InvestGen Archives | Page 35 of 65

Oct

2023

How to Read a Financial Statements: The Basics

How to Read Financial Statements: The Basics

By Austin Kilham | Growing Wealth, invest, Investing | Comments Off

A company’s financial statements are like a report card that tells investors how much money a company has made, what it spends on, and how much money it currently has.

Knowing how to read a financial statement and understand the key performance indicators it includes is essential for evaluating a company. Any investor conducting fundamental analysis will pull much of the information they need from past and present financial statements when valuing a stock and deciding whether to buy it.

Each publicly traded company in the United States must produce a set of financial statements every quarter. These include a balance sheet, income statement, and cash flow statement. In addition, companies produce an annual report. These statements tell a fairly complete story about a company’s financial health.

Understanding Each Section of a Financial Statement

Along with a company’s earnings call, reading financial statements can give investors clues about whether or not it’s a good idea to invest in a given company.

Here’s what the different sections of a financial statement consist of.

Balance Sheet

A company’s balance sheet is a ledger that shows its assets, liabilities, and shareholder equity at a given point in time. Assets are anything the company owns with quantifiable value. This includes tangible items, such as real estate, equipment, and inventory, as well as intangible items like patents and trademarks. The cash and investments a company holds are also considered assets.

On the other side of the balance sheet are liabilities — the debts a company owes — including rent, taxes, outstanding payroll expenses and money owed to vendors. When liabilities are subtracted from assets, the result is shareholder value, or owner equity. This figure is also known as book value and represents the amount of money that would be left over if a company shut down, sold all its assets, and paid off its debt. This money belongs to shareholders, whether public or private.

Income Statement

The income statement, also known as the profit and loss (P&L) statement, shows a detailed breakdown of a company’s financial performance over a given period. It’s a summary of how much a company earned, spent, and lost during that time. The top of the statement shows revenue, or how much money a company has made selling goods or providing services.

The income statement subtracts the costs associated with running the business from revenue. These include expenses, costs of goods sold, and asset depreciation. A company’s revenues less its costs are its bottom-line earnings.

The income statement also provides information about net income, earnings per share, and earnings before interest, taxes, depreciation, and amortization (EBITDA).

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Cash Flow Statement

A cash flow statement is a detailed view of what has happened with regards to a business’ cash over the accounting period. Cash flow refers to the money that’s flowing in and out of a company, and it is not the same as profit. A company’s profit is the money left over after expenses have been subtracted from revenue. The cash flow statement is broken down into three sections:

• Cash flow from operating activities is cash generated by the regular sale of a company’s goods and services.

• Cash flow from investment activity usually comes from buying or selling assets using cash, not debt.

• Cash flow from financing activity details cash flow that comes from debt and equity financing.

At established companies, investors typically look for cash flow from operating activities to be greater than net income. This positive cash flow may indicate that a company is financially stable and has the ability to grow.

Annual Report and 10-K

Public companies must publish an annual report to shareholders detailing their operations and financial conditions. Look for an annual report to include the following:

• A letter from the company’s CEO that gives investors insight into the company’s mission, goals, and achievements. There may be other letters from key company officials, such as the CFO.

• Audited financial statements that describe financial performance. This is where you might find a balance sheet, income statement and cash flow statement. A summary of financial data may provide notes or discussion of financial statements.

• The auditor’s report lets investors know whether the company complied with generally accepted accounting principles as they prepared their financial statements.

• Management’s discussion and analysis (MD&A).

In addition, the Securities and Exchange Commission (SEC) requires companies to produce a 10-K report that offers even greater detail and insight into a company’s current status and where it hopes to go. The annual report and 10-K are not the same thing. They share similar data, but 10-Ks tend to be longer and denser. The 10-K must include complete descriptions of financial activities. It must outline corporate agreements, an evaluation of risks and opportunities, current operations, executive compensation and market activity. They must be filed with the SEC 60 to 90 days after the company’s fiscal year ends.

MD&A

The management’s discussion and analysis provides context for the financial statements. It’s a chance for company management to provide information they feel investors should have to understand the company’s financial statements, condition, and how that condition has changed or might change in the future. The MD&A also discloses trends, events and risks that might have an impact on the financial information the company reports.

Footnotes

It can be really tempting to skip footnotes as you read financial statements, but they can reveal important clues about a company’s financial health. Footnotes can help explain how a company’s accountants arrived at certain figures and help explain anything that looks irregular or inconsistent with previous statements.

💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.

Financial Statement Ratios and Calculations

Financial statements can be the source of important ratios investors use for fundamental analysis. Here’s a look at some common examples:

Debt-to-Equity

To calculate debt-to-equity, divide total liabilities by shareholder equity. It shows investors whether the debt a company uses to fund its operation is tilted toward debt or equity financing. For example, a debt-to-equity ratio of 2:1 suggests that the company takes on twice as much debt as shareholders invest in the company.

