What Is Gamma in Options Trading?

What Is Gamma in Options Trading?

Gamma is one of the indicators that comprise the Greeks, a model for pricing options contracts and discerning their risks. Traders, analysts, portfolio managers, and other investment professionals use gamma — along with delta, theta, and vega — to quantify various factors in options markets. Gamma expresses the rate of change of an option’s delta, based on a $1 price movement — or, one-point movement — of the option’s underlying security. You might think of delta as an option’s speed, and gamma as its acceleration rate.

Understanding Gamma

In the Greeks, gamma is an important metric for pricing options contracts. Gamma can show traders how much the delta — another Greeks metric — will change concurrent with price changes in an option’s underlying security. An option’s delta is relevant for short amounts of time only. An option’s gamma offers a clearer picture of where the contract is headed going forward.

Expressed as a percentage, gamma measures an option’s, or another derivative’s, value relative to its underlying asset. As an options contract approaches its expiration date, the gamma of an at-the-money option increases; but the gamma of an in-the-money or out-of-the-money option decreases. Gamma can help traders gauge the rate of an option’s price movement relative to how close the underlying security’s price is to the option’s strike price. Put another way, when the price of the underlying asset is closest to the option’s strike price, then gamma is at its highest rate. The further out-of-the-money a security goes, the lower the gamma rate is — sometimes nearly to zero. As gamma decreases, alpha also decreases. Gamma is always changing, in concert with the price changes of an option’s underlying asset.

Gamma is the first derivative of delta and the second derivative of an option contract’s price. Some professional investors want even more precise calculations of options price movements, so they use a third-order derivative called “color” to measure gamma’s rate of change.

Recommended: What Is Options Trading? A Guide on How to Trade Options

Calculating Gamma

Calculating gamma precisely is complex and requires sophisticated spreadsheets or financial software. Analysts usually calculate gamma and the other Greeks in real-time and publish the results to traders at brokerage firms. Below is an example of how to calculate the approximate value of gamma. The equation is the difference in delta divided by the change in the underlying security’s price.

Gamma Formula

Gamma = Difference in delta / change in underlying security’s price

Gamma = (D1 – D2) / (P1 – P2)

Where D1 is the first delta, D2 is the second delta, P1 is the first price of the underlying security, and P2 is the second price of the security.

Example of Gamma

For example, suppose there is an options contract with a delta of 0.5 and a gamma of 0.1, or 10%. The underlying stock associated with the option is currently trading at $10 per share. If the stock increases to $11, the delta would increase to 0.6; and if the stock price decreases to $9, then the delta would decrease to 0.4. In other words, for every 10% that the stock moves up or down, the delta changes by 10%. If the delta is 0.5 and the stock price increases by $1, the option’s value would rise by $0.50. As the value of delta changes, analysts use the difference between two delta values to calculate the value of gamma.

Using Gamma in Options Trading

Gamma is a key risk-management tool. By figuring out the stability of delta, traders can use gamma to gauge the risk in trading options. Gamma can help investors discern what will happen to the value of delta as the underlying security’s price changes. Based on gamma’s calculated value, investors can see any potential risk involved in their current options holdings; then decide how they want to invest in options contracts. If gamma is positive when the underlying security increases in value in a long call, then delta will become more positive. When the security decreases in value, then delta will become less positive. In a long put, delta will decrease if the security decreases in value; and delta will increase if the security increases in value.

Traders use a delta hedge strategy to maintain a hedge over a wider security price range with a lower gamma.

Gamma as an Options Hedging Strategy

Hedging strategies can help professional investors reduce the risk of an asset’s adverse price movements. Gamma can help traders discern which securities to purchase by revealing the options with the most potential to offset loses in their existing portfolio. In gamma hedging, the goal is to keep delta constant throughout an investor’s entire portfolio of stocks and options. If any of their assets are at risk of making strong negative moves, investors could purchase other options to hedge against that risk, especially when close to options’ expiration dates.

