Mar
22
2023
How to Value a Stock
Here are a few of the most common stock valuation metrics, including financial ratios, SEC filings, and other ways to learn how to value a stock before you buy.
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SoFi
Student Loan Consolidation and Refinancing
Mar
22
2023
Federal Reserve Interest Rates, Explained
If you pay attention to the news, you have probably noticed that the Federal Reserve (or Fed, for short) makes headlines every so often. The Fed has recently been in the spotlight because it has been making policy moves to combat rising prices. In the face of the highest inflation rate in 40 years, the Fed has raised interest rates – otherwise known as the federal funds rate – swiftly and for the ninth time, to between 4.75% and 5.00% as of March 2023.
There’s a connection between the Fed’s interest rate decisions, the national economy, and your personal finances. The Fed works to help balance the economy over time—and its actions and influence on monetary policy can affect household finances. Here’s what consumers should know about the Federal Reserve interest rate and how it trickles down to the level of individual wallets.
What Is the Federal Funds Rate?
The federal funds rate, or federal interest rate, is a target interest rate assessed on the bank-to-bank level. It’s the rate at which banks charge each other for loans borrowed or lent overnight.
The federal funds rate is not directly connected to consumer interest rates, like those that might be paid on a personal loan or mortgage. But it can significantly influence those interest rates and, over time, can impact how businesses and individuals access lines of credit.
How Is the Federal Funds Rate Set?
The Federal Open Market Committee (FOMC) sets the federal funds rate. The FOMC is a 12-member group made up of seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis.
The FOMC meets a minimum of eight times per year—though the committee will meet more often than that if deemed necessary. The group decides the Fed’s interest rate policy based on key economic indicators that may show signs of inflation, rising unemployment, recession, or other issues that may impact economic growth.
The FOMC often slashes rates in response to market turmoil as an attempt to boost the economy. Lower rates may make it easier for businesses and individuals to take out loans, thus stimulating the economy through more spending. The Federal Reserve enacted a zero-interest rate policy in 2008 and maintained it for seven years to boost the economy following the Great Recession.
On the other hand, the FOMC may raise interest rates when the economy is strong to prevent an overheated economy and keep inflation in check. Higher interest rates make borrowing more expensive, disincentivizing businesses and households from taking out loans for consumption and investment. Because of this, higher interest rates theoretically will cool the economy.
Current Federal Funds Rate
As noted above, the current federal funds rate is between 4.75% and 5.00% as of March 2023. The FOMC raised interest rates rapidly throughout 2022 in an effort to bring down inflation, which was at the country’s highest levels since the 1980s.
The federal funds rate is a recommended target—banks can ultimately negotiate their own rate when borrowing and lending from one another. Over the years, federal fund targets have varied widely depending on the economic outlook. The federal funds rate was as high as 20% in the early 1980s due to inflation and as low as 0.0% to 0.25% in the post-Covid-19 environment when the Fed used its monetary policy to stimulate the economy.
How Does the Fed Influence the Economy?
The Federal Reserve System is the U.S. central bank. The Fed is the primary regulator of the U.S. financial system and is made up of a dozen regional banks, each of which is localized to a specific geographical region in the country.
The Fed has a wide range of financial duties and powers to take measures to ensure systemic financial and economic stability. These duties include:
• Maintaining widespread financial stability, in part by setting interest rates
• Supervising and regulating smaller banks
• Conducting and implementing national monetary policy
• Providing financial services like operating the national payments system
The Fed has authority over other U.S. banking institutions and can regulate them in order to protect consumers’ financial rights. But perhaps its most famous job is setting its interest rate, otherwise known as the federal funds rate.
💡 Recommended: How Do Federal Reserve Banks Get Funded?
How Does the Federal Funds Rate Affect Interest Rates?
Although the federal funds rate doesn’t directly influence the interest levels for loans taken out by consumers, it can change the dynamics of the economy as a whole through a kind of trickle-down effect.
The Fed’s rate changes impact a broad swath of financial areas—from credit cards to mortgages, from savings rates to life insurance policies. The Fed’s rate change can affect individual consumers in various ways.
