InvestGen Archives | Page 56 of 65

Jul

2022

ETFs vs Index Funds: Differences and Similarities, Explained

By Kim Franke-Folstad | invest, Investing, Terminology | No Comments

While most exchange-traded funds, or ETFs, are passively managed just like index funds (meaning they track a certain market index), these funds have different structures, which can have a significant impact on investors.

Index funds are a type of mutual fund, which means they are less transparent, liquid, and tax efficient compared with ETFs. Exchange-traded funds shares, for example, trade on exchanges throughout the day, similar to stocks — while index funds do not. Owing to disclosure regulations, index ETFs are also more transparent than index mutual funds.

Here’s what else you need to know before you decide whether to invest in an index fund vs. an ETF.

An Overview of Index Funds

In order to understand some of the similarities between index funds and ETFs, both of which adhere to passive investing strategies (though a small fraction of ETFs are actively managed), let’s start with what a market index is and how it works.

What Is an Index?

A market index tracks a representative sample of securities in a particular sector or asset class. For example, the S&P 500 index tracks the performance of the 500 largest companies in the U.S., while the Russell 2000 index tracks small-cap domestic companies. Typically, the index is weighted according to the size of the companies.

Most indices are used as benchmarks to measure the performance of assets in a particular sector. Meaning: large-cap U.S. mutual funds might measure their performance against the S&P 500 index as a benchmark.

You can’t invest in an index, but you can invest in funds that track the index.

So index funds or index ETFs that track the S&P 500 seek to mimic the performance of that benchmark by investing in the same large-cap U.S. companies that are in the index, and giving them a similar weight in the fund.

The same goes for funds that track any other benchmark, whether that’s the Nasdaq 100 Index (which includes 100 of the largest domestic and international non-financial companies), or the MSCI World Index (mid- and large-cap global companies), or one of the many bond indices. Index funds and ETFs simply track the performance of the index, thus they are passively managed.

What Is Passive Investing?

As noted above, an index fund mirrors the performance of its index, which is known as passive investing. An actively managed fund, however, follows the strategy of an active management team. So active investing is a strategy where human portfolio managers pick investments they believe will outperform the market — whereas passive investing relies on a formula to mirror the performance of certain market sectors.

There are thousands of mutual funds available to investors, and the vast majority of them rely on active strategies. In 2021, there were over 6,600 actively managed funds, and about 500 passively managed (index) funds in the U.S., according to Statista.

Even though the number of index funds is much smaller, these funds track a wide range of benchmarks, which naturally has an impact on index fund returns. A fund that tracks a corporate bond index versus a fund that tracks an index of biotech stocks will typically have different returns.

What’s the Differences Between an ETF and Index Fund?

When picking ETFs, however, bear in mind that the world of ETFs is the opposite of mutual funds: the majority of ETFs are passively managed; i.e. they are index ETFs.

Only about 2% of ETFs are actively managed, owing to rules about transparency for these products.

That’s why many actively managed ETFs rely on a certain fund structure that allows for less transparency. These are called active non-transparent or ANT ETFs.

So: ETF vs. index fund, what are the primary differences?

How an Index Fund Works

Index funds are mutual funds. They are a collection of stocks, bonds, or other securities that are bundled together into a single unit (the mutual fund). Some may invest in large-cap stocks; some in ESG companies; some in tech; some in international companies, and so on. Most investors own more than one type of mutual fund in their portfolio, and you can also own more than one type of index fund.

Like any other type of mutual fund, index fund shares can be traded only once per day. You can put in the order in the morning, but it won’t go through until the market closes. This means the price you anticipated when you entered the order to buy or sell isn’t necessarily what you’ll get.

💡 Recommended: Learn what actively managed ETFs are and how they work.

How an ETF Works

An ETF is an exchange-traded fund, so its wrapper — or structure — is not the same as a traditional mutual fund. While an exchange-traded fund is also a basket of securities, shares of these funds can be traded on exchanges throughout the day, just like stocks. As a result, ETF shares are not only more liquid from a cash standpoint, they are also more fluid.

Mutual fund shares vs. ETF shares are relatively fixed. ETFs can generate more shares, depending on investor demand. But because an ETF is listed on a stock exchange, a sale can go through any time the market is open. An investor can get real-time pricing information with relative ease by checking financial websites or calling a broker. That’s a plus for investors and financial professionals who like the idea of making moves based on market conditions.

When trading ETFs, bear in mind that the expense ratio of ETFs is generally lower than most mutual funds. And owing to the way shares are created and redeemed, ETFs can be more tax efficient.