In gamma hedging, investors generally purchase options that oppose the ones they already own in order to create a balanced portfolio. For example, if an investor already holds many call options, they might purchase some put options to hedge against the risk of price drops. Or, an investor might sell some call options at a strike price that’s different from that of their existing options.

Benefits of Gamma for Long Options

Gamma in options Greeks is popular among investors in long options. All long options, both calls and puts, have a positive gamma that is usually between 0 and 1, and all short options have a negative gamma between 0 and -1. A higher gamma value shows that delta might change significantly even if the underlying security only changes a small amount. Higher gamma means the option is sensitive to movements in the underlying security’s price. For every $1 that the underlying asset increases, the gamma rate increases profits. With every $1 that the asset increases, the investor’s returns increase more efficiently.

When delta is 0 at the contract’s expiration, gamma is also 0 because the option is worthless if the current market price is better than the option’s strike price. If delta is 1 or -1 then the strike price is better than the market price, so the option is valuable.

Risks of Gamma for Short Options

While gamma can potentially benefit long options buyers, for short options sellers it can potentially pose risks. The gamma rate can accelerate losses for options sellers just as it accelerates gains for options buyers.

Another risk of gamma for option sellers is expiration risk. The closer an option gets to its expiration date, the less probable it is that the underlying asset will reach a strike price that is very much in-the-money — or out-of-the-money for option sellers. This probability curve becomes narrower, as does the delta distribution. The more gamma increases, the more theta — the cost of owning an options contract over time — decreases. Theta is a Greek that shows an option’s predicted rate of decline in value over time, until its expiration date.

For options buyers, this can mean greater returns, but for options sellers it can mean greater losses. The closer the expiration date, the more gamma increases for at-the-money options; and the more gamma decreases for options that are in- or out-of-the-money.

How Does Volatility Affect Gamma?

When a security has low volatility, options that are at-the-money have a high gamma and in- or out-of-the-money options have a very low gamma. This is because the options with low volatility have a low time value; their time value increases significantly when the underlying stock price gets closer to the strike price.

If a security has high volatility, gamma is generally similar and stable for all options, because the time value of the options is high. If the options get closer to the strike price, their time value doesn’t change very much, so gamma is low and stable.

Start Investing With SoFi

Gamma and the Greeks indicators are useful tools for understanding derivatives and creating options trading strategies. However, trading in derivatives, like options, is primarily for advanced or professional investors.

If you’re ready to invest, an options trading platform like SoFi’s is worth exploring. This user-friendly platform features an intuitive design, as well as the ability to trade options from either the mobile app or web platform. You can also access a library of educational resources to keep learning about options.

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.


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

Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
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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SoFi Invest may waive all, or part of any of these fees, permanently or for a period of time, at its sole discretion for any reason. Fees are subject to change at any time. The current fee schedule will always be available in your Account Documents section of SoFi Invest.


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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What Is Historical Volatility & How Do You Use It?

A Guide to Historical Volatility

Historical volatility (HV) measures the range of returns on a market index or security over a given time period. When an asset’s historical volatility is going up, that means its price is moving further away from its average (in either direction) more quickly than usual.

A stock’s historical volatility is typically one standard deviation using daily returns, and it’s one factor that investors often look at to gauge the risk of a potential investment. An asset’s historical volatility is different from its implied volatility. Read on to learn what historical volatility is, how historical volatility works, and how to calculate historical volatility.

What Is Historical Volatility?

Historical volatility is a statistical measurement of the price dispersion of a financial security or index over a period. Investors calculate this by determining the average deviation from an average price. Historical volatility typically looks at daily returns, but some investors use it to look at intraday price changes.

Analysts can use any number of trading days when calculating historical volatility, but typically options traders focus on a time period between 10 and 180 days. Options traders use historical volatility and implied volatility when analyzing trading ideas.

Investors typically express historical volatility as a percentage reflecting the standard deviation from the average price, based on past price behavior, but there are also other methods they can use to determine an asset’s historical volatility. Unstable daily price changes often result in high historical volatility readings.

