Nov
18
2024
What Is the Average Stock Market Return?
Wondering how much you’ll gain by investing in stocks? It helps to look at the average stock market return for the last 10, 20, and 30 years.
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Student Loan Consolidation and Refinancing
Nov
18
2024
What Is a Stock Market Crash?
Table of Contents
The specter of a stock market crash weighs on the mind of many investors. After all, stock market crashes have played a substantial role in the United States during the 20th and 21st centuries. But knowing what is a stock market crash as well as the history and effects of stock market crashes can help investors weather the storm when the next one occurs.
Key Points
• A stock market crash occurs when major indices experience significant declines, usually driven by panic selling rather than specific company issues.
• Key factors that can trigger a crash include economic crises, natural disasters, and investor behavior, often exacerbated by rapid declines in stock prices.
• Historical crashes, such as those in 1929, 1987, 2000, 2008, and 2020, illustrate the profound impact of bubbles and external shocks on the market.
• Crashes can lead to bear markets and recessions, as declining stock values negatively affect corporate growth and consumer spending.
• Strategies for navigating crashes include maintaining long-term focus, diversifying investments, and considering opportunities to buy undervalued stocks during downturns.
What Happens When the Stock Market Crashes?
A stock market crash occurs when broad-based stock indices like the S&P 500, Dow Jones Industrial Average, or the Nasdaq Composite experience double-digit declines over a single or several days. This means that the stocks of a wide range of companies sell off rapidly, generally because of investor panic and macroeconomic factors rather than company-specific fundamentals.
While no specific percentage decline defines a stock market crash, investors generally know one is occurring while it’s happening.
💡 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.
What Causes the Market to Crash?
Stock market crashes are usually unexpected and occur without warning. Often, crashes are caused by investor dynamics; when stocks start to sell off, investors’ fear takes over and causes them to panic sell shares en masse.
Though stock market crashes are usually unexpected, there are often signs that one could be on the horizon because a stock market bubble is inflating. A bubble occurs when stock prices rise quickly during a bull market, outpacing the value of the underlying companies. The bubble forms as investors buy certain stocks, driving prices up. Other investors may see the stocks doing well and jump on board, further raising prices and initiating a self-sustaining growth cycle.
The stock price growth continues until some unexpected event makes investors wary of stocks. This unexpected event causes investors to unload shares as quickly as possible, with the herd mentality of panic selling resulting in a stock market crash.
Catastrophic events such as economic crises, natural disasters, pandemics, and wars can also trigger stock market crashes. During these events, investors sell off risky assets like stocks for relatively safe investments like bonds.
Stock markets can also experience flash crashes, where the stock market plummets and rebounds within minutes. Computer trading algorithms can make these crashes worse by automatically reacting and selling stocks to head off losses. For example, on May 6, 2010, the Dow Jones Industrial Average fell 1,000 points in 10 minutes but recovered 70% of its losses by the end of the day.
Recommended: What Is the Average Stock Market Return?
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Examples of Past Stock Market Crashes
There have been several crashes in the stock market history, the most recent being the crash associated with the coronavirus pandemic in early 2020. The following are some of the most well-known crashes during the past 100 years.
Stock Market Crash of 1929
The most devastating stock market crash in the history of the United States occurred in October 1929. The crash occurred following a period of relative prosperity during the Roaring Twenties, when new investors poured money into the stock market.
The crash began on Thursday, October 24, when the Dow Jones Industrial Average declined about 11%, followed by a 13% decline on Monday, October 28, and a 12% drop on Tuesday, October 29. These losses started a downward trend that would continue until 1932, ushering in the Great Depression.
Black Monday Crash of 1987
On Monday, October 19, 1987, the Dow Jones Industrial Average plummeted nearly 23% in a single day. Known as Black Monday, this selloff occurred for various reasons, including the rise of computerized trading that made it easier for panicked investors to offload stocks quickly, and stock markets around the world crashed.
Dotcom Crash of 2000
The Dotcom crash between 2000 and 2002 occurred as investors started to pull money away from internet-based companies. The Nasdaq Composite index declined about 77% from March 2000 to October 2002.