Price-to-earnings (P/E)

Calculate price-to-earnings by dividing a company’s stock price by its earnings per share. This ratio gives investors a sense of the value of a company. Higher P/E suggests that investors expect continued growth in earnings, but a P/E that’s too high could indicate that a stock is overvalued compared to its earnings.

Return on equity (ROE)

Calculated by dividing net income by shareholder’s equity, return on equity (ROE) shows investors how efficiently a company uses its equity to turn a profit.

Earnings per share

Calculate earnings per share by dividing net earnings by total outstanding shares to understand the amount of income earned for each outstanding share.

Current Ratio

This metric measures a company’s abilities to pay off its short-term liabilities with its current assets. Find it by dividing current assets by current liabilities.

Asset turnover

Used to measure how well a company is using its assets to generate revenue, you can calculate asset turnover by dividing net sales by average total assets.

The Takeaway

The financial statements that a company provides are all related to one another. For instance, the income statement reflects information from the balance sheet, while cash flow statements will tell you more about the cash on the balance sheet.

Understanding financial statements can give you clues that could help you determine whether a stock is a good value and whether it makes sense to buy or sell.

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

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Oct

2023

What Is a Financial Instrument? Types & Asset Classes Explained

By Rebecca Lake | Growing Wealth, invest, Investing | Comments Off

A financial instrument is simply a contract between entities that represents the exchange of money for a certain asset. Financial instruments include most types of investments: cash, stocks, bonds, mutual funds, exchange-traded funds (ETFs), certificates of deposit (CDs), loans, derivatives, and more.

Financial instruments facilitate the movement of capital through the markets and the broader economic system. While this may take different forms, the flow of capital remains a central feature.

What Is a Financial Instrument?

Generally Accepted Accounting Principles (GAAP) defines a financial instrument as cash; evidence of an ownership interest in a company or other entity; or a contract. A financial instrument confers either a right or an obligation to the holder of the instrument, and is an asset that can be created, modified, traded, or settled.

Investors can trade financial instruments on a public exchange. The New York Stock Exchange (NYSE) is an example of a spot market in which investors can trade equity instruments for immediate delivery.

💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.

Financial Instrument vs Security

A security is a type of financial instrument with a fluctuating monetary value that carries a certain amount of risk for the individual or entity that holds it. Investors can trade securities through a public exchange or over-the-counter market.

The federal government regulates securities and the securities industry under a series of laws, including the Securities Act of 1933, the Securities Exchange Act of 1934, and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

All securities are financial instruments but not all financial instruments are securities.

Like financial instruments, securities fall into different groups or categories. The four types of securities include:

• Equities. Equities represent an ownership interest in a company. Stocks and mutual funds are examples of equity securities.

• Debt. Debt refers to money lent by investors to corporate or government entities. Corporate and municipal bonds are two examples of debt securities.

• Derivatives. Derivatives are financial contracts whose value is tied to an underlying asset. Futures and stock options are derivative instruments.

• Hybrid. Hybrid securities combine aspects of debt and equity. Convertible bonds are a type of hybrid instrument.

Types of Financial Instruments

Financial instruments are not all alike. There are different types of financial instruments in different asset classes. Certain financial instruments are more complex in nature than others, meaning they may require more knowledge or expertise to handle or trade.

1. Cash Instruments

Cash instruments are financial instruments whose value fluctuates based on changing market conditions. Cash instruments can be securities traded on an exchange, such as stocks, or other types of financial contracts.

For example, a certificate of deposit account (CD) is a type of cash instrument. Loans also fall under the cash instrument heading as they represent an agreement or contract between two parties where money is exchanged.

2. Derivative Instruments

Derivative instruments or derivatives draw their value from an underlying asset, and fluctuate based on the changing value of the underlying security or benchmark.

As mentioned, options are a type of derivative instrument, as are futures contracts, forwards, and swaps.

3. Foreign Exchange Instruments

Foreign exchange instruments are financial instruments associated with international markets. For example, in forex trading investors trade currencies from different currencies through global exchanges.

Asset Classes of Financial Instruments

Financial instruments can also be broken down by asset class.

4. Debt-Based Financial Instruments

Companies use debt-based financial instruments as a means of raising capital. For example, say a municipal government wants to launch a road improvement project but lacks the funding to do so. They may issue one or more municipal bonds to raise the money they need.

Investors buy these bonds, contributing the capital needed for the road project. The municipal government then pays the investors back their principal at a later date, along with interest.

5. Equity-Based Financial Instruments

Equity-based financial instruments convey some form of ownership of an entity. If you buy 100 shares of stock in XYZ company, for example, you’re purchasing an equity-based instrument.

Equity-based instruments can help companies raise capital, but the company does not have to pay anything back to investors. Instead, investors may receive dividends from the stock shares they own, or realize profits if they’re able to sell those shares for a capital gain.

Are Commodities Financial Instruments?

Commodities such as oil or gas, precious metals, agricultural products and other raw materials are not considered financial instruments. A commodity itself, such as pork or copper, doesn’t direct the flow of capital.

That said, there are certain instruments whereby commodities are traded, including stocks, exchange-traded funds, and futures contracts.