How Historical Volatility Works

Historical volatility takes past price data to calculate an annualized standard deviation value that measures how much past prices deviate from an average price over a given period. When a stock sees large daily price swings compared to its history, it will typically have a historical volatility reading. Historical volatility does not measure direction; it simply indicates the deviation from an average.

When a stock’s historical volatility is rising or above average, it means daily price changes are larger than normal. When it is lower than average, a stock or index has been relatively calm.

How Historical Volatility is Calculated

The historical volatility formula is typically a standard deviation measurement. It takes a stock’s daily price changes and averages them over a period. There are several steps to calculating historical volatility:

1.    Collect historical prices

2.    Calculate the average historical price over a period

3.    Find the difference between each day’s price change versus the average

4.    Square those differences

5.    Find the sum of those squared differences

6.    Divide those differences by the total number of prices (this finds the variance)

7.    Calculate the square root of the variance

The historical volatility formula is a tedious step-by-step process, but most brokerage platforms automatically calculate it. Many brokers even offer historical volatility charts. With a historical volatility chart, you can easily compare changes through time. For example, if a stock reacted sharply to an earnings release, the historical volatility charts will show a jump immediately after the earnings date while implied volatility might drop sharply after the earnings report.

How to Use Historical Volatility

Traders sometimes use historical volatility to help set stop-loss levels. For example, a day trader might take three times a stock’s daily average range – a measure of historical volatility – to set a stop price. This is known as volatility ratio trading.

Traders also use historical volatility when analyzing a stock, fund, or index to get a sense of its riskiness. High or low historical volatility stocks are not inherently bullish or bearish. Day traders might seek high historical volatility stocks as candidates for high-profit trading opportunities (but they also come with high loss potential).

You can also use historical volatility to help determine whether a stock’s options are expensive to help determine an options trading strategy. If implied volatility is extremely high when compared to a stock’s historical volatility, traders may decide that options are undervalued.

Historical vs Implied Volatility

Like historical volatility, it measures fluctuations in an underlying stock or index over a period, but there are key differences between the two indicators. Implied volatility is a forward-looking indicator of a stock’s future volatility.

The higher the historical volatility, the riskier the security has been. Implied volatility, on the other hand, uses option pricing to arrive at a calculation and estimate of future volatility. If implied volatility is significantly less than a stock’s historical volatility, traders expect a relatively calm period of trading, and vice versa.

Typically, when implied volatility is low, options pricing is low. Low options prices can benefit premium buyers. Sometimes investors will use a graph to determine how an option’s implied volatility changes relative to its strike price, using a volatility smile.

Historical Volatility

Implied Volatility

Measures past price data to gauge volatility on a security Uses forward-looking option-pricing data to gauge expected future volatility on a security
Higher historical volatility often leads to higher options pricing and higher implied volatility Imminent news, like a company earnings report or a key economic data point, can drive implied volatility higher on a stock or index
Traders can use historical volatility to help set exit prices Traders can use implied volatility to find stocks expected to exhibit the biggest price swings

The Takeaway

Historical volatility is a useful indicator for both institutional and retail investors looking to get a feel for the level of recent fluctuations in a stock or index has been in the recent past. It measures a security’s dispersion of returns over a defined period. Implied volatility is a similar tool, but it is forward-looking and uses option pricing to arrive at its output.

Options trading and the use of historical volatility is helpful for some advanced traders. If that sounds like you, an options trading platform like SoFi could be worth considering. Its intuitive and approachable design offers investors the ability to place traders from the mobile app or desktop platform. Plus, there are educational resources about options available in case you want to answer a question or learn more about a certain topic.

Trade options with low fees through SoFi.

FAQ

What is considered a good number for historical volatility?

It depends. While one stock might have a high historical volatility reading, perhaps above 100%, another steady stock might have a low figure around 20%. The key is to understand the securities you trade. Historical volatility can be an indicator of a stock’s volatility, but unforeseen risks can turn future volatility drastically different than the historical trend.

What is a historical volatility ratio?