In the mid to late 1990s, the internet was widely available to consumers worldwide. Investors turned their eyes to internet-based companies, leading to rampant speculation as they snapped up stocks of newly public internet companies. Eventually, startups that enthusiastic investors had fueled began to run out of money as they failed to turn a profit. The bubble eventually burst.
Recommended: Lessons From the Dotcom Bubble
Financial Crisis of 2008
The stock market crash of 2008 was fueled by rising housing prices, which came on the heels of the dot-com crash recovery. At the time, banks were issuing more and more subprime mortgages, which financial institutions would bundle and sell as mortgage-backed securities.
As the Federal Reserve increased interest rates, homeowners, who often had been given mortgages they couldn’t afford, began to default on their loans. The defaults had a ripple effect throughout the economy. The value of mortgage-backed securities plummeted, causing major financial institutions to fail or approach the brink of failure. This financial crisis spilled over into the stock market, and the S&P 500 fell nearly 60% from a peak in October 2007 to a low in March 2009.
Coronavirus Crash of 2020
As the coronavirus pandemic swept the United States in February 2020, the government responded with stay-at-home orders that shut down businesses and curtailed travel. The U.S. economy entered a recession, and the stock market plunged. The S&P 500 fell 30% into bear market territory in just one month, including a one day decline of 12% on March 16, 2020.
What Are the Effects of a Crash?
Stock market crashes can lead to bear markets, when the market falls by 20% or more from a previous peak. If the crash leads to an extended period of economic decline, the economy may enter a recession.
A market crash could lead to a recession because companies rely heavily on stocks as a way to grow. Falling stock prices curtail a company’s ability to grow, which can have all sorts of ramifications. Companies that aren’t able to earn as much as they need may lay off workers. Workers without jobs aren’t able to spend as much. As consumers start spending less, corporate profits begin to shrink. This pattern can lead to a cycle of overall economic contraction.
A recession is usually declared when U.S. gross domestic product, or GDP, shrinks for two consecutive quarters. There may be other criteria for declaring a recession, such as a decline in economic activity reflected in real incomes, employment, production, and sales.
💡 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.
Preventing Stock Market Crashes
Major stock exchanges like the New York Stock Exchange (NYSE) have instituted circuit breaker measures to protect against crashes. These measures halt trading after markets drop a certain percentage to curb panic selling and prevent the markets from going into a freefall.
The NYSE’s circuit breakers kick in when three different thresholds are met. A drop of 7% or 13% in the S&P 500 shuts down trading for 15 minutes when the drop occurs between 9 am and 3:25 pm. A market decline of 20% during the day will shut down trading for the rest of the day.
Suppose a crash does occur, and it threatens to weaken the economy. In that case, the federal government may step in to ease the situation through monetary and fiscal policy stimulus measures. Monetary policy stimulus is a set of tools the Federal Reserve can use to stimulate economic growth, such as lowering interest rates. Fiscal stimulus is generally infusions of cash through direct spending or tax policy.
Investment Tips During a Market Crash
A stock market crash can be alarming, especially when it comes to an investor’s portfolio. Here are some investment tips to consider for navigating a market downturn.
Don’t Panic and Focus on the Long-Term
It will help if you remain calm when the stock market is plummeting. That’s often easier said than done, especially when your portfolio’s value declines by more than 10% in a short period. It’s tempting to join the panic selling, to make sure stock losses are minimized.
But remember, investing is a long game. In general, making decisions based on something happening now when your investing time horizon might be 30 years, may not be the best choice. If you don’t need access to your money right away, it may be better to hold on to your investments and give them time to recover.
Diversify Your Portfolio
Stocks and the stock market get most of the media’s attention, especially when the stock market is crashing, but there are other potential ways to help you realize your financial goals. Other assets like bonds, commodities, or emerging market stocks may be attractive investment opportunities to consider during a crash.
Consider Buying The Dip
While it depends on an individual’s specific situation and risk tolerance, a stock market crash might present opportunities to purchase stocks at a lower, more attractive share price that some investors may want to consider.
The Takeaway
The stock market tends to recover following a stock market crash; it took the S&P 500 six months to recover the losses experienced during the coronavirus crash. So any rash moves investors make during a stock market crash may prevent them from seeing gains in the long term.
