even more difficult to determine if your own investing strategy aligns.

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How to Detect Options Sweeps

Options sweeps are difficult to detect without the aid of dedicated trade scanners that monitor options flow activity.

Many third-parties and brokerage accounts that offer advanced trading capabilities may include this as part of a subscription fee, or as a part of their trading suite.

If you don’t have access to these paid programs, there are still ways to detect unusual options activity on stocks you follow.

First, options are useful hedging tools for institutional investors and are therefore typically used during times of heightened market volatility.

You can watch for open options interest on calls and puts, expiring close to earnings reports or dividend announcements. Beyond company-specific announcements, traders can often gauge options interest close to market-moving events, economic reports, or even Federal Reserve statements.

While this won’t necessarily inform the direction of an upcoming trade, it will certainly shed some light on where volatility is likely to occur as the expiration date on the options approach.

Who Uses Options Sweeps

Options sweeps are used almost exclusively by large well-capitalized institutional traders.

Due to the large amount of capital needed to execute an options sweep, and the massive risk profile that this entails, it’s unlikely that anyone without a substantially large bankroll would be able to conduct an options sweep trade.

Virtually all retail investors would be excluded from the list of candidates capable of executing options sweeps.

The Takeaway

While options sweeps are not usually executable by everyday investors, their existence still serves as a useful indicator of institutional activity.

Unusual options activity has historically been a popular short-term metric for gauging the direction of stocks. While there’s no guarantee as to the accuracy of the implied price moves, they’re nonetheless another useful tool in the arsenal for short-term options traders.

If you’re ready to try your hand at options trading, You can set up an Active Invest account and trade options online from the SoFi mobile app or through the web platform.

And if you have any questions, SoFi offers educational resources about options to learn more. SoFi doesn’t charge commissions, and members have access to complimentary financial advice from a professional.

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

FAQ

Are call sweeps considered bullish?

Call option sweeps are large purchases or sales of call options that can be considered either bullish or bearish, depending on the price where the trade completes.

All options trades have both a bid and an ask price; the bid price indicates the price you’d receive for selling to open the option while the ask price indicates the price you’d pay to buy to open the option.

If a call sweep is shown executing near the bid price, that means that an institutional trader likely sold a large number of call options at the bid price, which may imply a bearish signal.

Conversely, if a call sweep is shown executing near the ask price, that indicates that an institutional trader likely purchased a large number of call options at the ask price, which could imply a bullish signal.

How can you find options sweeps?

Finding options sweeps isn’t as simple as searching for trade ideas. Detecting option sweeps requires scanning software that can sleuth through public trade data for unusual options activity.

There are a number of options activity scanners available on the web and through third-party information services; in most cases, these require paid subscriptions.

Many popular online brokerage accounts also sometimes offer their own activity scanners as part of their suite of advanced trading platforms.

What does it mean for a sweep to be near the ask?

If a sweep is near the ask, this means a large sweep order was made to trade securities near the ask price.

This may be interpreted as a “bullish” signal that the stock price may rise in the short term.

Photo credit: iStock/Drazen Zigic

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

May

2023

Cost of Carry, Explained and Defined

By Dan Miller | Growing Wealth, invest, Investing, Terminology | Comments Off

What Is Cost of Carry?

Cost of carry refers to any and all ongoing costs that you need to pay in conjunction with holding a given investment. Transaction costs, which are incurred upon the purchase or sale of the asset, are typically not considered a carrying cost.

Cost of carry can come in a variety of different forms — here are a few types of carrying costs that you’ll want to be aware of:

• Storage costs, if you are investing in the futures market for physical goods

• Interest paid on loans used for an investment

• Interest in margin accounts when borrowing to invest in stocks or options

• Costs to insure or transport physical goods

• The opportunity cost of investments

Most if not all investments have carrying costs, and savvy investors will take them into account when deciding whether an investment is worth it. Even if a particular investment doesn’t have obvious carrying costs, there is always the opportunity cost of making one investment over the other.

How Cost of Carry Works

The way that cost of carry works depends on the type of investment that you are considering. If you are investing in the futures markets for tangible goods like coffee, oil, gold, or wheat, you may have carrying costs associated with these physical goods. For example, if you buy a commodity like crude oil, you must pay the costs for transporting, insuring and storing that oil until you sell it.

To accurately calculate your trading profits you must include those carrying costs.

In a purely financial transaction like buying stock or trading options, there can still be carrying costs involved. You may have to pay interest if you are borrowing money with a margin account. You may also incur what are called opportunity costs. Opportunity costs refer to the money you could have made if you had invested your money in other areas.

If you are holding $10,000 in your stock account waiting for an option assignment, you can’t use that $10,000 for other investments.

Which Markets Are Impacted by Cost of Carry?

Cost of carry is a factor in a variety of different types of investments. Options trading has carrying costs from interest costs if you trade in a margin account to holding costs.