The historical volatility ratio is the percentage of short-to-long average historical volatility on a financial asset. You can interpret the historical volatility ratio by looking at short versus long historical volatility. If short volatility on a stock drops below a threshold percentage of its long volatility, a trader might think there will be a jump in future volatility soon.

This is similar to analyzing volatility skew in options. It is important to remember that the interpretation and technical rules of historical volatility can be subjective by traders.

How is historical volatility calculated?

Historical volatility calculations require finding the average deviation from the average price of an asset over a particular time. An asset’s standard deviation is often used. Historical volatility is usually stated as one standard deviation of historical daily returns.

Many trading platforms automatically calculate historical volatility, so you don’t have to do the calculations manually.


Photo credit: iStock/Eva-Katalin

SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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What Does Bullish and Bearish Mean in Investing and Crypto?

What Does Bullish and Bearish Mean in Investing and Crypto?

Markets are often described as being either bullish vs. bearish. These are common terms used to refer to how a market is performing over a short or longer period of time. Investors can also be bullish or bearish on a specific stock, a sector, an asset class such as cryptocurrency, or on the economy in general.

Read on to learn more about the definitions of bearish vs. bullish, where the terms bullish and bearish come from, and the bullish and bearish meaning for investors in stocks, cryptocurrency, or other markets.

What Does Bullish Mean?

Bullish refers to stock market sentiment that the direction of the overall market will go up. A market that is increasing in value over a long period of time is said to be in a bull market. A bullish trend means that there may be an upward trend in prices for an asset.

For investors, being bullish means they feel positive about a stock, index, or the overall stock market. For example, if an investor says she is bullish on Apple (AAPL) stock, the investor expects the market value of AAPL stock to increase in the long-term. That bullishness may even compel the investor to buy more shares of the company.

A bullish market is one where prices go up by 20% after a sustained 20% decline.

What Does Bearish Mean?

Bearish refers to a sentiment that the direction of securities or the overall market will move down in price. An investor characterized as a bear believes the stock market will decrease in value, even if current prices are going up. An investor investing in a bearish market may even sell shares of their portfolio if they believe the market will turn negative.

A bear market is one that has fallen 20% from recent highs and remains below that threshold for at least two months. Since investors are bearish during this period, there may be lower trading activity.

Where Do the Terms Bullish and Bearish Come From?

While there are several theories as to the origins of bullish vs. bearish. The consensus believes the difference between bullish and bearish reflects the way each animal responds when they attack. When a bull goes into attack mode, it races at its target with confidence. In a bull market, investors are confident that stock prices will rise and correspondingly, the value of the market will trend upward.

When bears attack, they swipe their paws in a downward motion and often in fear. That is why in a bear market, prices drop. When investors are bearish, they do not have confidence in stocks and usually end up selling off some of their investments.

Bullish vs Bearish in Cryptocurrency

The terms bullish and bearish have historically been used in the context of the stock market. But these terms can apply to any market, including the cryptocurrency market. The definitions of bullish and bearish are largely similar in the context of trading crypto.

When cryptocurrencies are rallying, this means crypto is in a bull market. During this period, there is strong demand and, in some cases, limited supply. Bullish crypto traders may talk about prices going “to the moon,” which refers to periods when prices might surge or suddenly spike (these price moves can also happen in times of extreme volatility).

A bearish trend in the crypto market reflects falling prices accompanied by selling. But sometimes, crypto traders may consider a bear market a great time to add to their crypto portfolio. These traders may be hoping to “HODL,” which stands for “hold on for dear life,” and refers to the goal of investors riding out volatility.

Recommended: Crypto 101: Learn the Basics of Cryptocurrency

Pump-and-Dump in Crypto

Sometimes bullish or bearish movements in cryptocurrency reflect more than market sentiment. A “pump and dump” scheme in the crypto market refers to a group of market participants buying up large amounts of a cheap cryptocurrency to artificially increase its price.

They then relay positive messages about the asset to get other investors to buy in. Once prices soar, they sell off their assets and pocket the profits while others lose value.

How Bullish Markets Can Impact Investors

In a bull market, demand is greater than supply. There are many investors who want to buy stocks while only a few are willing to sell. Bullish traders tend to have long positions in stocks or other assets.

