Investing Archives | Page 184 of 191

Dec

2021

What Is the Put/Call Ratio?

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

The put to call ratio (PCR) is a mathematical indicator that investors use to determine market sentiment. The ratio reflects the volume of put options and call options placed on a particular market index. Analysts interpret this information into either a bullish (positive) or bearish (negative) near-term market outlook.

The idea is simple: the ratio of how many people are betting against the market versus how many people are betting in favor of the market, should provide a gauge of the general mood investors are in.

A high put-call ratio is thought to be bearish (because more investors are taking short positions) while a low put-call ratio is thought to be bullish (because more investors are taking long positions). Investor Martin Zweig invented the put-call ratio and used it to forecast the 1987 stock market crash.

What are Puts and Calls?

Puts and calls are the most basic types of options contracts. Options contracts give holders the right, but not the obligation, to buy or sell a specific number of shares of a given security by a certain date (the expiration date) at an agreed upon price (the strike price). For both puts and calls, one options contract is usually for 100 shares of the underlying security.

The seller of an option is also sometimes called the writer. Options writers receive a fee, called a premium, in exchange for the risk of having to buy or sell shares when the holder of the option chooses to exercise their contract.

There are many factors that influence an option’s premium, and many ways to calculate the value and the risk of options, including the Black-Sholes, trinomial, and Monte Carlo simulations.

Those interested in trading calls and puts and other options strategies may want to research the details further with our options trading guide.

For now, we’re concerned with the basics of call vs. put options so we can better understand the put-call ratio and what it means.

Puts

A put option (or “put”) gives its owner the right to sell a certain number of shares at a predetermined price by a certain date. Investors may also refer to puts as “short positions” because they represent bearish bets on a security’s future.

An investor who buys a put has the option to sell the stock at some point leading up to the expiration date of the contract. Investors may use puts in a variety of ways within the portfolio. For example, a protective put allows an investor who already owns the underlying asset to benefit even if the price of that stock asset goes down.

Calls

A call gives its owner the right to buy a certain number of shares at a predetermined price by a certain date. Calls are also referred to as long positions because they represent bullish bets on a security’s future.

An investor who buys a call has the option to buy the stock at some point leading up to the expiration date.

What Is Put Call Ratio?

The put-call ratio is a measurement of the number of puts versus the number of calls traded on a given security over a certain timeframe. The ratio is expressed as a simple numerical value.

The higher the number, the more puts there are on a security, which shows that investors are betting in favor of future price declines. The lower the number, the more calls there are on a security, indicating that investors are betting in favor of future price increases.

Analysts most often apply this metric to broad market indexes to get a feel for overall market sentiment in conjunction with other data point. For example, the Chicago Board Options Exchange put-to-call ratio is one of seven factors used to calculate the Fear & Greed Index by CNN Business.

The put-call ratio can also be applied to individual stocks by looking at the volume of puts and calls on a stock over a certain period.

How to Calculate the Put-Call Ratio

The put-call ratio equals the total volume of puts for a given time period on a certain market index or security divided by the total volume of calls for the same time period on that same index or security. The CBOE put call ratio is this calculation for all options traded on that exchange.

There can also be variations of this. For example, total put open interest could be divided by total call open interest. This would provide a ratio for the number of outstanding puts versus the number of outstanding calls. Another variation is a weighted put-call ratio, which calculates the dollar value of puts versus calls, rather than the number.

Looking at a put call ratio chart can show you how that ratio has changed over time.

Put-Call Ratio Example

Suppose an investor is trying to assess the overall sentiment for a stock. The stock showed the following volume of puts and calls on a recent trading day:

Number of puts = 1,400

Number of calls = 1,800

The put call ratio for this stock would be 1,400 / 1,800 = 0.77.

How to Interpret the Put-Call Ratio

A specific PCR value can broadly be defined as follows:

• A PCR of less than 1 implies that investors are expecting upward price movement, as they’re buying more call options than put options.

• A PCR of more than 1 implies that investors are expecting downward price movement, as they’re buying more put options than call options.

• A PCR equal to 1 indicates investors expect a neutral trend, as purchases of both types of options are at the same level.

However, while PCR has a specific, mathematical root, it is still open to interpretation, depending on your options trading strategy. Different investors might take the same value to have different meanings.

