Aug
17
2023
What is the VIX Volatility Index? How Investors Can Use It

What Is the VIX Volatility Index? How Investors Can Use It

By | Growing Wealth, invest, Investing | Comments Off on What Is the VIX Volatility Index? How Investors Can Use It

The Cboe Global Markets Volatility Index, known as the VIX for short, is a tool used to measure implied volatility in the market. In simple terms, the VIX index tells investors how professional investors feel about the market at any given time.

This can be helpful for gauging and assessing risk in order to capitalize on anticipated market movements. Depending on which way the VIX is trending, it may throw off buy or sell signals to investors.

The volatility index is sometimes referred to as the “fear index” or “fear gauge” because traders rely on it as an indicator of the fearfulness of sentiment surrounding the market. While not a crystal ball, understanding the VIX and how it works can provide a useful predictor of investor behavior.

What Is the VIX Index?

The VIX Index is a real-time calculation designed to measure expected volatility in the U.S. stock market. One of the most recognized barometers of fluctuations in financial markets, the VIX measures how much volatility investing experts expect to see in the market over the next 30 days. This measurement reflects real-time quotes of S&P 500 Index (SPX) call option and put option prices.

Stock volatility represents the up and down price movements of various financial instruments that occur over a set period of time. The larger and more frequent price swings, the higher the volatility.

Implied volatility reflects market sentiment and which way it expects a security or financial instrument’s price to move.


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How Does the VIX Work?

The VIX Index is a forward-looking trend indicator used to quantify expectations for future volatility. Cboe designed the index to estimate expected volatility by aggregating weighted prices of S&P 500 Index puts and calls over a wide range of strike prices.

In options trading, the strike price represents the price at which a trader can exercise an option. Call options give an investor the right to buy shares of an underlying security; put options give them the right to sell shares of an underlying security.

The Cboe Options Exchange (Cboe Options) calculates the VIX Index using standard SPX options and weekly SPX options listed on the exchange. Standard SPX options expire on the third Friday of every month. Weekly SPX options expire on all other Fridays. VIX index calculations include:

•   SPX options with Friday expirations

•   SPX options with more than 23 days and less than 37 days to their Friday expiration

The index weights these options to establish a constant-maturity, 30-day measure of the amount of volatility the S&P 500 Index is likely to produce. The VIX index works differently from the Black Scholes model, which estimates theoretical value for derivatives and other financial instruments based on a number of factors, including volatility, time, and the price of underlying assets.

The VIX is one of seven inputs used by CNN to determine its Fear and Greed Index.

What Does the VIX Tell You?

In securities trading, the VIX index is a measure of market sentiment. The volatility index has a negative correlation with stock market returns. If the VIX moves up that means investor fear is on the rise. The S&P 500 tends to see price drops in that scenario as investors may begin to sell off securities to hedge against expanded volatility that may be on the horizon.

On the other hand, when the VIX declines, that could signal a decline in investor fear as well. In that situation, the S&P may be experiencing lower levels of volatility and higher prices as investors buy and sell with confidence. This doesn’t necessarily mean that prices will remain high, however, as volatility is fluid and can increase or decrease sharply due to changing market conditions.

The volatility index can be read as a chart, with each day’s reading plotted out. Generally, a reading of 0 to 12 represents low volatility in the markets, while a range of 13 to 19 is normal volatility.

Once the VIX reaches 20 or above, that means you can typically expect volatility to be higher over the coming 30 days. For perspective, the VIX notched a 52-week high of 34.88 and a 52-week low of 12.73 as of August 11, 2023.

Example of VIX in Action

The beginning of 2020 saw a gradual rise in the level of concern surrounding the coronavirus and its potential to become a public health crisis. As more cases appeared in the United States, the financial markets began to react. The VIX index, which had hovered around 20 or below since January 2019, began to climb in the third week of February. By March 16, it had reached a peak of 82.69 and the Dow Jones had dropped 12.93%.

After the market crashed, the VIX began to slowly decline. By early November 2021, the volatility index was once again implying volatility on par with pre-pandemic levels, measuring 18.58 as of November 24.


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How Investors Can Trade the VIX

Investors interested in trading the VIX index have a few options for doing so. Cboe offers both VIX options and VIX futures as a starting point.