A stock market crash can be scary, causing you to panic and fret over your savings and investments. But often, with investing, the best advice is not to make rash decisions. Even during a stock market crash, there may still be some opportunities and strategies to help build wealth over time.
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).
FAQ
When was the last market crash?
The last stock market crash was in 2020, at the onset of the coronavirus pandemic, when business shut down and the stock market plunged. The S&P 500 fell 30% in just one month. Within six months, however, the S&P 500 had recovered its losses.
What goes up when the stock market crashes?
Bonds generally tend to go up when the stock market crashes, although not always. Government bonds such as U.S. Treasuries typically do best during a market crash, though again, there are no guarantees.
Do stocks recover after a crash?
Historically, the stock market has recovered after a crash, although it’s impossible to say how long a recovery might take. Some stock market recoveries have taken a year or less, some have taken much longer.
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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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Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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Read moreNov
18
2024
Exploring Futures in Financial Markets: A Comprehensive Guide
Some investors may trade futures contracts in order to hedge against risk, or to speculate on the price movements of a given asset or security — or because their business will benefit if they lock in a commodity at a certain price. Trading futures can provide opportunities for a range of investors.
A futures contract requires both parties to honor the terms, no matter what the price is in the market when the contract expires. If you want to trade futures, there are various ways they can fit into your portfolio or plan.
Key Points
• Trading futures contracts allows investors to hedge against risks or speculate on price movements of various assets, including commodities and financial instruments.
• Futures contracts are standardized agreements that obligate parties to buy or sell an asset at a predetermined price on a future date.
• Investors can utilize leverage when trading futures, which can amplify both potential gains and losses due to margin trading practices.
• Hedging with futures helps businesses secure prices for commodities, mitigating the impact of unexpected price fluctuations in the market.
• Understanding the risks and benefits of futures trading is crucial, as it involves leveraged positions that can lead to significant financial consequences.
What are Futures?
Futures are derivatives that take the form of a contract in which two traders agree to buy or sell an asset for a specified price at a future date. Popular underlying assets for futures may include physical commodities like gold, corn, or oil, as well as currencies, or financial instruments like stocks.
The most commonly traded futures contracts use standardized terms, and are traded on a futures exchange. For example, if you want to buy or sell corn futures, one contract would equal 5,000 bushels and be traded via the Chicago Board of Trade (CBOT). Oil is traded on the Chicago Mercantile Exchange (CME), and one oil futures contract equals 1,000 barrels of oil.
Traders buy and sell in increments specified by the contract. To buy 50,000 bushels of corn or 10,000 barrels of oil, you’d buy 10 contracts of each. Given the quantities and dollar amounts of these trades, investors often use leverage, thereby paying only a fraction of the total cost of the position.
💡 Quick Tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, options trading can be risky, and best done by those who are not entirely new to investing.
Understanding How Futures Work
Futures work by obligating a buyer or seller to purchase or offload an asset — it’s a contract.
Mechanism of Futures Trading
A futures contract obliges the buyer to buy a certain asset, or the seller to sell an asset, at an agreed-upon price, by a certain date. Each party must fulfill the terms of the contract, no matter what the market price or spot price is when the contract expires (or trade the contract before the expiration).
Futures contracts are standardized, as noted above, and each contract also spells out the contract terms, which includes among other things:
• The unit of the trade (e.g., tons, gallons, bushels, etc.).
• The grade or quality of the commodity, where relevant. For example, there are different types of corn, oil, soy, etc.
• Terms of settlement (e.g., physical delivery or a cash settlement).
• Quantity of goods covered by the contract.
• Currency in which the contract is priced.
Recommended: How Does a Margin Account Work?
The Role of Futures in Markets
A futures contract allows investors to speculate on the direction of the underlying asset, either long or short, using leverage. (Leverage means the trader doesn’t have to put up the full amount of the contract. Instead, futures traders use a margin account.) As such, they’re a tool that allows investors to use leverage and speculation.
Types of Futures Contracts
There are numerous types of futures contracts, including those tied to underlying assets such as equities and commodities. They can even be tied to other futures.
Equity, Commodity, and Other Futures
Futures contracts allow investors to make bets on the prices of a wide array of assets:
• Commodity futures, which allow investors to buy or sell physical goods like crude oil, pork bellies, natural gas, orange juice, corn, wheat, and more.
