Nov
21
2024
What Is Extrinsic Value?

What Is Extrinsic Value?

By | Growing Wealth, invest, Investing | Comments Off on What Is Extrinsic Value?

Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.

What Is Extrinsic Value?

Extrinsic value is the difference between an option’s market price, known as the premium, and its intrinsic value.

Extrinsic value reflects factors beyond the underlying asset’s price that can influence the overall worth of an option. This value fluctuates based on the time to expiration and the volatility of the underlying asset.

Key Points

•   Extrinsic value is the difference between an option’s market price and intrinsic value, influenced by time and volatility.

•   Longer contracts and higher implied volatility increase extrinsic value.

•   Interest rates and dividends affect extrinsic value differently for call and put options.

•   Extrinsic value cannot be negative; it represents the portion of an option’s price that exceeds its intrinsic value.

•   At-the-money options have the most extrinsic value due to sensitivity to time and volatility changes.

Understanding Intrinsic and Extrinsic Value

The intrinsic value of an option is the difference between an option’s strike price and the current price of the underlying asset, which can be calculated only when the underlying asset is in the money. An out-of-the-money option has no intrinsic value.

Remember, an option that is “in the money” would be profitable for the owner if exercised today, while an option that is “out of the money” would not.

An out-of-the-money option may present an investment opportunity for some, however, because of its potential to become in-the-money at expiration.

Extrinsic value equals the price of the option minus the intrinsic value. As an option’s expiration approaches, extrinsic value usually diminishes since there is less time for the price of the underlying asset to potentially move in a way that benefits the option holder (also known as time decay).

For example, an option that has two weeks before expiry typically has a higher extrinsic value than one that’s one week away. This does not imply it has more intrinsic value, however. It just means there is more time for it to move up or down in price.

Out-of-the-money option premiums consist entirely of extrinsic value, while in-the-money options have both intrinsic value and extrinsic value. Options that trade at-the-money might have a substantial proportion of extrinsic value if there is a long time until expiration and if volatility is high.


💡 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.

How Extrinsic Value Works

Simply put, the more time until expiration and the more a share price can fluctuate, the greater an option’s extrinsic value. Extrinsic value demonstrates the time that remains for potential price movement, and the uncertainty in that movement. There are a few different factors that could influence extrinsic value, and understanding them is crucial for evaluating an option’s pricing.

Factors that Affect Extrinsic Value

Two key factors affect an option’s extrinsic value: contract length and implied volatility. In general, the longer the contract, the greater the extrinsic value of an option. That’s because the more time allowed until expiration, the more a stock price might move in favor of the option’s holder. It’s possible, however, that the price moves in the opposite direction; if the holder keeps the option in the hope that the price will rebound, they may lose some or all of their investment.

The second factor that determines extrinsic value is implied volatility. Implied volatility measures the expected magnitude of how much a stock might move over a specific period. Volatility impacts an option’s extrinsic value, and its sensitivity is represented by the Greek letter vega.

Recommended: Understanding the Greeks in Options Trading

1. Length of Contract

An option contract generally has less value the closer it is to expiration. The logic is that there is less time for the underlying security to move in the direction of the option holder’s benefit. As the time to expiration shortens, the extrinsic value decreases, all else equal.

To manage this risk, many investors use the options trading strategy of buying options with varying contract lengths. As opposed to standard option contracts, a trader might choose to buy or sell weekly options, which usually feature shorter contract lengths.

On the opposite side of the spectrum, Long-Term Equity Anticipation Securities (LEAPS) sometimes have contract lengths that measure in years. Extrinsic value could be a large piece of the premium of a LEAPS option.

Some traders will also use a bull call spread, in order to reduce the impact of time decay (and the loss of extrinsic value) on their options.

Recommended: A Beginner’s Guide to Options Trading

2. Implied Volatility

Implied volatility measures how much analysts expect an asset’s price to move during a set period. In general, higher implied volatility means more expensive options, due to higher extrinsic value. That’s because there is a greater chance a stock price could significantly move in the favor of the owner by expiration (or out of favor if the markets shift in the opposite direction). High volatility gives an out-of-the-money option holder more hope that their position will go in-the-money.

So, if implied volatility rises from 20% to 50%, for example, an option holder may benefit from higher extrinsic value (all other variables held constant). On the flip side, an out-of-the-money option on a stock with extremely low implied volatility may have a lower chance of ever turning in-the-money.

3. Others Factors

There is more than just the length of the contract and implied volatility that affect the premium of an option, however.

•   Time decay: The time decay, or the rate at which time decreases an option’s value, can greatly impact the premium of near-the-money options, this is known as theta. Time decay works to the benefit of the option seller, also known as the writer.

•   Interest rates: Even changes in interest rates, or rho, impact an option’s value. A higher risk-free interest rate pushes up call options’ extrinsic value higher, while put options have a negative correlation to interest rates.

•   Dividends: A stock’s dividend will decrease the extrinsic value of its call options while increasing the extrinsic value of its put options.

•   Delta: An option’s delta is the sensitivity between an option price and its underlying security. In general, the lower an option’s delta, the less likely it is to be in-the-money, meaning it likely has higher extrinsic value. Options with higher delta are in-the-money and may have more intrinsic value.



💡 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.

Extrinsic Value Example

Let’s say a trader bought a call option through their brokerage account on shares of XYZ stock. The premium paid is $10 and the underlying stock price is $100. The strike price is $110 with an expiration date in three months. Also assume there is a company earnings report due out in the next month.

Since the share price is below the call’s strike, the option is out-of-the-money. The option has no intrinsic value because it is out-of-the-money. Thus, the entire $10 option premium represents extrinsic value, or time value.

As expiration draws nearer, the time value declines, also known as time decay. A trader who takes the long position with a call option hopes the underlying asset appreciates by expiration.

An increase in volatility, perhaps due to the earnings report or another catalyst, might push the option’s price higher. Let’s assume the stock has risen to $120 per share following strong quarterly earnings results, and the call option trades at $11 immediately before expiration.

The call option’s intrinsic value is now $10, but the extrinsic value has declined to just $1, in this scenario, since there is little time to expiration and the earnings date volatility-driver has come and gone. In this case, the trader can sell the call for a small profit or they might choose to exercise the option.

Note that if the stock price had instead fallen below the strike price of $110, the call option would have expired worthless and the trader would have lost the premium they paid for the option.

Extrinsic vs Intrinsic Value

Extrinsic value reflects the length of the contract plus implied volatility, while intrinsic value is the difference between the price of the stock and the option’s strike when the option is in the money.