VIX options are not exactly the same as traditional stock options. They trade nearly 24 hours a day, five days a week during extended trading hours. Investors can trade a call option or put option to make speculative investments based on anticipated volatility in the markets.

Cboe introduced VIX futures in 2004 to allow investors to trade a liquid volatility product using the VIX index as a guide. The difference between options and futures lies largely in the execution.

With options trading, the investor has the right but not the obligation to buy or sell a particular investment. A futures contract, on the other hand, requires the buyer to purchase shares and the seller to sell them at an agreed-upon price.

With VIX options or VIX futures, you’re making investments based on what you expect to happen in the markets based on how the volatility index is trending. Options and futures are speculative investments that carry more risk than some other types of investments. If you’re looking for another way to trade the VIX, you might look to VIX exchange-traded funds (ETFs) or volatility ETFs instead.

Volatility ETFs

Exchange-traded funds hold a basket of securities but they trade on an exchange like a stock. VIX ETFs and volatility ETFs often hold futures contracts or track the movements of a volatility index.

Choosing volatility or VIX ETFs in lieu of trading VIX options or VIX futures directly doesn’t eliminate risk. But it can help you to spread the risk out over a diverse group of investments. If you’re already trading stocks and other securities through an online brokerage account, VIX or volatility ETFs may be included as an investment option.

The Takeaway

The volatility index or VIX is a highly useful tool for measuring market sentiment. While it’s impossible to predict exactly which way the market will move, the VIX index can help with interpreting implied volatility when making investment decisions.

That’s information you can use whether you’re trading options or less risky investments such as stocks or ETFs.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).


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

Photo credit: iStock/dolgachov

SoFi Invest®

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

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

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

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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Aug
17
2023

What Is the Ebitda Formula?

By | Growing Wealth, Investing, Terminology | Comments Off on What Is the Ebitda Formula?

EBITDA is an acronym that stands for earnings before interest, taxes, depreciation, and amortization. The EBITDA formula is a common way for companies to assess their performance. By looking at earnings without deducting taxes, interest, or other expenses, it’s easier to assess business results and compare them to other companies in the same industry.

The EBITDA formula can also be useful for investors. When investing in the stock market, it’s important to research companies before buying shares of their stock, and EBITDA is a basic measure of profitability that can help investors gauge an organization’s performance.

What Is EBITDA, and How Is EBITDA calculated?

The EBITDA formula is a way of considering a company’s net income — without deducting costs like interest, taxes, depreciation, and amortization. The idea is to create a more apples-to-apples view of how different companies’ perform. Two similar companies in the same industry could have very different tax rates or different capital structures (which can impact debt, and therefore interest paid), making it hard to compare one to the other.

By not deducting certain expenses that aren’t related to performance, EBITDA helps level the playing field and help investors evaluate companies.

EBITDA is also relatively easy to calculate. The information can be found on a company’s balance sheet and income statement. Here’s a quick breakdown of each letter of the acronym, and why it matters in the EBITDA formula:

Earnings

Earnings are a company’s net income over a specific period of time like a fiscal year or a quarter. This number can be found on the company’s income statement; it’s essentially the bottom line, after subtracting all expenses from total revenue.

Interest

This refers to any interest that the company pays on loans and debts. In some cases interest might include interest income, in which case you’d use the total interest amount (interest income – interest paid). Interest is added back to total earnings in the EBITDA formula because the amount of interest paid depends on the types of loans and funding a company has. This number can muddy the waters, when trying to compare two companies that might have very different financing situations.

Taxes

Federal, state, and local taxes are also added back because tax rates depend on where a company is based geographically, and where they conduct business. Thus, taxes aren’t something that a company has much control over, so they aren’t an indicator of performance.

Depreciation & Amortization

Depreciation calculates the decreasing value of tangible physical assets or capital expenditures over time (e.g., equipment, vehicles, buildings, etc.). Amortization is a way to account for the expenses of non-tangible assets like intellectual property, like patents and copyrights.

Depreciation and amortization are added back to earnings because they are non-cash expenses. As such, they don’t necessarily reflect on a company’s overall performance or profitability.


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EBITDA Formula and Calculation

EBITDA can be calculated simply by adding a company’s interest, taxes, depreciation, and amortization to net income. Another method is to add a company’s operating income — or Earnings Before Interest and Taxes (EBIT) to its non-cash expenses of depreciation and amortization.

