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Q: How Do You Execute a Carry Trade?

Imagine that the US dollar has a 1% interest rate, but the British pound has a 2% interest rate. A trader could take 100 US dollars, and then invest that 100 dollars into the equivalent number of pounds (according to the exchange rate), and earn a higher return in interest.

Jul

2023

What Is a Carry Trade in Currency Markets?

What Is A Currency Carry Trade in Forex Markets?

By Samuel Becker | Growing Wealth, invest, Investing | Comments Off

Carry trade is a strategy used by some traders who invest in currency markets to take advantage of differences in interest rates. In a carry trade, an investor buys or borrows a security or asset at a low interest rate, and then uses it to invest in another security or asset that provides a higher rate of return.

Carry trades have some clear uses in the foreign exchange market, or “forex” market. Given that they can be used to drive returns, they can be important for investors of all stripes to understand.

What Is a Carry Trade?

In a carry trade, forex traders borrow money at a low interest rate in order to invest it in an asset with a higher rate of return. In the forex markets, the currency carry trade is a bet that one foreign currency will hold or increase its value relative to another currency.

Of course, this investing strategy hinges on whether or not interest rates and exchange rates are in the traders’ favor. The wider the exchange rate between two currencies, the better the potential returns for the investor.

Recommended: What Is Forex Trading?

Even so, a carry trade strategy can be a relatively simple way to increase an investor’s returns, assuming they understand the difference in interest rates. In that way, it’s similar to understanding “spread trading” as they relate to stocks.

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

How Do You Execute a Carry Trade?

Executing a carry trade can seem nebulous without an example. Here’s a runthrough.

Carry Trade Example

Imagine that the U.S. dollar has a 1% interest rate, but the British pound has a 2% interest rate. A trader could take 100 U.S. dollars, and then invest that 100 dollars into the equivalent number of pounds (according to the exchange rate), and earn a higher return in interest. The discrepancy in interest rates allows traders to take advantage and earn higher returns.

This is a rather simplistic carry trade example, professional traders and investors can engage in complex carry trade strategies, and even employ the use of a carry trade formula to help them figure out expected returns, and whether the strategy is worth pursuing in a given situation.

Rather than simply buying one currency with another, traders often execute a carry trade that involves borrowing money in one currency and using it to purchase assets in another currency. In this scenario, traders want to borrow the money at the lowest possible interest rate, and do so using a weak or declining currency.

That can create higher profits when they close the deal and pay back the borrowed money. In general, carry trade is a short-term strategy, rather than one focused on the long-term.

Recommended: Short-Term vs Long-Term Investments

Is a Carry Trade Risky?

The concept of a carry trade is simple, but in practice, it can involve investment risk.

Most notably, there’s the risk that the currency or asset a trader is investing in (the British pounds in our previous example) could lose value. That could put a damper on a trader’s expected returns, as it would eat away at the gains the difference in interest rates could provide. Currency prices tend to be very volatile, and something as mundane as a monthly jobs report released by a government can cause big price changes.

The greater the degree of leverage an investor uses to execute a carry trade, the higher the potential returns — and the larger the risk. In addition to currency risk, the carry trade is subject to interest rate risk. Given the risks, carry trades in the currency markets may not be the most appropriate strategy for investors with a low tolerance for risk.

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

The Takeaway

Carry trades are one way for investors or traders to generate returns, although the approach involves some risks that aren’t present in other types of investment strategies. While the carry trade concept is straightforward, it can quickly get complex when institutional investors put it in place.

Carry trades can be advanced trading tools or strategies. For that reason, they may not be appropriate for all investors or traders. If you feel like you’re in over your head, it may be a good idea to speak with a financial professional for guidance, or to do some more homework to further your understanding.

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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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Jul

2023

Why is the U.S. Dollar the World's Reserve Currency?

How the dollar Became the World’s Reserve Currency

By Colin Dodds | Growing Wealth, invest, Investing | Comments Off

The U.S. dollar bears a lot of responsibility when it comes to global finance: It’s the currency kept on hand by central banks and other major financial institutions around the world to make transactions and investments, and to repay debts overseas.