Extrinsic Value Factors (Call Option)

Intrinsic Value Factor (Call Option)

Length of Contract Stock Price Minus Strike Price
Implied Volatility

Extrinsic Value and Options: Calls vs Puts

Both call options and put options can have extrinsic value.

Calls

Extrinsic value for call options can be high. Consider that a stock price has no upper limit, so call options have infinite potential extrinsic value. The more time until expiration and the greater the implied volatility, the more extrinsic value a call option will have.

Puts

Put options have a lower potential value since a stock price can only drop to zero. Thus, there is a limit to how much a put option can be worth, which is the difference between the strike price and zero. Out-of-the-money puts, when the stock price is above the strike, feature a premium entirely of extrinsic value.

Recommended: Understanding the Greeks in Options Trading

The Takeaway

Understanding the fundamentals of intrinsic and extrinsic value is important for options traders. Although intrinsic value is a somewhat simple calculation, extrinsic value takes a few more factors into consideration — specifically time and volatility of the underlying asset. The more time until the contract expires, and the more a share price can fluctuate, the greater an option’s extrinsic value.

[product_push_invest_options]

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

FAQ

Which options have the most extrinsic value?

At-the-money options typically have the most extrinsic value since their price is closest to the strike price, thus being most sensitive to changes in time and volatility.

Can an option’s extrinsic value be negative?

No. Extrinsic value represents the portion of an option’s price beyond its intrinsic value, so it can never be less than zero. If an option’s market price is lower than its intrinsic value, it can only be as low as zero.

Photo credit: iStock/alvarez

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.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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.
Claw Promotion: Customer must fund their Active Invest account with at least $50 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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Nov
19
2024
woman on phone at desk

Alternative Investments: Definition, Examples, Strategies

By | Growing Wealth, invest, Investing | Comments Off on Alternative Investments: Definition, Examples, Strategies

While most investors are familiar with stocks, bonds, and cash, there is a world of investment opportunities beyond these assets.

Alternative investments are those outside of traditional assets. While they can be higher risk, alternatives can offer various potential upsides for investors, such as diversifying an existing investment portfolio, higher returns compared to stocks and bonds, and the opportunity to earn passive income.

Key Points

• Alternative investments include assets other than stocks, bonds, and cash, such as collectibles, commodities, derivatives, real estate, private equity, venture capital, hedge funds, and more.

• Alternative investments may provide portfolio diversification, as they often have a low correlation with traditional asset classes.

• Alternative investments have the potential to generate higher risk-adjusted returns compared with traditional assets, though this also comes with higher risk.

• Alternative investments tend to be illiquid, not as transparent as other financial assets, and may include the risk of total loss.

• You can invest in alternative investments through mutual funds, ETFs, interval funds, REITs, MLPs, or by working with an experienced asset manager.

What Are Alternative Investments?

Alternative investments — commonly known as alts — are those that are different from conventional investment categories such as stocks, bonds, and cash. Alts include a wide variety of securities as well as tangible assets such as commodities, foreign currencies, real estate, art and collectibles, venture capital, derivative contracts, and more.

Alts typically have a lower correlation with traditional asset classes, meaning they tend to move independently of them, and thus they may provide investment portfolio diversification. They also have the potential to generate higher returns when compared to stocks and bonds, and some are structured to provide passive income to investors. But alts typically include higher-risk assets and strategies, which can be illiquid and harder to track, owing to a lack of transparency.

Alts used to be accessible mainly to high net-worth and accredited investors, but now they’re available to a range of investors, thanks to the emergence of vehicles such as mutual funds and ETFs that include various alts and strategies.

The lack of liquidity for most alts means that determining the fair market value of these assets can be quite challenging. Often there is little by way of public data available regarding price changes or asset appreciation or depreciation, making it difficult to assess historical performance.

💡 Quick Tip: While investing directly in alternative assets often requires high minimum amounts, investing in alts through a mutual fund or ETF generally involves a low minimum requirement, making them accessible to retail investors.

Alternative investments,
now for the rest of us.

Start trading funds that include commodities, private credit, real estate, venture capital, and more.

Types of Alternative Investments

The following list encompasses some common types of alternative investments and alternative strategies available to investors today.

1. Real Estate

•   Summary: You can invest in real estate by owning rental property, investing in commercial real estate, industrial real estate, healthcare facilities, and more. Investors can also buy into Real Estate Investment Trusts, or REITs.

•   Pros and cons: Although real estate tends to hold its value over time, there are no guarantees. Different properties can be vulnerable to a host of factors including business trends, land values, interest rate risk, and more.

Recommended: How to Invest in Real Estate: 7 Ways for Beginners

2. Commodities

•   Summary: Commodities are raw materials that include agricultural products (e.g. grain, meat), precious metals such as gold, silver, copper, energy (including renewables), and more. Generally, investors participate in commodity trading using futures contracts, index funds, mutual funds, or ETFs.

•   Pros and cons: Some investors consider commodities a good hedge against inflation and they have the potential to deliver a profit. However, commodities can suffer from any number of unexpected risk factors, from weather conditions to supply chain breakdowns and more.

Recommended: How to Invest in Commodities

3. Private Equity

•   Summary: Private equity firms invest capital in companies that aren’t publicly traded, often with the aim of taking over the company. Because PE is a high-stakes endeavor, these opportunities are generally available to high net-worth and accredited investors. Now, however, retail investors can gain exposure to private funds through vehicles such as interval funds.

•   Pros and cons: Private equity is considered a high-risk investment, but if a private company goes public or gets acquired, these investments may perform well. The risk with private equity investments is that these are often focused on distressed companies, with a complex track record, and sometimes startups (see Venture Capital below).

Recommended: How to Invest in Private Equity

4. Venture Capital

•   Summary: VC investing is a way of putting money into startups with the hope of later gains, though there is no guarantee of a return. Investors can buy a slice of startup or private companies, through equity crowdfunding platforms (which differ from traditional crowdfunding in that investors own equity in the company) and interval funds.

•   Pros and cons: Venture capital investing is considered a subset of Private Equity, as noted above. It can be risky because if the startup fails, investors may lose all of their money. On the other hand, if a startup does well, investors may see a significant profit.

Learn more: What Is Venture Capital and How Does It Work?

5. Private Credit

•   Summary: Private credit involves direct loans made to companies from non-bank entities. Private credit can be a more expensive way to borrow, but it can be faster for the companies needing capital, and for investors it offers the potential for steady interest payments.

•   Pros and cons: Private credit funds tend to see greater inflows when the stock market is underperforming, and they usually pay higher rates than conventional fixed income instruments. The risk here is that most PC funds offer only quarterly redemptions — so they’re quite illiquid — and they can be vulnerable to defaults.