The Prime Rate
A change to the federal funds rate can influence the prime interest rate (also known as the Bank Prime Loan Rate). The prime interest rate is the rate banks offer their most creditworthy customers when they’re looking to take out a line of credit or a loan.
While each bank is responsible for setting its own prime interest rate, many banks choose to set theirs mainly based on the federal funds rate.
Generally, the rate is set approximately three percentage points higher than the federal funds rate—so, for example, if the rate is at 5.00%, a bank’s prime interest rate might be 8.00%.
Even for consumers who don’t have excellent credit, the prime interest rate is important; it’s the baseline from which all of a bank’s loan tiers are calculated.
That applies to a wide range of financial products, including mortgages, credit cards, automobile loans, and personal loans. It can also affect existing lines of credit that have variable interest rates.
Savings Accounts and Certificates of Deposit
Interest rates bend both ways. Although a federal rate hike may mean a consumer sees higher interest rates when borrowing, it also means the interest rates earned through savings, certificates of deposit (CDs), and other interest-bearing accounts will increase.
In many cases, this increase in interest earnings influences consumers to save more, which can help as an incentive to build and maintain an emergency fund that one can access immediately, if necessary.
How Does the Federal Funds Rate Affect the Stock Market?
While the federal funds rate has no direct impact on the stock market, it can have the same kind of indirect, ripple effect that is felt in other areas of the U.S. financial system.
Generally, lower rates make the market more attractive to investors looking to maximize growth. Because investors cannot get an attractive rate in a savings account or with lower-risk bonds, they will put money into higher-risk assets like growth stocks to get an ideal return. Plus, cheaper or more available money can translate to more spending and higher company earnings, resulting in rising stock performance.
On the other hand, higher interest rates tend to dampen the stock market since investors usually prefer to invest in lower-risk assets like bonds that may offer an attractive yield in a high-interest rate environment.
💡 Recommended: How Do Interest Rates Impact Stocks?
What Other Factors Affect Consumer Interest Rates?
Although the Federal Reserve interest rate can impact personal finance basics in various ways, it may take up to 12 months to feel the full effect of a change.
On a consumer level, financial institutions use complex algorithms to calculate interest rates for credit cards and other loans. These algorithms consider everything from personal creditworthiness to loan convertibility to the prime interest rate to determine an individual’s interest rate.
The Takeaway
The federal funds rate — or federal interest rate — set by the Federal Reserve is intended to guide bank-to-bank loans but ends up impacting various parts of the national economy—down to individuals’ personal finances. For investors, changes in the federal funds rate can indicate where the stock market may be headed. At least, it’s a factor that investors may watch.
If you’re paying attention to the Federal Reserve interest rate policy changes and want to make investing decisions based on those moves, SoFi can help. With a SoFi Invest® online brokerage account, you can trade stocks, exchange-traded funds (ETFs), and cryptocurrency with no commissions for as little as $5.
SoFi Invest®
The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
Investment decisions should be based on an individual’s specific financial needs, goals, and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.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. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A.
Claw Promotion: Customer must fund their Active Invest account with at least $10 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.
SOIN1122034
Read moreMar
21
2023
What Is a Swaption? Guide to Understanding Swap Options
A swaption, also known as a swap option, is an option contract that grants the owner the right but not the obligation to enter into a swap contract with specified terms. The swap contracts tend to be interest rate swaps, but can be other types of swaps as well.
With swaptions, one party can exchange a currency of the same value, an interest rate, or the liability of repaying a loan. Read on for how they work, the different types, pros and cons, and more.
How Swaptions Work
As mentioned above, a swaption is an option on a swap rate. Like other types of options contracts, the buyer pays a premium to enter into the swaption, and beyond that they are not obligated to act on the contract.
Although Swaptions are a type of option, they are more similar to a swap than to an option. Similarities to swaps include:
• They are traded over-the-counter instead of on centralized exchanges.
• They are customizable and offer a lot of flexibility since they are not standardized exchange products.
When two parties want to enter into a swap option agreement, they decide on the terms of the contract, such as the the premium, the expiration date, the notional amount, the swap’s legs (fixed vs. float), the benchmark for the floating leg, and the frequency of adjustment for the variable leg.