Earnings, or net income, can be calculated as follows:

Net income = Revenue – Cost of Goods Sold – Expenses

How to calculate EBITDA

EBITDA = Net Income + Taxes + Interest Expense + Depreciation & Amortization

Or

EBITDA = Operating income (EBIT) + Depreciation & Amortization

For example, if a company has $4,500,000 in revenue and $500,000 in expenses, their operating income (EBIT) is $4,000,000.

If the company’s assets have depreciated by $100,000 and they have an amortization amount of $75,000, the calculation would be as follows:

EBITDA = $4,000,000 (EBIT) + $100,000 (D) + $75,000 (A)

EBITDA = $4,175,000

It’s possible for EBITDA to be negative if a company has significant losses within a particular quarter or year.

A more specific EBITDA formula is LTM EBITDA, or Last Twelve Months EBITDA, also called Trailing Twelve Months EBITDA (TTM). This calculation finds EBITDA for only the past year.

How Does EBITDA Differ From Other Measurements of Income?

There are a number of different ways to view an organization’s income, each with their pros and cons. Depending on which lens you use, or which formula, one metric can provide insights into a company’s performance that another won’t. Here are a few common measurements of company income:

•   Cash Flow is an analysis of the amount of money coming into a business versus the amount of money going out. Because of timing issues with sales, you can be profitable without being cash flow positive and vice versa.

•   EBIT is also known as operating income, as discussed above. EBIT adds back the expenses related to interest and taxes, but keeps deductions for depreciation and amortization to give a clearer picture of a company’s earnings inclusive of actual operating costs.

•   EBT is another variation on EBIT. It allows for interest expenses, but eliminates the impact of taxes — since a company’s tax burden has nothing to do with its performance.

•   Net Income appears at the bottom of an income statement, after subtracting all business expenses (including interest, taxes, depreciation, and amortization) from total revenue.

•   Revenue is also called gross income. It specifically refers to the money a company earns from sales. As such, it’s really only a window into one aspect of the business’s performance.

Understanding company performance can be a complex endeavor, and it’s best to use a combination of metrics that are most meaningful for that company or industry.

Why Is EBITDA Important?

The EBITDA formula is useful because it provides a view of company profitability, without the impact of capital expenditures and financing. By using the EBITDA formula, analysts can compare companies within an industry and investors can quickly use a technical analysis to evaluate companies they might want to invest in.

In that way, EBITDA can also be a tool used by financial advisors to help their clients make investment decisions.

It’s also useful for business owners to calculate their EBITDA each year to see how their company is performing. This is especially important if they are looking to take out a loan or seek investment. Business owners can use the EBITDA formula to gain insight into operating performance, how their company stands in relation to others in the same industry, and the company’s ability to meet its obligations and grow.

What Makes a Good EBITDA?

EBITDA is a measure of a company’s performance, so higher EBITDA is better than lower EBITDA when comparing two or more organizations in the same sector. This is important, because companies that vary in size or operate in different sectors can, of course, also vary widely in their financial performance. So one way to determine whether a company has “good” EBIDTA is to compare it to others of a similar size in the same industry.

Here are two other ways to gauge whether a company’s EBIDTA is good or not.

The EBITDA Coverage Ratio

To add more helpful information to the EBITDA calculation, the EBITDA Coverage Ratio compares EBITDA to debt and lease payments.

The EBITDA coverage ratio calculates a company’s ability to pay off lease payments, debts, and other liabilities.

The calculation for the EBITDA coverage ratio is:

EBITDA Coverage Ratio = (EBITDA + Lease Payments) / (Interest Payments + Principal Payments + Lease Payments)

A ratio equal to or greater than 1 indicates that a company will have a better ability to pay off liabilities. If the ratio is lower, a company may not be able to pay off its debts. The higher the ratio, the more solvent a company is. The current average coverage ratio is 2.


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EBITDA Margins

Another EBITDA calculation investors can do to learn about a company’s performance is the EBITDA Margin calculation. This formula compares annual cash profits to sales. It’s a useful indicator to find out if a company’s EBITDA is ‘good’ or not. The EBITDA Margin calculation is:

EBITDA Margin = EBITDA / Total Revenue

The resulting number is a percentage that shows what portion of revenue was able to be converted into profit within a year. The higher this percentage is, the better a company is performing because it means their expenses aren’t eating into their profits. In general, an EBITDA margin of 60% or higher is considered a good number.