Learn more: Private Credit: Types and Investing Benefits

6. Art & Collectibles

•   Summary: Works or art and other types of collectibles (e.g., wine, jewelry, antiques, cars, rare books) can personally appeal to investors, and may grow in value over time. It’s also possible to invest in fractional shares of art, or in shares of an art-focused fund.

•   Pros and cons: Investing in art or collectibles may provide a hedge against inflation or other market factors. That said, the price of upkeep, insurance, and maintenance can be considerable. And while some pieces may gain value over time, art and collectibles can also be subject to changing trends and tastes. Fraud is another risk to consider.

7. Hedge Funds

•   Summary: Hedge funds offer investors access to alternative investing strategies, like arbitrage, leveraged trades, short-selling, and more. Hedge funds aren’t as heavily regulated as other types of funds, so they’re able to make riskier investments and lean into aggressive strategies, with the goal of delivering outsized returns.

•   Pros and cons: While hedge fund managers sometimes deliver a significant profit, they charge high fees and investment minimums that often put them beyond the reach of mainstreet investors. Today, investors may be able to access mutual funds, ETFs, funds of funds, or other vehicles that employ similar alternative strategies.

8. Farmland/Timberland

•   Summary: Like many types of real estate, farmland and timberland tend to hold their value over time, as long as they remain productive. This type of property can be similar to commodities in that there is potential profit in the products that come from the land (e.g. produce and timber).

•   Pros and cons: Owners of farmland can lease out the land to earn income, which can be profitable for investors. The potential downside of investing in farmland and timberland are the environmental and weather-related risks that can impact both the value of the land and its productivity.

9. Infrastructure

•   Summary: Infrastructure refers to the physical structures that economies depend on: roads and highways, bridges and tunnels, energy pipelines, and more. Municipal bonds are one way to invest in infrastructure, as are some types of REITs (real estate investment trusts).

•   Pros and cons: As a non-cyclical type of asset, infrastructure investments may offer the benefit of less exposure to market risk factors, steady cash flows, and low variable costs. The risks of infrastructure investments include political and environmental factors that can impact or delay the execution of a project.

10. Foreign Currencies

•   Summary: Foreign currencies are an example of an alternative investment that can be highly liquid, and thus easier to trade.

•   Pros and cons: Currency trading is known for its volatility, and currency traders often make leveraged trades, assuming a high degree of risk. Retail investors may find it potentially less risky to invest via mutual funds, ETFs, foreign bond funds, and even certain types of CDs (certificates of deposit), although the underlying volatility of most currencies will influence the performance of these investments as well.



💡 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.

Advantages and Disadvantages of Alternative Investments

In sum, alternative investments are certainly worth considering given their potential advantages, but it’s important to keep in mind the possible disadvantages to make the best choices in light of your own goals and risk tolerance.

Advantages

•   May offer the potential for higher risk-adjusted returns.

•   Are typically not correlated with traditional stock and bond markets, so they may help diversify a portfolio and mitigate risk.

•   May have the potential to deliver passive income.

•   Some alts may hedge against inflation or interest rate fluctuations.

•   May appeal to an individual’s personal interests: e.g., art, wine, memorabilia.

Disadvantages

•   Are often higher risk, or can be subject to greater volatility.

•   Can be less liquid than traditional investments due to limited availability of buyers and lack of a convenient market.

•   Often limited to high net-worth and accredited investors.

•   May have higher minimum investment requirements and higher upfront fees.

•   May have less available public data and transparency about performance, making it difficult to determine a financial asset’s value.

Recommended: Why Invest in Alternative Investments?

How to Invest in Alternative Investments

As mentioned above, alternative investments used to be limited to institutional investors and high net-worth investors, but they’re now available to average investors through mutual funds, ETFs, and sometimes even through companies’ IRAs.

If you’re thinking about adding alternative investments to your portfolio, finding the right brokerage and/or asset manager can help you incorporate alts into your portfolio in the way that makes sense for your long-term plan. SoFi, for example, is working with knowledgeable asset fund managers in the alts space to provide access to mutual funds across a variety of categories.

Once you’ve identified the types of alternative investments that would suit your goals, your risk tolerance, and your plan (e.g., you might prefer commodities to owning art), you can look for the funds that would help you buy into these alternative asset classes.

Here are some of the more traditional methods to invest in alternatives:





ETFs

An exchange-traded fund, or ETF, is an investment vehicle that enables investors to buy a group of stocks, bonds, commodities, or other securities in one bundle, thus promoting investment diversification and efficiency. They’re widely available, usually through major investment fund companies.

Interval Funds

These closed-end funds are not traded on the secondary market and have limitations on redemptions (among other risks and restrictions). But because the funds are highly illiquid and have infrequent redemptions, fund managers may use alternative investments to pursue higher yields.

MLPs

A master limited partnership, or MLP, is a business partnership that’s publicly traded on an exchange. While an MLP may sound like a company, these partnerships have a different type of structure and are restricted to natural resources and energy-related products and sometimes real estate.

MLPs can provide the liquidity of stocks, but the tax treatment can be complex — and they are higher risk than regular equities.

Mutual Funds

A mutual fund is an investment vehicle that pools money from many investors in order to invest in different securities. Mutual funds may hold any combination of stocks, bonds, money market instruments, or cash and cash equivalents.

They may also include alternative investments, such as real estate, commodities, or investments in precious metals.

REITs

A real estate investment trust, or REIT, is a way of investing in shares of different types of real estate within a single fund. REITs invest in companies that own, operate, or finance a wide variety of real estate types.

Things to Consider When Investing in Alts

Alternative investments are complex, and while the risk may be worth the potential reward for some investors, there are some additional caveats to bear in mind about these assets.

How Are Alternative Investments Taxed?

Unlike conventional asset classes, which are typically subject to capital gains tax or ordinary income tax, different alts can receive very different tax treatments, even when investing in these assets via a mutual fund or ETF. When investing in alts, it’s wise to involve a professional to help address the tax-planning side of the equation.

What Role Should Alts Play in Your Portfolio?

Remember, because alts don’t generally move in sync with traditional asset classes, they may offset certain risk factors. And while alts come with risks of their own, including volatility and lack of transparency, within the context of your portfolio as a whole, alts, and funds that invest in alts, may enhance returns. Some alts can provide passive income as well as gains.

It’s important to know, however, that alternative investments are higher risk, tend to be more illiquid, and less transparent. As such, alts should typically only be one part of your portfolio to complement other assets. Some advisors, for example, recommend up to a 10% allocation for alternative investments, though this number can vary.

