Investing Archives | Page 11 of 221

Mar

2024

Understanding Market Sentiment

By Amanda Holden | Growing Wealth, invest, Investing, Terminology | Comments Off

Market sentiment concerns a complicated blend of thoughts, feelings, and actions, all of which have an effect on stock prices and markets. Flip on the cable news and the vibe might have you believe that political statements, economic data points, natural disasters, or global unrest have some sort of predictable or unilateral effect on investing behavior.

And they might! But in a slightly more roundabout way. These events may well change how investors feel about owning certain investments, which leads them to buy or sell those investments. And it is the forces of supply and demand that push asset prices higher or lower. Said another way, investor sentiment, also known as market sentiment, can cause price volatility.

Market Sentiment Defined

The collection of all investor feelings — and actions — amounts to what is called market sentiment. It is a powerful force in the markets and is the subject of much study (and cable news discourse).

Market sentiment is affected by millions of factors daily. That’s because there are at least as many participants in popular marketplaces, like the stock market.

While one investor may be selling stocks because of poor corporate earnings, others might simply sell because they woke up on the wrong side of the bed. It is overly simplified to assume only one cause of changes to asset prices.

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Collective Mood Swings

Market sentiment is the phrase used to describe the overall spirit of investors in a market. (The stock market was used in the example above, but market sentiment exists in all investment markets.) Think of market sentiment as a giant mood ring for a particular market at a particular time.

The collective psychology of the market has the power to move stock prices. (How much “we” demand something gives it its value.)

When prices go up, the overall tone of the market is said to be positive, or bullish. When prices move downward, it generally means that investor sentiment is negative, or bearish. Investor attitudes about investments are realized in the price of those investments.

And anyone who watches the market knows that investors can be quite emotional at times. It’s human nature. It’s best that investors accept this reality.

In fact, investors should find it freeing that humans aren’t always rational and that sometimes asset prices can have major swings along with global moods. It is not up to the investor to control the swings of the stock market, but instead to weather them calmly.

While company earnings are the engine that drives stock market returns over time, it is the act of buying and selling that, in the shorter term, can cause the stock market to wiggle.

The stock market is of particular interest when looking at market sentiment. It’s a popular, global market, for one. Second, volatility can be dramatic, unlike markets for bonds. Third, it is easy to witness changes happening in real time.

The stock marketplace is like few marketplaces in the world, where prices are updated constantly in direct relation to the buying and selling of items in question. (Imagine how wild that would be if it happened at a grocery store.)

Market sentiment is considered an important tool for market analysis. It is used to make decisions about the very market the sentiment applies to.

Market Sentiment as an Indicator

When analyzing markets in an effort to predict them, indicators are used. An indicator is a sign or trigger that may hold some sort of valuable information. Market sentiment is one such indicator.

Compare market sentiment as an indicator with fundamental analysis, which largely relates to business performance, projected business performance, and the prevailing conditions for business performance.

Imagine a new tax law that’s expected to have a strong impact on the profitability of businesses in a certain industry. This would be considered a fundamental indicator.

Sometimes sentiment indicators and fundamental indicators can be at odds with each other. Fundamental indicators appear to point in one direction, but investor emotion may say otherwise.

For example, a business could have poor business fundamentals, and investors may still feel exuberant about that company and pile into its stock, which pushes the price of that stock higher.

Examples of Market Sentiment as an Indicator

There are many ways in which market sentiment is used as a market indicator. Then there are even more interpretations for what that data could mean.

It’s important to realize that no market indicators should be taken alone as fact. Why? Market indicators are in the business of predicting the future, which, in the stock market and otherwise, is a difficult thing to do.

In forecasting the general trajectory of the stock market, investor sentiment is sometimes used as a contrary indicator.

As the old adage goes, “Be fearful when others are greedy and greedy when others are fearful.” In a broad sense, when market sentiment is poor, it could indicate that it’s a good time to invest. When market sentiment is hot, it could be a bad time to invest.

When do people feel the worst about investing? At market bottoms, when prices are low. When do investors feel best? After the market has done well, which could indicate that prices are too high.

This is a characteristic of market bubbles, where investor mania causes prices to soar beyond their fundamental value. (Exhibit A was the dot com bubble, which saw investors piling into internet stocks, some of which never had so much as a quarter of positive earnings.)

Another instance in which sentiment might be used to assess an investment is through a strategy called value investing. With this method, investors attempt to uncover underpriced stocks — stocks whose price is lower than the believed value.