Downsides of the EBITDA Formula

Although the EBITDA formula is a useful tool for investors, it also has some drawbacks. For example: EBIDTA is considered a “non-GAAP” measure, meaning it doesn’t fall under generally accepted accounting principles (a set of rules issued by the Financial Accounting Standards Board and procedures commonly followed by many businesses). This also means that the way EBIDTA is calculated isn’t wholly standardized.

Thus, companies also may not include the same information in each report, and they aren’t required to record all information that may be relevant to the equation. For these reasons, it’s best to calculate EBITDA along with other types of evaluations, such as net income and debt payments.

Companies with a low net income may use the EBITDA formula to make themselves look better since the EBITDA number will likely be higher than their income.

Or, because EBITDA tends to obscure the impact of debt and capital investments, a company that’s spending heavily on development costs, or has incurred a lot of debt, may look more robust than it is.

Also, the formula doesn’t work well with certain types of companies, such as companies that have a need to constantly upgrade their equipment.

The Takeaway

Comparing companies you may want to invest in can take a lot of time and technical analysis. If you’re choosing your first stocks, the amount of information and choices can be overwhelming.

EBITDA is one measure of company performance that can be useful, because it takes net income and then removes certain factors that can be confounding: interest paid or earned; federal, state, and local taxes; the impact of capital depreciation and amortization.

For investors interested in learning more about specific companies and building a stock portfolio, opening an online brokerage account can be a good way to get started with investing.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).


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

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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.

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.

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Aug
16
2023
What Is Modern Monetary Theory (MMT)?

Modern Monetary Theory, Explained

By | Financial Independence, Growing Wealth, invest, Investing | Comments Off on Modern Monetary Theory, Explained

Money Monetary Theory or MMT is an alternative economic theory which says that governments that create and control their own currency should be able to do so without limits. More specifically, the heterodox theory argues that these governments shouldn’t fear incurring debt to further economic growth because they can not run out of money.

MMT emphasizes the creation of more money to meet a variety of economic needs, such as improving infrastructure, improving the quality of government-funded education, or expanding access to healthcare. While that may sound appealing, critics of the theory believe it could lead to an increase in inflation and skyrocketing national debt.

What Is MMT?

Modern Monetary Theory is an economic theory often associated with investment fund manager Warren Mosler, author of “The 7 Deadly Innocent Frauds of Economic Policy.” In the 2010 book, Mosler suggests governments that control their own currency can never run out of money or go bankrupt, since they can simply print more money.

Modern Monetary Theory challenges the idea that governments should pay for spending with taxes. Instead, the theory holds that taxes are a means of controlling inflation amid rising prices rather than funding the government’s spending initiatives. MMT can be seen as an extension of quantitative easing, in which a government’s central bank purchases long-term securities in order to boost the money supply.

Both seek to put more money into circulation, though Modern Monetary Theory doesn’t necessarily support the idea of resorting to negative interest rates to stimulate spending, which can occur with quantitative easing.


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Traditional Economics vs Modern Monetary Theory

In terms of its application, MMT economics is quite different from traditional economic theory. Specifically, it challenges the idea that printing more money to fund spending is inherently bad. Traditional economists view printing money as a less-than-ideal way to manage fiscal policy, since doing so can lead to rising inflation or a devaluation of currency.

Here’s a closer look at how traditional economic theories and modern economic theory compare.

Traditional Monetary Theory Explained: Key Concepts

•   When the economy is struggling, the government can give it a boost using monetary and fiscal stimulus, or quantitative easing.

•   Governments rely on interest rate policy to control inflation and the stability of currency values.

•   Interest rate policy can also be used to stimulate spending during recessionary environments by encouraging borrowing while rates are low.

•   Taxes and debt insurance are the two primary means by which governments fund their spending.

•   Unlimited government spending and debt can lead to economic destabilization.

Modern Monetary Theory Explained: Key Concepts

•   Governments that control their own currency effectively have access to unlimited spending, as they can always print more money.

•   A country that follows MMT cannot go bankrupt or become insolvent unless it’s by political choice.