How Bearish Markets Can Impact Investors

In a bear market, supply is greater than demand — and investors look to offload their shares when there is not a lot of demand for market participants to buy. As a result, share prices decrease. A bear market is challenging for investors because stock prices keep falling, and that means more losses in an investment portfolio.

Your first instinct may be to sell in a bear market, but to increase chances of securing a profit in the long-term, it may make more sense to remain invested. Bear markets do not last forever.

Still, some investors prefer to adjust their investments in a bear market, turning to defensive stocks like consumer staples, healthcare, or utilities. They also may consider going into safer investments like bonds that offer stable fixed-income.

Bear markets can also present a good buying opportunity for investors who use dollar-cost averaging. This involves investing a fixed amount of money consistently. This way, investors can purchase stocks at a more affordable price. Learn more about

Tips on Withstanding Bullish vs Bearish Markets

One of the best investing strategies during a bull or bear market is diversification. Diversifying your investment portfolio with different securities in a variety of different industries — along with various asset classes — will protect a portfolio by minimizing losses and maximizing gains over the long-term. Diversification means buying shares of companies in different sectors and companies of different sizes, rather than just investing in a select few of stocks.

Stock Market

Investors who are not sure how to pick individual stocks can purchase an exchange-traded fund (ETF) or index fund, which are pre-selected baskets of securities all in one investment vehicle. For example, investors who own a fund that follows the S&P 500 will see their investments perform in line with that index.

In an ETF, investors own hundreds of companies, which means they don’t need to painstakingly choose one or two companies, rather, they own the entire index. This is a great strategy to ensure portfolio growth in the long-term.

Cryptocurrency

Because cryptocurrency is a relatively new asset class that has only been around for about 12 years, it can be difficult to know when a bull or bear period is approaching and how long it may last. One of the main characteristics of cryptocurrencies is their volatility. Assets with more volatility are riskier for investors. A crypto bear market or bull market can last for a period of hours, days, weeks, or months.

Crypto investors can also diversify by purchasing different types of cryptocurrencies, and keeping their overall crypto assets to a certain percentage of their wider portfolio.

The Takeaway

A market doesn’t necessarily have to be either bearish or bullish. It can actually be neither. The stock market can be in a state that is flat. This may mean there are normal market fluctuations leading to either small gains or small losses. Even if markets experience a sharp decline or rise in the short-term, this still cannot be defined as bearish or bullish because bull and bear markets are maintained over a period of time.

Whether you believe we’re in a bullish or a bearish market, a good way to get started investing is by opening an online brokerage account on the SoFi Invest® investment platform. With SoFi Invest, users can easily buy and sell stocks and exchange-traded funds directly from their phone.

FAQ

Does being bearish mean that you want to sell your crypto or other assets?

A bearish market period means investors think an asset’s price is headed downward. In some cases, people are not even aware of a bear market until it’s over because it’s difficult to predict the direction of the markets. Investors who are invested for the long run do not pay attention to the peaks and troughs of the market and take a dollar-cost averaging approach by investing consistently over time in both bear and bull markets.

What do bullish and bearish mean in crypto?

A bullish market in crypto means the value of the cryptocurrency will increase, while a bearish market means the asset will go in the opposite direction. Bearish investors are pessimistic that the market will decline — but there is so much momentum in the crypto market that when there is a bearish period, it is often seen as a buying opportunity to get more crypto.

How can you tell if a market is bearish or bullish?

Predicting and timing the markets is a challenging task. However, if stock prices have fallen by more than 20% from their recent peaks, and remained there for more than two months, that’s typically considered a bear market. A sustained increase in prices is a bull market.


Photo credit: iStock/NoSystem images

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.


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

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What Is a Derivative? How Financial Derivatives Work

What Is a Derivative?

A derivative is a financial instrument that derives its value from an underlying asset, such as a stock or bond, or a benchmark, such as a market index. Derivatives can also represent statistics or numerical indexes not related to financial assets.