This could mean looking for a stock that has a strong fundamental foundation but that has yet to catch fire with investors, or a stock that is being punished (perhaps unnecessarily) by investors. Finding the proverbial diamond in the rough requires both an understanding of a company’s fundamentals and the market sentiment surrounding it.

Day trading, which is the practice of making bets on the price movement of a security during the trading day, relies on what are called technical indicators. And because of the power of investor attitudes to move prices, factors of sentiment can play an important role in short-term market changes.

For example, technical traders may look at a security’s historical price movement, called moving averages, in an attempt to surmise what will happen going forward. It is common to look at both 50-day and 200-day simple moving averages in an attempt to predict what happens next.

Other examples of sentiment indices are the High-Low Index, the CBOE Volatility Index, also known as the “fear” index, and the Bullish Percent Index.

The BPI measures the number of stocks with bullish and bearish patterns according to point and figure charts, ultimately producing a read on the sentiment of the overall market. An output of 50% is neutral, while reads above 80% are bullish and below 20%, bearish.

Some investors might argue that the above technical indicators have a serious limitation: They are using data from the past to project into the future and that the future is more or less unknown.

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Building an Investment Strategy

Market sentiment concerns the overall thoughts, feelings, and actions of market participants, and has an effect on what happens in the stock market. Negative sentiment can drive stock values down, while positive sentiment can lead to market euphoria and higher values.

It can be difficult to keep up with market sentiment, or to even read it accurately. But knowing what sentiment is, and how it can affect the markets, can be important when making investment decisions.

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Mar

2024

What Is an Exponential Moving Average (EMA) in Stock Trading? How Does It Work?

What Is Exponential Moving Average (EMA)?

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

An exponential moving average (EMA) is a commonly used average price calculation done for a specific time period that places more weight and importance on the most recent price data. Since it is weighted this way it reacts faster to recent price changes than a simple moving average (SMA) which is a type of average price calculation, which equally weights all data points within a time period.

Moving averages are technical analysis trading indicators used by traders to help them understand the direction, market trend, and strength of price movement of an asset. They measure the average price of a security by taking averages of the prices of the security over a specific period of time, and can be used to show traders the location of support and resistance levels. Read on to learn more about the meaning of EMA in stocks, the EMA formula, and how to calculate EMA.

What is EMA?

An EMA, exponentially weighted moving average, is a type of moving average (MA) used by traders to evaluate the potential trajectory of a financial security. Using the EMA calculation, the most recent price data has the greatest impact on the moving average, while older data has a lower impact. The previous EMA value is included in the calculation, so the current value includes all the price data.

As noted, it reacts faster to price changes than a simple moving average, which may be helpful to some investors.

EMA Formula

The formula for calculating EMA is:

EMA = (K x (C – P)) + P

Where:

C = Current Price

P = Previous Period’s EMA (for the first period calculated the SMA is used)

K = Exponential Smoothing Constant (this applies appropriate weight to the most recent security price, using the number of periods specified in the moving average. The most common smoothing constant is 2, but the higher it is the more influence recent data points have on the EMA)

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How to Calculate EMA

Technical analysts follow three steps to calculating an EMA.

1. Calculate the simple moving average (SMA) to find the initial EMA data point. The SMA is used as the previous period’s EMA for the first calculated data point of the EMA. To calculate the SMA of the last 20 days, a trader would add the amounts of the last 20 closing prices of the security and then divide that sum by 20.

2. Calculate the weighting multiplier for the number of periods that will be used to calculate the EMA. The number of periods used for the EMA has a significant impact on the value of the weighting multiplier.

The formula for finding the weighting multiplier is:

EMA(current) = ((Price(current) – EMA (prev)) x Multiplier) + EMA(prev)

3. Calculate the EMA using the formula described above.

Some traders also use the open, high, low, or median price instead of the closing price for the EMA calculation.

Example of EMA

Taking the above into consideration and following the three steps to calculate EMA, here’s an example of how it might all come together.

Again, here’s the EMA formula: EMA = (K x (C – P)) + P

We’ll assume that the previous period’s EMA is 50, and that the current price is 60. We’ll also assume that our smoothing constant is 2, for simplicity’s sake.

So: EMA= (2 x (60 – 50)) + 50 = 70

What Does EMA Show You?

An EMA follows prices more closely than a SMA since it puts more weight on recent data points. This is helpful for determining when to enter and exit trades. EMA is a lagging indicator that shows market trends and directions and the strength of price movements. It’s best used in trending markets.

By looking at past trends traders can gain an understanding of what might happen with a security’s price in the future, which may help them identify investment opportunities. Although past performance is no guarantee of future performance.