The U.S. dollar is also the currency in which the world prices and trades vital commodities like gold and oil. And buyers and sellers in every country have to keep large amounts of U.S. dollars on hand to pay for them.

Historians disagree on exactly when the dollar became the reserve currency of the world. Some say the change took place right after the First World War, others say it happened closer to 1929, at the outset of the Great Depression.

But all are in agreement that as the Second World War drew toward a conclusion in 1944, the U.S. dollar had unseated the British Pound as the world’s undisputed reserve currency.

The Pound vs the dollar

The U.S. dollar as we know it didn’t actually exist until 1913, under the Federal Reserve Act of 1913, which created the Federal Reserve System.

The new central bank was created to set monetary policy and stabilize the U.S. currency, which had been issued based on bank notes issued by a number of individual banks.

At that point, the British pound was the world’s reserve currency. Though the U.S. economy was the largest in the world as World War I started in 1914, Britain remained at the center of the world’s trade, and most international transactions took place in British pounds. Like most countries’ currencies at the time, the British Pound was backed by gold.

Recommended: What Is Monetary Policy?

World War I changed all of that. The fighting was so ferocious, so widespread, and so costly that many countries had to deviate from that gold standard just to pay their armies.

Great Britain took the Pound off the gold standard in 1919, and the pound plummeted — which was catastrophic for international merchants and banks that traded primarily in pounds. Some scholars maintain that that was when the dollar became the world’s reserve currency.

Other historians maintain that global trade, especially international debt offerings, were denominated equally in dollars and Pounds until 1929. They even point to data that shows the British Pound was regaining ground on the dollar as the currency of choice for international trade up until 1939. Then World War II began.

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World War II and Bretton Woods

Although Germany didn’t surrender to the Allied nations until 1945, the outcome of World War ll was clear by the middle of 1944. In July of 1944, more than 700 delegates from 44 countries met in Bretton Woods, N.H., to negotiate and come to an agreement on the kind of economy that would emerge from the ashes.

The Bretton Woods conference lasted three weeks, and established the U.S. dollar as the currency par excellence for the world. Attendees agreed upon the Bretton Woods system, which established a number of key global economic points:

• The U.S. agreed that the dollar would be backed by gold, which was priced at $35 an ounce when the agreement took effect.

• The countries who signed the agreement promised that their central banks would establish fixed exchange rates between their own currencies and the U.S. dollar. If their currency weakened, their central bank would buy up the currency until its value stabilized relative to the dollar.

On the other hand, if the country’s currency grew too strong compared with the dollar, their central bank would issue more currency until the price fell and the relationship with the dollar returned to normal.

• Those countries also promised not to lower their currencies to goose trade. But it allowed them to take steps to increase or decrease the value of their currencies for other reasons, like stabilizing their economy, or to help with post-war rebuilding.

💡 Quick Tip: Newbie investors may be tempted to buy into the market based on recent news headlines or other types of hype. That’s rarely a good idea. Making good choices shouldn’t stem from strong emotions, but a solid investment strategy.

The dollar Since Bretton Woods

By 1971, the gold owned by the U.S. government had reached a limit at which it could no longer cover the number of dollars in circulation. That’s when President Richard M. Nixon took the step of reducing the U.S. dollar’s comparative value to gold. This led to the collapse of the Bretton Woods system in 1973.

After the system fell, the countries took a wide range of approaches to how they valued their currency, and what policies their central banks would pursue. But the end of the system led to the creation of the foreign exchange or forex market, now the biggest and most active financial market in the world, with a daily trading volume of $6.6 trillion.

While the U.S. dollar — now considered a fiat currency — goes up and down in relation to other currencies every day, it is still the world’s reserve currency, with 59% of all non-U.S. bank reserves denominated in dollars, according to the International Monetary Fund (IMF).

The dollar retains its prominence not because of an international agreement, but because of a broad consensus about the size, strength and stability of the U.S. economy relative to other options. Globally, investors still see U.S. Treasury securities as an extremely safe bet, as is evidenced by their low yields.

The Takeaway

Most of the world’s trade happens in U.S. dollars. But it hasn’t always been that way. And while it’s been preeminent for about a century, the dollar’s status has changed over time.