Derivative investments work as a contract between two parties, a buyer and seller. The derivative is a secondary security, meaning it is not an asset itself, but rather it tracks the value of an underlying asset. This puts it into the category of secondary securities. The value of a derivative is based on market events, price changes, and other factors related to the underlying asset.

Experienced investors often use derivative finance to hedge their investments against future loss or profit from upcoming market shifts, but some investors also use them to profit or speculate on commodities like gold or oil. They can serve different purposes for different people, such as limiting risk related to possible future events.

How Does a Derivative in Finance Work?

A derivative is a contract that includes information about rules and asset costs for a particular future transaction that may take place. For instance, if an investor has a significant amount of a particular stock with an unrealized gain, they might choose to enter into a derivative contract that gives them the ability to sell it at today’s prices on a future date. This will give them some protection against future losses.

Derivatives are also a way to give investors exposure to a certain asset class without having to actually buy the assets. The seller of a derivative doesn’t have to actually own the underlying asset. They can give the buyer money to buy the asset, or they can give the buyer another derivative contract of the same value of the first one.

Derivative Example

You might have a derivative that provides you with the right to purchase 50 shares of a particular stock for a set price of $1,000 per share in six month’s time. This will be a valuable contract if the stock is trading higher than $1,000 and continues to trade at that level in six months. But if the stock goes down in value and trades under $1,000 per share then the derivative won’t have any value.

3 Types of Derivatives

There are two categories of derivatives: lock and option. Lock contracts include swaps and futures. These form an obligation between the two parties. Option contracts give the parties the right, but not the obligation, to fulfill the contract transaction.

Options

One of the most common examples of a derivative is an options trade, which gives traders the right to buy or sell a stock at a specific price within a certain period of time. The options buyer will pay a “premium” is paid upfront, but when the contract expires the right to buy or sell is no longer valid.

If a call option is “in the money,” that means that the strike price is lower than the stock price, while a put option is “in the money” when the strike price is higher than the stock’s price. “Out-of-the money” options are the opposite, and “at the money” options have a value that’s roughly equal to their strike price.

The difference between options and futures is that options give traders the right to buy or sell but they are not obligated to do so. If the options contract doesn’t go the way the option buyer had hoped, they wouldn’t exercise their right and they would only lose the premium they paid upfront. There are many different options-trading strategies.

For example, some options traders use a straddle technique, which is a neutral options trading strategy creating the opportunity for an investor to profit whether the underlying asset goes up or down in price.

Investors may also sell naked options, in which they have not set aside the cash or underlying security to meet the obligation of the contract. If the option holder in that case decides to execute their option, the seller will need to buy the security or provide the cash that they now owe.

Recommended: Popular Options Trading Terminology to Know

Futures

With futures derivatives, the buyer and seller set a price for the future exchange of an asset or commodity. The contract includes the price, the amount, and the future settlement date. The contract obligates them to execute on the transaction.

Only a small amount of the total asset value is deposited into one’s account, but a higher amount must be kept in the account to cover losses that might occur. Once the contract is entered into, the price of the underlying asset is tracked daily, and any gains or losses are added to or removed from the trader’s account until the contract is sold or expires.

There are specific futures exchanges set up to monitor and standardize futures trading. But some similar contracts known as forwards are sold in over-the-counter markets that are unregulated and allow for more negotiation.

Swaps

Swaps are contracts traded over the counter for the exchange of financial terms or cash flows such as interest rates and currencies. Companies can swap types of interest rates in order to get better terms. Oftentimes one rate is variable and the other rate is fixed. With currency swaps, companies can invest overseas with a lower risk of exchange rate fluctuations.

How Derivative Trading Works

A derivatives contract says that one will either earn or pay money related to the underlying asset. Although there is an initial deposit for the derivative contract, there is the risk of having to pay more depending on how the asset’s value shifts during the period of the contract.

There is additional risk involved in trading derivatives because there is a possibility that the losing party won’t pay the money owed, and this can lead to legal trouble as well. If there is a contract related to an unregulated market this can also be risky because there is potential for market manipulation.