• Financial futures, including index contracts and interest rate or debt contracts.
• Precious metal futures allow investors to bet on the future prices of gold, platinum, and silver.
• Currency futures for fiat currencies like the euro, yen, the British pound, and more.
• U.S. Treasury futures allow investors to make bets on the future value of government bonds.
What are stock futures? Like futures contracts where the underlying is a physical commodity, some futures are tied to shares of a single stock or ETF. Stock index futures, however, are tied to the price movements of an index like the S&P 500 index.
Trading and Speculating with Futures
There are two key aspects to futures trading, which are hedging and speculating. Both play an important role in the markets, and determining whether futures are actually traded or not. There are also trading strategies to keep in mind, too.
Strategies for Futures Trading
There are many strategies for trading futures contracts, just as there are many strategies for trading almost any other type of security or derivative. To name a few of the basic strategies, investors can look at strategizing around price pullbacks, breakout trading, or even spread trading — each requires its own gameplan, and some background research to get started.
Futures as Speculation and Hedging Tools
Hedging is a big reason why investors buy futures contracts: It’s a way to protect against losses resulting from price changes in commodities.
Among the businesses that hedge using futures, the goal is to reduce the risk they face from unexpected price movements, and to guarantee the price they pay or receive for a particular asset.
If a large food manufacturer wants to lock in the price of corn, for example, they might enter into a contract for $10 a bushel. Since corn contracts are typically standardized at 5,000 bushels per contract, the total amount of the futures contract would be $50,000 ($10 x 5,000), to be delivered in six months. Entering into this futures contract would offer the buyer some protection against the possibility of rising corn prices in the future.
Let’s say the price of corn does rise to $12/bushel by the time the contract expires. In that case, the buyer still only pays the agreed-upon price of $10/bushel, even though the spot price is now $12/bushel.
For the corn producer in this scenario, even though it turned out that the futures contract terms weren’t quite as favorable as the actual market price — the contract guaranteed they would get at least $10/bushel, which provided a hedge against a potentially bigger loss.
Although it’s possible to settle a futures contract for the physical asset specified in the contract, most futures contracts are cash-settled. That’s because speculation on price movements is one of the main reasons that investors purchase futures contracts. A futures contract gives traders the opportunity to speculate whether a commodity will go up or down and potentially profit from the price change.
If the underlying asset of the futures contract — such as gold, oil, or corn — is above the price specified in the futures contract, then the investor can sell that contract for a profit before it expires. In that case, the contract would sell for the difference between the market price of the underlying commodity and the purchase price as specified in the contract.
In such a transaction, the underlying commodities don’t change hands between the counterparties of the contract. Instead, the trade would be cash-settled in the brokerage account of the investor.
Alternatively, an investor using futures for speculation could lose money if the price of the commodity is lower than the purchase price specified in the futures contract.
Risks and Benefits of Trading Futures
Futures trading has some significant risks and potential rewards — investors would be wise to know what they’re getting into, accordingly.
Understanding the Risks
Owing to the nature of futures trading, i.e., the binding nature of the contracts and the use of leverage, there are some obvious risks to bear in mind.
In a speculative trade, a futures contract allows you to bet on a commodity’s price movement. If you bought a futures contract, and at expiration the price of the commodity was trading above the original contract price, you’d see a profit. However, you could also lose if the commodity’s price was lower than the purchase price specified in the futures contract.
The potential risks here can be greater than they seem, because trading on margin permits a much larger position than the actual amount held by the brokerage. As a result, margin investing can amplify gains, but it can also magnify losses.
Imagine a trader who has $5,000 in their brokerage account and is in a trade for a $50,000 position in crude oil. If the price of oil moves against the trade, the losses could far exceed the account’s $5,000 initial margin amount. In this case, the broker would make a margin call requiring additional funds to be deposited to cover the market losses.
Speculators can also take a short position if they believe the price of the underlying asset will decline. An investor would realize a gain if the underlying asset’s price was below the contract price, and a loss if the current price was above the contract price. Again, using leverage to place these bets, long or short, can potentially expose investors to more risk than they intended.