For investors interested in understanding the world’s currencies, the dollar’s rise to prominence has implications for the U.S. economy, as well as many other world economies.

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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.
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Jul

2023

Purchasing Power 101: Examining the Value of the US Dollar

By Colin Dodds | invest, Investing, Preparing for Retirement | Comments Off

Purchasing power is a concept used to express the amount of goods and services a consumer or business can buy with a given unit of currency. In the United States, purchasing power is directly linked to the value of the dollar.

Due to inflation, a dollar today typically won’t go as far as it did last year. And a dollar next year won’t buy the same things that it did this year. This fluctuation in US dollar purchasing power is constant, and goes unnoticed, except in times of extreme inflation.

How Does Purchasing Power Impact Investors?

Once you understand the purchasing power definition, you can start to understand its context for investing. The purchasing power of a dollar affects investors because it makes an impact on virtually every aspect of the broader economy. When the dollar buys less, it changes the shopping decisions of consumers, the hiring practices of employers, the strategic decisions of corporations, and the monetary policy of the Federal Reserve.

One way to track inflation and purchasing power of a dollar is the Consumer Price Index (CPI), a statistic compiled by the US Bureau of Labor Statistics (BLS), which reports the figure every month. The statistic measures the average of prices of a set of goods and services in sectors such as transportation, food, and healthcare. Economists consider it a valuable gauge of the ever-changing cost of living, though it does exclude some important spending categories, including real estate and education.

Investors, executives and policymakers use CPI as a lens through which to scrutinize other economic indicators, including sales numbers, revenues, earnings and so on. It also determines the payments made to the millions of people on Social Security, which gets adjusted for the cost of living every year, and retirees drawing a pension from the military or the Federal Civil Services.

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

Why Does the Value of the Dollar Change?

A number of factors drive the value of the US dollar, including large scale factors having to do with economic cycles, government politics and international relations. But the dollar has also experienced inflation for most of the last century.

Inflation rose after World War I amid increased demand for food and other raw materials, which raised prices of most consumer goods up until the Great Depression, in which the country experienced prolonged deflation.

That’s when President Franklin Roosevelt stepped in with a surprising policy decision: He banned private ownership of gold, and required people to sell their holdings to the government. That allowed the Federal Reserve to increase the money supply and stop deflation in its tracks.

Since 1933, through World War II, the Cold War, and a host of changing monetary and economic policies, the US dollar has seen various rates of inflation. It reached its peak during the late 1970s and early 1980s oil and gas shortages exacerbated existing inflation and led to a gas shortage, and an increase in the price of manufacturing and shipping of nearly every single consumer good.

Inflation rose at a more steady pace through the 1990s, falling to historically low levels in the past decade. One reason for the ongoing inflation is that the Federal Reserve continually increased the money supply via economic stimulus. The logic is simple supply and demand: If there are more dollars, then each one is worth less in terms of purchasing power.

In response to the Covid-19 pandemic and the ensuing lockdowns, the Federal Reserve injected trillions into the economy. That, along with other stimulus measures, has had many investors worried about the impact on the purchasing power of the dollar, and what that might mean for the broader economy. In 2022, inflation rose at the fastest pace in 40 years, making prices more expensive and resulting in many consumers having less money to spend.

What Purchasing Power Means for Investors

Generally, investors consider inflation a headwind for the markets, as it drives up the costs of materials and labor, boosts the cost of borrowing and tends to reduce consumer spending. That all tends to translate to lower earnings growth, which can depress stock prices.

But after decades of steady inflation, the markets have priced in a certain amount of shrinkage when it comes to the purchasing power of the dollar. Inflation has a great impact when it occurs suddenly and unexpectedly.

But inflation can have benefits for investors as well. During an economic upswing, inflation is a reliable side effect of prosperity, since economic booms produce higher profits, which drives up the markets. Historically, some experts say that the decades when the S&P 500 Index has delivered the highest returns have been when inflation has been between 2% to 3% annually.

Investors saving for long-term goals, such as retirement, must take declining purchasing power into account when determining how much they’ll need to reach those goals.