Contrarian investors, for example, typically believe that the majority is wrong. The best move is to act contrary to what others are doing, in this view. If everyone else is buying something, contrarians believe it might be a good time to sell, or vice-versa. A contrarian investor might therefore perceive a high put/call ratio to be bullish because it suggests that most people believe prices will be heading downward soon.

Momentum investors believe in trying to capitalize on prevailing market trends. “The trend is your friend,” they might say. If the price of something is going up, it could be best to capitalize on that momentum by buying, in this view. A momentum investor could believe the opposite, and that a high PCR should be seen as bearish because prices could be trending downward soon.

To take things a step further, a momentum investor might short a security with a high put-call ratio, hoping that since most investors appear to already be short, this will be the right move. On the other hand, a contrarian investor could do the opposite and establish a long position, based on the idea that what most people expect to happen is the opposite of what’s actually coming.

The Takeaway

The put-call ratio is a simple metric used to gauge market sentiment. While often used on broad market indexes, investors may also apply the PCR to specific securities. Calculating it only involves dividing the volume of puts by the volume of calls on the market for a security.

The put-call ratio is one factor you might consider as you start trading options. A platform like SoFi’s allows you to get started with options trading, thanks to its intuitive and user-friendly design. Investors can also reference a library of educational resources about options.

Trade options with low fees through SoFi.

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

Dec

2021

Investing in Bitcoin ETFs

By SoFi Editors | Growing Wealth, invest, Investing | Comments Off

The first three bitcoin ETFs (exchange-traded funds) became available in the U.S. in October and November of 2021. All three are tied to bitcoin futures contracts; they aren’t tied to bitcoin’s daily market price.

Bitcoin spot ETFs have existed in Canada and Europe for years, and there are several applications for spot ETFs in the U.S., but the Securities and Exchange Commission (SEC), which regulates financial markets, has not yet approved them here.

Keep reading to learn more about the advantages of a bitcoin-based ETF, the controversy in bringing these new funds to market, and whether bitcoin futures ETFs might suit your investment strategy.

Why a Bitcoin ETF?

In order to understand the evolution of the first bitcoin ETFs, it’s important to grasp the significant changes crypto has brought to the field of finance.

Ever since the launch of Bitcoin in 2009 as the world’s first decentralized, digital currency, investors’ appetite for cryptocurrency has only grown. And no wonder: In just over a dozen years, the market has gone from a single coin to thousands of alt coins, tokens, and blockchain platforms that promise to revolutionize everything from our monetary systems to supply chains, art, and more. As of December 6, 2021, the total market capitalization of all cryptocurrencies was about $3 trillion, with no signs of slowing.

For some crypto speculators, the rewards have outweighed the potential downsides of this highly volatile market. But for many retail investors, putting their money into coins and exchanges that are largely unregulated has seemed fraught with risk.

Recommended: What Is Bitcoin and How Does It Work?

Buying bitcoin or any form of crypto has also presented challenges to by-the-book investors, who need to embrace new skills in order to execute even a basic crypto trade — from setting up a crypto wallet to understanding how to use and store public and private keys. As many readers know, investors who lose the private keys that give them access to their crypto assets essentially lose those assets. By some estimates, as much as 20% of bitcoin has been lost due to investors losing those all-important keys.

Thus, the idea of creating more traditional investments like bitcoin ETFs was appealing on many levels. A bitcoin ETF offered a way to give investors exposure to the world’s oldest and biggest cryptocurrency, while mitigating some of the potential risks and logistical challenges of buying and owning crypto. And bitcoin ETFs and mutual funds could be traded from standard brokerage accounts.

So why has it been so complicated to launch a bitcoin ETF?

Bitcoin ETFs: The History

Before an ETF can be listed on a U.S. exchange, it must be approved by the SEC. Thus far, however, the regulatory agency has taken a firm stand against bitcoin and other crypto-related funds because bitcoin, being unregulated itself and traded on exchanges that are largely unregulated as well, can be susceptible to fraud and manipulation.

Crypto entrepreneurs Cameron and Tyler Winklevoss, known for their Gemini digital currency exchange (among other things), were among the first to petition to launch a bitcoin ETF, but it was rejected owing to bitcoin’s potential vulnerabilities. In its 2017 denial of the petition, the SEC wrote: “Based on the record before it, the Commission believes that the significant markets for bitcoin are unregulated.”