Potential Benefits and Rewards
Some of the potential benefits of trading futures include the fact that investors can use leverage to try and generate outsized returns, the markets are liquid (meaning there’s plenty of trading action) and it offers up a chance to make some relatively quick (and potentially large) returns. That should, of course, be weighed against the aforementioned risks.
Futures vs Other Derivative Instruments
There are other financial derivatives with similar characteristics to futures contracts, such as options and forwards.
Comparing Futures with Options and Forwards
American-style options grant the buyer the right, but not the obligation, to buy or sell the contract’s underlying asset at any time until the contract expires.
Unlike a futures contract, however, option contracts don’t require the investor to purchase or sell the underlying asset. The investor can simply let the option expire. A futures contract, on the other hand, obligates the buyer to purchase the underlying asset, or to pay the seller of the futures contract the cash equivalent of that asset at the time of the contract’s expiration.
Similarly, a forward contract looks and functions a lot like a futures contract, with the primary difference being that forward contracts are only settled once — on their expiration date. Forwards are also often settled in the underlying asset (as opposed to cash), and the forwards market tends to be less liquid.
💡 Quick Tip: In order to profit from purchasing a stock, the price has to rise. But an options account offers more flexibility, and an options trader might gain if the price rises or falls. This is a high-risk strategy, and investors can lose money if the trade moves in the wrong direction.
Opening and Managing Futures Positions
Opening and managing futures positions can be relatively simple, granted you’re using a platform that allows for futures trading, and can follow a few steps.
Steps to Start Trading Futures
It’s common for some brokerages to have their own futures-trading capabilities, as well as their own rules about what an investor needs in terms of assets in order to trade futures contracts. Be sure to verify what those requirements are before selecting a broker.
Once you’re eligible to open a margin account and trade futures, those contracts trade on different exchanges, such as the Chicago Mercantile Exchange (CME), ICE Futures U.S. (Intercontinental Exchange), and the CBOE Futures Exchange (CFE).
From there, depending on the brokerage or platform being used, investors should be able to open and swap futures positions.
Managing Futures Contracts Effectively
Most investors in futures contracts have no interest in either receiving or having to deliver the physical commodities that underlie these contracts. Rather, they’re interested in the cash profit. The means of doing so is to trade the futures contract before its expiration date.
The standardized nature of most futures makes it so that a great many (but not all) futures contracts will expire on the third Friday of each month. Some commodities are seasonal, and only trade during specific months. High-grade corn trades on the CBOT in March, May, July, September, and December, for example.
As with any type of trading or investing, making sure you know what you’re dealing with when it comes to futures — and paying attention to the market — is going to be paramount to finding success as a trader. There are risks at play, and there’s no guarantee that the chips will fall your way. But for some, futures trading has proven fruitful.
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).
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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.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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SOIN1023183
Nov
18
2024
What Is Volatility Skew and How Can You Trade It?
Key Points
• Volatility skew refers to the variation in implied volatility between at-the-money, in-the-money, and out-of-the-money options for the same asset.
• Investors can use volatility skew as an indicator to decide on buying or selling options contracts based on market sentiment and price movements.
• Two main types of volatility skew are horizontal, which focuses on different expiration dates, and vertical, which examines varying strike prices with the same expiration date.
• Measuring volatility skew involves plotting implied volatility against strike prices or expiration dates, allowing traders to identify market trends and opportunities.
• Trading based on volatility skew can be risky, especially with complex strategies like calendar spreads, making it more suitable for experienced investors.
What Is Volatility Skew?
Volatility skew, also known as Option Skew, is an options trading concept that refers to the difference in volatility between at-the-money options, in-the-money options, and out-of-the-money options. These terms in options trading refer to the relationship between the market price and the strike price of the contract.
Options contracts for the same underlying asset with the same expiration date but different strike prices have a range of implied volatility. In other words, it’s a graph plot of implied volatility points representing different strike prices or expiration dates for options contracts.
Each asset type looks different on a graph, but they tend to resemble a smile or a smirk. The volatility skewness is the slope of the implied volatility on that graph. A balanced curve is called a “volatility smile,” and if it is unbalanced to one side it is called a “volatility smirk.”
What Is Implied Volatility (IV)?