Recommended: Options Trading 101 Guide
Who Often Uses Swaptions
Swaptions are typically used by institutional investors instead of retail investors, although some private banks offer them to their clients. Large corporations, investment banks, commercial banks, and hedge funds use them for various purposes. It takes a lot of work and experience to create a portfolio of swaptions, so they generally aren’t used by individuals or small firms.
They are often used to hedge against macroeconomic risks such as interest rate risk or securities risks. If an institution thinks interest rates might change, they can enter into an agreement to protect against that. Financial institutions can also use them to change their interest payoff terms.
They tend to be used to hedge specific financings, but they can also be used to hedge a broader change in future interest rates. This can be useful if an institution holds a lot of debt maturities for the year and doesn’t want to risk losses.
The way swaptions are generally set up, their strikes are a strike above the current 10 year swap rate. Therefore the borrower takes on risk between the current rate and the higher rate, but not more than that.
Swaptions can be purchased in most major currencies, such as the U.S. Dollar, Euro, and British Pound.
Recommended: Popular Options Trading Terminology to Know
What Are the Different Types of Swaptions?
There are different types of swap options that each have different types of ‘legs’ in the predetermined swap contract they represent. The two types of options are payer and receiver.
Payer Swaption
If a buyer enters into a payer swaption, they are purchasing the right but not the obligation to enter into a future swap contract. When exercised, the buyer would become the fixed-rate (non-changing) payer and receive the floating rate (variable) payments.
Fixed interest rates don’t change with the market, they stay the same through the duration of a loan. Floating rates change based on a reference rate, the most common one being LIBOR. LIBOR is an average of interest rates that are collected from some of the top banks in London.
Receiver Swaption
In a receiver swaption contract, the swap holder has the option to pay the floating rate and receive the fixed rate.
When Can a Swaption Be Exercised?
There are also swaptions that have different terms of execution. The three most common are:
American
American swaptions can be exercised on any date prior to and including the expiration date.
European
European options can only be exercised on the expiration date, making them less flexible.
Bermudan
Bermudan swaptions have several specific dates when they can be exercised prior to the expiration date.
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.
Swaption Example
A borrower wants to purchase rate protection on their current floating rate debt maturities totalling $50 million. They decide that they would like to purchase the right, but not the obligation, to pay a fixed rate on their debts for ten years.
For this right, they are willing to take on the risk of 10 year interest rates up to 3.8%, but no higher than that.
The borrower enters into an agreement with a settlement date in the current year, for a notional amount of $50 million, with a 10 year term and a strike of 3.8%. The premium they must pay to enter in this contract is $400,000.
Including the premium, the rate is actually hedged higher than 3.8%, but for the sake of this example we will call the strike 3.8%.
If the strike is lower or the settlement date is farther in the future, this increases the value of the swaption and therefore increases the cost of the premium.
The borrower enters into this agreement to hedge against a large increase in swap rates but without choosing a specific rate they want when the contract expires.
It’s important to note that the swaption isn’t tied to the 10 year Treasury, it’s tied to 10 year swap rates, although their movements tend to be related. Also, swaptions are derivatives, so they aren’t the underlying assets themselves, but contracts derived from rates or assets.
When the settlement date occurs, there are two ways the swaption could turn out.
- If 10 year swap rates are below 3.8%, the option contract expires, the lender keeps the premium and the borrower uses the current swap rate.
- If 10 year swap rates are higher than 3.8%, the borrower exercises the option. In this case the provider of the swaption pays the borrower the difference between the swap rate and 3.8%. The borrower locks in the current swap rate for a swap agreement, and uses the payment they received to buy down the rate on this new swap.
Pros and Cons of Swaptions
There are a few reasons why financial institutions use swaptions, but there can be downsides to them as well. Some of the pros and cons of swap options are:
| Pros | Cons |
|---|---|
| Can be used to hedge against risk when there is a possibility that an interest rate will go up. | Swaptions can have longer durations than other types of options. |
| If the swaption is not exercised, the buyer loses the premium amount they put in. | There is a risk of the other party defaulting on the agreement. |
The Takeaway
Entering into swaption agreements is one type of options trading strategy commonly used by institutional investors. They are usually used to help with restructuring a current financial position, alter a portfolio, hedge options positions on bonds, or adjust payoff profiles.