Crypto as currency, security, or commodity?

The approval of crypto-related funds was further hampered by a debate over how cryptocurrencies should be categorized — a question that would determine how the market was regulated. Although most crypto are referred to as currencies, in fact cryptocurrencies aren’t widely used as legal tender to pay for goods or services (although that seems to be changing).

In a statement by SEC chair Gary Gensler in September 2021, he indicated that many types of crypto should be considered securities, raising concerns in the industry about the level of oversight that could follow, given that securities are regulated by the SEC.

Bitcoin and Ethereum, however, are among those considered to be commodities. Given that commodity markets are generally not as closely regulated as securities — which are subject to rules on price transparency, as well as higher standards for reporting, and market abuse oversight — some companies saw this as an opportunity.

The path to approval

Even though regulators in Canada and some countries in Europe have approved a range of bitcoin and crypto-related ETFs and mutual funds over the last few years, the SEC’s stance regarding U.S. markets only began to shift in 2021 when Chair Gary Gensler indicated an openness to ETFs tied to bitcoin futures contracts rather than the spot price of the crypto.

Because futures contracts are overseen by the Commodity Futures Trading Commission, and fall under the Investment Company Act of 1940, the SEC considered this structure to potentially offer investors more protection. The SEC approved the first bitcoin ETF in October 2021.

What Are the First 3 Bitcoin ETFs?

As of December 6, 2021, there were three bitcoin ETFs in the U.S.

On October 19, 2021, the ProShares Bitcoin Strategy ETF (BITO) became the first ETF to offer investors exposure to Bitcoin futures, with two more launched shortly after its debut. A few days after the ProShares’ ETF went public, the Valkyrie Bitcoin Strategy ETF (BTF) launched, followed by the VanEck Bitcoin
Strategy ETF (XBTF) on Nov. 15, 2021.

These funds do not invest directly in “physical” bitcoin (i.e. actual bitcoin assets) but shorter-term, cash-settled contracts that are traded on the Chicago Mercantile Exchange or CME.

Recommended: Is Crypto a Commodity or a Security?

The bitcoin ETF debate continues

Despite initial excitement and a wave of investor interest in the funds, some financial institutions are challenging the SEC’s decision to limit bitcoin ETFs to derivatives, and increasing pressure on the agency to reconsider its ruling on bitcoin spot ETFs.

Lawyers for one of the applicants, Grayscale Bitcoin Trust, argued that the SEC has “no basis for the position that investing in the derivatives market for an asset is acceptable for investors while investing in the asset itself is not.”

They also asserted that the SEC is obligated to treat like situations alike, and to do otherwise is “arbitrary and capricious,” meaning that to be fair the SEC must consider similar investments in a similar light.

What Are Bitcoin Futures?

Bitcoin futures are similar to any futures contract for an underlying asset like a commodity or stock. This allows investors to speculate on the future price of bitcoin.

Investors can purchase monthly contracts for cash settlement (rather than actual bitcoin) on the CME. Thus it’s possible to trade bitcoin futures without needing a bitcoin wallet, and holding onto a volatile asset and then being subject to potential price fluctuations.

Uses of bitcoin futures

Trading bitcoin futures may offer a number of benefits. For bitcoin miners, futures can allow them to lock in prices that ensure a return on their mining investments, regardless of bitcoin’s price trajectory.

Bitcoin investors can also use futures to hedge against their positions in the spot market.

And because bitcoin futures contracts are regulated by the Commodity Futures Trading Commission (CFTC), large institutional investors may now consider these assets as a possibility for their portfolios. Prior to this, bitcoin has been largely unregulated, making it too risky an asset for most institutional investors.

What Other Bitcoin ETFs and Funds Exist?

Investors have channeled billions of dollars into a wide and growing variety of crypto ETFs and other funds that are thriving in Canada and Europe. While some of these funds are from smaller players, in Q4 of 2021 Fidelity became the largest asset manager to launch a bitcoin spot ETF on the Toronto exchange.

In addition to crypto-related instruments, it’s possible to invest in a number of other crypto- and blockchain-related companies, including crypto exchanges and mining technology companies.