Implied volatility, denoted by the sigma symbol (σ), is an estimate of the volatility that a particular underlying asset will have between the current moment and the time when the options contract for the asset expires. It’s basically the uncertainty that investors have about an underlying stock and how likely traders think the stock will reach a particular price on a particular date.
The volatility of an underlying asset changes constantly. The more the price of the asset changes, the more volatility it has. But implied volatility doesn’t necessarily follow the same pattern because it depends on how investors view the asset and whether they predict it will have volatility. Implied volatility is usually shown using standard deviations and percentages over a particular period of time.
Option pricing assumes that options for the same asset that have the same expiration have the same implied volatility, even if they have different strike prices. But investors are actually willing to overpay for downside-striked stock options because they think there is more volatility to the downside than the upside.
Different types of options contracts have different levels of volatility, and it’s important for traders to understand this when determining their options trading strategy.
💡 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.
What Does Volatility Skew Mean for Investors?
Volatility depends on supply and demand as well as investor sentiment about the options. The volatility skew helps investors understand the market and decide whether to buy or sell particular contracts. It’s an important indicator for investors who trade options.
Stocks that are decreasing in price tend to have more volatility. If there is implied volatility of an underlying entity, the price of an option increases, resulting in a downside equity skew.
If a skew has higher implied volatility, this means prices will be higher. So investors can look at volatility skews to find low- and high-priced contracts to decide whether to buy or sell.
There are two types of volatility skew. Vertical skew shows the volatility skew of different strike prices of options contracts that have the same expiration date. This is more commonly used by individual traders. Horizontal skew shows the volatility skew of expiration dates of options contracts that have the same strike price.
How Do You Measure Volatility Skew?
Investors measure volatility skew by plotting graph points of different implied volatility of strike prices or expiration dates. For example, a trader could look at a list of bid/ask prices for options contracts for a particular asset that expire on the same date. They take the midpoint implied volatility points from the bid/ask prices and chart them out.
The tilt of the skew changes over time as market sentiment changes. Observing these changes can give investors additional insights into the direction the market is heading, which they can use in skew trading. For instance, if the stock price increases in value significantly, traders might think it is overbought and therefore that it will decrease in value in the future. This will change the skew so its curve increases, showing more pressure for on-the-money or downside put options.
There are five factors that influence the price of options:
• Underlying stock or asset market price
• Strike price
• Time to expiry
• Interest rate
• Implied volatility
Investors can calculate the volatility at different strike prices and graph those out to see the volatility skew.
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How Do You Trade With Volatility Skew?
As mentioned above, the two types of volatility skew are horizontal and vertical. These can both be used in trading.
Horizontal Skew
There are many factors that drive changes in horizontal skew, such as product announcements, earnings reports, and global events. For instance, if traders are uncertain about the short-term future of a stock because of an upcoming earnings report, the implied volatility may increase and the horizontal skew could flatten.
Traders look for opportunities by using calendar spreads to look at the differences between option expiration implied volatility. Where there is implied volatility in a horizontal skew, there may be inefficient pricing that traders can take advantage of.
If the implied volatility is higher than expected in the front month, the option contract will be relatively more expensive, which is referred to as positive horizontal skew.
On the other hand, if the implied volatility of the back month is higher than expected this is known as negative horizontal skew or “reverse calendar spread.” In this situation traders would sell the back month and buy the front month because they can profit when the price of the underlying asset increases before the back month contract expires.
For example, a trader might look at the market for a stock and find that there is a horizontal skew in the option calls, meaning traders are putting in buy and sell orders with the prediction that it’s more likely the stock will increase a lot in the long term than in the short term.
If the trader doesn’t think the current market predictions are correct, they can use a reverse calendar call spread, similar to shorting a stock and predicting it will go down. If the price of the stock plummets, both the long- and short-term contracts will decrease in value and the trader can buy them back at a lower price than they sold them for.
In this case the trader can also profit if the implied volatility of the options decreases. They chose to sell when the implied volatility was high during the front month, so if the implied volatility decreases they can buy back at a lower price.
Although this has the potential to be a profitable way to trade, it is also risky because it’s a short call that requires a lot of margin. Stock exchanges require traders to have significant funds in their account if they want to do this type of trade.
💡 Quick Tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, options trading can be risky, and best done by those who are not entirely new to investing.