ETFs can offer that flexibility and more transparency: Investors can review holdings daily and monitor portfolio risk exposures more frequently than with indexed mutual funds.

Similarities Between ETFs and Index Funds

As noted above, ETFs and index funds are both pooled investments, like baskets that include dozens, sometimes hundreds of securities in a single package. This helps provide investors with diversification within the fund that can help mitigate risk and may improve performance. In addition, these two fund types share some other similarities.

Cost

ETF vs. index fund — which is cheaper? The cost per share varies widely, of course, but when it comes to expense ratios of these funds the two are increasingly competitive. Time was when ETFs fees were far lower, but now many index funds have ultra-low expense ratios.

Still, many ETFs no longer charge brokerage fees or commissions, which cuts out a cost that many mutual funds still charge. Mutual funds also tend to have higher administrative costs.

Diversification

Both ETFs and index funds can offer investors the potential to add diversification to their portfolios.

ETF vs Index Fund: Pros and Cons of Each

There’s no cut-and-dried answer to whether ETFs are better than index funds, but there are a number of pros and cons to consider for each type of fund.

Transparency

By law, mutual funds are required to disclose their holdings every quarter. This is a stark contrast with ETFs, which disclose their holdings each day.

Transparency may matter less when it comes to index funds, however, because index funds track an index, so the holdings are not in dispute. That said, many investors prefer the transparency of ETFs, whose holdings can be verified day to day.

Pricing

Because a mutual fund’s net asset value (NAV) isn’t determined until markets close, it can be hard to know exactly how much an index fund costs until end of day. That’s partly why mutual funds, including index funds, allow straight dollar amounts to be invested, as well as purchasing shares. If you buy an index fund at noon, you can buy $100 worth, for example, regardless of the share price.

ETF shares, which trade throughout the day like stocks, are priced by the share, so you always know how much you’re paying for an ETF.

This pricing structure also allows investors to use stop order or limit orders to set the price they’re willing to buy or sell.

Taxes

ETFs are generally considered more tax efficient than mutual funds, including index funds.

The way mutual funds are structured, there can be more tax implications as investors buy in and out of an index fund, and the cost of taxes is shared among different investors. ETF shares are redeemed directly for cash, so if there are capital gains, you would only owe them based on your ETF shares.

How Do Investors Find the Right ETF?

Choosing between ETFs vs. index funds typically comes down to cost and flexibility, as well as understanding the tax implications of the two fund types. While both ETFs and index funds are low-cost, passively managed funds — two factors which can provide an upside when it comes to long-term performance — ETFs generally have the upper hand when it comes to taxes.

If taxable gains are a concern for you, ETFs may be a more tax-efficient option vs. index funds, which are structured such that gains are dispersed among shareholders. Also consider the tax structure of the container: i.e. are you holding the fund in a taxable portfolio, or a tax-deferred retirement account?

Once your goals are clear, selecting an ETF is easy when you set up a brokerage account with SoFi Invest. You can explore ETFs from the secure SoFi app at your convenience, and invest in ETFs in a taxable account or an IRA. SoFi also enables you to trade stocks, IPO shares, and more. Whatever your aims are, SoFi can get you started on your investing future.

Download the SoFi app to get started.

FAQ

Is it better to choose an ETF or an index fund?

ETFs and index funds each have their pros and cons. ETFs tend to cost less and be more tax efficient, and you can trade ETFs like stocks throughout the day. If you’re interested in more of a buy-and-hold strategy, an index fund may make more sense.

What are the similarities between an ETF and an index fund?

All index funds, and about 98% of ETFs, are passively managed — meaning, they track a certain market index. In addition, both ETFs and index funds tend to be much cheaper to own, versus their actively managed counterparts.

What are the differences between an ETF and an index fund?

ETFs generally cost less, are more transparent, and more tax efficient compared with index funds.

SoFi Invest®

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

Jul

2022

Exercising in Options? What Does It Mean & When to Exercise

By Laurel Tincher | Growing Wealth, invest, Investing | Comments Off

Investors in stock option contracts have the right to buy or sell underlying stocks (or other assets) at a predetermined price within a certain time period. When an investor decides they want to take action on their right to buy or sell, it’s called exercising. There are a number of ways investors can choose to exercise their options contract, depending on their individual goals and financial situation.

Option contracts are complex investment vehicles. They’re a multi-faceted tool that involves precise timing and are backed by lots of strategizing. While options are not for all investors, if handled by experienced traders, options could add diversity to a well-diversified portfolio.

In this article, we focus on the concept of exercising in options. What does it really mean to “exercise an option?” And how do you do it?

What Does Exercising Mean?