The Takeaway

Alternative investments have the potential for high returns and may offer portfolio diversification. The scope and variety of these investments means investors can look for one (or more) that suits their investing style and financial goals. Unlike more conventional investments, alts tend to be higher risk, more expensive, and subject to complex tax treatment.

It’s important to research and do due diligence on any alternative investment option in order to make the best purchasing decisions and reduce risk. While some alternative investments are less accessible, others can be purchased through vehicles such as mutual funds and ETFs.

Ready to expand your portfolio's growth potential? Alternative investments, traditionally available to high-net-worth individuals, are accessible to everyday investors on SoFi's easy-to-use platform. Investments in commodities, real estate, venture capital, and more are now within reach. Alternative investments can be high risk, so it's important to consider your portfolio goals and risk tolerance to determine if they're right for you.

Invest in alts to take your portfolio beyond stocks and bonds.

FAQ

Are ETFs considered alternative investments?

Generally no. For the most part, exchange-traded funds (ETFs) are passive investments — meaning they track an index — and typically that index is for a conventional asset class like stocks or bonds. That said, some ETFs track niche parts of the market, including certain types of alternative strategies, including options, long-short strategies, managed futures, real estate investment trusts (REITs), and more.

Are alternative investments worth it?

For some investors, choosing to add alts to their portfolio might be worth it because alternative assets can add diversification (which can help manage risk), and alts may enhance returns over time. But alts also come with their own set of risk factors, including the fact that some alternative assets are illiquid, and are not regulated like other financial products.

How do alternative investment funds work?

Alternative investment funds work in a range of ways. A mutual fund focused on alternative strategies, like derivatives, is likely to be actively managed and employ techniques like leverage or short selling. Before investing in an alternative fund, it’s wise to make sure you understand the underlying strategy, assets, and fees.

What are the key characteristics of alternative investments?

Alternative investments may offer portfolio diversification with low correlation to traditional assets, potentially higher returns, and may provide protection against inflation or interest rate fluctuations. However, they can be illiquid, may have redemption restrictions, and determining their real-world value can be challenging due to limited transparency and public data.


An investor should consider the investment objectives, risks, charges, and expenses of the Fund carefully before investing. This and other important information are contained in the Fund’s prospectus. For a current prospectus, please click the Prospectus link on the Fund’s respective page. The prospectus should be read carefully prior to investing.
Alternative investments, including funds that invest in alternative investments, are risky and may not be suitable for all investors. Alternative investments often employ leveraging and other speculative practices that increase an investor's risk of loss to include complete loss of investment, often charge high fees, and can be highly illiquid and volatile. Alternative investments may lack diversification, involve complex tax structures and have delays in reporting important tax information. Registered and unregistered alternative investments are not subject to the same regulatory requirements as mutual funds.
Please note that Interval Funds are illiquid instruments, hence the ability to trade on your timeline may be restricted. Investors should review the fee schedule for Interval Funds via the prospectus.

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.

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
Fund Fees
If you invest in Exchange Traded Funds (ETFs) through SoFi Invest (either by buying them yourself or via investing in SoFi Invest’s automated investments, formerly SoFi Wealth), these funds will have their own management fees. These fees are not paid directly by you, but rather by the fund itself. these fees do reduce the fund’s returns. Check out each fund’s prospectus for details. SoFi Invest does not receive sales commissions, 12b-1 fees, or other fees from ETFs for investing such funds on behalf of advisory clients, though if SoFi Invest creates its own funds, it could earn management fees there.
SoFi Invest may waive all, or part of any of these fees, permanently or for a period of time, at its sole discretion for any reason. Fees are subject to change at any time. The current fee schedule will always be available in your Account Documents section of SoFi Invest.


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


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

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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Nov
18
2024

How Are IPO Prices Set?

By | Growing Wealth, invest, Investing | Comments Off on How Are IPO Prices Set?

Before listing a stock for sale on a public exchange, companies undergo a rigorous process of preparation and compliance — which includes a suggested starting price for the shares they plan to sell in their initial public offering (IPO).

This price then creates an IPO valuation for the company.

Companies and their bankers use a variety of factors and steps to determine the IPO price. Here’s a closer look at the IPO valuation process.

Key Points

•   The IPO process involves a rigorous preparation phase, where companies set a suggested starting price for shares before going public.

•   Investment banks analyze various factors like market conditions and growth potential to establish the IPO price, which is aimed at attracting investors.

•   Companies typically go public to raise capital, enhance visibility, and provide liquidity for early investors, though they may face new challenges post-IPO.

•   The initial public offering price is distinct from the opening price; the latter may fluctuate based on market demand once trading begins.

•   Investing in IPOs can be risky due to potential volatility, making it crucial for investors to assess their financial goals and risk tolerance before participating.

What Is IPO Price?

An IPO price is the price at which a company’s stock is sold to accredited and institutional investors right before the stock trades on a public exchange. The purpose of the public offering price is to attract investors to buy the shares.

IPO stocks are considered high-risk investments, and while some companies may present an opportunity for growth, there are no guarantees. Like investing in any other type of stock, it’s essential for investors to do their due diligence.

The investment banks that underwrite a company’s public offering set the IPO price, using several variables including an analysis of the company’s growth potential, a comparison to related firms, and a determination of market demand conditions.

💡 Quick Tip: Keen to invest in an initial public offering, or IPO? Be sure to check with your brokerage about what’s required. Typically IPO stock is available only to eligible investors.

Initial Public Offerings 101

When privately owned companies, such as unicorn companies, begin to sell shares of stock to the public, they hold an initial public offering, or IPO. Before an IPO, companies are usually owned by the founders, employees, and early investors, such as venture capital firms and angel investors. The process of selling shares to investors is called going public. Typically the initial offering is limited, and there are a number of people eligible for those shares first.

For this reason, it can be difficult for individual investors to buy IPO stock when it’s first issued. In most cases, individuals can trade IPO shares on the secondary market through their brokerage. In some cases, a brokerage may set certain requirements in order for individual investors to buy shares.

An IPO can help a company raise significant capital. It can also be a source of publicity. However, the IPO process is also time-consuming and expensive. Once a company has gone public, it faces new challenges such as regulatory scrutiny and an increased need to please shareholders.

Recommended: What Is an IPO and How Does it Work?

Why Do Companies Go Public?

The main reason companies choose to go public is to raise money. Holding an IPO can create significant value for a company and its management. In some cases, IPOs raise millions and even billions of dollars for the company, but some companies also face losses after an IPO.

Bringing in public investment benefits the business, but it also benefits early investors. These initial investors, who have invested time and money in a company, can sell their shares following an IPO, unlocking shareholder value.