Limitations of Using EMA

Although EMA is a very useful trading tool, it does have some constraints.

• Spotting trends and directions using EMA is difficult in a flat market.

• The EMA shows present market trends but is not a predictor of future trends and prices. It also doesn’t show exact highs and lows or precise entry and exit points.

• The EMA can show false signals and can show more short term price changes that aren’t trading indicators.

• Even though it is weighted toward recent prices, the EMA does rely on past price movements, so it is a lagging indicator. Because of this the optimal time to enter a trade may have already passed by the time the trend direction shows up in an EMA chart.

How Investors Can Use EMA

Usually traders look at the direction the EMA is going in and they trade in the direction of the trend. In addition to spotting market trends and direction, EMA can also identify spot reversals that occur when a security is overbought or oversold.

The EMA is a fairly accurate tool because stock prices typically only stray so far from the average before returning to test the average, creating support or resistance and continuing to rise or fall. Even beginning investors can use EMA to spot trends and gain an understanding of what direction the market is heading.

Like other indicators, It’s best to use EMA in conjunction with other tools such as relative strength index (RSI) and moving average convergence divergence (MACD) to get a more comprehensive and accurate picture of the market. There are a few ways investors can use EMA:

Trend Trading

Traders can use the EMA to discover and trade primary market trends. When the EMA rises this is a bullish indicator, a trader may buy when the stock price dips to hit the EMA line or just below it. When EMA goes down, a trader might sell their position when the stock price goes up to hit the EMA line or just above. If the stock has a closing price that crosses over the average line, the trader closes out their trade.

Support and Resistance

EMA lines can track support and resistance levels, another useful way to track price movements and trends. If EMA goes up, this is a support indicator, while if it goes down this shows resistance to the security’s price movement.

Buy and Sell Signals

Traders can set up fast and slow moving averages and then find buy and sell signals when the two lines cross each other.

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The Takeaway

EMA is a useful tool for both advanced and beginner traders to understand market trends and directions. It’s a technical indicator that evaluates a stock’s price trend with a greater emphasis on recent price levels.

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FAQ

Which EMA is best?

Day traders often use 8- and 20-day EMA periods, while long-term investors use 50- and 200-day EMA. Indicators such as the moving average convergence divergence (MACD) and percentage price oscillator (PPO) use 12- and 26-day periods. If a security passes over a 200-day EMA this is a technical sign that a trend reversal has occurred.

What’s the difference between EMA and SMA?

Both simple moving average and exponential moving average are used by traders to measure market trends. They both create a graphical line that smoothes out price fluctuations using calculated averages. But they weigh price data differently, and may have different sensitivities to price changes.

What is 5 EMA and 20 EMA?

There are different EMAs referring to different time periods that can identify trends. In that sense, 5 EMA and 20 EMA refers to the 5-day and 20-day EMA, a shorter and longer-term EMA measure.

Photo credit: iStock/South_agency

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Mar

2024

Dollar Cost Averaging: Definition, Formula, Examples

By AJ Smith | Growing Wealth, invest, Investing | No Comments

Dollar cost averaging is a way to manage volatility as you continue to save and build wealth. Volatility is a natural part of investing. Virtually every part of the market is impacted by volatility in one way or another — thus, nearly every investor must contend with inevitable price fluctuations, and one way to do this is by using dollar cost averaging.

With this strategy, you decide on the securities you want to purchase, and the dollar amount you want to invest each month (or the interval you choose), and then ideally automate that amount to be invested on a regular basis.

What Is Dollar Cost Averaging (DCA)?

Dollar cost averaging is a basic investment strategy where you buy a fixed dollar amount of an investment on a regular basis (e.g. weekly or monthly). The goal is not to invest when prices are high or low, but rather to keep your investment steady and repeatable, and thereby avoid the temptation to time the market.

That’s because with dollar cost averaging (DCA) you invest the same dollar amount each time, so that, effectively, when prices are lower, you buy more; when prices are higher, you buy less. Otherwise, you might be tempted to follow your emotions and buy less when prices drop, and more when prices are increasing (a common tendency among investors).

How Dollar Cost Averaging Works

Dollar cost averaging works by making more or less the same investment over and over on a repeating basis. For an investor, it may be as simple as investing $5 in Stock A every Monday, or something similar, no matter what’s going on in the market.

That way, you’re investing the same amount whether the market goes up, down, or sideways. For example, if you invest $100 in Stock A at $20 per share, you get 5 shares. The following month, say, the price has dropped to $10 per share, but you stay the course and invest $100 in Stock A — and you get 10 shares.