The Takeaway

For investors curious about the cryptocurrency market but not yet ready to take the plunge, a bitcoin ETF may represent a convenient option. But as of December 2021, the SEC has rejected applications to create any securities tied to the daily spot price of bitcoin, limiting bitcoin-related investments to the derivatives market.

While investing in a bitcoin futures ETF is different than investing in a “physical” or spot bitcoin fund, it may offer some advantages. But it’s wise to understand how futures work before investing in these funds. To better understand how bitcoin and other cryptocurrency works, you can get started trading right away when you open a SoFi Invest® account, which also enables you to trade stocks, ETFs, and more.

Get started on 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.

Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments. Limitations apply to trading certain crypto assets and may not be available to residents of all states.

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.
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Nov

2021

What Is a Protective Put? Definition, Graphs, & Example

What Is a Protective Put? Definition & Example

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

A protective put is an investment strategy that employs options contracts to mitigate the risk that comes with owning a particular security or commodity. In it, an investor buys a put option on the security or commodity.

Typically, put options are used by investors who hope to benefit from a price decline in a given investment. But in a protective put strategy, the investor owns the underlying asset, and is positioned to benefit if the price of the asset goes up.

Essentially, the investor is buying the right to also make money if the investment goes down. But while this protection is a nice thing to have, it isn’t free.

To buy the option, the investor pays a fee, called a premium. It is a way of managing uncertainty and risk (sort of like an insurance policy). An investor may take out a protective put on anything they own, including equities, currencies, commodities like oil, and index funds. But if the investment they own does go up, the investor will have to deduct the cost of the put-option premiums from their returns.

Understanding Protective Puts

Investors typically purchase protective puts on assets that they already own as a way of limiting or capping any future potential losses.

The instrument that makes a protective put strategy works is the put option. A put option is a contract between two investors. The buyer of the put acquires the right to sell an agreed-upon amount of a given asset security at a given price during a predetermined time period.

Important Options Terms to Know

There is some key options trading lingo to know, in order to fully understand a protective put.

• The price at which the purchaser of the put option can sell the underlying asset is known as the “strike price”.

• The amount of money the buyer pays to acquire this right is called the “premium”.

• And the end of the time period specified in the options contract is the expiration date, or “expiry date”.

• The strike price is also known as the “floor price”, after which the investor will not face losses on their investment. The options allow the investor to sell the underlying asset at the floor price, no matter where it is trading, which serves the purpose of wiping out the losses the investor would face below the strike price.

For complete coverage in a protective put strategy, an investor might buy put options contracts equal to their entire position. For large positions in a given stock, that can be expensive. And whether or not that protection comes in handy, the put options themselves regularly expire — which means the investor has to purchase new put options contracts on a regular basis.

How Strike Price and Premiums Affect Protective Puts

An investor can buy a protective put option contract when they buy the underlying security, or at any time while they’re holding it. But whenever they buy the put option, that option’s strike price will bear one of three relationships to the security they own.

These three relationships between a security’s price and the price of a given option are sometimes called the “moneyness.” The varieties of moneyness are:

1. At the money (ATM): This is when the option’s strike price and the asset’s market price are the same. An option purchased ATM will offer 100% protection against losses for the duration of the option contract.

2. Out of the money (OTM): In this situation, the option’s strike price is lower than the asset’s market price. With an OTM option, the further the strike price is below the market value, the lower the premium. An OTM put option won’t provide complete protection against loss, but it will limit the losses to just the difference between the price at which the investor bought the stock price and the option’s strike price.

3. In the money (ITM): This is when the asset’s market price is lower than the option’s strike price. In this scenario, the option might be worth exercising in order to cover the price of the premium.

Recommended: How to Sell Options for Premiums

Protective Put Scenarios

An investor who is pursuing a protective put strategy will own the underlying security, commodity, currency or asset. If the underlying asset goes up in value and the put options related to it expire, then the investor gets to keep all of the upside growth, minus the premiums connected with the put options. To keep the protection, the investor will have to buy new put options once the original options expire.

Investors may use protective puts differently. Some investors use the strategy to cover only a portion of a long position. Others may use protective puts for the entirety of their position. When protective put coverage is the same as the amount of stock the investor owns, it is often referred to as “married put.”