An IPO can also benefit employees of the company. That’s because when an individual joins a company, sometimes they are granted employee stock options. Companies will often give early employees the options over several months or years — a process called vesting. Usually, employees must wait to sell their vested stock until the end of a lock-up period — a period after an IPO during which employees have to wait before selling their shares.

Other reasons companies go public are to gain media attention, grow a broad base of financial supporters, and create a windfall for venture capital firms that helped fund the company in its early stages.

The number of publicly traded, exchange-listed companies in the U.S. has decreased from the peak in the mid-to-late 1990s when it reached about 8,000. In 2021, the figure was closer to 6,000 companies that traded on different stock exchanges, such as the New York Stock Exchange (NYSE) and Nasdaq.

Steps in IPO Valuation

When a company decides to hold an IPO, they work with an investment bank to determine the company’s IPO valuation. The process of investment bankers handling an IPO is called underwriting.

How Underwriting Works in IPOs

Each underwriting process can be slightly different, but investment bankers’ factors in determining IPO prices and valuations are essentially the same. Some questions include:

•   Why has the company decided to go public?

•   What is the current status of the market?

•   Who are the company’s competitors?

•   What are the company’s assets?

•   How much has been invested in the company and by whom?

•   What is the history of the company and its team?

•   What are the company’s prospects for growth?

Recommended: What Is IPO Due Diligence?

Process of Determining IPO Prices

The rules of supply and demand apply to how the company and its underwriters will set an IPO price. Essentially, the underwriters must determine the demand for the shares based on the supply of shares that will be offered and sold to investors. These underwriters try to figure out what investors are willing to pay for each share of a company when it decides to go public.

To create a balance in this tradeoff that makes both existing and new investors happy, the company must decide how many new shares to issue and the estimated IPO price they plan to sell each share. The company’s executives and their investment bank determine the number of new shares by deciding how much money they hope to raise and how much ownership they are willing to give up.

Institutional Investors in IPO Process

Once executives and bankers decide on the number of new shares to issue, they reach out to institutional investors to start asking them how many shares they are interested in buying. Institutional investors include hedge funds, mutual funds, high net worth individuals, and pension funds in good standing with the investment bank.

Days before the IPO, the institutional investors place requests for how many shares they actually want to purchase. The company and its investment bankers then set the price for the IPO, and they know how much money they will raise.

The underwriting investment bank goes through the complex process of selling and allocating all the newly public shares to the institutional investors. They want to create a balance of different types of investors.

Retail Investors in IPO Process

Unfortunately for the at-home retail investor, it can be difficult to buy a stock at its IPO price. However, some brokerage platforms, like SoFi, have started to offer IPO Investing services that allow individuals to buy closer to the IPO price.

Determining Opening Price Point

Before the first day of trading, the stock exchanges on which the company decides to list look at all the incoming orders for the newly issued stock, which may be either buy or sell orders, and report the predominant price.

They then go through a process of price discovery to determine what the opening price will be. The goal is to have the maximum number of trades be executed from all the placed orders. At Nasdaq, this is done electronically, while human traders are involved at the NYSE.

Following this price discovery period, the opening price point is set, and the trading day continues. The stock is open for public trading.


💡 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.

Post-IPO Trading

In an ideal situation for the company and the underwriters, the stock’s closing price is relatively close to the opening price on opening day. This means the shares were priced accurately for what investors are willing to pay and the company had an appropriate valuation.

However, the IPO price isn’t necessarily a good indicator of the value of a stock. Broader market interest in the stock is impossible to plan for, and IPO conditions differ from the company’s long-term presence in the market.

IPO Price vs Opening Price: Similarities & Differences

Many analysts use the terms IPO price and opening price interchangeably when discussing a newly public company. However, there is a distinction between the two price points.

The IPO price is the price at which a company’s shares are first offered to institutional and accredited investors. The underwriters of the IPO sell the newly issued public share to these investors and clients at the initial public offering price.

In contrast, the opening price is the price at which the stock trades when it first begins trading on the stock market. The two prices are usually very close, but the opening price may be higher or lower than the IPO price.

Do IPO Stocks Always Rise?

IPO stocks don’t always rise in price once they are available for public trading. Many highly talked-about IPOs have disappointed in their opening weeks. This may be because investors feel these companies are overvalued and don’t want to risk putting money into them when they haven’t yet shown a profit.

It can take time for a stock to increase following an IPO, so the initial sale isn’t necessarily an indicator of long-term success or failure. The initial stock offering doesn’t always result in an immediate rise, but the influx of new capital can allow the company to grow.

Many stocks experienced tumultuous action for months before seeing a steadier climb. As an investor, looking for companies with a solid team and business plan, rather than just hype and a high valuation, can result in long-term portfolio growth.

How to Invest in IPOs

You can expose yourself to IPO stocks through an exchange-traded fund (ETF). Certain ETFs offer a weighted balance of newly public stocks and are adjusted over time. By diversifying your portfolio, you benefit from any gains while avoiding steep losses.

Also, some online brokerages, like SoFi, offer IPO investing for retail investors.

But, as mentioned above, IPOs can be very volatile. Although there is potential for significant returns, investors can also see severe losses in the weeks and months after a company goes public.

Rather than investing immediately, you can wait a quarter or six months to see how a company’s stock fluctuates following the IPO and then decide whether to invest. Stocks can often fall to form a base price before beginning to rise again.

Recommended: How to Find Upcoming IPO Stocks Before Listing Day

The Takeaway

It’s exciting when a company opens up to public investment. Although the IPO price is set as part of the lengthy IPO process, once the stock goes public all bets are off. Now the market determines the stock price, and the valuation of the company itself.

That’s one reason it can be challenging for most investors to know when and how to add new IPO stocks to their portfolios. Ultimately, investing in newly public stocks can be risky; the decision should be based on financial goals, time horizon, and risk tolerance.

Whether you’re curious about exploring IPOs, or interested in traditional stocks and exchange-traded funds (ETFs), you can get started by opening an account on the SoFi Invest® brokerage platform. On SoFi Invest, eligible SoFi members have the opportunity to trade IPO shares, and there are no account minimums for those with an Active Investing account. As with any investment, it's wise to consider your overall portfolio goals in order to assess whether IPO investing is right for you, given the risks of volatility and loss.

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

FAQ

Is it good to buy at IPO price?

Like all investments, there is risk in buying a stock when it goes public. IPOs can be suitable investments if the stock price increases after the IPO, but there is also a risk that the stock price could decrease. When buying a stock at an IPO price, investors don’t have the benefit of history to help analyze the stock.