•   Unlimited spending fuels economic growth and reduces unemployment.

•   Taxes can curb inflation but they’re not their primary source of government funding.

•   If a government incurs national debt, it can print more money to meet those obligations without fear of runaway inflation, deflation, or devaluing its currency.

In terms of inflation theory, MMT says the biggest risk is a government outspending its available supply of resources, such as raw materials or workers. But this scenario is rare, since it would require full employment or a shortage of supplies. If it did occur, MMT would dictate that the government could use taxation to manage inflation.

Modern Monetary Theory also states that governments don’t need to sell bonds to raise funds, since they can print their own money. Under this theory, the bond market becomes optional, rather than a requirement for maintaining government cash flows.

Modern Monetary Theory: Potential Benefits

While MMT is considered a radical theory in some circles, it has a simplistic appeal. If governments that control their currency can simply print more money as needed, then they have endless resources to promote economic growth. Deficits don’t disappear under this type of modern economic theory, rather they may grow.

From a taxpayer perspective, Modern Monetary Theory also has benefits, since it may mean fewer tax hikes to pay for government funding initiatives. Just like deficits, taxes wouldn’t disappear. But there’d be less fear of the government introducing new tax measures solely as a means of managing its own spending or debt.


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Modern Monetary Theory Flaws

While MMT has many vocal supporters, it’s also drawn plenty of critics, including Federal Reserve Chair Jerome Powell and Kenneth Rogoff, former Chief Economist and Director of Research at the International Monetary Fund. The consensus, for the most part, is that Modern Monetary Theory poses too great of a risk to national economies. Specifically, critics raise these arguments:

•   Unlimited spending is not a catch-all solution. While MMT gives governments leeway to print money as needed, doing so is not necessarily a foolproof solution for tackling problems like unemployment or rising inflation. Again, if there’s a scarcity of resources or full employment, governments still have to rely on taxation to bring inflation under control.

•   Unchecked debt is problematic. When an economy experiences a boom cycle, the national deficit may receive less attention. But it can become a very real financial problem governments have to deal with when the economy enters a recession and printing more money may not be a realistic solution.

•   Rising rates could trigger hyperinflation. If rising deficits are accompanied by rising interest rates, the scales could tip from inflation to hyperinflation. This means rapid, out-of-control price increases and steep declines in currency values. Both of those can contribute to an economic crisis or collapse.

Those who suggest MMT is problematic may point to countries like Venezuela and Zimbabwe as examples of how it can go wrong. Though neither country specifically subscribed to Modern Monetary Theory, both relied on the printing of currency to navigate economic troubles. In both cases, the end result was severe hyperinflation and financial crises.

The Takeaway

Money Monetary Theory (MMT) says that governments that create and control their own currency should be able to do so without limits. If applied to the U.S. economy, Modern Monetary Theory could potentially impact your investments in different ways. So it’s important to keep this theory in mind when building a portfolio.

For example, it’s important to consider how inflation might affect the value of your investments. If inflation rises or the government has to impose tax increases to fund spending, that could affect the profitability and spending of the companies you invest in. Investing in companies that are more inflation- or recession-proof may help to insulate your portfolio against those risks.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

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.

Photo credit: iStock/ferrantraite

SoFi Invest®

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

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

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

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Aug
15
2023
How Does the Iron Butterfly Spread Work?

What Is an Iron Butterfly Option Strategy?

By | Growing Wealth, invest, Investing | Comments Off on What Is an Iron Butterfly Option Strategy?

An iron butterfly spread is a type of options trade involving four separate options contracts. It’s a complicated and advanced options trade, meaning that many beginner investors will likely never use it — they may not have even heard of it.

Iron butterfly spreads can be used as a part of a larger options trading strategy, however, so long as investors understand the ins and outs of how it works, and most importantly, the risks involved.

What Is an Iron Butterfly?

An iron butterfly spread, sometimes called an “Iron Fly” or a “Butterfly Spread” is a trade involving four separate options contracts.

As a strategy that earns investors money when stocks or futures prices make moves within a defined range, it’s especially popular with traders who expect a decrease in implied volatility. To succeed with an iron butterfly spread, traders will try to forecast when option prices will likely decline, usually when the broader markets are in a holding pattern, or gradually moving upwards.