Most often, investors will enter into married puts at the time they buy a given stock, though they can enter into a married put at any time they want to protect their investment.

A married ATM put effectively limits the maximum loss an investor faces to the costs connected with buying the stock, including commissions, plus the premium and other costs related to purchasing the put option.

Pros & Cons of Protective Puts

As with most investing strategies, there are both upsides and downsides to using protective puts.

Pros of Protective Puts

Protective puts allow investors to set a limit on how much they stand to lose in a given investment. Here’s why investors are drawn to them:

• Protective puts offer protection from the possibility that an investment will lose money.

• The protective put strategy allows an investor to participate in nearly all of an investment’s upside potential.

• Investors can use at-the-money (ATM), or out-of-the-money (OTM) options, or a mix of the two to tailor their risks and costs.

Cons of Protective Puts

Like any form of insurance, buying protective put options comes at a cost.

• An investor using protective puts will see lower returns if the underlying stock price rises, because of the premiums paid to buy the put options.

• If a stock doesn’t experience much movement up or down, the investor will see a steady loss of assets as they pay the option premiums.

• Options with strike prices close to the asset’s current market price can be prohibitively expensive.

• More affordable options that are further away from the stock’s current price offer only partial protection and can put the investor in the position of losing money.

The Takeaway

Protective put options are risk-management strategies that use options contracts to guard against losses. This options-based strategy allows investors to set a limit on how much they stand to lose in a given investment.

Looking to start options trading? With SoFi’s options trading platform, you can trade options on the web platform or through the mobile app, thanks to an intuitive and approachable design.

Trade options with low fees through SoFi.

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

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Nov

2021

What Is a Bond Option? Definition & Examples

By Brian O'Connell | Growing Wealth, invest, Investing, Terminology | Comments Off

A bond option allows the contract holder to buy or sell an underlying investment (in this case, a bond) at a specific price and at a specific time. While considered less risky than stock options, bond options still typically carry higher risk than more traditional investments.

Like all options, bond options are derivative securities, used by investors to bet on the direction of an underlying security. Understanding what bond options are and how they work can help you understand these risks and determine whether bond options make sense for your portfolio.

Here’s a closer look at bond options, and the risks and rewards they bring to investors.

What are Bond Options?

A bond option is a legal contract to buy and sell underlying bond assets, usually via a call bond (i.e., the option to buy an underlying bond) or a put bond (the option to sell a bond) at a specific price (known as the “strike price)” at or before a specific time deadline (known as the “expiration date”).

For example, an investor might purchase a bond call option with a strike price of $900. The level value (also known as “par value”) of the underlying U.S. government bond is $1,000. Let’s say market conditions push the value of that bond up to $1,100. In that scenario, the option holder has the right to buy the government bond at $900 – even as the value of that underlying bond now stands at $1,100.

Investors typically trade options, including bond options, through over-the-counter exchanges. Bond options are also typically available wherever U.S. Treasury bonds are sold in fund form through investment companies.

Recommended: A Beginner’s Guide to Options Trading

Pros and Cons of Bond Options

There are benefits and drawbacks to incorporating bond options in your portfolio.

Pros of Bond Options

Higher return potential. As discussed in the example above, when executed well a bond options strategy can increase a trader’s gains on a particular investment. Bond options can also protect against downside risk. Investors often use bond options as hedges against more risk-laden investment strategies.

Risk hedging. Bond options investors can leverage derivative contracts to take advantage of interest rates and other short-term drives of investment performance. Investors can also lean on bond options to take advantage of pricing variations in options pricing or to position their portfolios ahead of major geopolitical events, like presidential elections, potentially big Federal Reserve policy decisions, or major recessions and other powerful economic forces.

Cons of Bond Options

The risk of non-exercise. Bond options investors may do well to let an options contract expire rather than execute a trade that goes awry and loses money. While a bond options investor isn’t obligated to exercise their bond options contracts, letting a contract expire means the original money used to buy or sell a bond option is gone forever. So, too, are the fees investment companies charge to handle options trades.

The risk of unlimited investment loss. While call options provide an investor with the possibility of unlimited gain if the underlying security rises in value, that same investor faces unlimited loss potential if that investor is selling a call or put option. If the underlying assets plummet to a value of zero, the options investor could face massive financial losses.