Over time, the average cost of your investments – the dollar amount you’ve paid – may end up being a little lower, which can benefit the overall value of your portfolio.

Example of Dollar Cost Averaging

Here’s an example of how dollar cost averaging might look in practice.

Investor A might buy 20 shares of an exchange-traded fund (ETF) at $50 per share, for $1,000 total. This would be investing a lump-sum, rather than using a dollar cost averaging strategy.

Investor B, however, decides to use a dollar cost averaging strategy.

• The first month, Investor B buys shares of the same ETF at $50/share, but spends $300 and gets six shares.

• The next month the ETF price drops to $30 per share. So Investor B once again invests $300 and now gets 10 shares.

• By the third month, the ETF is worth $50 per share again, and their regular $200 investment gets them six shares.

Investor B now owns 22 shares of the ETF, at an average price of $40.90 per share, compared with Investor A, who paid $1,000 ($50 per share for 20 shares) in one lump sum.

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Benefits and Disadvantages of DCA

Every strategy has its pros and cons, of course. Here are some of the advantages and disadvantages of DCA.

Dollar Cost Averaging Benefits

DCA forces you to stay the course, regardless of volatility. It keeps you from trying to “time the market.” By investing the same amount of money every month, you will buy more shares when the market is down and fewer shares when the market is up. You’re not investing with your emotions, which can lead to impulsive choices.

DCA allows you to “set it and forget it.” Investing the same dollar amount every month is a straightforward strategy, and technology makes it easy to automate. You don’t have to keep your eye on different investments or even market volatility. Just stick to the plan.

You also don’t have to be wealthy in order to use the dollar cost averaging method. You can start small, but all the while, you will be contributing to and growing an investment portfolio.

Dollar Cost Averaging Disadvantages

In some cases, investing a lump sum may net you a higher return over time. Although DCA works well in terms of helping to manage the impact of volatility, the reality is that over the course of many years, the market trends upward, as the average market return shows. Although there are many factors to consider when it comes to investing returns — including the impact of fees, of selling when the market is down and locking in losses, and so forth — the market’s upward trajectory is something to bear in mind.

When you use any kind of “set it and forget it” strategy, you run the risk of missing out on certain market opportunities — and red flags. Although the upside of dollar cost averaging is its consistency, the potential downside is that you may be less aware if there are new opportunities or the need to avoid losses.

Last, dollar cost averaging doesn’t solve the problem of rebalancing — another strategy that’s designed to mitigate volatility.

💡 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.

When to Use Dollar Cost Averaging

There are certain times when dollar cost averaging makes sense, and certain investments that are suited to this strategy.

• For example, many people believe they need to invest large sums of money to invest successfully. In fact, DCA is evidence that you can invest small amounts, steadily over time, and reap the benefits of market growth.

• Funds: Mutual funds allow you to purchase a share, which represents a very small allocation of the underlying investment portfolio. This means that you can diversify with much smaller dollar amounts than if you purchased the securities on your own.

• ETFs (exchange-traded funds): Similar to mutual funds, ETFs provide an opportunity to diversify with smaller dollar amounts. Additionally, ETFs are available to trade throughout the day, generally have low expenses, no investment minimums, and may offer greater tax-efficiency.

The Takeaway

Dollar cost averaging is a fairly straightforward strategy that can help mitigate the impact of volatility on your portfolio, and also help you avoid giving into emotional impulses when it comes to buying or selling. Thus, dollar cost averaging can help you stay in the market, even when it’s fluctuating, with the result that you buy more when prices are low and less when prices are high — but overall, you may end up paying less on average.

But dollar cost averaging isn’t an excuse for literally “setting and forgetting” your portfolio. It’s still important to check on your investments in case there are any new opportunities or bona fide laggards. And once a year, it’s wise to rebalance your portfolio to restore your original asset allocation (unless of course your risk tolerance or goals have changed).

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FAQ

Is dollar cost averaging a good idea?

Dollar cost averaging may be a good strategy for many investors to employ, as it has certain advantages that beginner investors, in particular, may use to their benefits. But it’s important to consider the downsides or disadvantages, too.

When is the best time to do dollar cost averaging?

There isn’t really a bad time to use a dollar cost averaging strategy, as such, investors interested in implementing one could likely do it at nearly any time.

How often should you do dollar-cost averaging?

When using a dollar cost averaging strategy, investors can choose a cadence that is best suited to their overall financial goals. For some, it may involve weekly investments, while it may involve daily or monthly investments for others.

Where is dollar-cost averaging most commonly done?

Dollar cost averaging is a strategy commonly used in retirement plans, such as 401(k)s, although it can be used in various types of investment accounts.