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How Does an Iron Butterfly Trade Work?

An Iron Butterfly is a four-legged options spread, since an investor buys four options contracts, two calls and two puts. The call options allow the investor to buy a stock at a given price, and the put options allow the investor to sell a stock at a given price.

In the trade, the calls and puts have three strike prices, but the same expiration date.

In a put or call option, the strike price is the price an investor can sell the underlying security when it is exercised. With a call option, the strike price is the price at which the investor can buy the security. With a put, the strike price is the value at which they can sell the security.

The three strike prices consist of one in the middle, called the options straddle, and two other strike prices, called the strangle, positioned above and below that price. As a trade, the Iron Butterfly has the propensity to deliver profits when the option’s underlying stock hits its expiration date at the middle strike price.

Recommended: Popular Options Trading Terminology to Know

Example of an Iron Butterfly

For the strategy to work, the call and put options that sit on either side of the target stock price should be far enough apart that they can still make money regardless of the unexpected price movement of the stock between the time when the trade is executed, and the expiration of the options.

As an example, you’re an investor with a sense that a stock would reach $50 in the next month, and that it would be at least within a range of $10 above or below the target price. To make an Iron Butterfly trade, you’d buy a call and a put option with a strike price of $50. Then you’d buy a call option ten dollars higher, followed by a put option ten dollars lower than the target price, or saddle price, of $50.

The theory behind the Iron Butterfly strategy is that there’s a high likelihood that the eventual price of the stock targeted in the strategy will trade within a profitable range by the time the strike price of the options arrives.

Pros and Cons of Iron Butterfly Spreads

There is a limit to the maximum profit that an investor can earn by using the Iron Butterfly. That’s because of the cost of the options they have to buy to make money on their bet, as well as the cost of the options they purchase to protect themselves in the event that their hunch is wrong.

In the strategy, the most money the investor can make becomes possible when the underlying stock reaches the stock price at which they’ve purchased the saddle options. But even in this best-case scenario, at least half of the options expire worthless.

While this limited return may seem like a downside, it also comes with limited risk. As long as the stock rises or falls — at the time of the options’ expiration — between the target price and the strike prices of the outlying call and put options, then the trade will not lose money. But the closer it is to the target price, the more money it will make.

The biggest risk in an Iron Butterfly strategy is that the stock trades outside of the strangle, making all of the options worthless.

Recommended: What Is Your Risk Tolerance?

How to Sell out of an Iron Butterfly Spread

The investor will have at least one option that is in the money, and possibly two options that are in the money, when the options expire. They will exercise those options, and make money on the trade.

Traders realize that it’s unrealistic that any given trade will reach its expiration date exactly at the strike price, or straddle price, that they choose. But with a smart spread on the outer range of the call and put options in the trade, the strategy can deliver returns on the capital put at risk that are consistently in the 15-20% range.

What Is the Difference Between Iron Condor and Iron Butterfly?

An Iron Butterfly is similar to another option strategy known as an Iron Condor. The strategies differ in terms of their strike prices and premiums. In an Iron Condor the strike prices are different and in an Iron Butterfly they’re the same. The premiums are higher in an Iron Butterfly than an Iron Condor.


💡 Quick Tip: In order to profit from purchasing a stock, the price has to rise. But an options account offers more flexibility, and an options trader might gain if the price rises or falls. This is a high-risk strategy, and investors can lose money if the trade moves in the wrong direction.

The Takeaway

The Iron Butterfly is a trading strategy that investors use when they believe that a stock price will trade within a specific range. Rather than buying the stock itself, an Iron Butterfly involves purchasing four options based on the investor’s price prediction for a certain security.

Again, trading options is an advanced investment strategy that requires a good amount of background knowledge and market experience. It may not be a good idea for beginning investors to wade into options, or advanced moves like the Iron Butterfly. However, speaking with a financial professional may help get you prepared for trading options.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

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.

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

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.
Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Aug
15
2023
Beginners Guide to KYC

What Is Know Your Customer (KYC) for Financial Institutions?

By | Growing Wealth, invest, Investing | Comments Off on What Is Know Your Customer (KYC) for Financial Institutions?

There are banking regulations in place that are known as KYC. The definition of KYC is “know your customer,” and these rules provide guidelines for financial institutions to know more about their customers.