How is an IPO price determined?

The IPO price is the initial public offering price of a stock. The IPO price is the price the underwriters will sell stock to institutional and accredited investors. The investment bank that works with the company going public determines the IPO price.

Can you lose money on an IPO?

Yes. An investor can lose money on an IPO if the company’s stock price falls below the price at which the investor bought the shares.

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.

Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. IPOs offered through SoFi Securities are not a recommendation and investors should carefully read the offering prospectus to determine whether an offering is consistent with their investment objectives, risk tolerance, and financial situation.

New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For SoFi’s allocation procedures please refer to IPO Allocation Procedures.

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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Nov
18
2024

What Is a Stock Market Crash?

By | Growing Wealth, invest, Investing, Terminology | Comments Off on What Is a Stock Market Crash?

The specter of a stock market crash weighs on the mind of many investors. After all, stock market crashes have played a substantial role in the United States during the 20th and 21st centuries. But knowing what is a stock market crash as well as the history and effects of stock market crashes can help investors weather the storm when the next one occurs.

Key Points

•   A stock market crash occurs when major indices experience significant declines, usually driven by panic selling rather than specific company issues.

•   Key factors that can trigger a crash include economic crises, natural disasters, and investor behavior, often exacerbated by rapid declines in stock prices.

•   Historical crashes, such as those in 1929, 1987, 2000, 2008, and 2020, illustrate the profound impact of bubbles and external shocks on the market.

•   Crashes can lead to bear markets and recessions, as declining stock values negatively affect corporate growth and consumer spending.

•   Strategies for navigating crashes include maintaining long-term focus, diversifying investments, and considering opportunities to buy undervalued stocks during downturns.

What Happens When the Stock Market Crashes?

A stock market crash occurs when broad-based stock indices like the S&P 500, Dow Jones Industrial Average, or the Nasdaq Composite experience double-digit declines over a single or several days. This means that the stocks of a wide range of companies sell off rapidly, generally because of investor panic and macroeconomic factors rather than company-specific fundamentals.

While no specific percentage decline defines a stock market crash, investors generally know one is occurring while it’s happening.

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

What Causes the Market to Crash?

Stock market crashes are usually unexpected and occur without warning. Often, crashes are caused by investor dynamics; when stocks start to sell off, investors’ fear takes over and causes them to panic sell shares en masse.

Though stock market crashes are usually unexpected, there are often signs that one could be on the horizon because a stock market bubble is inflating. A bubble occurs when stock prices rise quickly during a bull market, outpacing the value of the underlying companies. The bubble forms as investors buy certain stocks, driving prices up. Other investors may see the stocks doing well and jump on board, further raising prices and initiating a self-sustaining growth cycle.

The stock price growth continues until some unexpected event makes investors wary of stocks. This unexpected event causes investors to unload shares as quickly as possible, with the herd mentality of panic selling resulting in a stock market crash.

Catastrophic events such as economic crises, natural disasters, pandemics, and wars can also trigger stock market crashes. During these events, investors sell off risky assets like stocks for relatively safe investments like bonds.

Stock markets can also experience flash crashes, where the stock market plummets and rebounds within minutes. Computer trading algorithms can make these crashes worse by automatically reacting and selling stocks to head off losses. For example, on May 6, 2010, the Dow Jones Industrial Average fell 1,000 points in 10 minutes but recovered 70% of its losses by the end of the day.

Recommended: What Is the Average Stock Market Return?

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Examples of Past Stock Market Crashes

There have been several crashes in the stock market history, the most recent being the crash associated with the coronavirus pandemic in early 2020. The following are some of the most well-known crashes during the past 100 years.

Stock Market Crash of 1929

The most devastating stock market crash in the history of the United States occurred in October 1929. The crash occurred following a period of relative prosperity during the Roaring Twenties, when new investors poured money into the stock market.

The crash began on Thursday, October 24, when the Dow Jones Industrial Average declined about 11%, followed by a 13% decline on Monday, October 28, and a 12% drop on Tuesday, October 29. These losses started a downward trend that would continue until 1932, ushering in the Great Depression.

Black Monday Crash of 1987

On Monday, October 19, 1987, the Dow Jones Industrial Average plummeted nearly 23% in a single day. Known as Black Monday, this selloff occurred for various reasons, including the rise of computerized trading that made it easier for panicked investors to offload stocks quickly, and stock markets around the world crashed.

Dotcom Crash of 2000

The Dotcom crash between 2000 and 2002 occurred as investors started to pull money away from internet-based companies. The Nasdaq Composite index declined about 77% from March 2000 to October 2002.

In the mid to late 1990s, the internet was widely available to consumers worldwide. Investors turned their eyes to internet-based companies, leading to rampant speculation as they snapped up stocks of newly public internet companies. Eventually, startups that enthusiastic investors had fueled began to run out of money as they failed to turn a profit. The bubble eventually burst.

Recommended: Lessons From the Dotcom Bubble

Financial Crisis of 2008

The stock market crash of 2008 was fueled by rising housing prices, which came on the heels of the dot-com crash recovery. At the time, banks were issuing more and more subprime mortgages, which financial institutions would bundle and sell as mortgage-backed securities.

As the Federal Reserve increased interest rates, homeowners, who often had been given mortgages they couldn’t afford, began to default on their loans. The defaults had a ripple effect throughout the economy. The value of mortgage-backed securities plummeted, causing major financial institutions to fail or approach the brink of failure. This financial crisis spilled over into the stock market, and the S&P 500 fell nearly 60% from a peak in October 2007 to a low in March 2009.

Coronavirus Crash of 2020

As the coronavirus pandemic swept the United States in February 2020, the government responded with stay-at-home orders that shut down businesses and curtailed travel. The U.S. economy entered a recession, and the stock market plunged. The S&P 500 fell 30% into bear market territory in just one month, including a one day decline of 12% on March 16, 2020.

What Are the Effects of a Crash?

Stock market crashes can lead to bear markets, when the market falls by 20% or more from a previous peak. If the crash leads to an extended period of economic decline, the economy may enter a recession.

A market crash could lead to a recession because companies rely heavily on stocks as a way to grow. Falling stock prices curtail a company’s ability to grow, which can have all sorts of ramifications. Companies that aren’t able to earn as much as they need may lay off workers. Workers without jobs aren’t able to spend as much. As consumers start spending less, corporate profits begin to shrink. This pattern can lead to a cycle of overall economic contraction.

A recession is usually declared when U.S. gross domestic product, or GDP, shrinks for two consecutive quarters. There may be other criteria for declaring a recession, such as a decline in economic activity reflected in real incomes, employment, production, and sales.

💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

Preventing Stock Market Crashes

Major stock exchanges like the New York Stock Exchange (NYSE) have instituted circuit breaker measures to protect against crashes. These measures halt trading after markets drop a certain percentage to curb panic selling and prevent the markets from going into a freefall.

The NYSE’s circuit breakers kick in when three different thresholds are met. A drop of 7% or 13% in the S&P 500 shuts down trading for 15 minutes when the drop occurs between 9 am and 3:25 pm. A market decline of 20% during the day will shut down trading for the rest of the day.

Suppose a crash does occur, and it threatens to weaken the economy. In that case, the federal government may step in to ease the situation through monetary and fiscal policy stimulus measures. Monetary policy stimulus is a set of tools the Federal Reserve can use to stimulate economic growth, such as lowering interest rates. Fiscal stimulus is generally infusions of cash through direct spending or tax policy.

Investment Tips During a Market Crash

A stock market crash can be alarming, especially when it comes to an investor’s portfolio. Here are some investment tips to consider for navigating a market downturn.

Don’t Panic and Focus on the Long-Term

It will help if you remain calm when the stock market is plummeting. That’s often easier said than done, especially when your portfolio’s value declines by more than 10% in a short period. It’s tempting to join the panic selling, to make sure stock losses are minimized.

But remember, investing is a long game. In general, making decisions based on something happening now when your investing time horizon might be 30 years, may not be the best choice. If you don’t need access to your money right away, it may be better to hold on to your investments and give them time to recover.

Diversify Your Portfolio

Stocks and the stock market get most of the media’s attention, especially when the stock market is crashing, but there are other potential ways to help you realize your financial goals. Other assets like bonds, commodities, or emerging market stocks may be attractive investment opportunities to consider during a crash.

Consider Buying The Dip

While it depends on an individual’s specific situation and risk tolerance, a stock market crash might present opportunities to purchase stocks at a lower, more attractive share price that some investors may want to consider.

The Takeaway

The stock market tends to recover following a stock market crash; it took the S&P 500 six months to recover the losses experienced during the coronavirus crash. So any rash moves investors make during a stock market crash may prevent them from seeing gains in the long term.

A stock market crash can be scary, causing you to panic and fret over your savings and investments. But often, with investing, the best advice is not to make rash decisions. Even during a stock market crash, there may still be some opportunities and strategies to help build wealth over time.

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.

FAQ

When was the last market crash?

The last stock market crash was in 2020, at the onset of the coronavirus pandemic, when business shut down and the stock market plunged. The S&P 500 fell 30% in just one month. Within six months, however, the S&P 500 had recovered its losses.

What goes up when the stock market crashes?

Bonds generally tend to go up when the stock market crashes, although not always. Government bonds such as U.S. Treasuries typically do best during a market crash, though again, there are no guarantees.

Do stocks recover after a crash?

Historically, the stock market has recovered after a crash, although it’s impossible to say how long a recovery might take. Some stock market recoveries have taken a year or less, some have taken much longer.

Photo credit: iStock/Prostock-Studio


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.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.


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

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Nov
18
2024
What Are Futures? A Guide to Futures Trading

Exploring Futures in Financial Markets: A Comprehensive Guide

By | Growing Wealth, invest, Investing | Comments Off on Exploring Futures in Financial Markets: A Comprehensive Guide

Some investors may trade futures contracts in order to hedge against risk, or to speculate on the price movements of a given asset or security — or because their business will benefit if they lock in a commodity at a certain price. Trading futures can provide opportunities for a range of investors.

A futures contract requires both parties to honor the terms, no matter what the price is in the market when the contract expires. If you want to trade futures, there are various ways they can fit into your portfolio or plan.

Key Points

•   Trading futures contracts allows investors to hedge against risks or speculate on price movements of various assets, including commodities and financial instruments.

•   Futures contracts are standardized agreements that obligate parties to buy or sell an asset at a predetermined price on a future date.

•   Investors can utilize leverage when trading futures, which can amplify both potential gains and losses due to margin trading practices.

•   Hedging with futures helps businesses secure prices for commodities, mitigating the impact of unexpected price fluctuations in the market.

•   Understanding the risks and benefits of futures trading is crucial, as it involves leveraged positions that can lead to significant financial consequences.

What are Futures?

Futures are derivatives that take the form of a contract in which two traders agree to buy or sell an asset for a specified price at a future date. Popular underlying assets for futures may include physical commodities like gold, corn, or oil, as well as currencies, or financial instruments like stocks.

The most commonly traded futures contracts use standardized terms, and are traded on a futures exchange. For example, if you want to buy or sell corn futures, one contract would equal 5,000 bushels and be traded via the Chicago Board of Trade (CBOT). Oil is traded on the Chicago Mercantile Exchange (CME), and one oil futures contract equals 1,000 barrels of oil.

Traders buy and sell in increments specified by the contract. To buy 50,000 bushels of corn or 10,000 barrels of oil, you’d buy 10 contracts of each. Given the quantities and dollar amounts of these trades, investors often use leverage, thereby paying only a fraction of the total cost of the position.


💡 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.

Understanding How Futures Work

Futures work by obligating a buyer or seller to purchase or offload an asset — it’s a contract.

Mechanism of Futures Trading

A futures contract obliges the buyer to buy a certain asset, or the seller to sell an asset, at an agreed-upon price, by a certain date. Each party must fulfill the terms of the contract, no matter what the market price or spot price is when the contract expires (or trade the contract before the expiration).

Futures contracts are standardized, as noted above, and each contract also spells out the contract terms, which includes among other things:

•   The unit of the trade (e.g., tons, gallons, bushels, etc.).

•   The grade or quality of the commodity, where relevant. For example, there are different types of corn, oil, soy, etc.

•   Terms of settlement (e.g., physical delivery or a cash settlement).

•   Quantity of goods covered by the contract.

•   Currency in which the contract is priced.

Recommended: How Does a Margin Account Work?

The Role of Futures in Markets

A futures contract allows investors to speculate on the direction of the underlying asset, either long or short, using leverage. (Leverage means the trader doesn’t have to put up the full amount of the contract. Instead, futures traders use a margin account.) As such, they’re a tool that allows investors to use leverage and speculation.

Types of Futures Contracts

There are numerous types of futures contracts, including those tied to underlying assets such as equities and commodities. They can even be tied to other futures.

Equity, Commodity, and Other Futures

Futures contracts allow investors to make bets on the prices of a wide array of assets:

•   Commodity futures, which allow investors to buy or sell physical goods like crude oil, pork bellies, natural gas, orange juice, corn, wheat, and more.