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Mar

2024

How to Convert a Traditional 401k to a Roth IRA

By Pam O’Brien | Growing Wealth, invest, Investing | Comments Off

When moving on to a new job, it may be difficult to keep track of the 401(k) left behind at your last job.

What’s more, administrative fees on the account that may have been previously covered by your employer might now shift to you—making it more expensive to maintain the 401(k) account once you’ve left the company. This may leave you wondering, can you roll over a 401(k) to a Roth IRA?

You can! In fact, one of the rollover options for a 401(k) is to convert it to a Roth IRA. For some people, especially those at a certain salary level, this may be an attractive option.

Read on to learn more about rolling over a 401(k) to a Roth IRA, and explore the benefits, restrictions, and ways to execute a rollover, so that you can decide if that’s the right financial move for you.

What Happens When You Convert a 401(k) to a Roth IRA?

Converting, or rolling over, your 401(k) to a Roth IRA means taking your money out of one retirement fund and placing it into a new one.

When you convert your 401(k) to a Roth IRA this is known as a Roth IRA conversion. However, because of some important differences between a traditional 401(k) and a Roth IRA, you will owe taxes when you make this kind of rollover.

The reason: A traditional 401(k) is funded with pre-tax dollars. You don’t pay taxes on the money when you contribute it. Instead, you pay taxes on the funds when you withdraw them in retirement. A Roth IRA, on the other hand, is funded with after-tax dollars. You pay taxes on the contributions in the year you make them, and your withdrawals in retirement are generally tax free.

Because with a 401(k) you haven’t yet paid taxes on the money in your account, when you roll it over to a Roth IRA, you’ll owe taxes on the money at that time. The money will be taxed at your ordinary income rate, depending on what tax bracket you’re in. For the 2023 and 2024 tax years, the income tax brackets range from 10% to 37%.

💡 Quick Tip: How much does it cost to set up an IRA? Often there are no fees to open an IRA account, but you typically pay investment costs for the securities in your portfolio.

Steps to Converting a 401(k) to a Roth IRA

These are the actions you’ll need to take to convert your 401(k) retirement plan to a Roth IRA.

1. Open a new Roth IRA account.

There are multiple ways to open an IRA, including through online banks and brokers. Choose the method you prefer.

2. Decide whether you want the rollover to be a direct transfer or indirect transfer.

With a direct transfer, you will fill out paperwork to transfer funds from your old 401(k) account into a Roth IRA. The money will get transferred from one account to another, with no further involvement from you.

With an indirect transfer, you cash out the 401(k) account with the intention of immediately reinvesting it yourself into another retirement fund. To make sure you actually do transfer the money into another retirement account, the government requires your account custodian to withhold a mandatory 20% tax — which you’ll get back in the form of a tax exemption when you file taxes.

The caveat: You will have to make up the 20% out of pocket and deposit the full amount into your new retirement account within 60 days. If you retain any funds from the rollover, they may be subject to an additional 10% penalty for early withdrawal.

3. Contact the company that currently holds your current 401(k) and request a transfer.

Tell them the type of transfer you want to make, direct or indirect. They will then send you the necessary forms to fill out.

4. Keep an eye out to make sure the transfer happens.

You’ll likely get an alert when the money is transferred, but check your new Roth IRA account to see that your funds land there safely. At that point, you can decide how you want to invest the money in your new IRA to start saving for retirement.

Considerations Before Rolling a 401(k) to a Roth IRA

There are a few rules to consider when rolling over 401(k) assets to a Roth IRA.

Roth IRA Contribution Limits

Contribution limits for Roth IRAs and traditional IRAs are much lower than they are for 401(k)s. For tax year 2023, you can contribute up to $6,500 in a Roth or traditional IRA. Those aged 50 and up can contribute up to $7,500, which includes $1,000 of catch-up contributions. For tax year 2024, individuals can contribute up to $7,000 in a Roth IRA, and those 50 and over can contribute up to $8,000.

By comparison, contribution limits for a 401(k) are $22,500 in 2023, and $23,000 in 2024 for those under age 50. Those aged 50 and over can make an additional $7,500 in catch-up contributions to a 401(k) in 2023 and 2024.

Income Limits for Roth IRA Eligibility

Unlike traditional IRAs, which anyone can contribute to, Roth IRAs have an income cap on eligibility. These income limits are adjusted each year to account for inflation. However, when you are rolling a 401(k) to a Roth IRA, the income limits do not apply. So if you are a high earner, a conversion from a 401(k) to a Roth IRA could be a good option for you.