Vertical Skew
Many investors prefer trading with vertical skew because it is simpler than horizontal skew and requires less margin and, therefore, less risk. Also referred to as volatility skew and option skew, vertical skew looks at the differences between the implied volatility of different stock strike prices that have the same expiration date. Using vertical skew, traders can find opportunities to trade debit spreads and credit spreads, finding the best strike prices to buy or sell.
For example, a trader might find a stock they believe will increase in value before its option contract expires. So they want to find a bull put spread to buy to get profits when the price increases. They will have many strikes to choose from, so they can use vertical skew to identify which are the best trades, meaning those that are low or high priced. The trader can identify one with a good price to buy, wait until it increases and sell it for a profit.
The Takeaway
Options trading is popular with many investors, and volatility skew is one way for options traders to evaluate the price of options contracts. Traders might look at either horizontal or vertical skew to make a decision about whether an options contract purchase makes sense for their investing strategy.
However, options trading is risky. It’s generally best for experienced investors and not for beginners. If you’re interested in options, it’s wise to talk to a financial professional before you do anything else.
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SoFi Invest® INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
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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.
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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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Read moreNov
18
2024
Comparing Stock Warrants vs Stock Options
Stock warrants give the holder the right to buy shares of stock at a set price on a set date directly from the public company that issues them, whereas stock options convey the right to buy or sell shares on or before a specific date at a specific price.
The chief difference between stock warrants and stock options is that warrants are issued directly by a company that’s seeking to raise capital. Stock options are derivative contracts that investors can trade, in order to take advantage of price fluctuations in the underlying security.
Key Points
• Stock warrants allow investors to buy shares at a specified price on a set date, directly from the issuing company, while stock options are derivative contracts traded among investors.
• Companies typically issue stock warrants to raise capital, whereas stock options are created and traded by investors, allowing for more flexibility in trading.
• Exercising a warrant results in the issuance of new shares, which can lead to dilution, while exercising options does not create new shares and is settled between traders.
• Both stock warrants and options provide speculative opportunities but differ in terms of issuance, market trading, and potential dilution effects.
• Understanding the differences between stock warrants and options is crucial for investors, as each serves distinct purposes and carries unique risks and benefits.
What Are Stock Warrants?
A stock warrant is a contract that allows the holder the right to buy shares of stock at a future date at a specified price. The wording in a stock warrant typically allows the holder to purchase shares at a premium to the stock’s price at the time of issue.
Companies issue stock warrants directly to investors. The companies set the terms of the warrant, including the stock’s purchase price and the final date by which the investor can exercise the warrant. Warrant holders do not have an obligation to buy the shares, but if they decide to do so they would exercise the warrants via their brokerage account.
Public companies may issue stock warrants as a means of raising capital to fund new expansion projects. A company may also issue stock warrants to investors if it faces financial trouble and needs to raise funds to avoid a bankruptcy filing.
💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.
What Are Stock Options?
A stock option is a contract that gives holders the right — not the obligation — to buy or that represents the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put option) an underlying security on or before a specified date at a specified price. With stock options, holders of the contract do not have to buy the underlying shares, but they have the right to do so.
Again, the options holder does not have to buy; they simply have the right to do so. Exercising options means you agree to buy the shares If an investor chooses not to exercise the option, it expires worthless. Investors can trade some options on a public exchange alongside stocks and other securities.
Recommended: How to Trade Options: An In-Depth Guide
Similarities and Differences Between Warrants and Options
Warrants and options sound alike and at first glance, they seem to imply the same thing: A right to trade shares of a particular stock. But there are also important differences between these two contracts that investors need to understand.
Similarities
Warrants and options both offer investors an opportunity to gain exposure to a particular stock without requiring them to purchase shares.
With both warrants and options, the investor must exercise the security to actually acquire shares. Both have specific guidelines with regard to the price at which investors can purchase (or sell in the case of put options) their shares and the deadline for exercising them.
Warrants and options are both speculative in nature, since investors are essentially betting on which way the underlying asset’s price will move. Investors can use different strategies when trading options or exercising warrants to maximize profitability while minimizing losses.
Differences
Warrants and options also have important differences. While companies issue stock warrants, traders typically buy and sell options with each other directly. Warrants create new shares of companies, while options do not cause any dilution.