Once a derivative contract is entered into, the buyer can either hold onto it until the expiration date when they purchase the asset at the agreed upon price, or they can sell the contract to someone else, potentially for a profit. Trading one derivative for another one prior to the contract end date is common. Generally the contract will sell for only a tiny amount of the value of the underlying asset, but the value of the contract can fluctuate along with asset price fluctuations.

There is a small down payment involved for entering into the contract, known as “paying on margin.” It’s typical for derivatives for stocks and market indexes to represent groups of 100 shares. For example, there could be a contract to purchase 100 shares of a stock for $3,000 per share, and the contract might trade at $3 per share per contract.

Before entering into a derivative contract, it’s important to understand how derivatives work and read what the contract entails, including the disclosure statement. There will be an agreement to sign stating that both parties have read and understand the terms.

Also, trading derivatives requires ongoing work and attention. Markets can change quickly and there may be obligations throughout the contract period such as tracking the value of the underlying asset.

Costs

When entering into a derivative contract, there may be a deposit and an initial fee, and there may also be a holding fee involved as well as additional hidden fees. Pricing for derivatives vary depending on the type and value of the underlying asset as well as the broader market for that derivative.

Pros and Cons of Trading Derivatives

There are several pros and cons to trading derivatives. Some of the main ones are:

Pros

Derivatives traders enjoy several advantages by using the financial instrument. Those include:

•   A hedge against the risk of future losses

•   An opportunity for speculation

•   Exposure to an asset without having to purchase it

•   Can help predict future cash flows

•   Provides the ability to lock in prices

Cons

In addition to the advantages, there are several drawbacks that derivatives traders should understand.

•   Trading derivatives is very complex and can be risky for inexperienced traders

•   The derivative contract may not be liquid or easily sellable on the open market

•   There is a risk of losing more than you invest, if you’re using naked options

•   Online scams in derivatives trading are common, adding to the risk

•   There are fees and costs associated with the contract

•   There may be ongoing maintenance and time commitment required

Financial Derivatives Regulations

Regulations around derivatives depend on where they are traded. The Securities and Exchange Commission regulates derivatives traded on national securities exchanges, while over-the-counter derivatives may not have any regulating body.

In the latter case, the parties negotiate the terms of contracts on their own. Sometimes these parties include banks and financial institutions regulated by the SEC. Futures brokers and commercial traders must be registered with the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC).

The Chicago Board Options Exchange (CBOE) is the most well known options exchange platform and is regulated by the SEC. These regulating bodies help to prevent fraud and abusive trading practices and keep the markets running fairly and smoothly.

Start Investing Today with SoFi Invest

Derivatives can be a riskier type of investment but they can provide value to both institutional and retail investors’ portfolios when used wisely. Trading derivatives requires more work than simply buying and selling more traditional securities, but the additional risk and additional work can also yield greater rewards.

SoFi offers an intuitive and approachable options trading platform, thanks to its user-friendly design and the educational resources about options it provides. Investors can trade options from the mobile app or the web platform, depending on their preference.

Pay low fees when you start options trading with SoFi.


Photo credit: iStock/fizkes

SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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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Forex Binary Options, Explained: What They Are & How They Work

Forex Binary Options, Explained: What They Are & How They Work

If you have experience trading options in the stock market, you may also be interested in trading options in the forex world. Forex (short for foreign exchange) is a trading market separate from the stock market where traders buy and sell different types of foreign currency.

Two parties might exchange currency if one is traveling in a different country or part of a multinational company. Many people also trade foreign currency as an investment, just as people do with the stock market.

Binary options, also known as digital options, are one way to trade in the foreign currency market. This all-or-nothing investment option can be attractive to some traders. Below, we’ll explore how binary options work and why one might choose to trade them.

What Are Binary Options?

Binary options are one of the more exotic options out there. With a binary option, you set a currency pair (like USD/EUR), a strike price, and a timeframe. Both the buyer and the seller put down their money upfront. Binary options are typically priced from 0 to 100, and the price represents the approximate probability that the given currency pair will be at or above the strike price when the option expires.