What are those income caps? For tax year 2023, single filers with a modified adjusted gross income (MAGI) below $138,000 can contribute the full amount to a Roth IRA. However, those with a MAGI of $138,000 to $153,000 can only make a partial contribution to a Roth, while those who make more than $153,000 cannot contribute at all.

For individuals married filing jointly for tax year 2023, those with a MAGI of less than $218,000 can contribute the full amount, while those whose MAGI is $218,000 to $228,000 may contribute a partial amount, and those making more than $228,000 can’t contribute to a Roth IRA.

For tax year 2024, single filers with a MAGI below $146,000 can contribute the full amount to a Roth IRA, those with a MAGI between $146,000 and $161,000 can make a partial contribution, and those making more than $161,000 can’t contribute.

For individuals married filing jointly for tax year 2024, those with a MAGI under $230,000 can contribute the full amount, those whose MAGI is $230,000 to $240,000 can contribute a partial amount, and those making more than $240,000 can’t contribute to a Roth IRA.

As you can see, for high earners, the fact that these income limits do not apply to a 401(k) to Roth conversion, could be a potential reason to consider this type of rollover.

Rollover Amount Will be Taxed

You will have to pay taxes on your IRA rollover. Since your 401(k) account was funded with pre-tax dollars and a Roth IRA is funded with post-tax dollars, you’ll need to pay income tax on the 401(k) amount being rolled over in the same tax year in which your rollover takes place.

A Roth IRA is Subject to the Five-Year Rule

Once you transfer money into your new Roth IRA, it pays to keep it there for a while. If you withdraw any earnings that have been in the account for less than five years, you will likely be required to pay income tax and an additional 10% penalty. This is known as the five-year rule. After five years, any earnings withdrawn through a non-qualified distribution is subject to income tax only, with no penalties.

Penalties for Early Withdrawals

In addition to the five-year rule, non-qualified distributions or withdrawals from a Roth IRA — meaning those made before you reach age 59 ½ — can result in penalties and taxes. While there are certain exceptions that may apply, including having a permanent disability or using the funds to buy or build a first home, it’s wise to think twice and research any potential consequences before withdrawing money early from a Roth IRA.

💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

Should You Convert Your 401(k) to a Roth IRA ?

Converting a 401(k) to a Roth IRA may be beneficial if you anticipate being in a higher tax bracket when you retire since withdrawals from the account in retirement are tax-free. And if you are a high earner, a 401(k) rollover to a Roth IRA may give you the opportunity to participate in a Roth IRA that you otherwise wouldn’t have.

Another advantage of a Roth IRA is that you can withdraw the money you contributed (but not the earnings) at any time without paying taxes or penalties. And unlike 401(k)s, there are no required minimum distributions (RMDs) with a Roth IRA. Finally, IRAs generally offer more investment options than many 401(k) plans do.

Can You Reduce the Tax Impact?

There are some potential ways to reduce the tax impact of converting a 401(k) to a Roth IRA. For instance, rather than making one big conversion, you could consider making smaller conversion amounts each year, which may help reduce your tax bill.

Another way to possibly lower the tax impact is if you have post-tax money in your 401(k). This might be the case if you contributed more than the maximum deductible amount allowed to your 401(k), for instance. You may be able to avoid paying taxes currently by rolling over the after-tax funds in your 401(k) to a Roth IRA, and the rest of the pre-tax money in the 401(k) to a traditional IRA.

In general it’s wise to consult a tax professional to see what the best strategy is for you and your specific situation.

The Takeaway

One way to handle a 401(k) account from a previous employer is by rolling it over into a Roth IRA. For some individuals, it might be the only way to take advantage of a Roth IRA, which typically has an income limit. With a Roth IRA, account holders can contribute post-tax dollars now, and enjoy tax-free withdrawals in retirement.

Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

Easily manage your retirement savings with a SoFi IRA.

FAQ

Can I roll over my 401(k) to an existing Roth IRA?

Yes, you can roll over a 401(k) to an existing Roth IRA — or to a new Roth IRA.

Can I roll my 401(k) into a Roth IRA without penalty?

You can roll over 401(k) to a Roth IRA without penalty as long as you follow the 60-day rule if you’re doing an indirect rollover. You must deposit the funds into a Roth IRA within 60 days to avoid a penalty.

How much does it cost to roll over 401k to Roth IRA?

Typically there is no charge to roll over a 401(k) to a Roth IRA, unless you are charged processing fees by the custodian of your old 401(k) plan or the new Roth IRA. However, you will owe taxes on the money you roll over from a 401(k) to a Roth IRA. The money will be taxed at your ordinary income tax rate.