This isn’t just a matter of curiosity but of national security and crime prevention. Banks need to protect themselves from unwittingly participating in illicit activities.

If a criminal uses a bank for illicit purposes, such as money laundering money, the financial institution could be held accountable. It’s the bank’s responsibility to always know who their customers are. That way, they can help avoid being involved in criminal activity.

KYC plays an important role in financial institutions maintaining accurate information about their clients. KYC procedures and anti-money laundering (AML) laws can work together to minimize risk. Read on to learn more about know your customer regulations.

3 Components of KYC

There are three main parts of a KYC compliance framework: customer identification, customer due diligence, and enhanced due diligence. Each phase of the process of this kind of financial regulation gets more intensive according to the estimated risk that the potential client might pose.

Customer Identification Program (CIP)

The first of the three main KYC requirements is to identify a customer. (Incidentally, some people refer to KYC as know your client vs. know your customer.)

Organizations must verify that a potential customer’s ID is valid, real, and doesn’t contain any inconsistencies. The person must also not be on any Office of Foreign Assets Control (OFAC) sanctions lists.

An organization also needs to know if their prospective customer is “politically exposed.” A politically exposed person (PEP), such as a public figure, is thought to be more susceptible to corruption than the average individual, and is therefore considered high-risk, requiring special attention.

As part of their AML/KYC compliance program, all financial institutions are required to keep records of their Customer Identification Program (CIP) as mandated by the Financial Crimes Enforcement Network (FinCEN).

FinCEN works under the guidance of the department of Treasury and is charged with guarding the financial system against illicit activity and money laundering.

The following information will satisfy the minimum KYC requirements for a Customer Identification Program:

•   Customer name (or name of business)

•   Address

•   Date of birth (not required for businesses)

•   Identification number

For individuals, the customer’s residential address must be validated. US Postal Office boxes are not accepted. Individuals with no physical residential address can use an Army Post Office box (APO), Fleet Post Office Box (FPO), or the residential or business street address of their next of kin.

For business banking customers, the address provided for know your customer laws can be the principal place of business, a local office, or another physical location utilized by the business.

The ID number for most individuals will be their social security number or Taxpayer Identification Number (TIN).

For business entities, the number will usually be their Employer Identification number (EIN). Foreign businesses without ID numbers can be verified by alternative government-issued documents.

Recommended: Opening a Bank Account While Living in a Foreign Country

Customer Due Diligence (CDD)

Due diligence includes:

•   Collecting all relevant information on a customer from trusted sources

•   Determining what the customer will be using financial services for

•   Maintaining ongoing surveillance of the situation to further verify that customer activity remains in line with recorded customer information.

The goal of this phase of the know your customer process is to assess the risks a potential customer might pose and assign them to one of three categories — low-, medium-, or high-risk.

Several variables — including the customer’s expected cash transactions, the type of business, source of income, and location — will help determine the customer’s risk level.

Other categories for assessing risk include the customer’s business industry, whether they use a foreign or domestic account, and their past financial history. The customer is also screened against politically exposed persons (PEP) and Office of Foreign Assets Control’s (OFAC) sanctions lists.

Enhanced Due Diligence (EDD)

Enhanced due diligence (EDD) involves increased monitoring of customers deemed to be high-risk. This may include customers from high-risk third countries, those with political exposure, or those that have existing relationships with financial competitors.

Conducting enhanced due diligence on high-risk business entities requires identifying all beneficiaries of those entities when they open an account. Customers that are legal entities are those that have had legal documentation filed with a Secretary of State or other state office, and include:

•   Limited liability companies (LLC)

•   Corporations

•   Business trusts

•   General partnerships

•   Limited partnerships

•   Any other entity created via filing with a state office or formed under the laws of a jurisdiction outside of the US

On May 11, 2018, a new AML/KYC requirement came into effect. This change to KYC laws states that all banking and non-banking firms subject to the Bank Secrecy Act (BSA) must verify the identity of beneficiaries of legal entity customers when they open an account.

Firms must also develop risk profiles and continually monitor these customers. This must be done regardless of what risk category the customer falls into.

Due diligence is an ongoing process and requires financial institutions to constantly update customer profiles and monitor account activity.