Exercising a stock option means that a trader purchases or sells the underlying stock associated with the options contract at the price set by the contract, which is called the strike price. This price may differ from the current market price of the stock.

Options contracts are valid for a certain amount of time. So if the owner doesn’t exercise their right to buy or sell within that period, the contract expires worthless, and the owner loses the right to buy or sell the underlying security at the strike price.

There is also an upfront fee, called a premium, that gets paid when a trader enters into an options contract. If the trader doesn’t exercise the contract, they forfeit that fee along with any other brokerage fees. Most options contracts never get exercised. Some contracts are sold instead of exercised, because the contract itself has value if it has the potential to be exercised later.

There are two main choices of types of options contracts, call options and put options. Purchasing a call option gives traders the right, but not the obligation, to purchase the underlying security at the strike price. Selling put options gives traders the right to sell the underlying security at the strike price.

Each contract is different, and there are also different types of options. American-style options let traders exercise them prior to the contract’s expiration date, while European-style options can only be exercised after the expiration date.

How Do You Exercise an Option?

Generally, traders have several choices when it comes to exercising their stock options. When a trader is ready to exercise an option, they can let their brokerage firm know. The broker will create an exercise notice to the Options Clearing Corporation (OCC) to let the individual or entity buying or selling the underlying stock know that the trader wants to execute a trade on a particular date. The option seller is required to fulfill the obligations of the contract.

The OCC assigns the exercise notice to one of their clearing members, which tends to be the trader’s brokerage firm. The broker then assigns the option to one of their customers who has written an option contract that they have not yet covered. Depending on the broker, the customer they choose may either be chosen randomly or picked on a first-in-first-out (FIFO) principle .

Holding

If a trader thinks a stock will go up in value, they can purchase options at a lower market price, then wait until the market price goes up to exercise the option. Then they purchase at their original lower price and can decide to sell at the new, higher market price. This is one of the benefits of trading stock options. However, traders can’t wait forever, because options contracts do have expiration dates.

Exercise-and-Hold

It is common for company employees to receive stock options, which give them the right to purchase company stock. They can purchase the stock and then hold onto it if they think it will rise in value. However, it’s important for employees to understand the rights they have with their options. Often, stock shares are vested for a certain amount of time, so an employee has to wait for that time to end before they are allowed to exercise the option.

Exercise-and-Sell-to-Cover

Sometimes there are fees, commissions, and taxes involved in exercising company stock options. To cover those fees, traders can exercise options, purchase shares of company stock and simultaneously sell some of those shares to cover the expenses.

Exercise-and-Sell

If a company employee wants to immediately sell their stock options after exercising their right to buy the stock, they can choose to exercise and sell. They will receive the cash amount of the current market value of the stock minus any fees and taxes.

Early Exercise

In addition to profiting off of a stock’s price increase, options traders may want to exercise early so that they can earn dividends off of the underlying security. Traders who write call options should be prepared to close out a trade at any time prior to the contract’s expiration date, especially if the contract is in-the-money. If a put option is in the money, most likely the owner will exercise it before it expires.

Advantages and Disadvantages of Exercising an Option

Exercising options presents opportunities to earn a profit, but there also are potential downsides to exercising options.

Exercising Options

Advantages	Disadvantages
Earn dividends from owning the underlying stock.	Fees, taxes, transaction costs potentially could cancel out any profit.
Sell the underlying stock for a profit.	Increases chance of risk: margin call, stock’s value could decrease.
In general, traders can make a greater profit via closing positions — by buying or selling options rather than exercising them. One of the few instances where it could be advantageous to exercise a contract is if you’d like to own the stock outright instead of basing a contract on it.	The one way that exercising a contract could actually make you lose out on money has to do with the complicated price structure of options, which consists of two components: extrinsic (time value) and intrinsic value. If you own options contracts that are in the money, then the price of those contacts will comprise both extrinsic and intrinsic value. If you sell these options, you’d benefit from both the intrinsic and the extrinsic price components. But if you exercised them instead, you would only benefit from the intrinsic value. Why? Extrinsic value serves to compensate the writer (seller) of options contracts for the risk they are taking. Once you exercise an options contract, the contract itself effectively ceases to exist, so that all extrinsic value is lost.

Advantages

Disadvantages

Earn dividends from owning the underlying stock.

Fees, taxes, transaction costs potentially could cancel out any profit.

Sell the underlying stock for a profit.

Increases chance of risk: margin call, stock’s value could decrease.

In general, traders can make a greater profit via closing positions — by buying or selling options rather than exercising them.

One of the few instances where it could be advantageous to exercise a contract is if you’d like to own the stock outright instead of basing a contract on it.