How Do Forex Binary Options Work?

Unlike traditional call and put options in the stock market, forex binary options have only two possible outcomes: if you’re on the right side of the strike price, you make money, and if you’re on the “wrong” side of it, you lose money.

For example, if an option is priced at 40, then the buyer must pay $40 per contract and the seller must pay $60 ($100 – the $40 price) upfront. When the option closes, whichever side is on the right side of the strike price collects the entire $100. The fact that there are only two possibilities leads to the name binary option.

Pros and Cons of Forex Binary Options Trading

Here are some of the pros and cons of trading binary options when forex trading:

Pros

Cons

Limited and defined risk More expensive than traditional forex trading
Can trade even with a smaller budget Supported by a limited number of brokers
Easier to understand since there are only two possible outcomes Even as a seller, you must put your money down upfront
100% loss of your position if you are wrong

Binary Option Risks and Rewards

Like all investments, investing in binary forex options comes with risks and rewards. These risks and rewards are different for the buyer and seller.

Risk for Buyers

While there is risk in trading binary options, a trader knows the amount of money they’re risking upfront. With a binary option, you put down a specific amount of money (the option price). If the currency is below the strike price at expiration, you will lose all of the money you put down.

Reward for Buyers

The potential rewards for a buyer purchasing a binary option are set when the option contract is set. If the currency is at or above the strike price at expiration, you will get the total amount of the contract (usually $100).

Risk For Sellers

The risk for sellers of a binary forex option is known when the contract is agreed upon. Unlike sellers of traditional options in the stock market, sellers of binary options must put their money down upfront. This is usually $100 minus the price of the contract. If the option closes at or above the strike price, the option seller will lose all of the money they put down.

Reward for Sellers

On the other hand, if the currency closes below the strike price at expiration, the option will expire worthless and the seller will collect the entire $100. This could be a significant percentage gain, depending on how much was put down originally.

Binary Option in Forex Examples

Here are a few examples of how you could use a binary option in forex trading:

•   EUR/USD binary option for 1.15 closing in one hour, trading at 30. A buyer would need to put down $30 and the seller $70, per contract. If the price of Euros is at or above 1.15 dollars in one hour, the buyer will collect $100. Otherwise the seller will take $100.

•   AUS/JPY binary option for 83 closing next Friday, trading at 75. A buyer would put down $75 and the seller of this option would put down $25 per contract. If the price of the Australian dollar is at or above 83 yen, the buyer would take $100. If it is below 83 yen, the seller would collect the entire $100, minus commissions.

The Takeaway

Binary options are a way to invest in the foreign currency market. At its simplest, a binary option is a bet on the ratio of two different currencies. With a binary option, both the buyer and seller put down their money upfront. At expiration, whichever side is on the correct side of the strike price collects the entire premium put down (usually $100 per contract). Binary options can be incredibly risky because you have to be right on the direction of the move, the magnitude and the timing.

To guide your options trading platform, it can be helpful to use a platform like SoFi that offers educational resources about options. What’s more, SoFi’s options trading platform has an intuitive and approachable design that gives investors the ability to make trades from the mobile app or the web platform.

Trade options with low fees through SoFi.

FAQ

Are forex and binary options the same thing?

If you are comparing options vs. forex, you may be wondering what the difference is between forex and binary options. The two terms are similar in that they both refer to trading on the foreign currency markets, but they are slightly different. Forex refers usually to buying and selling the actual currency itself, while binary options allow you to invest in forex for a smaller budget with more leverage.

Are binary options better than forex?

Binary options are a particular kind of currency option that have only two possible outcomes. They come with their own set of risks and rewards. Which one is better will depend on your personal risk tolerance and knowledge of the foreign currency markets.

Can you trade binary options on forex?

Yes, binary options are typically traded in foreign currency pairs (like EUR/USD or AUS/JPY). Binary options give you an additional way to speculate or trade on movements in the foreign currency markets.


Photo credit: iStock/simonapilolla

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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