Is there a time limit when rolling over a 401(k) to a Roth IRA?

If you do an indirect rollover, in which you cash out the money from your 401(k), you have 60 days to deposit the funds into a Roth IRA in order to avoid being charged a penalty.

Is there a limit on rollover amounts to a Roth IRA?

No, there is no limit to the amount you can roll over to a Roth IRA. The standard annual contribution limits to a Roth IRA do not apply to a rollover.

How do you report a 401(k) rollover to a Roth IRA?

You will need to report a 401(k) rollover on your taxes. Your 401(k) plan administrator will send you a form 1099-R with the distribution amount. You typically report the distribution amount on IRS form 1040 when filing your taxes. You can consult a tax professional with any questions you might have.

Can you roll over partial 401(k) funds to Roth IRA?

You can typically roll over partial 401(k) funds as long as your plan allows it. Check with your plan’s administrator.

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Mar

2024

What Is a Put Option? How They Work and How to Trade Them

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

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

What Is a Put Option?

In options trading, a put option is the purchase of a contract that gives an investor the right, but not the obligation, to sell a specific security at a certain price by a certain date. Put options are different from call options, the purchase of which gives buyers the right, but not the obligation, to buy a particular security at a certain price by a certain date.

Investors can use put options to trade a variety of securities, including stocks, bonds, futures and commodities. Trading options can potentially lead to greater returns, but it can also amplify losses, making it a potentially riskier strategy.

Understanding certain options terminology — including what a put option is and how it works — can be helpful if you’re thinking about incorporating options trading strategies into your portfolio.

Options Basics

Before digging into the details of put options, it’s helpful to understand a little about how options trading works in general. An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying security at a certain price — this is called the strike price. Options must also be exercised by a specific expiration date.

An investor who buys an options contract pays a premium to do so, which can be determined by the volatility of the underlying asset and the option’s expiration date. If the option holder does not exercise the option by the expiration date, they lose their right to buy or sell the underlying security and the option has no value.

Options are derivative investments, since they derive their value from the underlying assets. They can be bought and sold on an exchange, just like the underlying assets they’re associated with.

Finally, user-friendly options trading is here.*

Trade options with SoFi Invest on an easy-to-use, intuitively designed online platform.

*Check out the OCC Options Disclosure Document.

How Does a Put Option Work?

A put option is a specific type of options contract. Here’s an example: The buyer of the put option has the right, but not the obligation, to sell shares of an underlying asset at the agreed-upon strike price up until the option’s expiration date. Meanwhile, the seller of the put option has an obligation to buy those shares from the buyer if the buyer chooses to exercise the put option.

Put options increase in value as the price of the underlying security decreases. Likewise, put options lose value as the price of the underlying stock increases. Depending on where the underlying asset’s price is in relation to a put option’s strike price, the option can be one of the following:

• In the money: An in-the-money put option has a strike price that’s higher than the underlying asset’s price.

• At the money: An at-the-money (or on-the-money) put option has a strike price that’s equal to the underlying asset’s price.

• Out of the money: An out-of-the-money put option has a strike price that’s below the underlying asset’s price.

Of the three, the in-the-money put option is more desirable because it means a put option has intrinsic value. If you’re the buyer of a put option and that option is in the money, it means you can sell the underlying asset for more than what it’s valued at by the market.

Put Option Example

An example might make things even more clear.

Assume you own shares of XYZ stock. The stock is currently trading at $50 a share but you believe its price will dip to $40 per share in the near future.
You purchase a put option which would allow you to sell the stock at its current price of $50 per share. The options contract conveys the right to sell 100 shares of the stock, with a premium of $1 per share.

If your hunch about the stock’s price pays off and the price drops to $40 per share, you could exercise the option. This would allow you to sell each of the 100 shares in the contract for $10 more than what it’s worth, resulting in a gross profit of $1,000. When you factor in the $1 per share premium, your net profit ends up being $900, less any commission fees paid to your brokerage.

Difference Between Put and Call Option

It’s important to understand the difference between put and call options in trading. A call option is an options contract that gives the buyer the right, but not the obligation, to purchase shares of an underlying asset at the strike price by the expiration date. The seller of the call option is obligated to sell those shares to the call option buyer, should they decide to exercise the option.

Like put options, call options can also be in the money, at the money, or out of the money. An in-the-money call option has a strike price that’s below the underlying asset’s actual price. An out-of-the-money call option has a strike price that’s above the underlying asset’s actual price.