💡 Quick Tip: Don’t think too hard about your money. Automate your budgeting, saving, and spending with SoFi’s seamless and secure online banking features.

5 Key Steps Involved in Know Your Customer?

There are five main steps of complying with the know your customer rule, which is part of how banks are regulated. These include:

1. Customer Identification Program (CIP)

As mentioned above, the first step is to ensure that a prospective client’s ID is valid, real, and consistent. The address and other details must be checked. The applicant must be screened to be sure they are not on any OFAC sanctions list and their PEP status must be investigated.

2. Customer Due Diligence (CDD)

The next step of due diligence involves researching and vetting the customer’s intentions regarding the financial services they are seeking.

3. Enhanced Due Diligence (EDD)

Further scrutiny may determine that some applicants are considered risky. If the customer is deemed high-risk, additional ongoing screening is required to make sure activity doesn’t cross any lines.

4. Account Opening

If verification is successful and a client is eligible, the customer can open a bank account, with some clients requiring closer monitoring than others.

5. Annual Review

Once an account is opened, the institution will conduct an annual review of their activity. The higher the risk category a customer falls into, the more often their activities will be reviewed.

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4 Key Elements of a KYC Policy?

KYC compliance involves four key elements. When gathering KYC information, organizations must:

1. Identify Their Customers

In this step, the financial institution will gather information about the customer’s identity.

2. Verify That the Customer’s ID Is True and Valid

The identification documents will be checked against independent sources to make sure identity theft isn’t occurring

3. Understand Their Customer’s Source of Funding and Activities

In this step, a review of the customer’s activities and background can shed light on how likely it is that the client would do reputational damage or could commit crimes that involve money laundering or the financing of terrorism.

4. Monitor the Activities of Their Customers

Monitoring of customer activities is an ongoing process, particularly for high-risk clients. Most firms review clients based on their level of risk.

Low-risk clients might only be reviewed once every two or three years, moderate-risk clients every one to two years, while high-risk clients tend to be reviewed once a year or even once every six months.

Recommended: Guide to Keeping Your Bank Account Safe Online

Why Does KYC Matter?

KYC procedures matter because they are an important screening step. Their implementation can help verify customers and assess and minimize risk.

The KYC process provides guardrails and can help protect against such crimes as money laundering, terrorism funding, and other illegal activities.

Is KYC Successful?

KYC programs are seen as improving a financial institution’s reputation and integrity, though it can add a layer to a prospective client’s application process and banking life.

As the banking landscape evolves quickly with technological advances, banks are finding new ways to track customers and comply with protective KYC and other guidelines. For instance, artificial intelligence (AI) may be able to perform some of these functions.

AML vs KYC

KYC and AML are both ways that financial institutions comply with regulations designed to inhibit terrorism financing and money laundering.

•   AML is the more general practice of an institution seeking to identify and stop such activity.

•   KYC is one aspect of AML, focusing on customer identification and verification.

AML and KYC Similarities AML and KYC Differences
Designed to inhibit money laundering, including terrorism financing Focuses on customer identification
Both are implemented by financial institutions to comply with government guidelines KYC represents one aspect of larger AML procedures

The Takeaway

KYC, or know your customer, is a regulation that helps financial institutions prevent fraud by their customers. KYC involves constant check-ups and ongoing measures to ensure customer information and account profiles are kept up-to-date.

Wherever you decide to bank, know that teams are likely to be at work, ensuring compliance with KYC regulations.

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Better banking is here with SoFi, NerdWallet’s 2024 winner for Best Checking Account Overall.* Enjoy up to 4.00% APY on SoFi Checking and Savings.

FAQ

What is a KYC procedure in banking?

KYC procedures in banking are regulations that involve a financial institution verifying potential clients’ identities and backgrounds and monitoring their activity if they become customers. This can be a part of the bank ensuring that it’s not being used in criminal activity such as money laundering.

Do all banks require KYC?

Yes. FinCen, or the US Financial Crimes Enforcement Network, requires financial institutions and their customers to adhere to KYC regulations.

Why is KYC mandatory in banks?

KYC is an important measure as banks work to know their customers and make sure accounts are not being used for illegal purposes. KYC regulations are one way that the government seeks to prevent money laundering and terrorism financing.

Photo credit: iStock/Andrii Yalanskyi

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Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.

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

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