Investing in commodities may require a cost of storing, insuring, or transporting your goods. You should be aware that most types of investments also have opportunity costs.

Cost-of-Carry Calculation

The simplest cost-of-carry calculation just includes all of your carrying costs as a factor when you analyze the profitability of a particular investment. So, if

• P = Purchase price of an investment

• S = Sale price of the same investment

• C = carrying costs while holding the investment

The profit of this investment could be expressed as Profit = S – P – C.

Futures Cost of Carry

The futures market has two different prices for each type of commodity. The spot price refers to the price for immediate delivery (i.e. on the spot). A futures price is the price for goods at some specified time in the future. Because most futures contracts of commodities come with non-zero carrying costs, the futures price is usually (but not always) higher than the spot price.

Options Cost of Carry

When trading options the costs of carry fall into a few categories:

• Interest costs – Some investors borrow money to purchase options, i.e. a loan from a friend, a bank loan, or a brokerage margin account.

Whatever the source of the money, the interest paid to service the borrowing is a carrying cost.

• Opportunity costs – You’ve chosen to invest in options. But where else could you have invested that money? Because most alternative investments carry risk, as does investing in options, it’s difficult to make an apples-to-apples comparison.

In finance, we look at risk-free investing rates to assess the opportunity cost. “Risk-free” is defined as the return available by investing in U.S. Treasuries. In the past, 30-year bonds were the standard, but 10-year returns and even the return on short-term Treasury notes may also be used.

• Forgoing Dividends – One of the disadvantages of owning options compared to owning stock, is that you are not eligible for dividends as an option holder. The market makes an effort to price dividends into the option premium, but just as interest rates can fluctuate, so can dividend rates.

Examples of Cost of Carry

Here is a simple example of cost of carry and how it might affect an investment in purchasing Brent Crude Oil.

Say you buy a contract for 1,000 barrels of Brent Crude at $80/barrel. Six months later, the price of oil has gone up to $90/barrel, and you sell. You might think that you have earned a $10,000 profit, but that is not accounting for the cost of carrying the oil.

If it cost you $3,000 to store and insure those barrels of oil for the six months that you owned them, those carrying costs must be subtracted from your profit. You also are liable for delivering the oil, which might cost another $1,000. Considering the cost to carry, your actual profit was only $6,000. While these costs are easiest to understand with physical goods like commodities, most types of investments have carrying costs.

Cash and Carry Arbitrage

Like crypto arbitrage, there sometimes exists a type of arbitrage called cash-and-carry arbitrage. In cash-and-carry arbitrage, an investor will purchase a position in a stock or commodity and simultaneously sell a futures contract for the same stock or commodity.

If the futures price is higher than the combined amount of the stock price plus carrying costs, you can secure a relatively risk-free profit via cash and carry arbitrage.

Cost of Carry and Net Return

As we’ve discussed already, the cost of carry can have an impact on the net return of any investment. When determining your total profit and the return on investment (ROI), you need to account for any and all costs that you incur as part of the investment.

These might include transaction costs like commissions as well as carrying costs. Subtract all such costs from your gross profit to calculate the net return of your investment.

Can You Do Anything About Cost of Carry?

Since the cost of carry directly and negatively affects your total profit, you may be wondering if you can do anything about it. While there are carrying costs with almost every type of investment, one way to minimize the cost of carry is to avoid investments that have significant carrying costs.

On the other hand, if your specific situation allows you to have below market carrying costs, you may be able to earn a profit with cash and carry arbitrage.

The Takeaway

The cost of carry is a term used in options and futures trading that refers to the ongoing costs incurred in an investment while you are holding it.

With physical commodities, the cost of carry refers to storage, insurance, delivery and other costs specific to the fulfillment of your contract.

When applied to options trading the carrying costs are financial in nature, such as, interest costs, opportunity costs, and forgoing dividends.

If you’re ready to try your hand at options trading, you can set up an Active Invest brokerage account and trade trade options from the SoFi mobile app or through the web platform.

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

FAQ

How can you calculate cost of carry?

The cost of carry refers to any costs that you incur during the course of your investment. In commodities trading, this generally refers to costs like storage, insurance, or delivery of the commodity. In other types of investments, the cost of carry could include interest charges or the opportunity cost of using your money.

Do bonds have a cost of carry?

Yes, nearly all investments, including bonds, have some sort of cost of carry. In the bond market, the cost of carry generally refers to the difference between the face value of the bond plus premiums minus applicable discounts.

How are ordering and carrying costs different?

Ordering costs are the costs that you pay as part of the ordering process. In a stock or option transaction, any broker’s commissions that you pay would be considered ordering costs. While ordering costs are usually incurred only once (at buy and/or sale), carrying costs are the costs that you must pay to hold an investment throughout its duration.

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