The one way that exercising a contract could actually make you lose out on money has to do with the complicated price structure of options, which consists of two components: extrinsic (time value) and intrinsic value.

If you own options contracts that are in the money, then the price of those contacts will comprise both extrinsic and intrinsic value. If you sell these options, you’d benefit from both the intrinsic and the extrinsic price components.

But if you exercised them instead, you would only benefit from the intrinsic value. Why?

Extrinsic value serves to compensate the writer (seller) of options contracts for the risk they are taking. Once you exercise an options contract, the contract itself effectively ceases to exist, so that all extrinsic value is lost.

How Do You Know Whether to Hold or Exercise an Option?

It can be difficult to know when and whether to exercise an option. There are different options trading strategies that can prove beneficial to exercising early, or to waiting or even selling the option contract itself. Many factors come into play when making the decision to exercise an option, such as

• the amount of time left in the contract,

• whether it is in-the-money and if so by how much, and

• whether the trader wants to buy, sell, or hold shares of the underlying security.

Time Value

One key thing to know about options trading is how options pricing works. Options lose value over time until they are finally worth nothing at their expiration date. If a trader owns an option that still has time left on it, they may consider selling the option or waiting to exercise it. Often it is more profitable to sell the option than to exercise it if it still has time value. If an option is in the money and close to expiring, it may be a good idea to exercise it. Options that are out-of-the-money don’t have any intrinsic value, they only have time value.

Transaction Costs

In addition to the premium a trader pays when buying an option, they must also pay transaction and commission fees to their broker. There can be fees both when exercising an option and when buying or selling the underlying shares.

Increased Chance of Risk

Buying a call option is fairly low risk because the most a trader can lose is the premium amount they paid when they bought into the contract. Exercising an option increases risk, because even if the trader profits in the short term by exercising and buying the stock at a good price, the stock could decrease in value any time. Because the trader already lost the premium amount, they would need to earn at least that amount back to break even on the trade.

Exposure to Margin Risk

To purchase the shares of the underlying security, a trader needs to use cash from their account or take out a margin loan from their broker. If they take out a loan, they increase their chances for risk and greater expenses.

Options Obligations

The owner of a long option contract has the right to buy shares of the underlying stock if they choose to exercise it. The selling trader on the other side of the contract is obligated to fulfill the contract if the owner decides to buy. If the buyer exercises their right, the seller must deliver the number of shares — generally 100 shares per contract — for the strike price set by the contract. If the buyer does exercise the contract, they are then obligated to pay the seller for those shares.

The brokerage firm gives notice to a random seller when a buyer exercises an option that fits the transaction parameters. This could happen at any time prior to the expiration date. A seller can close out their option contract early if it hasn’t been exercised yet. The process of assigning and exercising options is all automated. So if a trader sells an option, when it gets exercised the stock will automatically be removed from their account, and they receive cash in their account in return. The buyer will receive the shares in exchange for cash from their brokerage account.

The Takeaway

Stock options are a popular investing tool to gain exposure to securities with a smaller upfront cost and level of risk. If you’re interested in starting to build a portfolio, a great tool to use is SoFi Invest. The online trading platform lets you research, track, buy and sell stocks, ETFs, and other assets right from your phone — all with 24/7 convenience.

More ways to invest — all in one place. You can connect your banking and any other investment accounts to the SoFi Invest app to see all your financial information easily in one simple dashboard.

Get started trading on SoFi Invest today.

FAQ

How can you tell when to exercise an option?

It could be beneficial to exercise an option if the underlying security’s price is more than the strike price of a call option; or the underlying security’s price is less than the strike price of a put option.

How are early-exercise options different from exercise options?

Early-exercise options differ from exercise options in one way: Early exercise is possible with American-style option contracts only. You cannot do this with European-style option contracts, as they rule that you may exercise on the expiration date only.

What is a cashless exercise in options?

Also called the “same-day sale,” a cashless exercise is when an employee exercises their stock options via a short-term loan provided by a brokerage firm.

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

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.
*Borrow at 12%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
SoFi Invest®

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

Photo credit: iStock/whyframestudio
SOIN0122054

May

2022

Target Date Funds: What Are They and How to Choose One

By AJ Smith | invest, Investing, Preparing for Retirement | No Comments

A target date fund is a type of mutual fund designed to be an all-inclusive portfolio for long-term goals like retirement. While target date funds could be used for shorter-term purposes, the specified date of each fund — e.g. 2040, 2050, 2065, etc. — is typically years in the future, and indicates the approximate point at which the investor would begin withdrawing funds for their retirement needs (or another goal, like saving for college).