A futures contract represents an agreement to buy or sell a certain commodity at a specific price at a future date. So, for example, an orange grower might sell a futures contract agreeing to sell a certain amount of their crop for a set price. An orange juice company could then buy a contract to purchase oranges at X price.

For the everyday investor, futures trading in commodities typically doesn’t mean you plan to take delivery of two tons of coffee beans or 4,000 bushels of corn. Instead, you buy a futures contract with the intention of selling it before it expires.

💡 Quick Tip: It’s smart to invest in a range of assets so that you’re not overly reliant on any one company or market to do well. For example, by investing in different sectors you can add diversification to your portfolio, which may help mitigate some risk factors over time.

Uses of Financial Instruments

Investors and businesses may use financial instrument for the following purposes:

1. As a Means of Payment

You already use financial instruments in your everyday life. When you write a check to pay a bill or use cash to buy groceries, you’re exchanging a financial instrument for goods and services.

Likewise, business entities may charge purchases to a business credit card. They’re borrowing money from the credit card company and paying it back at a later date, often with interest.

2. Risk Transfer

Investors use financial instruments to transfer risk when trading options and other derivative instruments, such as interest rate swaps. With options, for example, an investor has the option to buy or sell an underlying asset at a specified price on or before a predetermined date. A contract exists between the individual who writes the option and the individual who buys it. This type of financial instrument allows an investor to speculate about which way prices for a particular security may move in the future.

3. To Store Value

Businesses often use financial instruments in this way. For example, say you default on a credit card balance. Your credit card company can write off the amount as a bad debt and sell it to a debt collector. Meanwhile, businesses with outstanding invoices they’re awaiting payment on can use factoring or accounts receivables financing to borrow against their value.

4. To Raise Capital

Companies may issue stocks or bonds in order to get access to capital that they can invest in their business. In this case, the financial instruments could be a means of raising capital for one party and a store of value for the other.

Importance of Financial Instruments

Financial instruments are central to not only the stock market, but also the financial and economic system as a whole. They provide structures and legal obligations that facilitate the regulated exchange of capital via investing, lending and borrowing, speculation and growth.

In short, financial instruments keep the financial markets moving, and they also help businesses to keep their doors open and allow consumers to manage their finances, plan for the future, and invest with the hope of future gains.

For example, you may also have a savings account that you use to hold your emergency fund, an Individual Retirement Account (IRA) that you use to save for retirement and a taxable brokerage account for trading stocks. Your checking account is one of the basic tools you might use to pay bills or make purchases.

You might be paying down a mortgage or student loans while occasionally using credit cards to spend. All of these financial instruments allow you to direct the flow of money from one place to another.

The Takeaway

Financial instruments are integral to every aspect of the financial world, and they also play a significant part in business transactions and day-to-day financial management. If you trade stocks, invest in an IRA, or write checks to your landlord, then you’re contributing to the movement of capital with various financial instruments. Understanding the different types of financial instruments is the first step in becoming a steward of your own money.

Invest with as little as $5 with a SoFi Active Investing account.

Photo credit: iStock/Love portrait and love the world

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.

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.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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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Oct

2023

Guide to Options Trading for Beginners

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

Editor's Note: Options are not suitable for all investors. 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. Please see the Characteristics and Risks of Standardized Options.

An option is a financial instrument whose value is tied to an underlying asset; this is known as a derivative. Instead of buying an asset, such as company stock, outright, an options contract allows the investor to potentially profit from price changes in the underlying asset without actually owning it.

Because options contracts may be much cheaper to come by than the underlying asset, trading options can offer investors leverage that may result in significant gains if the market moves in the right direction. But options are very risky, and also can result in steep losses. That’s why investors must meet certain criteria with their brokerage firm before being able to trade options.

What Is Options Trading?

Knowing how options trading works requires understanding what an option is, and what the advantages, disadvantages, and risks of options trading may be.

What Are Options?

Buying an option is simply purchasing a contract that represents the right but not the obligation to buy or sell a security at a fixed price by a specified date.

• The options buyer (or holder) has the right, but not the obligation to buy or sell a certain asset, like shares of stock, at a certain price by a specific date (the expiration date of the contract). Buyers pay a premium for each options contract; this is the total price of the option.

• The options seller (or writer), who is on the opposite side of the trade, has the obligation to buy or sell the underlying asset at the agreed-upon price, aka the strike price, if the options holder exercises their contract.

Options buyers and sellers may use options if they think an asset’s price will go up (or down), to offset risk elsewhere in their portfolio, or to increase the profitability of existing positions. There are many different options-trading strategies.

💡 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.

Why Are Options Called Derivatives?

An option is considered a derivative instrument because it is based on the underlying asset: An options holder doesn’t purchase the asset, just the options contract. That way, they can make trades based on anticipated price movements of the underlying asset, without having to own the asset itself.

In stock options, one options contract typically represents 100 shares.

Other types of derivatives include futures, swaps, and forwards. Options that exist for futures contracts, such as the S&P 500 index or oil futures, are also popular derivatives.