When investors exercise a warrant, they receive the stock directly from the company, while options are settled between traders.
💡 Quick Tip: If you’re an experienced investor and bullish about a stock, buying call options (rather than the stock itself) can allow you to take the same position, with less cash outlay. It is possible to lose money trading options, if the price moves against you.
Stock Warrants vs Stock Options: A Summary
Here’s a closer look at options vs. warrants.
| Stock Warrants | Stock Options |
|---|---|
| Confers the right to purchase shares of stock at a specified price on a specified date. | Confers the right to buy (in the case of a call) or sell (in the case of a put) shares of stock at a specified price on or before a specified date. Holders of the contract have the right, but not the obligation, to exercise the contract. |
| Warrants create new shares, which can result in dilution. | Options do not create new shares so there’s no dilution. |
| Issued by the company directly to investors. | Issued by traders who write call or put options. |
| Original issue warrants are not listed on exchanges, but there is a secondary market for the securities. | Options can be traded on public exchanges alongside other securities. |
| Used to raise capital for the company. | Traders can write options to maximize profits based on price movements. |
| Warrant holders may have a decade or more in which to exercise their right to buy shares. | Options tend to be shorter-term in nature, with expiration periods lasting anywhere from a few days up to 18 months. |
| Less commonly used in the U.S. | Options are regularly traded on public exchanges in the U.S. |
Pros and Cons of Warrants
If you’re considering warrants versus options, it’s helpful to understand the advantages and disadvantages of each.
Stock warrants can offer both advantages and disadvantages to investors. Whether it makes sense to include stock warrants in a portfolio can depend on your individual goals, time horizon for investing and risk tolerance.
| Stock Warrant Pros | Stock Warrant Cons |
|---|---|
| Warrant holders have the right to purchase shares of stock but are not required to do so. | Price volatility can diminish the value of stock warrants over time. |
| Stocks may be offered to investors at a premium price to the current market price. | When warrants are exercised, new shares are issued which can result in dilution. |
Pros and Cons of Options
Like stock warrants, there trading stock options has both upsides and potential downsides. Beginning traders may benefit from having a guide to options exercising to help them understand the complexities and risks involved. Here are some of the key points to know about trading options.
| Stock Option Pros | Stock Option Cons |
|---|---|
| Higher return potential compared to trading individual shares of stock. | Stock options are more sensitive to volatility which can mean higher risk for investors. |
| May be suited to active day traders who are hoping to capitalize on short-term price movements. | Frequent options trades can mean paying more in commissions, detracting from overall returns. |
| Traders can use options as a hedging tool to manage risk in uncertain market environments. | Time value constantly decays the value of options. |
The Takeaway
Understanding the difference between options and warrants matters if you’re considering either of these types of securities. While the language of stock warrants may sound similar to some of the terms used in options trading, these are really two different instruments.
Companies issue stock warrants largely to raise capital, whereas traders typically buy and sell options with each other directly. Warrants create new shares of companies, while options do not cause any dilution.
Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.
FAQ
Is a warrant the same thing as an option?
Is a warrant the same thing as an option?
No. Warrants and options are not the same thing. Companies issue stock warrants to give investors the right to buy shares of stock at a specified price on a specified date. Stock warrants can allow investors to purchase shares of stock at a premium while giving them plenty of time in which to decide whether to exercise the warrant.
Options are derivatives contracts that give buyers the right, but not the obligation to buy (in the case of a call) or sell (in the case of a put) an asset at a specific price within a certain period of time.
Can warrants exist in a SPAC?
Yes. A Special Purpose Acquisition Company, SPACs, are typically created for the purpose of acquiring or merging with an existing company. This type of arrangement allows private companies to circumvent the traditional IPO process. A SPAC may use warrants to raise capital from investors. These warrants are generally good for up to five years following the completion of a merger or acquisition.
About the author
Rebecca Lake
Rebecca Lake has been a finance writer for nearly a decade, specializing in personal finance, investing, and small business. She is a contributor at Forbes Advisor, SmartAsset, Investopedia, The Balance, MyBankTracker, MoneyRates and CreditCards.com. Read full bio.
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Photo credit: iStock/Inside Creative House
SoFi Invest® INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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