The risk of losing money quickly. As options, by nature, are short-term investing instruments, investors need to have extensive knowledge of near-term investment price movements to minimize the downside risk of investing in bond options. Often, traders make decisions about their options strategy based on a short time horizon. That means all options investors must master two key trading objectives – knowing the right time to purchase an options contract and knowing when to sell that contract, or cut losses by allowing the contract to expire without exercising the option to buy or sell by the expiration date.

Recommended: 10 Options Trading Strategies

Types of Bond Options

Bond options offer investors the right to buy or sell (via calls and puts) an underlying investment security at a specific time and at a set price.

Call Option Bonds

With a bond call option, if the price of the underlying bond option rises in value, the contract holder can earn a profit on the call by exercising the option to purchase the asset (with a call option) at a lower price and then selling it when the underlying asset goes up. A call option is in the money if the strike price is lower than the current market price of the underlying bond.

Bond Put Options

A bond options investor who buys believes a bond will go up in price may purchase a put option or put bond. With that option, buy the asset at the current low price and sell it at the rising strike price, assuming the price moves in the direction the trader had hoped. What a bond investor strives to avoid is being on the wrong side of an options trade, i.e., selling at a below market rate or buying at an above-market rate.

If an investor anticipates that bond prices will decline, given future expected market conditions, they’d purchase a put option. If the level value of the underlying bond option were$1,000, a bond put option gives the contract holder the right to sell the option contract at the strike price of $900 – on or before the expiration date. If bond prices fall, the underlying bond is now valued at $870. Now, that bond option investor can exercise the sale of the options contract at the strike price of $900, even as the bond’s value has fallen to $870. That guarantees a big profit for the investor, given the outsized nature of options contracts.

Embedded Bond Options

Embedded bond options are bonds in which the holder or the issuer has a right to take a specific action with a certain period going forward. Examples of embedded bond options include call provision, convertible provisions, and floored floating-rate provisions.

Callable Bond Options

Callable bonds are one type of embedded bond option. With callable bonds, the issuer has the option to repay investors the face value of the bond before the maturity date.

Bond Options Pricing

Given all the variables, including the current price and future price of a bond, volatility levels, interest rates, and time to expiration, it can be very complicated to properly price a bond option. Investors rely on several different mathematical formulas for this, including the Black-Derman-Toy Model and the Black Model.

The Takeaway

Options traders may use a bond option as a hedge against economic volatility in key areas like interest rates, currency rates, and bond yield rates, a bond option can be a useful portfolio management tool. However, there are plenty of other types of investments that an investor can use when building a portfolio, without trading bond options.

But for investors who are curious to start options trading, SoFi offers a user-friendly platform to do so. With an intuitive and approachable design, you can trade options on the web platform or through the mobile app.

Trade options with low fees through SoFi.

Photo credit: iStock/PeopleImages

SoFi Invest®

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

Oct

2021

What Is a Credit Spread? Explained and Defined

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

The term “credit spread” refers to two separate financial terms.

A credit spread is an important indicator of investor sentiment that compares the yields offered by Treasuries and corporate bonds as a way of understanding how optimistic or risk-averse investors are feeling.

But credit spread also refers to an options-trading strategy where an investor sells a high-premium option and simultaneously purchases a low-premium option on the same underlying security.

Credit Spread – the Market Indicator

A credit spread is the gap between the interest rate offered to investors by a U.S. Treasury bond versus another debt security with the same maturity. The differences in the yield of the different bonds, or credit spread, typically reflects differences in credit quality between Treasuries and other bonds.

Investors will also sometimes call credit spreads “bond spreads” or “default spreads.” For investors, credit spreads give investors a quick shorthand for comparing a particular corporate bond versus its risk-free alternative.

When investors refer to credit spreads, they usually describe them in terms of basis points, each of which is a percent of a percent. For example, a 1% difference in yield between a Treasury bond and a debt security of the same duration would be called a credit spread of 100 basis points.

For example, if a 10-year Treasury note offers investors a yield of 3%, while a 10-year corporate bond offers to pay investors a 7% interest rate. There would be a 400 basis-point spread.

Recommended: What is Yield?