There are other types of options on the market that retail investors often trade.
If you’re ready to try your hand at options trading, You can set up an online options trading account and trade from the SoFi mobile app or through the web platform.
And if you have any questions, SoFi offers educational resources about options to learn more. SoFi doesn’t charge commissions, and members have access to complimentary financial advice from a professional.
SoFi Invest®
The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
Investment decisions should be based on an individual’s specific financial needs, goals, and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.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. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A.
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.
SOIN0821366
Mar
21
2023
What Are Asian Options and How Are They Priced?
Asian options (also known as average strike options or average options) are a type of exotic option that is priced according to the average price of the underlying commodity, as opposed to the spot price.
Read on for how they’re priced, how they work, pros and cons, and more.
What Is an Asian Option?
Asian options are a type of exotic option that trade differently than standard American or European options.
American and European options allow the holder to exercise an option at a strike price known on the purchase date. They differ in when the option can be exercised.
American options can be exercised at any time up to and including the expiration date. European options can only be exercised on the expiration date.
Asian options, on the other hand, are priced based on the average price of the asset over a period of time and like European options they are exercised on the expiration date.
The various parameters of an Asian option are negotiable, but there are two different types of Asian options, average strike options and average price options.
Average strike options are sold with an unknown strike price. The strike price will be determined based on the average price of the underlying asset at selected time intervals.
Average price options are sold at a known strike price. The exercise price will be determined based on the average price of the underlying asset at selected time intervals.
In addition, both types of Asian options may be priced according to arithmetic or geometric averages.
Who Buys Asian Options?
Asian options are usually purchased to solve a particular business problem:
- A buyer wants to lock in an average price or exchange rate over a period of time.
- A buyer wants to protect against price manipulation in the market.
- A buyer wants to protect against volatility in the price movement of the underlying asset.
- A buyer wants to mitigate against inefficient pricing due to an asset being thinly traded.
How Asian Options Work
Like standard options, the price of a call or put in Asian options depends on the price of the underlying asset when the option expires. But unlike standard options, the price of an Asian option will depend on the average price of the underlying over a specified period of time.
Different kinds of Asian options will define average in different ways, so make sure that you check the details of the contract before investing. It’s common for Asian options to define average either as an arithmetic or geometric mean over a period of time.
One example might be for an Asian option to be priced as the arithmetic mean of the underlying stock’s price as measured every 30 days.
Maximum Payoff
Like standard options, the maximum payoff for an Asian option will depend on whether it is a call or put option. Even though the prices in an Asian option are determined by the average price instead of the spot price, the maximum payoff for Asian options works in the same way.
For a call option, the maximum payoff is unlimited, since there is no limit on how high the stock’s price can go.
For the purchase of a put option, the maximum payoff will be if the stock’s price goes to zero.
Maximum Loss
Losses on Asian options are limited to the premiums paid at initiation of the trade. Because of average pricing and lowering the volatility of large price swings, the purchase premiums are also typically lower than available with regular options.
Breakeven
The breakeven price of an Asian option depends on the strike price of the option and the amount of premium that you paid for the option originally. If you paid $1.50 for a call option with a strike price of $50. Your breakeven price in this scenario will be $51.50 (the strike price of 50 plus the $1.50 in premium paid originally).
If the stock’s average price when the option expires is above $51.50, you will earn a profit on the option investment.
It’s more complicated to know in advance what the breakeven will be on an Average strike option but the calculation is the same.
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.
Pros and Cons of Asian Options
Here are some of the pros and cons of trading with Asian options:
| Pros | Cons |
|---|---|
| Less volatility than standard options due to the averaging of the price | Not supported by all brokers |
| Generally less expensive than standard options due to lower volatility | Lower liquidity than standard options |
| Useful for traders who have exposure to the underlying asset over time, like suppliers of commodities | More complicated to price than standard options |
Asian Option Pricing
Because Asian options are priced based on an average price instead of the closing price on the date of expiration, they experience lower volatility. This makes intuitive sense, since averaging several price values over time will tend to dampen out extreme values. Because volatility is a key measure of the price of an option, the lower volatility of Asian options generally means lower prices for options.