What is the difference between trading using margin vs. options? Having a margin account does offer investors leverage for other trades (e.g. trading stocks). But while a brokerage may require you to have a margin account in order to trade options, you can’t purchase options contracts using margin. That said, an options seller (writer) might be able to use margin to sell options contracts.

Recommended: What Are Derivatives?

What Are Puts and Calls?

There are two main types of options: calls vs. puts.

Call Options 101

When purchased, call options give the options holder the right to buy an asset.

Here’s how a call option might work. The options buyer purchases a call option tied to Stock A with a strike price of $40 and expiration three months from now. Stock A is currently trading at $35 per share.

If Stock A appreciates to a value higher than $40 per share, the option holder may choose to exercise the contract, or sell their option for a premium. If the value of Stock A goes up, the value of the call option should, all else being equal, also go up.

The opposite would also be true. If shares of Stock A go down, the value of the call should, all else being equal, go down.

If the options holder wanted to exercise their call option, with American-style options they have until the expiration date to do so (with European-style options, the option must be exercised on the expiration date). When they exercise, they can buy 100 shares at the strike price.

Put Options 101

Meanwhile, put options give holders the right to sell an asset at a specified price by a certain date.

Here’s how a put trade might work. A trader buys a put option tied to Stock B with a strike price of $45 and expiration three months from now. Stock B is currently trading at $50 per share.

If the price of Stock B falls to $44, below the strike price, the options holder can exercise the put. Alternatively, the value of the option would likely also rise in this scenario, as owners of Stock B might look to lock in profits and sell shares before the stock falls further. A scenario like that may give the option holder the choice of selling the option itself for a profit.

What Is the Put-Call Ratio?

A stock’s put-call ratio is the number of put options traded in the market relative to calls. It is one measure that investors look at to determine sentiment toward the shares. A high put-call ratio indicates bearish market sentiment, whereas a low one signals more bullish views.

💡 Quick Tip: It’s smart to invest in a range of assets so that you’re not overly reliant on any one company or market to do well. For example, by investing in different sectors you can add diversification to your portfolio, which may help mitigate some risk factors over time.

Options Trading Terminology

• The strike price is the price at which the option holder can exercise the contract. If the holder decides to exercise the option, the seller is obligated to fulfill the contract.

• With American-style options the expiration is the date by which the contract needs to be exercised. The closer an option is to its expiration, the lower the value of the contract. That is what’s called the time value.

• Premiums reflect the value of an option; it’s the current market price for that option contract.

• Call options are considered in the money, when the shares of the underlying stock trade above the strike price. Put options are in the money when the underlying shares are trading below the strike price.

• Options are at the money when the strike price is equal to the price of the asset in the market. Contracts that are at the money tend to see more volume or trading activity, as holders look to exercise the options.

• Options are out of the money when the underlying security’s price is below the strike price of a call option, or above the strike price of a put option. For example, if shares of Stock C are trading at $50 each and the call option’s strike price is $60, the contracts are out of the money.

For an out-of-the-money put option, the shares of Stock C may be trading at $60, while the put’s strike price is $50, so therefore, not yet exercisable.

“The Greeks” in Options Trading

Traders use a range of Greek letters to gauge the value of options. Here are some of the Greeks to know:

• Delta measures the impact of the price of the underlying asset on the option’s value.

• Beta measures how much a single stock moves relative to the overall stock market.

• Gamma tracks the sensitivity of an option’s Delta.

• Theta is the sensitivity of the option to time.

• Vega is the sensitivity of the option to implied volatility.

• Rho is the sensitivity of the option to interest rates.

How to Trade Options

The market for stock options is typically open from 9:30am to 4pm ET, Monday through Friday, while futures options can usually be traded almost 24 hours.

This is how you may get started trading options:

1. Pick a Platform

Log into your investment account with your chosen brokerage.

2. Get Approved

Your brokerage may base your approval on your trading experience. Trading options is riskier than trading stocks because losses can be steeper. That’s why not all investors should trade options.

3. Place Your Trade

Decide on an underlying asset and options strategy and place your trade.

4. Manage Your Position

Monitor your position to know whether your options are in, at or out of the money.

Basic Options Trading Strategies

Options offer a way for holders to express their views of an asset’s price through a trade. But traders may also use options to hedge or offset risk from other assets that they own. Here are some important options trading strategies to know:

Long Put, Long Call

In simple terms, if the buyer purchases an option — be it a put or a call — they are ‘long’. A long put or long call position means the holder owns a put or call option.

• A holder with a long call strategy effectively locks in a lower purchase price for the underlying asset in case it increases in value.

• A holder with a long put strategy effectively locks in a higher sales price for the underlying asset in case it decreases in value.

Covered and Uncovered Calls

If an options writer sells call options on a stock or other underlying security they also own outright, the options are referred to as covered calls. The selling of options helps the writer generate an additional stream of income while committing to sell the shares they own for the predetermined price if the option is exercised.