Unlike a regular mutual fund, which might include a relatively static mix of stocks and bonds, the underlying portfolio of a target date fund shifts its allocation over time, following what is known as a glide path. The glide path is basically a formula or algorithm that adjusts the fund’s asset allocation to become more conservative as the target date approaches, thus protecting investors’ money from potential volatility as they age.

If you’re wondering whether a target date fund might be the right choice for you, here are some things to consider.

What Is a Target Date Fund?

A target date fund (TDF) is a type of mutual fund where the underlying portfolio of the fund adjusts over time to become gradually more conservative until the fund reaches the “target date.” By starting out with a more aggressive allocation and slowly dialing back as years pass, the fund’s underlying portfolio may be able to deliver growth while minimizing risk.

This ready-made type of fund can be appealing to those who have a big goal (like retirement or saving for college), and who don’t want the uncertainty or potential risk of managing their money on their own.

While many college savings plans offer a target date option, target date funds are primarily used for retirement planning. The date of most target funds is typically specified by year, e.g. 2035, 2040, and so on. This enables investors to choose a fund that more or less matches their own target retirement date. For example, a 30-year-old today might plan to retire in 38 years at age 68, or in 2060. In that case, they might select a 2060 target date fund.

Investors typically choose target date funds for retirement because these funds are structured as long-term investment portfolios that include a ready-made asset allocation, or mix of stocks, bonds, and/or other securities. In a traditional portfolio, the investor chooses the securities — not so with a target fund. The investments within the fund, as well as the asset allocation, and the glide path (which adjusts the allocation over time), are predetermined by the fund provider.

Sometimes target date funds are invested directly in securities, but more commonly TDFs are considered “funds of funds,” and are invested in other mutual funds.

Target date funds don’t provide guaranteed income, like pensions, and they can gain or lose money, like any other investment.

Whereas an investor might have to rebalance their own portfolio over time to maintain their desired asset allocation, adjusting the mix of equities vs. fixed income to their changing needs or risk tolerance, target date funds do the rebalancing for the investor. This is what’s known as the glide path.

How Do Target Date Funds Work?

Now that we know what a target date fund is, we can move on to a detailed consideration of how these funds work. To understand the value of target date funds and why they’ve become so popular, it helps to know a bit about the history of retirement planning.

Brief Overview of Retirement Funding

In the last century or so, with technological and medical advances prolonging life, it has become important to help people save additional money for their later years. To that end, the United States introduced Social Security in 1935 as a type of public pension that would provide additional income for people as they aged. Social Security was meant to supplement people’s personal savings, family resources, and/or the pension supplied by their employer (if they had one).

💡 Recommended: When Will Social Security Run Out?

By the late 1970s, though, the notion of steady income from an employer-provided pension was on the wane. So in 1978 a new retirement vehicle was introduced to help workers save and invest: the 401(k) plan.

While 401k accounts were provided by employers, they were and are chiefly funded by employee savings (and sometimes supplemental employer matching funds as well). But after these accounts were introduced, it quickly became clear that while some people were able to save a portion of their income, most didn’t know how to invest or manage these accounts.

The Need for Target Date Funds

To address this hurdle and help investors plan for the future, the notion of lifecycle or target date funds emerged. The idea was to provide people with a pre-set portfolio that included a mix of assets that would rebalance over time to protect investors from risk.

In theory, by the time the investor was approaching retirement, the fund’s asset allocation would be more conservative, thus potentially protecting them from losses. (Note: There has been some criticism of TDFs about their equity allocation after the target date has been reached. More on that below.)

Target date funds became increasingly popular after the Pension Protection Act of 2006 sanctioned the use of auto-enrollment features in 401k plans. Automatically enrolling employees into an organization’s retirement plan seemed smart — but raised the question of where to put employees’ money. This spurred the need for safe-harbor investments like target date funds, which are considered Qualified Default Investment Alternatives (QDIA) — and many 401k plans adopted the use of target date funds as their default investment.

Today nearly all employer-sponsored plans offer at least one target date fund option; some use target funds as their default investment choice (for those who don’t choose their own investments). Approximately $1.8 trillion dollars are invested in target funds, according to Morningstar.

What a Target Date Fund Is and Is Not

Target date funds have been subject to some misconceptions over time. Here are some key points to know about TDFs:

• As noted above, target date funds don’t provide guaranteed income; i.e. they are not pensions. The amount you withdraw for income depends on how much is in the fund, and an array of other factors, e.g. your Social Security benefit and other investments.