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

How Does Inflation Influence Stocks?

Inflation impacts different types of stocks differently, and there are several strategies that investors can use to hedge against inflation. During periods of high inflation, growth stocks tend to underperform, simply because so much of their value is tied up in the expectation of future earnings, and inflation diminishes those expectations.

Value stocks, on the other hand, typically boast steadier earnings, and are valued in line with those earnings. As a result, value stocks, as a category, tend to hold up better during periods of high inflation.

Other investments to consider during periods of high inflation include dividend-paying utility stocks and REITs, gold and other commodities. And because periods of high inflation usually brings higher interest rates, it can be a good time to buy bonds, especially government bonds

The Takeaway

The value of the dollar, in terms of what it can buy, changes over time, but inflation isn’t always bad news for investors. Some stocks may perform better than others in an inflationary environment, and higher interest rates may be good news for bond investors and savers.

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SoFi Invest®

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

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

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.

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Jul

2023

What Is a Divestiture?

By Brian Nibley | Financial Independence, Growing Wealth, invest, Investing | Comments Off

A divestiture, also known as a divestment, involves the liquidation of a company’s assets, such as building or intellectual property, or a part of its business, such as a subsidiary. This can occur through several different means, including bankruptcy, exchange, sale, or foreclosure.

Divestitures can be partial or total, meaning some or all of the company could be spun off or otherwise divested, depending on the reason for the company getting rid of its assets. Corporate mergers and acquisitions are a common example of one type of divestiture.

What Are Reasons a Company Would Divest Itself?

Often a divestiture reflects a decision by management that one part of the business no longer helps it meet its operational goals. A divestiture can be an intelligent financial decision for a business in certain situations.

If one aspect of a business (e.g., a product line or a subsidiary) isn’t working, has become unprofitable, or is likely to soon consume more capital than it can create, then instead of letting that be a continued drain on resources, a company can divest.

This not only does away with the troublesome aspect of the company, but also frees up some money the company can put toward more productive endeavors, such as new research and development, marketing, or new product lines.

There are many other potential reasons for a company to divest itself of a particular aspect of its business as well. The growth of a rival may prove overwhelming and insurmountable, in which case divesting might make more sense than continuing to compete.

A company may choose to undergo a divestment of some sort, such as closing some store locations, in order to avoid bankruptcy, to take advantage of new opportunities, or because new market developments might make it difficult for part of the company to survive.

Companies also sometimes must divest some of their business because of a court order aimed at breaking up monopolies. This can happen when a court determines that a company has completely cornered the marketplace for its goods or services, preventing fair competition.

💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

What Happens in a Divestiture?

When a divestiture involves the sale of part or all of a company, the process has four parts. The first two parts involve planning for the actual divestment transaction itself. Once management decides which part of the company to divest and who will be buying it, the divestment can begin.

1. Monitoring the Portfolio

When pursuing an active divestiture strategy, the company’s management team will review each business unit and try to evaluate its importance to the company’s overall business strategy. They’ll want to understand the performance of each part of the business, which part needs improvement, and if it might make sense to eliminate one part.

2. Identifying a Buyer

Once the business identifies some or all of the company as a potential divestment target, the team moves on to the next problem that logically follows: Who will buy it?

The goal is to find a buyer that will pay enough for the business to cover the estimated opportunity cost of not selling the business unit in question. If the buyer does not have the liquidity to make the purchase with cash, they might offer an equity deal or borrow money to cover the cost.

3. Executing the Divestiture

The divestiture involves many aspects of the business, including a change of management, company valuation, legal ownership, and deciding which employees will remain with the company and which ones will have to leave.

4. Managing the Financials

Once the sale closes, attention turns to managing the transition. The transaction appears on the company’s profit-and-loss statement. If the amount that the company receives for the asset it sells is higher than the book value, that difference appears as a gain. If it’s less the company will record it as a loss.

The company will typically share the net impact of the divestiture in its earnings report, following the transaction.

What Are The Different Types of Divestitures?

There are several different ways companies can define divest for themselves. A few of these options include:

• An equity carve-out, when a company can choose to sell a portion of its subsidiaries through initial public offerings but still retain full control of them.