The bonds issued by the U.S. Treasury are the benchmark of choice because the financial-services industry considers them relatively risk-free, given their backing by the U.S. government. Investors consider corporate bonds, on the other hand, riskier, even when they’re issued by the largest, longest-tenured and most highly rated companies in the most stable industries.

To purchase debt securities with that added risk, investors look for compensation in the form of extra yield. That’s why investors sometimes look at a debt security’s credit spread as an indicator of the perceived riskiness of a company’s bonds or the creditworthiness of the company itself.

Because they have a lower risk of defaulting, higher quality bonds can offer lower interest rates – and lower credit spreads – to investors. Conversely, lower quality bonds have a greater risk default, and so they must offer higher rates – and higher credit spreads – to compensate investors for taking on that risk.

Recommended: Pros and Cons of High-Yield Bonds

Why Do Credit Spreads Fluctuate?

The credit spreads of the bonds issued by a given company may change over time for a number of reasons. They may change because of macroeconomic fluctuations such as inflation, or the degree of market enthusiasm for the company issuing the bond.

When the equity markets seem headed for a downturn, both institutional and retail investors often sell stocks and corporate bonds, and then reinvest in U.S. Treasuries. That pushes down the yields offered by U.S. Treasury bonds as investors flee to safety, while the yields paid by corporate bonds rise in order to entice skittish investors. The result is a general widening of credit spreads across the board.

That dynamic is one reason that investors look at average credit spreads as a window into the overall market sentiment, in which wider credit spreads indicate declining investor sentiment. Narrower credit spreads typically signify more bullish sentiment among investors. That’s because during a bull market the safety of Treasuries holds less appeal to investors, forcing the notes to offer higher rates. Meanwhile, that same confidence leads investors to see corporate debt as less risky, allowing companies to issue bonds with lower yields.

What Is a Credit Spread in Option Trading?

Sometimes, investors use the term “credit spread” to refer not just to the difference in yield offered by a Treasury bond and a similar security, but also as a specific options trading strategy. The strategy is also sometimes known as a “credit spread option” or a “credit risk option.”

In an option credit spread strategy, an investor buys and sells options on the same underlying security with the same expiration, but at different strike prices. The premiums the investor receives on the option they sell should be higher than the premiums they pay on the option they buy, which leads to a net return for the investor.

The strategy takes two forms:

Bull Put Spread

In the bull put spread, in which the investor buys and sells options in which they’ll make a maximum return if the value of the underlying security goes up.

A bull put spread is often also called a put credit spread. In it, an investor sells a put option and purchases a second put option with a lower strike price. For the strategy to work, the investor buys the same amount of both options and, both options will have the same expiration date.

In a bull put spread strategy, as long as the price of the underlying security remains above a certain level, the strategy will begin to produce profits as the differences between the value of the two options begins to evaporate as a result of time decay. Time decay is how much the value of an options contract declines as that contract grows closer to its expiration date.

As the name indicates, the bull put spread is a strategy used by investors who are bullish on a security. And the higher the underlying security rises during the options contract, the better the investor will do. But if the underlying security falls below the long-put strike price, then the investor can lose money on the strategy.

Bear Call Spread

The other credit-spread is called the bear call spread, or a call-credit spread. That strategy is, in many ways, the mirror opposite of the bull put spread. Investors in this strategy expect that a security’s price will go down. In it, the investor buys and sells two options on the same security, with the same expiration date but at prices where the investor will receive the maximum return if the price of the underlying security sinks.

A bull put spread can be a profitable strategy if the investor remains under a certain level over the duration of the options contracts. If the security is below the short call’s strike price at expiration, then the spread seller gets to keep the entire premium, giving the investor a healthy return. But the risk is that if the price of the security rises above the long-call strike price at the expiration of the strategy, then the investor faces a loss.

Recommended: A Guide to Options Trading

The Takeaway

A credit spread is an important indicator of investor sentiment. It’s also an options strategy where a high premium option is written and a low premium option is bought on the same security. Understanding the meaning of terms like credit spread is an important step for new investors who are just starting to invest in stocks.

The SoFi options trading platform is a great way to get started, thanks to its user-friendly design. Investors can trade from the mobile app or web platform. And should any questions come up along the way, there’s a library of educational resources about options available.

Trade options with low fees through SoFi.

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