• Target date funds don’t “stop” at the retirement date. This misconception can be especially problematic for investors who believe, incorrectly, that they must withdraw their money at the target date, or who believe the fund’s allocation becomes static at this point. To clarify:

◦ The withdrawal of funds from a target date fund is determined by the type of account it’s in. Withdrawals from a TDF held in a 401k plan or IRA, for example, would be subject to taxes and required minimum distribution (RMD) rules.

◦ The TDF’s asset allocation may continue to shift, even after the target date — a factor that has also come under criticism.

• Generally speaking, most investors don’t need more than one target date fund. Nothing is stopping you from owning one or two or several TDFs, but there is typically no need for multiple TDFs, as the holdings in one could overlap with the holdings in another — especially if they all have the same target date.

Example of a Target Date Fund

Most investment companies offer target date funds, from Black Rock to Vanguard to Charles Schwab, Fidelity, Wells Fargo, and so on. And though each company may have a different name for these funds (a lifecycle fund vs. a retirement fund, etc.), most include the target date. So a Retirement Fund 2050 would be similar to a Lifecycle Fund 2050.

How do you tell target date funds apart? Is one fund better than another? One way to decide which fund might suit you is to look at the glide path of the target date funds you’re considering. Basically, the glide path shows you what the asset allocation of the fund will be at different points in time. Since, again, you can’t change the allocation of the target fund — that’s governed by the managers or the algorithm that runs the fund — it’s important to feel comfortable with the fund’s asset allocation strategy.

How a Glide Path Might Work

Consider a target date fund for the year 2060. Someone who is about 30 today might purchase a 2060 target fund, as they will be 68 at the target date.

Hypothetically speaking, the portfolio allocation of a 2060 fund today — 38 years from the target date — might be 80% equities and 20% fixed income or cash/cash equivalents. This provides investors with potential for growth. And while there is also some risk exposure with an 80% investment in stocks, there is still time for the portfolio to recover from any losses, before money is withdrawn for retirement.

When five or 10 years have passed, the fund’s allocation might adjust to 70% equities and 30% fixed income securities. After another 10 years, say, the allocation might be closer to 50-50. The allocation at the target date, in the actual year 2060, might then be 30% equities, and 70% fixed income. (These percentages are hypothetical.)

As noted above, the glide path might continue to adjust the fund’s allocation for a few years after the target date, so it’s important to examine the final stages of the glide path. You may want to move your assets from the target fund at the point where the predetermined allocation no longer suits your goals or preferences.

Pros and Cons of Target Date Funds

Like any other type of investment, target date funds have their advantages and disadvantages.

Pros

• Simplicity. Target funds are designed to be the “one-stop-shopping” option in the investment world. That’s not to say these funds are perfect, but like a good prix fixe menu, they are designed to include the basic staples you want in a retirement portfolio.

• Diversification. Related to the above, most target funds offer a well-diversified mix of securities.

• Low maintenance. Since the glide path adjusts the investment mix in these funds automatically, there’s no need to rebalance, buy, sell, or do anything except sit back and keep an eye on things. But they are not “set it and forget it” funds, as some might say. It’s important for investors to decide whether the investment mix and/or related fees remain a good fit over time.

• Affordability. Generally speaking, target date funds may be less expensive than the combined expenses of a DIY portfolio (although that depends; see below).

Cons

• Lack of control. Similar to an ordinary mutual fund or exchange-traded fund (ETF), investors cannot choose different securities than the ones available in the fund, and they cannot adjust the mix of securities in a TDF or the asset allocation. This could be frustrating or limiting to investors who would like more control over their portfolio.

• Costs can vary. Some target date funds are invested in index funds, which are passively managed and typically very low cost. Others may be invested in actively managed funds, which typically charge higher expense ratios. Be sure to check, as investment costs add up over time and can significantly impact returns.

What Are Target Date Funds Good For?

If you’re looking for an uncomplicated long-term investment option, a low-cost target date fund could be a great choice for you. But they may not be right for every investor.

Good For…

Target date funds tend to be a good fit for those who want a hands-off, low-maintenance retirement or long-term investment option.

A target date fund might also be good for someone who has a fairly simple long-term strategy, and just needs a stable portfolio option to fit into their plan.

In a similar vein, target funds can be right for investors who are less experienced in managing their own investment portfolios and prefer a ready-made product.

Not Good For…

Target date funds are likely not a good fit for experienced investors who enjoy being hands on, and who are confident in their ability to manage their investments for the long term.

Target date funds are also not right for investors who are skilled at making short-term trades, and who are interested in sophisticated investment options like day-trading, derivatives, and more.

Investors who like having control over their portfolios and having the ability to make choices based on market opportunities might find target funds too limited.