Uncovered calls, or naked calls, also exist, when options writers sell call options without owning the underlying asset. However, this is a much riskier trade since the exercising of the option would oblige the options seller to buy the underlying asset in the open market, in order to sell the stock to the option buyer.

Note that the seller wants the option to stay out of the money so that they can keep the premium (which is how the seller makes money).

Spreads

Option spread trades involve buying and selling an equal number of options for the same underlying asset but at different strikes or expirations.

A bull spread is a strategy in which a trader expects the price of the underlying asset to appreciate.

A bearish spread is a strategy in which a trader expects a decline in the price of the underlying asset.

Horizontal spreads involve buying and selling options with the same strike prices but different expiration dates. Vertical spreads are created through the simultaneous buying and selling of options with the same expiration dates but different strike prices.

Straddles and Strangles

Strangles and straddles in options trading allow traders to profit from a move in the price of the underlying asset, rather than the direction of the move.

In a straddle, a trader buys both calls and puts with the same strike prices and expiration dates. The options buyer would pocket a profit if the asset price posts a big move, regardless of whether it rises or falls.

In a strangle, the holder also buys both calls and puts but with different strike prices.

Pros & Cons of Options Trading

Like any other type of investment, or investment strategy, trading options comes with certain advantages and disadvantages that investors should consider before going down this road.

Pros of Options Trading

• Options trading is complex and involves risks, but for experienced investors who understand the fundamentals of the contracts and how to trade them, options can be a useful tool to make investments while putting up a smaller amount of money upfront.

• The practice of selling options to collect income can also be a way for writers who are seeking income to collect premiums consistently. This was a popular strategy particularly in the years leading up to 2020 as the stock market tended to be quiet and interest rates were low.

• Options can also be a useful way to protect a portfolio. Some investors offset risk with options. For instance, buying a put option while also owning the underlying stock allows the options holder to lock in a selling price, for a specified period of time, in case the security declines in value, thereby limiting potential losses.

Cons of Options Trading

• A key risk in trading options is that losses can be outsized relative to the cost of the contract. When an option is exercised, the seller of the option is obligated to buy or sell the underlying asset, even if the market is moving against them.

• While premium costs are generally low, they can still add up. The cost of options premiums can eat away at an investor’s profits. For instance, while an investor may net a profit from a stock holding, if they used options to purchase the shares, they’d have to subtract the cost of the premiums when calculating the stock profit.

• Because options expire within a specific time window, there is only a short period of time for an investor’s thesis to play out. Securities like stocks don’t have expiration dates.

Advantages and Disadvantages of Options Trading
Pros	Cons
Additional income	Potential outsized losses
Hedging portfolio risk	Premiums can add up
Less money upfront than owning an asset outright	Limited time for trades to play out

The Takeaway

Options are derivative contracts on an underlying asset (an options contract for a certain stock is typically worth 100 shares). Options are complex, high-risk instruments, and investors need to understand how they work in order to avoid steep losses.

When an investor buys a call option, it gives them the right but not the obligation to buy the underlying asset by the expiration date. When an investor buys a put option, it gives them the right but not the obligation to sell the underlying asset by the expiration date.

The contracts work differently for options sellers/writers.

The seller or writer of a call option has the obligation to sell the underlying asset at the agreed strike price to the options holder, if the holder chooses to exercise the option on or before the expiration.

The seller of a put option has the obligation to buy the shares of the underlying asset from the put option holder at the agreed strike price.

Qualified investors who are ready to try their hand at options trading, despite the risks involved, might consider checking out SoFi’s options trading platform. The platform’s user-friendly design allows investors to trade 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.

Invest with as little as $5 with a SoFi Active Investing account.

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.

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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Oct

2023

What is the Capital Asset Pricing Model (CAPM)?

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

The Capital Asset Pricing Model (CAPM) is an investment assessment formula that shines a light on the relationship between the systematic risk in a security and its estimated return. Investors use the CAPM to determine whether an investment’s expected return is the same as its risk-free return, and to determine an asset’s expected returns.

CAPM Defined

The Capital Asset Pricing Model makes the process of measuring investment return and risk more efficient, to determine whether a particular asset offers an acceptable rate of return.

CAPM is especially helpful when an investor faces significant investment risk, such as when trading equity options. The formula helps the investor determine whether the transaction has an acceptable measure of risk. By using CAPM, the investor is able to accurately assess if the potential investment return on a security is worth taking on.

Evaluating the fair value of a security is an ongoing endeavor, as investment risk factors and other variables change all the time. When those risks shift (think interest rate changes, company management changes, or a geopolitical crisis erupts, among other potential threats), investors can still use the capital asset pricing model to weigh an investment against constant risk and return variables.

Investors can factor market impactors, like interest rate flows, currency valuations, and stock market cycles, among other issues, into their CAPM analysis to better weigh risk versus return. Basically, the bigger the chance of risk, the more important CAPM becomes to investors weighing that risk against potential returns.

💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.

What Is the CAPM Formula?

CAPM can help evaluate an investment’s viability in a time of significant market angst, by measuring three important barometers in an investment equation – risk-free return, the market risk premium, and the investment beta.