How Asian Option Pricing Works
The pricing of Asian options is calculated using an average value. Different types of Asian options calculate the average in different ways, and it’s important to understand how the average will be calculated before you purchase the contract. The two most common ways that an average is calculated with Asian options are the arithmetic mean and the geometric mean.
Asian Options Pricing Example – Average Price Option
On March 1, you buy a 90-day call option for stock XYZ with a strike price of $50. This option costs you $1.25 and the average price is defined as the arithmetic mean of the underlying asset price taken every 30 days.
XYZ has a price of $51.00, $48.50 and $52.00 at the 30, 60 and 90 day mark. The arithmetic mean of those 3 prices is ($51 + $48.50 + $52) / 3, or $50.50. Since the option has a strike price of $50, the option closes with a value of $0.50 (calculated price at expiration less spot price, $50.50 – $50).
Because you purchased the option for $1.25 originally, in this scenario you would take a loss on the position.
As with standard options, if the average price of the underlying asset is below the strike price (for a call option), the option expires worthless.
Asian Options Pricing Example – Average Strike Price Option
On March 1, you buy a 90-day call option for stock XYZ. This option costs you $1.25 and the average strike price is defined as the arithmetic mean of the underlying asset price taken every 30 days.
XYZ has a price of $51.00, $48.50 and $52.00 at the 30, 60 and 90 day mark. The arithmetic mean of those 3 prices is ($51 + $48.50 + $52) / 3, or $50.50. Therefore, at expiration the strike price will be $50.50. The option closes with a value of $1.50 (price at expiration less calculated spot price, $52 – $50.50).
Because you purchased the option for $1.25 originally, in this scenario you would have a gain on the position.
The Takeaway
Unlike standard options that are valued based on the spot price of the underlying asset when the option expires, Asian options are valued based on an average price taken in discrete time periods before expiration.
Because the value of an Asian option is based on an average of prices, there is less volatility in the prices. Lower volatility leads to generally cheaper prices than standard options.
If you’re ready to try your hand at online stock options trading, You can set up an Active Invest account and trade options from the SoFi mobile app or through the web platform.
And if you have any questions, SoFi offers educational resources about options to learn more. SoFi doesn’t charge commissions, and members have access to complimentary financial advice from a professional.
FAQ
Are Asian options cheaper?
Asian options are usually (but not always) cheaper than standard American or European options. This is because Asian options are priced using an average price rather than the spot price of the underlying commodity on the date of expiration. Because an average price is used, this makes Asian options less volatile, and consequently, generally cheaper.
How are Asian options priced?
Rather than using the spot price of the underlying stock or commodity on the date of the option’s expiration, Asian options are priced using an average price over the preceding period of time. While there are different methods for calculating the average price, it’s usually calculated as either the arithmetic or geometric mean of the underlying stock or commodity.
Why can’t Black-Scholes models value Asian options?
The Black-Scholes pricing model is one of the most common ways to price standard American or European options. To price options, the Black-Scholes method makes a variety of assumptions about the price of the underlying stock. One assumption required by Black-Scholes is that the stock’s price will move following something called Brownian motion. Because arithmetically-priced Asian options do not follow Brownian Motion, the standard Black-Scholes pricing model does not apply.
Photo credit: iStock/Boris Jovanovic
SoFi Invest®
The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
Investment decisions should be based on an individual’s specific financial needs, goals, and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.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. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A.
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.
SOIN0422028
Mar
20
2023
A Guide to Tech IPOs
Tech IPOs involve a technology company going public, and making its stock available for purchase on the open market by any interested investor. Given the tech sector’s incredible growth over the past couple of decades, tech IPOs tend to garner a lot of attention from investors, who may feel that they’re investing in the next big thing.
But the IPO process isn’t simple or easy for firms to navigate, and for investors, buying shares of newly public companies can carry significant risk. As such, there are many things to consider and know about tech IPOs before stocking up on shares.