• A split-up demerger, when a company splits in two, and the original parent company ceases to be.

• A partial sell-off, where a business sells one of its subsidiaries to another company. The funds from the sale then go toward newer, more productive activities.

• A spin-off demerger, in which a company’s division becomes a separate business entity.

What Causes a Company to Divest?

A divestiture strategy can be part of an overall retrenchment strategy, when a company tries to reinvent itself by slimming down its activities and streamline its capital expenditures. When that happens, the company will divest those parts of the business that are not profitable, consuming too much time or energy, or no longer fit into the company’s big-picture goals.

Factors that could influence a company to adopt a divestiture strategy can be lumped into two broad groups:

External Developments

External developments include things outside the company, such as changing customer behavior, new competition, government policies and regulations, or the emergence of new disruptive technologies.

Internal Developments

Internal developments include situations arising from within the company, such as management problems, strategic errors, production inefficiencies, poor customer service, etc.

Divestiture Strategy Example

Imagine a fictitious company called ABC was the parent of a pharmaceutical company, a cosmetic company, and a clothing company. After some time and analysis, ABC’s management determines that the company’s financials have begun deteriorating and they need to make a change in the business.

Following the four-step process above, they begin by finding the weakest points of business. Eventually, they decide that the pharmaceutical branch of the company is under-performing and would also be the easiest for the company to divest. It makes more sense to stick to clothing and cosmetics.

After identifying a buyer (perhaps a larger pharmaceutical company or a promising startup looking to expand), the divestment transaction occurs. The employees who work in the pharmaceutical branch either lose their jobs, or they get roles working for the new owner of that part of the business. The cash infusion that ABC gets as a result of the sale of its pharmaceutical branch will go toward new marketing efforts and creating new product lines.

The Takeaway

Divesting is essentially the opposite of investing. It involves a company selling off parts of its business. A divestiture can have some positive outcomes on the value of a company, and there are several business reasons that a company would choose to divest. Depending on the circumstances, this process could theoretically be either a positive or a negative for shareholders.

Investors could see news of a divestment as a sign that a company is struggling, leading them to sell the stock. While this initial reaction could be one likely outcome, the company could eventually wind up doing even better than before if it manages itself better as a leaner company. In either case, the divestiture is one factor that investors can use in their analysis of that company’s stock.

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Jul

2023

Popular Options Trading Terminology to Know

By Samuel Becker | Growing Wealth, invest, Investing | Comments Off

Trading stocks can help investors build wealth over time. But for investors interested in more advanced investment strategies, options trading might be worth looking into – but be warned, options trading is its own world, with its own jargon.

When an investor trades options, they aren’t trading individual shares of stock. Instead, they’re trading contracts to buy or sell stocks and other securities under specific conditions. Beyond this, there are a number of important options trading strategies investors commonly use when trading options. In order to effectively deal in options, an investor might also want to familiarize themselves with certain lingo.

First, Understand What You Are Trading

Before learning the trading terms, it helps to have a firm grasp of what options trading is and what it involves. In layman’s terms, when you’re trading options, you’re investing in an option to buy or sell a stock, rather than the stock itself.

Again, this is a form of derivative trading, and there are numerous options trading strategies that can be put to use, too. It’s not exactly the same as trading stocks, and is often more complicated. For that reason, investors should know what they’re getting into before trading options.

💡 Quick Tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, options trading can be risky, and best done by those who are not entirely new to investing.

Options Trading Terms to Know

When it comes to options trading, these are some of the most important trading terms to understand.

Call Option

A call option is an options contract that gives the purchaser of the option the right to buy shares of a stock or another security at a fixed price. This price is called the “strike price.”

When an investor buys a call option, the option to buy is open for a set time period. The expiration date is the date when the call option is voided — though some options positions are automatically closed or exercised if they are in the money. Standard options contracts are no more than 90 days.

Put Option

A put option gives a purchaser the right to sell shares of a stock at the strike price by a specified day. When getting to know puts and calls definitions, it’s important to remember that each one has:

• A strike price

• An expiration date

Strike Price

With a call option or put option, the strike price is one of the most important trading terms to know.