Let’s take a look at how CAPM is calculated with all three factors included.

The (capital asset pricing model) CAPM formula is represented as below:

Expected Rate of Return = Risk-Free Premium + Beta * (Market Risk Premium) Ra = Rrf + βa * (Rm – Rrf)

The calculation reflects a series of financial metrics, which taken together can offer a balanced look at a potential investment’s risk and return, with the aforementioned metrics front and center.

Risk-Free Return (Rrf)

This metric represents the value given to an investment (like a stock or commodity trading, for example) that provides return with no risk. U.S. Treasury bond, backed by the full faith and credit of the United States government, are a good example of risk-free return in action.

Since the U.S. government guarantees the bonds, and there is virtually zero chance of the U.S. defaulting on its debt obligations, Treasuries are considered among the safest investments available. That’s a big reason why risk-free return value reflects the yield delivered by a 10-year U.S. government bond.

The Market Risk Premium (Rm-Rrf)

This financial metric represents the return an investor earns – or anticipates earning – from owning a more risk-abundant portfolio. The MPA is an important component of CAPM, as it enables an investor to assess risk and decide if the market premium rate is superior to an investment in a risk-free investment like U.S. bonds.

The Beta (Ba)

Wall Street analysts rely on beta to weigh the volatility of a given security against a broader market.

For instance, an investor looking to buy 100 shares of an emerging biotech company can use beta to evaluate that investment and see how it may perform if the broader stock market turns volatile. In that scenario, that biotech stock’s beta may be 13%, which means it would trigger a 130% variation from any significant (based on the exact calculation) of any shift in the broader stock market. Beta is always equal to 1 in any market evaluation equation, meaning it’s parallel to any potential shifts in a broader market

CAPM Formula Explained

Factoring in each component to the CAPM equation, the resulting formula looks like this:

Expected return = Risk-free rate + (beta x market risk premium).

The risk-free component focuses on the time value of money, or the concept that a cash amount in present form is potentially higher than the same amount of cash down the road, primarily because of money’s current earnings potential. A CAPM formula may also factor in excess risks taken on by an investor.

Next, beta is assessed to figure out just how much risk is on the table relative to the broader market. For instance, if ABC stock offers more risk than the broader market, its beta is higher than 1 (one). A beta that is lower than 1 assumes the investment will curb portfolio risk, which may make a security more palatable to risk-averse investors.

With the beta calculated, beta is multiplied by the market risk premium, and the result (value) is added into the investment’s risk-free rate to provide the security’s estimated rate of return.

In conducting a CAPM exercise, the investor must acknowledge some level of risk in any investment, primarily in two ways.

• Loss is always possible, as common market securities like stocks, commodities, funds, or currencies may lose money, making them a depreciation risk.

• The higher level of risk in a specific security often correlates to a higher potential investment return, as history shows that specific investments carry more risks and more rewards than others (stock options and future.

Advantages to Capital Asset Pricing Model

The chief advantages to the capital asset pricing model are that it’s relatively simple and easy to use, it takes systemic risk into consideration, it has a wide range of potential uses (when other models may not do the trick, for instance), and for that reason, is often seen as a superior model to others, such as the WACC formula.

Problems with the CAPM

While the CAPM is an extremely useful tool for investors, it does have some drawbacks. One such drawback is the reliance on the risk-free rate and the beta. As such, CAPM must be constantly recalculated in order to remain useful. It also does not account for transaction costs such as taxes and fees, which could make a potential investment less favorable than the model shows.

Efficient Frontiers and the Capital Asset Pricing Model

In theory, if an investor adhered perfectly to CAPM all of their investments would exist on the efficient frontier, meaning that all returns justify the risks taken. The efficient frontier is the optimal baseline for a portfolio, Since every investment comes with some risk, it’s important to make sure that the returns correspond to the level of risk.

CAPM and the Security Market Line (SML)

The security market line, or SML, is a graphical representation of the CAPM formula, and shows expected returns for a security. Specifically, it shows the relationship between beta and expected return. When used in conjunction with the CAPM formula, investors can use the SML to try and get a sense of whether a prospective investment offers a good enough expected return when all risks are taken into account.

Practical Value of the CAPM

Many investors probably wonder if, when it comes down to it, CAPM has much practical value. While that will ultimately depend on the individual investor, it may be fair to say that the CAPM has value in that it’s widely used, and can give investors a broad or general idea of the risks and potential returns involved with a single investment. Again, it’s not the only model or formula that does that – but can be yet another tool that an investor can have in their analytical tool box.

The Takeaway

CAPM can help investors understand how the risk and return of a given investment relate to each other. Having the answer to that question can help investors make more knowledgeable portfolio decisions on an ongoing basis.

CAPM is also a fairly high-level investing concept, and one that many investors may never use or encounter. That’s not to say it doesn’t have its uses – but if you feel that it’s over your head or too advanced, you can always consult with a financial professional for guidance.

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

What are some of the assumptions built into the CAPM model?