The Takeaway

Target date funds can be an excellent option for investors who aren’t geared toward day-to-day portfolio management, but who need a solid long-term investment portfolio for retirement — or another long-term goal like saving for college. Target funds offer a predetermined mix of investments, and this portfolio doesn’t require rebalancing because that’s done automatically by the glide path function of the fund itself.

The glide path is basically an asset allocation and rebalancing feature that can be algorithmic, or can be monitored by an investment team — either way it frees up investors who don’t want to make those decisions. Instead, the fund chugs along over the years, maintaining a diversified portfolio of assets until the investor retires and is ready to withdraw the funds.

Target funds are offered by most investment companies, and although they often go by different names, you can generally tell a target date fund because it includes the target date, e.g. 2040, 2050, 2065, etc.

If you’re ready to start investing for your future, you might consider opening a brokerage account with SoFi Invest® in order to set up your own portfolio and learn the basics of buying and selling stocks, bonds, exchange-traded funds (ETFs), and more. Note that SoFi members have access to complimentary financial advice from professionals.

SoFi Invest®

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

May

2022

Vega Options, Explained

By Laurel Tincher | Growing Wealth, invest, Investing | Comments Off

What Is Vega in Options Trading?

Vega is one of the Greeks — along with delta, theta, and gamma. And the Greeks, itself, is a set of indicators that quantitative analysts and traders use to measure the effect of various factors on prices of options contracts. Traders can use the Greeks to hedge against risks involved in trading options. Each indicator in the Greeks helps analysts to understand the level of risk, volatility, price direction, value over time, and interest rate of a particular options contract.

As a unit of measure, vega tries to assess, theoretically, the amount that a security’s price will change with every percentage point that its price fluctuates. So vega reflects how sensitive a contract is to changes in the price of its underlying security. When an underlying asset of an options contract has significant and frequent price changes, then it has high volatility, which also makes the contract more expensive.

How Vega Works

Vega changes over time as the price of the underlying asset changes and the contract moves closer to its expiration date. Because vega is always changing, investors tend to track it on an ongoing basis while they are invested in an options contract.

When options still have time before they expire, the vega is said to be positive. But when an options contract nears its expiration date, then vega decreases and becomes negative. This is because premiums are higher for future options than they are for options that are close to expiring. When an option’s vega is higher than the amount of the bid-ask spread, the option has what is known as a competitive spread. If vega is lower than the bid-ask spread, then the spread is not competitive.

Vega is a derivative of implied volatility.

Implied Volatility

The term, implied volatility is simply an estimate of where the price of an underlying security may be now, was in the past, or will be going forward. In pricing options, implied volatility is mostly used to predict future price fluctuations. Traders sometimes use a sigma symbol (𝞂) to represent implied volatility.

Traders use options pricing models to calculate implied volatility. These models try to estimate the speed and amount that an underlying security’s price changes — its volatility. As the volatility of the underlying asset shifts, the vega also changes. Pricing models can estimate volatility for present, past, and future market conditions. But, as the calculation is just a theoretical prediction, so the actual future volatility of the security may differ.

Characteristics of Vega

• Vega relates to the extrinsic value of an option, not its intrinsic value.

• Vega is always positive when an investor purchases calls or puts.

• It Is negative when writing options.

• Vega is higher when there is more time until the option expires.

• It’s lower when the option is close to expiring.

• When the option is at the money, vega is highest.

• When the option is in- or out-of-the-money, vega decreases. In other words, vega is lower when the market price of the underlying security is farther from the option strike price.

• When implied volatility increases, the option premium increases.

• When implied volatility decreases, the option premium decreases.

• The effect vega has on options trading is based on various factors that affect the option’s price.

• When gamma is high, vega is generally also high.

• Vega shows an investor the amount that an option should theoretically change for every percentage its underlying security’s volatility changes.

• Vega can also be calculated for an entire portfolio of options to understand how it is influenced by implied volatility.

What Does Vega Show?

Vega shows the theoretical amount that an option’s price could change with every 1% change in implied volatility of the underlying asset. It can also be used to show the amount that an option’s price might change based on the volatility of the underlying security — that is, how often and how much the security’s price could change.

Traders generally omit the percentage symbol when referring to vega, or volatility. And some analysts, too, display it without a percentage symbol or decimal point. In that case, a volatility of 16% would be displayed as “vol at 16.”

Vega Options Example

Let’s say stock XYZ has a market price of $50 per share in February. There is a call option with a March expiration date with a price of $52.50. The option has a bid price of $1.50 and an ask price of $1.55.