In a call option, the strike price is the price at which an investor may buy the underlying stock associated with the contract. In a put option, the strike price is the price at which they may sell the underlying stock.

The gap between the strike price and the actual price of a stock determines whether an investor is “in the money” or “out of the money.”

In the Money

When discussing stock movements, it’s typical to think in terms of whether a stock’s price is up, down, or flat. With options, on the other hand, there’s different language used to describe whether an investment is paying off or not, and it’s often described as “in the money” versus “out of the money.”

An option is in the money when the correlation between the strike price and the stock price is leaning in a buyer’s favor. Which way this movement needs to go depends on whether they have a call option or put option.

With a call option, a buyer is in the money if the strike price is below the stock’s actual price. Say, for example, you place a call option to purchase a stock at $50 per share but its actual price is $60 per share. You’d be up, or in the money, by $10 per share.

Put options are the opposite. An option buyer is in the money with a put option if the strike price is higher than the actual stock price.

Out of the Money

Being out of the money with call or put options means the option buyer doesn’t stand to reap any financial gain from exercising the option. Whether a call or put option is out of the money depends on the relationship between the strike price and the actual stock price.

A call option is out of the money when the strike price is above the actual stock price. A put option is out of the money when the strike price is below the actual stock price.

At the Money

Being “at the money” is another scenario an options buyer could run into with options trading.

In an at-the-money situation, the strike price and the stock’s actual price are the same. If the buyer of the option sells the option, they can make or lose money. If they exercise the option, they will lose money because of the premium paid.

Volatility Crush

When trading options, it’s important to understand stock volatility and how it can impact trading outcomes.

Volatility is a way to track up or down swings in a stock’s price across trading sessions. Implied volatility is a way of measuring or estimating which way a stock’s price might go in the future.

A volatility crush happens when there’s a sharp decline in a stock’s implied volatility that affects an option’s value. Specifically, this means a downward trend that can detract from a call or put option’s value.

Volatility crushes can happen after a major event that affects or could affect a stock’s price. For example, investors might see a volatility crush after a company releases its latest earnings report or announces a merger with a competitor.

Bid/Ask Price

When trading options, it’s helpful to know how bid and ask prices work.

The bid price is the highest price a buyer is willing to pay for an option. The ask price is the price a seller is willing to accept for an option. The difference between the bid price and ask price is known as the spread.

Holder and Writer

Other trading terms investors may hear associated with options are “holder” and “writer.” The person or entity buying an options contract may be referred to as the holder. The seller of an options contract can also be referred to as the writer of that contract.

An option is exercised when the buyer chooses to invoke their right to buy or sell the underlying security.

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

Pros and Cons of Options Trading

Options trading can offer both advantages and disadvantages for investors.

Pros of Options Trading

• Lower entry point. Unless an investor is able to purchase fractional shares, purchasing individual stock shares with higher price points can get expensive. Investing in options, on the other hand, may be more accessible for investors with a limited amount of money to put into the market.

• Downside protection for buyers. If the stock’s price isn’t moving in the direction a buyer anticipated, they don’t have to exercise their option to buy. This can limit losses.

• Greater flexibility. An investor has control over exercising the option to capitalize on the stocks rise or fall accordingly. An investor could exercise an option to buy and keep the shares, or buy and then resell them. Or they could choose not to exercise their option at all.

Cons of Options Trading

Options trading can be risky for sellers. Trading stocks is risky, but trading options have the potential to be more so for investors on the selling end of a contract. An investor might end up being out of the money on an options contract — but even that doesn’t determine the extent of the loss. The risk comes from the selling of uncovered puts and calls.

The Takeaway

Trading options can be appealing to investors who think an asset’s price will go up or down, or who want to attempt to offset risk from assets that they own. But before an investor engages in options trading, it’s a good idea to get familiar with put and call definitions and other options trading terms.

Knowing the specific jargon and terminology used by options traders can help investors cut through the noise and make better decisions. Of course, if you’re uneasy or unfamiliar with options terminology, you’d probably be better off learning more before starting to make trades.

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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