A few assumptions built into the CAPM model are that all investors are naturally risk-averse, that investors are evaluating investments within the same time period, and that investors have unlimited capital to borrow at a relatively risk-free rate of return.

What are alternatives to the CAPM?

Some alternatives to the CAPM include arbitrage pricing theory, or APT, and the Fama-French Model. There are others out there, too, which may or may not be perfect substitutes or alternatives to the CAPM.

What is the International Capital Asset Pricing Model (ICAPM)?

The International Capital Asset Pricing Model, or ICAPM, is more or less an extension of the CAPM, and incorporates or includes international investments.

Photo credit: iStock/PeopleImages

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

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Oct

2023

Understanding the Different Stock Order Types

By Austin Kilham | Growing Wealth, invest, Investing | Comments Off

There are several ways to execute stock trades, from the common and relatively simple market order, to more complex stop orders and timing instructions. Each type of order is a tool tailored to specific situations and needs of an investor or trader, and can result in a different outcome.

It’s important to understand the types of order in the stock market thoroughly to know when and how to use them. That way you’ll be able to know which order will best help you reach your goals as you buy and sell stocks.

Stock Order Types Explained

Different types of stock orders have different outcomes for investors. The best stock order type for you will depend on your investing style and risk appetite. You’ll need to understand each of them, particularly if you’re working with a self-directed brokerage account.

Recommended: 50 Investment Terms Decoded

Here’s a look at the different types of stock orders:

Market Order

Market orders are one of the most common types of trade you’ll encounter. A market order is an order to buy or sell a security as soon as possible at its current price. These types of orders make sense when you want to get a transaction done as quickly as possible.

A market order is guaranteed to be carried out, or executed. Investors buying stocks with a market order will pay an amount at or near the “ask” price. Sellers will sell for a price at or near the “bid” price.

However, while you’re guaranteed that your order will execute, you do not get a guarantee on the exact price. In volatile markets, stock prices may move quickly, deviating from the last quoted price, although.

For example, if you put in an order to buy a stock at an ask price of $50 per share, but many other buy orders are executed first, your market order may execute at a higher price as demand rises.

Recommended: What Is a Market-On-Open Order (MOO)?

Limit Order

Limit orders are another common type of stock orders. They are orders to buy or sell stock at a specific price or better within a certain time period. There are two basic types of limit orders:

• Buy limit orders can only be executed at the limit price or lower. For example, say you want to buy shares in a company only when prices hit $40. By placing a limit order for that amount, you can ensure your order only executes when that price, or a lower price, is reached.

• A sell limit order executes when stock hits a certain price or higher. For example, if you don’t want to sell your stock until it hits $40 or more, a sell limit will ensure that you own the stock until it hits that price.

Stop Order

In addition to the more commonly used market orders and limit orders, brokerage firms may also allow investors to use special orders and trading instructions, such as the stop order, also known as a stop-loss order. Stop orders are orders to buy or sell a stock when it reaches a predetermined price, known as the stop price. Stop orders help investors lock in profits and limit losses.

You enter a buy stop order at a price that is above current market price, which can help protect profit, especially if you are selling short. On the other hand, a sell stop order is an order to sell a stock at a price below the current market price, which can help you limit their losses.

When a stock’s price reaches the stop order price, the stop order becomes a market order. Like a market order, the stop price is not a guaranteed price. Fast moving markets can cause the execution price to be quite different.

Stop-Limit Order

Stop-limit orders are a sort of hybrid between stop orders and limit orders. Investors set a stop price, and when a stock hits that price, the stop order becomes limit order, executed at a specific price or better.

Stop-limit orders help investors avoid the risk that a stop order will execute at an unexpected price. That gives them more control over the price at which they’ll buy or sell.

For example, say you want to buy a stock currently priced at $100 but only if it shows signs that it’s on a clear upward trajectory. You could place a stop-limit order with a stop price of $110 and a limit of $115. When the stock reaches $110, the stop order becomes a limit order, and it will only execute when prices reach $115 or higher.

💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.

Trailing Stop Loss Order

Investors who already own stocks and want to lock in gains may use these relatively uncommon orders. While stop-loss orders help investors buy or sell when a stock hits a certain stop price, trailing stop loss orders put guardrails around an investment.

For example, if you buy a stock at $100 per share, you might put a trailing stop loss order of 10% on the stock. That way, if, at any time, the stock’s share price dips below 10%, the brokerage will execute the order to sell.

Bracket Order (BO)

Bracket orders are similar to stop-loss orders in that they’re designed to help investors or traders lock in their profits or gains. They effectively create an order “bracket” with two orders: A buy order with a high-side sell limit, and a sell order with a low-side limit.

With a bracket order set up and in place, an order will execute when a security’s value goes outside of the predetermined range, either too high or too low.

Timing Instructions

Investors use a set of tools, known as timing instructions, to modify the market orders and limit orders and tailor them to more specific needs.

Day Orders

If an investor does not specify when an order will expire, the brokerage enters it as a day order. At the end of the trading day, it expires. If at that point, the brokerage has not executed the trade, it will have to be reentered the following day.