•   Financial futures, including index contracts and interest rate or debt contracts.

•   Precious metal futures allow investors to bet on the future prices of gold, platinum, and silver.

•   Currency futures for fiat currencies like the euro, yen, the British pound, and more.

•   U.S. Treasury futures allow investors to make bets on the future value of government bonds.

What are stock futures? Like futures contracts where the underlying is a physical commodity, some futures are tied to shares of a single stock or ETF. Stock index futures, however, are tied to the price movements of an index like the S&P 500 index.

Trading and Speculating with Futures

There are two key aspects to futures trading, which are hedging and speculating. Both play an important role in the markets, and determining whether futures are actually traded or not. There are also trading strategies to keep in mind, too.

Strategies for Futures Trading

There are many strategies for trading futures contracts, just as there are many strategies for trading almost any other type of security or derivative. To name a few of the basic strategies, investors can look at strategizing around price pullbacks, breakout trading, or even spread trading — each requires its own gameplan, and some background research to get started.

Futures as Speculation and Hedging Tools

Hedging is a big reason why investors buy futures contracts: It’s a way to protect against losses resulting from price changes in commodities.

Among the businesses that hedge using futures, the goal is to reduce the risk they face from unexpected price movements, and to guarantee the price they pay or receive for a particular asset.

If a large food manufacturer wants to lock in the price of corn, for example, they might enter into a contract for $10 a bushel. Since corn contracts are typically standardized at 5,000 bushels per contract, the total amount of the futures contract would be $50,000 ($10 x 5,000), to be delivered in six months. Entering into this futures contract would offer the buyer some protection against the possibility of rising corn prices in the future.

Let’s say the price of corn does rise to $12/bushel by the time the contract expires. In that case, the buyer still only pays the agreed-upon price of $10/bushel, even though the spot price is now $12/bushel.

For the corn producer in this scenario, even though it turned out that the futures contract terms weren’t quite as favorable as the actual market price — the contract guaranteed they would get at least $10/bushel, which provided a hedge against a potentially bigger loss.

Although it’s possible to settle a futures contract for the physical asset specified in the contract, most futures contracts are cash-settled. That’s because speculation on price movements is one of the main reasons that investors purchase futures contracts. A futures contract gives traders the opportunity to speculate whether a commodity will go up or down and potentially profit from the price change.

If the underlying asset of the futures contract — such as gold, oil, or corn — is above the price specified in the futures contract, then the investor can sell that contract for a profit before it expires. In that case, the contract would sell for the difference between the market price of the underlying commodity and the purchase price as specified in the contract.

In such a transaction, the underlying commodities don’t change hands between the counterparties of the contract. Instead, the trade would be cash-settled in the brokerage account of the investor.

Alternatively, an investor using futures for speculation could lose money if the price of the commodity is lower than the purchase price specified in the futures contract.

Risks and Benefits of Trading Futures

Futures trading has some significant risks and potential rewards — investors would be wise to know what they’re getting into, accordingly.

Understanding the Risks

Owing to the nature of futures trading, i.e., the binding nature of the contracts and the use of leverage, there are some obvious risks to bear in mind.

In a speculative trade, a futures contract allows you to bet on a commodity’s price movement. If you bought a futures contract, and at expiration the price of the commodity was trading above the original contract price, you’d see a profit. However, you could also lose if the commodity’s price was lower than the purchase price specified in the futures contract.

The potential risks here can be greater than they seem, because trading on margin permits a much larger position than the actual amount held by the brokerage. As a result, margin investing can amplify gains, but it can also magnify losses.

Imagine a trader who has $5,000 in their brokerage account and is in a trade for a $50,000 position in crude oil. If the price of oil moves against the trade, the losses could far exceed the account’s $5,000 initial margin amount. In this case, the broker would make a margin call requiring additional funds to be deposited to cover the market losses.

Speculators can also take a short position if they believe the price of the underlying asset will decline. An investor would realize a gain if the underlying asset’s price was below the contract price, and a loss if the current price was above the contract price. Again, using leverage to place these bets, long or short, can potentially expose investors to more risk than they intended.

Potential Benefits and Rewards

Some of the potential benefits of trading futures include the fact that investors can use leverage to try and generate outsized returns, the markets are liquid (meaning there’s plenty of trading action) and it offers up a chance to make some relatively quick (and potentially large) returns. That should, of course, be weighed against the aforementioned risks.

Futures vs Other Derivative Instruments

There are other financial derivatives with similar characteristics to futures contracts, such as options and forwards.

Comparing Futures with Options and Forwards

American-style options grant the buyer the right, but not the obligation, to buy or sell the contract’s underlying asset at any time until the contract expires.

Unlike a futures contract, however, option contracts don’t require the investor to purchase or sell the underlying asset. The investor can simply let the option expire. A futures contract, on the other hand, obligates the buyer to purchase the underlying asset, or to pay the seller of the futures contract the cash equivalent of that asset at the time of the contract’s expiration.

Similarly, a forward contract looks and functions a lot like a futures contract, with the primary difference being that forward contracts are only settled once — on their expiration date. Forwards are also often settled in the underlying asset (as opposed to cash), and the forwards market tends to be less liquid.


💡 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.

Opening and Managing Futures Positions

Opening and managing futures positions can be relatively simple, granted you’re using a platform that allows for futures trading, and can follow a few steps.

Steps to Start Trading Futures

It’s common for some brokerages to have their own futures-trading capabilities, as well as their own rules about what an investor needs in terms of assets in order to trade futures contracts. Be sure to verify what those requirements are before selecting a broker.

Once you’re eligible to open a margin account and trade futures, those contracts trade on different exchanges, such as the Chicago Mercantile Exchange (CME), ICE Futures U.S. (Intercontinental Exchange), and the CBOE Futures Exchange (CFE).

From there, depending on the brokerage or platform being used, investors should be able to open and swap futures positions.

Managing Futures Contracts Effectively

Most investors in futures contracts have no interest in either receiving or having to deliver the physical commodities that underlie these contracts. Rather, they’re interested in the cash profit. The means of doing so is to trade the futures contract before its expiration date.

The standardized nature of most futures makes it so that a great many (but not all) futures contracts will expire on the third Friday of each month. Some commodities are seasonal, and only trade during specific months. High-grade corn trades on the CBOT in March, May, July, September, and December, for example.

As with any type of trading or investing, making sure you know what you’re dealing with when it comes to futures — and paying attention to the market — is going to be paramount to finding success as a trader. There are risks at play, and there’s no guarantee that the chips will fall your way. But for some, futures trading has proven fruitful.

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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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