Here’s a simple way to think of the differences between put options and call options: With buying put options, the goal is to sell an underlying asset for more than its market value. With buying call options, the goal is to buy an underlying asset for less than what it’s worth.

Pros and Cons of Trading Put Options

Options trading may appeal to a certain type of investor who’s comfortable moving beyond stock and bond trading. Like any other investment, put options can have both advantages and disadvantages. Weighing them both in the balance can help you decide if options trading is something you should consider pursuing.

Pros	Cons
• Low initial investment required compared to trading stocks. • The option buyer has the right but no obligation to sell the underlying asset. • Higher return potential, on a percentage basis.	• Losses may be amplified. • The option seller has the obligation to buy the underlying asset at the strike price if the buyer decides to execute the contract, which could result in greater downside for the seller. • Unforeseen volatility may drastically affect price movements.

Pros

Cons

• Low initial investment required compared to trading stocks.

• The option buyer has the right but no obligation to sell the underlying asset.

• Higher return potential, on a percentage basis.

• Losses may be amplified.

• The option seller has the obligation to buy the underlying asset at the strike price if the buyer decides to execute the contract, which could result in greater downside for the seller.

• Unforeseen volatility may drastically affect price movements.

Pros of Trading Put Options

• Lower investment. When you purchase a put option, you’re paying a premium and your brokerage’s commission fees. When you purchase shares of stock, you may be investing hundreds or even thousands of dollars at a time. Between the two, put options may be more attractive if you don’t want to tie up a lot of cash in the markets.

Also, buying a put option gives you the right to sell a particular asset at a set strike price but you’re not required to do so. You can always choose to let the option expire; you’d just be out the premium and commission fees you paid.

• Return potential. Trading put options can be lucrative if you’re able to sell assets at a strike price that’s well above their actual price. That might result in a higher profit margin than if you were trading the underlying asset itself.

Cons of Trading Put Options

• Loss amplification. While trading put options can potentially lead to better returns, it can also potentially amplify your losses. If you’re selling put options, you’re obligated to sell the underlying asset at the strike price, even if that strike price is not in your favor.

• Volatility. Volatility can threaten returns with put options if an asset’s price doesn’t move the way you were expecting it to. So it’s possible you might walk away with lower gains than anticipated if you choose to exercise a put option during a period of heightened volatility.

How Do You Trade Put Options?

It’s possible to trade put options inside an online brokerage account that allows for options trading (not all of them do). When deciding which put options contracts to buy, it’s important to consider:

• Where the underlying asset is trading currently

• Which way you think the asset’s price is most likely to move

• How much of a premium you’re willing to pay to purchase an options contract

It’s also important to consider the expiration date for a put option. Keep in mind that options with a longer expiration period may come with a higher premium.

Different Put Option Styles

There’s a difference between European-style and American-style put options.

With European-style options, you can only exercise the option on its expiration date.

With American-style put options you can exercise the option at any time between the date you purchased it and its expiration date, offering more flexibility for the investor.

Put Option Trading Strategies

Different options trading strategies can be used with put options. These strategies vary in terms of reward potential and risk exposure. As you get more familiar with how to trade stock puts, you might begin exploring more advantaged techniques. Here are some of the most common put option plays.

Long Put

A long put strategy involves purchasing a put option with the expectation that the underlying asset’s price will fall. For example, you might want to buy 100 shares of XYZ stock which is trading at $100 per share, which you believe will drop to $90 per share. If the stock’s price drops to $90 or below, you could exercise your contract at the higher $100 per share price point.

Short Put

A short put is the opposite of a long put. In a short put strategy, you’re writing or selling the put option with the expectation that the underlying security’s price will rise or remain above the strike price until it expires. The payoff comes from being able to collect the premium on the option even if the buyer doesn’t exercise it.

Recommended: How to Sell Options for Premium

Married Put

A married put strategy involves holding a long position in an underlying security while also purchasing an at-the-money option for the same security. The idea here is to minimize downside risk by holding both the asset itself and an at-the-money put option.

Long Straddle

A long straddle strategy involves buying both a call option and a put option for the same security, with the same strike price and expiration date. By straddling both sides, you can still end up turning a profit regardless of which the underlying asset’s price moves.

The Takeaway

Options trading may be right for retail investors who are comfortable taking more risk in exchange for a chance to potentially earn higher returns. Getting familiar with put options and how a stock put works is the first step.

Qualified investors who are ready to try their hand at options trading, despite the risks involved, might consider checking out SoFi’s options trading platform. The platform’s user-friendly design allows investors to trade through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.

Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors.

Trade options with low fees through SoFi.

Photo credit: iStock/Drazen_

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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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