The option’s vega is 0.25, and it has an implied volatility of 30%. Because vega is higher than the bid-ask spread, this is known as a competitive spread. A competitive spread does not mean the trade will be profitable or that it is automatically a good trade to enter into, but it is a positive sign.

The implied volatility of the underlying security increases to 31%. This changes the option’s bid price to $1.75 and changes the ask price to $1.80. This is calculated as

(1 x $0.25) + bid-ask spread

Conversely, if the implied volatility goes down 5%, the bid price would decrease to $0.25 and the ask price decreases to $0.30.

How Can Traders Use Vega in Real-Life?

Vega tends to be less popular with investors than the other Greeks (Delta, Theta, and Gamma) mostly because it can be difficult to understand. But vega has a significant effect on options prices, so it is a very useful analytic tool.

Benefits of Vega

If investors take the time to understand implied volatility and its effect on options prices, they’ll find that vega can be a useful tool for making predictions about future options price movements. It also helps with understanding the risks of trading different types of options contracts. Looking at the implied volatility of options can even guide investors as they choose which options to buy and sell. Some traders even utilize changes in volatility as part of their investing plan — with strategies like the long straddle and short straddle. Vega plays a key role in using these options trading strategies.

Vega Neutral: Another Strategy

For traders who want to limit their risk in options trading, the vega neutral strategy helps them hedge against the implied volatility in the market of the underlying security. Traders use the vega neutral strategy by taking both long and short option positions on a number of options. By doing this, they create a balanced portfolio that has an average vega of around zero. The zero value means that their options portfolio will not be affected by changes in the implied volatility of the underlying security, thereby reducing the portfolio’s level of risk.

Start Trading Stocks With SoFi Invest

Vega, one of the Greeks, along with the concept of implied volatility relate to advanced trading techniques. Trading options is usually appropriate for experienced traders.

Options are popular with investors who want exposure to assets with lower overhead capital requirements. If you’re looking to begin trading options, an options trading platform like SoFi’s can help. Its intuitive design makes it user-friendly. Investors can trade options from the mobile app or web platform and access educational resources about options if needed.

Trade options with low fees through SoFi.

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External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

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.

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.
SoFi Invest®

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

May

2022

What Is Gamma in Options Trading?

By Laurel Tincher | Growing Wealth, invest, Investing, Terminology | Comments Off

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.

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

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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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SOIN1021464

ETFs vs Index Funds: Differences and Similarities, Explained

An Overview of Index Funds

What Is an Index?

What Is Passive Investing?

What’s the Differences Between an ETF and Index Fund?

How an Index Fund Works

How an ETF Works

Similarities Between ETFs and Index Funds

Cost

Diversification

ETF vs Index Fund: Pros and Cons of Each

Transparency

Pricing

Taxes

How Do Investors Find the Right ETF?

FAQ

Is it better to choose an ETF or an index fund?

What are the similarities between an ETF and an index fund?

What are the differences between an ETF and an index fund?

Exercising in Options? What Does It Mean & When to Exercise

What Does Exercising Mean?

How Do You Exercise an Option?

Holding

Exercise-and-Hold

Exercise-and-Sell-to-Cover

Exercise-and-Sell

Early Exercise

Advantages and Disadvantages of Exercising an Option

How Do You Know Whether to Hold or Exercise an Option?

Time Value

Transaction Costs

Increased Chance of Risk

Exposure to Margin Risk

Options Obligations

The Takeaway

FAQ

How can you tell when to exercise an option?

How are early-exercise options different from exercise options?

What is a cashless exercise in options?

Target Date Funds: What Are They and How to Choose One

What Is a Target Date Fund?

How Do Target Date Funds Work?

Brief Overview of Retirement Funding

The Need for Target Date Funds

What a Target Date Fund Is and Is Not

Example of a Target Date Fund

How a Glide Path Might Work

Pros and Cons of Target Date Funds

Pros

Cons

What Are Target Date Funds Good For?

Good For…

Not Good For…

The Takeaway

Vega Options, Explained

What Is Vega in Options Trading?

How Vega Works

Implied Volatility

Characteristics of Vega

What Does Vega Show?

Vega Options Example

How Can Traders Use Vega in Real-Life?

Benefits of Vega

Vega Neutral: Another Strategy

Start Trading Stocks With SoFi Invest

What Is Gamma in Options Trading?

Understanding Gamma

Calculating Gamma

Gamma Formula

Example of Gamma

Using Gamma in Options Trading

Gamma as an Options Hedging Strategy

Benefits of Gamma for Long Options

Risks of Gamma for Short Options

How Does Volatility Affect Gamma?

Start Investing With SoFi

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