What Are Tech IPOs?
A technology initial public offering or IPO marks the debut of a company’s shares on the stock market. Issuing an initial public offering is a multi-step process that involves venture capitalists, investment bankers, regulators and stock exchanges.
Tech IPOs tend to garner excitement from investors of all stripes, but while newly public tech stocks are often believed to offer rapid growth potential, not all live up to expectations.
For that reason, investors may benefit from revisiting some best practices or tips for investing in tech companies before putting their money on the line.
The Appeal of Tech IPOs
Large tech companies have largely dominated gains in the U.S. stock market for several years. Investors have flocked to shares of the so-called FAANG stocks — Facebook, Apple, Amazon.com, Netflix and Google — as soaring prices of those companies left many investors looking for the next big thing out of Silicon Valley, Seattle, Austin, and other tech-dominated cities.
IPOs had traditionally been an important step for burgeoning tech companies and signaled a level of corporate maturation to the market. Going public means companies will be exposed to a broader array of investors, greater regulatory requirements, and increased trading of its company shares.
But in recent years, some tech companies have shunned the traditional IPO model, either by staying private for longer periods of time, or seeking alternative routes to going public, like direct listings, or by merging with special purpose acquisition vehicles (SPACs).
How Tech IPOs Work
A company may pursue an IPO in order to raise funds or obtain more liquidity for its shares. IPOs can also be an exit strategy for early stakeholders like corporate insiders, angel investors, and venture capitalists. And lastly, a small startup may think listing its shares will potentially increase its brand recognition and prestige. Public companies tend to have more shareholders than private ones.
When a tech company is ready to go public, it typically starts the IPO process by hiring investment bankers. The process by which investment bankers handle an IPO is called underwriting.
The investment bank will buy the shares from the company before trying to transfer them to the public market. One bank typically leads the IPO process, but a handful of banks are typically involved, typically as means of diluting risk.
Underwriters then typically hold roadshows — events in which they pitch institutional investors on the IPO. The idea is to build up hype and demand for the new stock, increasing its value.
Institutional investors include hedge funds, mutual funds, and pensions. If these investors want to buy the IPO shares, underwriters can allocate them a proportion of the shares that will be listed. This all occurs before the stock debuts on the public markets, where retail investors can purchase shares.
IPO Regulatory Requirements
Going public also means that companies become subject to regulations by the U.S. Securities and Exchange Commission (SEC) . Under those regulations, companies will be required to make quarterly and annual filings and disclose material events to the public, among other things.
If a company gets SEC approval to go public, the underwriter files an S-1 and puts together a prospectus. The prospectus includes financial data and describes what the proceeds will be used for, as well as potential risks to investors.
Listing Tech IPOs
Tech companies also need to choose their listing exchange. This isn’t the only market where investors can trade the company’s shares but a significant proportion of volume will be done on the listing venue. The two biggest markets for IPOs in recent years have been the New York Stock Exchange (NYSE) or Nasdaq, though there are many types of exchanges.
Nasdaq has attracted many large tech companies in its history, such as Apple, Amazon.com, Facebook, Google and Microsoft. But the NYSE has likewise drawn some big tech IPOs. The listing fees that companies pay for NYSE are more expensive than for Nasdaq, but only stocks listed on the Nasdaq qualify to enter the Nasdaq 100 Index, which is the basis for the popular Invesco QQQ exchange-traded fund.
The day of the IPO, the shares are listed on the exchange and trading commences. At Nasdaq, the process of price discovery is all done electronically, while at NYSE, floor traders also play a role. Underwriters typically underprice shares in order for them to have a strong performance, or “pop” on the first day. This basically means that they hope shares will gain significant value on the first day they’re listed for trading.
Recommended: What Determines a Stock’s IPO Valuation?
Many stocks, after an IPO, are subject to lock-up periods. This is a period of time after the public offering in which early investors aren’t allowed to sell their shares. Lock-up periods are designed to keep share prices stable post-IPO.
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Staying Private
In recent years, many tech companies have stayed private for relatively longer periods of time before going public, finding more avenues for funding as the venture capital world has expanded.