Good ‘Til Canceled (GTC)

A GTC order allows investors to put a time restriction on an order so that it lasts until the completion or cancellation of an order. Brokerage firms typically place a time limit on how long a GTC order can remain open.

Immediate or Cancel (IOC)

IOC orders allow investors to ask that the brokerage execute the buying or selling of stock immediately. It also allows for partial execution of the order. So, if an investor wants to buy 1,000 shares of a company but it’s only possible to buy 500 shares immediately, these instructions will alert the broker to buy the shares available. If the broker can not fulfill the order, or any portion of the order, immediately, the broker will cancel it.

Fill-Or-Kill (FOK)

Unlike IOC orders, fill-or-kill orders do not permit partial execution. The brokerage must execute the order immediately and in its entirety, or cancel it.

All-Or-None (AON)

Similar to FOKs, all-or-none orders require the complete execution of the order. However, AONs do not require immediate execution, rather the order remains active until the broker executes or cancels it.

💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

Which Order Type Is Best?

The type of order or special instructions you use when buying and selling stock depends on your goals with the transaction. Most beginner investors probably only need to execute market orders and perhaps limit orders.

Those trying to execute more complicated trades in shorter time frames, such as professional traders, may be more likely to use stop orders and special timing instructions.

The Takeaway

There are numerous types of stock orders, including limit orders, stop orders, bracket orders, and more. Investors and traders can use each individually or in concert to execute their strategy, though beginner investors likely won’t dig too far into their order tool kit when learning to navigate the markets.

Before using any of trade orders or timing instructions it’s critical to understand their function and to think carefully about how and whether they apply to your specific needs. Using the right order for your situation can potentially help you reduce risk and protect your portfolio, no matter how many stocks you own.

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

What is the safest type of stock order to use?

The stock order type that is all but guaranteed to execute per an investor’s desires is a market order, which executes immediately and at a given price. Other order types depend on specific conditions dictated by the investor and the market.

What is the difference between stop-loss vs stop-limit orders?

The main difference between a stop-loss order and a stop-limit order is that a stop-loss order guarantees to execute a market order if the stock hits the stop price, while a stop-limit order triggers a limit order when the assigned value is reached.

What is a standard stop-loss rule?

An example of a more or less standard stop-loss rule would be setting the stop-loss order parameters at 2% of the buy price, which would mean that an investor is not putting more than 2% of their initial investment at risk.

Photo credit: iStock/Alina Vasylieva

SoFi Invest®

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

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How to Read Financial Statements: The Basics

Understanding Each Section of a Financial Statement

Balance Sheet

Income Statement

Cash Flow Statement

Annual Report and 10-K

MD&A

Footnotes

Financial Statement Ratios and Calculations

Debt-to-Equity

Price-to-earnings (P/E)

Return on equity (ROE)

Earnings per share

Current Ratio

Asset turnover

The Takeaway

What Is a Financial Instrument? Types & Asset Classes Explained

What Is a Financial Instrument?

Financial Instrument vs Security

Types of Financial Instruments

1. Cash Instruments

2. Derivative Instruments

3. Foreign Exchange Instruments

Asset Classes of Financial Instruments

4. Debt-Based Financial Instruments

5. Equity-Based Financial Instruments

Are Commodities Financial Instruments?

Uses of Financial Instruments

1. As a Means of Payment

2. Risk Transfer

3. To Store Value

4. To Raise Capital

Importance of Financial Instruments

The Takeaway

Guide to Options Trading for Beginners

What Is Options Trading?

What Are Options?

Why Are Options Called Derivatives?

What Are Puts and Calls?

Call Options 101

Put Options 101

What Is the Put-Call Ratio?

Options Trading Terminology

“The Greeks” in Options Trading

Get up to $1,000 in stock when you fund a new Active Invest account.*

Access stock trading, options, auto investing, IRAs, and more. Get started in just a few minutes.

How to Trade Options

1. Pick a Platform

2. Get Approved

3. Place Your Trade

4. Manage Your Position

Basic Options Trading Strategies

Long Put, Long Call

Covered and Uncovered Calls

Spreads

Straddles and Strangles

Pros & Cons of Options Trading

Pros of Options Trading

Cons of Options Trading

The Takeaway

What is the Capital Asset Pricing Model (CAPM)?

CAPM Defined

What Is the CAPM Formula?

Risk-Free Return (Rrf)

The Market Risk Premium (Rm-Rrf)

The Beta (Ba)

CAPM Formula Explained

Advantages to Capital Asset Pricing Model

Problems with the CAPM

Efficient Frontiers and the Capital Asset Pricing Model

CAPM and the Security Market Line (SML)

Practical Value of the CAPM

The Takeaway

FAQ

What are some of the assumptions built into the CAPM model?

What are alternatives to the CAPM?

What is the International Capital Asset Pricing Model (ICAPM)?

Understanding the Different Stock Order Types

Stock Order Types Explained

Market Order

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