One reason: Going public is an expensive, often onerous process. Investment bank fees can take up 4% to 7% of an IPO’s proceeds alone. As such, many firms are incubating longer before IPOing. Between 1980 and 2021, the median age of tech companies going public was eight years. But for three of the last four years, the median age was 12.
This has led to the proliferation in Silicon Valley of so-called unicorn companies — privately held companies valued at greater than $1 billion.
New IPO Routes for Tech Companies
The IPO market experienced something of a resurgence in 2020 as the stock market reached new peaks. The tides turned in 2022, however, as the number of IPOs fell considerably, largely due to rising interest rates, inflation, and shaky economic sentiment.
For tech companies that have decided to go public in recent years, though, many have taken to experimenting with alternatives to the traditional IPO.
SPACs, or special purpose acquisition vehicles (or special purpose acquisition companies), have proven to be one effective method for some companies. Also known as blank-check companies, SPACs use the IPO process to raise money and then look for companies to merge with. They often have a two-year time horizon to find an acquisition.
For many startup companies, merging with a SPAC can offer a faster way to go public versus the drawn-out process of an IPO.
Some companies also opt for direct listings. In a direct listing, companies forgo the step of hiring an investment bank as an underwriter. In such listings, banks may still play a smaller advisory role, but companies instead rely on the auction by the stock exchange to set their IPO price.
No additional capital is raised in direct listings, meaning they’re typically done by cash-rich companies that are already widely recognized by the market and public.
Pros of Tech IPOs
All things considered, tech IPOs do offer investors a number of potential advantages.
Initial Momentum
If you’re able to invest early in a hot tech IPO, you may be able to ride an initial wave of enthusiasm to some serious gains. Those gains may be short-lived, however, and there’s always the risk that enthusiasm among investors never materializes in any significant way.
A Growing Sector
Long-term prospects for the tech sector are mostly positive. Tech has been a growth industry for many years, but there are many other areas in which tech companies are expanding: machine learning, artificial intelligence (AI), bio- and pharmatechnology, and many more, for example. This could prove to be a boon for long-term investors.
Further Income
It’ll depend on the specific stock, but investors may be able to take advantage of extra income opportunities from their holdings, such as dividend payments. Usually, more mature stocks tend to pay dividends, but if you hold on long enough, IPO shares could become revenue-generating holdings.
Cons of Tech IPOs
Tech companies have their downsides; they face stiff competition from other innovators and disruptors. So investing in a tech IPO includes certain risks.
Sector Risk
Tech is still growing, but it’s a volatile space. In fact, many tech companies may be described as high-risk stocks, as they may be relatively new to the fold compared to more established companies. As such, initial valuations may not fully price in how risky these companies are.
Too Much Hype
Some stocks may not live up to the initial build-up that comes with any IPO. Consider this: During 2021, roughly a quarter of IPO stocks experienced a loss in value during their first day on the market. So, it’s possible to get caught up in the hype, and overlook some glaring issues with some IPO stocks.
Regulatory Risks
Regulation and government oversight of tech companies could also be changing. Many tech companies have found themselves in the crosshairs of regulators for antitrust issues, among other things, and such cases could have widespread ramifications for tech companies when it comes to their regulatory landscape and competitive practices.
|
Tech IPOs: Pros and Cons |
|
|---|---|
| Pros | Cons |
| Initial momentum | Sector risk |
| Growing sector | Too much hype |
| Further income opportunities | Regulatory risks |
The Takeaway
Tech IPOs are when tech companies list their shares for purchase on a public stock exchange. Though the method through which many tech firms are going public has changed (through SPACs, etc.), many tech companies are still using the traditional IPO process.
Buying IPO stocks of tech firms can offer investors an opportunity to invest in high-growth stocks with the potential for sizable gains. However, risks include high valuations for unseasoned companies, as well as disappointed share price performance after the listing.
Interesting in IPO investing? Using SoFi’s Invest tools, investors can set up automated or active investing in a diverse array of stocks and ETFs. With pre-IPO trading, eligible SoFi members can even buy into companies before they begin trading — giving you a jump start on the market.
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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.
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