Dec
22
2023
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The Essentials of Stock Float and Its Impact on Investing

By | Growing Wealth, Investing | No Comments

Whether you’re a veteran or a rookie when it comes to the stock market, you likely have come across the term “stock float.” And regardless of your experience, the question, “What is a stock float?” may have you stumped.

Finding out the answer can play a major role in your investing future. Read on to learn about stock float.

Unpacking the Concept of Stock Float

So, what is a stock float exactly? Floating stock is the number of shares available for trade of a particular stock. The number of floating shares is referred to as the stock float or simply “the float.” Stock float is important because it indicates how many shares of a stock can be bought and traded by investors in general.

To calculate the amount of floating stock available, subtract the number of locked-in shares and restricted stock from a firm’s total outstanding shares.

Restricted stock generally refers to shares that cannot be traded without special exception from the Securities and Exchange Commission (SEC). One such example of this is stocks that are restricted by the SEC from sale during a lock-up period after an initial public offering, where certain shareholders (such as employees and major investors) are not allowed to sell their stock for that given period. This may be done in an attempt to stabilize the price of the stock.

No matter the reason, if there are shares that are not available for trade in the market, then they will not be tallied in the final float count.


💡 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.

How Stock Float Influences Market Dynamics

Stock float is something investors find helpful because it indicates the ownership structure of a company. Also, the lower the stock float, the more volatile the stock may be. If there is more demand from investors than available stock to buy, that could send the price of the stock up. And if demand for the stock drops, the stock’s price could fall.

The Significance of Stock Float in Investing

Investors find stock float useful because it tells them how many shares of stock are available to be publicly bought and sold. It also offers an indication of a stock’s volatility, as noted above. A stock float that’s low could push up the price of the stock if there is great demand for it.

Analyzing the Impact of Float on Stock Performance

Stock float can indicate to investors how many shares of stock are available to buy and sell, and thus, how volatile a stock may be. Stocks with a higher float tend to be less volatile, while those with a lower float tend to have higher volatility.

Stock float is just one metric or tool investors can use to analyze a stock and how it might potentially perform.

Stock Float Compared: Authorized, Outstanding, and Floating Shares

Authorized shares are the most shares of stock that a company can issue. Outstanding shares are the number of shares the company actually has issued. A company does not have to issue all of its authorized shares.

Floating shares refers to the number of a company’s shares that can be bought and sold. Stock float is calculated by subtracting a company’s restricted shares from their outstanding shares. If a company has 100 million outstanding shares, with 15 million of them locked in, this company’s float would be 85 million.

This means that 85 million shares of this company’s stock are available for trade on the open market. These are the shares that you could hypothetically purchase with a broker, brokerage account, or other trading platforms that have access to the major stock exchanges.

Identifying and Interpreting the Float of a Stock

Identifying the float of a stock requires a fairly simple calculation. You can find a stock’s float by subtracting any restricted shares of the stock from the outstanding shares.

Typically, you can also look at a company’s balance sheet to find the number of outstanding shares and floating shares.

Interpreting What the Float Tells You About a Stock

The float of a stock tells you how many shares of that stock are available for buying or selling. Low float stocks (those with fewer shares available to buy and sell) tend to be more volatile, as discussed earlier, because there are fewer shares available for trading.

The Implications of Low vs High Stock Float

When considering low float stocks and high float stocks, the following are some things investors might want to keep in mind.

Advantages and Risks of Low-Float Stocks

The benefits of low-float stocks apply mainly to day traders who hope to earn big profits in a short period of time. Each trade of a low-float stock could have a big impact on the value of the stock. For example, if there’s good news about a company whose stock float is low, demand for the stock may rise, and the stock’s price could go up.

Conversely, if news about the company is bad, demand for the stock could plummet, along with the stock’s price. This leads to a greater level of risk for investors.

The Stability and Volatility Factor in High-Float Stocks

High-float stocks tend to be less volatile because there are more shares available for public trading. That makes them more stable overall because there are more shares of the stock in circulation. The price of high-float stocks tends to be more stable than low-float stocks.


💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

The Investor’s Guide to Low-Float Stocks

Trading low-float stocks can be one strategy day traders use. Here’s what to know about evaluating and trading these stocks.

Best Practices for Trading Low-Float Stocks

Trading low-float stocks involves risks. Because there are few shares available, it may be difficult to buy them when an investor wants them and also to sell them in time to make a profit — this is referred to as a lack of liquidity.

One way traders might handle this is to look for stocks with low float and high volume, which is the number of shares of stock being traded daily. The more shares being traded, the lower the chances might be that an investor will have to deal with lack of liquidity.

Strategies for Evaluating Low-Float Stock Potential

Traders can use technical analysis and look at indicators like candlestick charts and moving averages to help evaluate a low-float stock. This typically requires some knowledge and experience as an investor.

Other methods of evaluating a low-float stock include:

Low-float stocks with a high relative volume. Relative volume is a way to help gauge a stock’s liquidity. It indicates a stock’s volume currently compared to other times in the company’s history. A stock with low liquidity might be difficult for an investor to sell.

News about the company. Both good and bad news about a company can affect a low-float stock’s value. It could quickly go up or down.

Float percentage. This refers to the percentage of total shares of stock available for trading. Most traders look for a percentage between 10% and 25%.

Insights Into Stock Float and Market Manipulation

Stocks with a low float may be more vulnerable to market manipulation. When a stock has fewer shares available for trading, it could easily be affected by comments on social media, for instance. There are also schemes such as a “pump and dump” in which unscrupulous investors buy up many of the shares of a low-float stock, which could affect the price dramatically. They might then dump the stock.

Day trading is risky and can result in investors losing significant amounts (although they could potentially make significant gains). And low-float stocks can be susceptible to practices like market manipulation. Those with a low tolerance for risk may find that low-float stocks are not the best investment for them.

Deep Dive: Case Study and Example of Floating Stock

One recent example of a low-float stock is General Electric (GE). In early fall 2023, there were 1.088 billion outstanding shares of GE stock. Of this number, approximately 76% of shares were not available for public trading. The float in this case was 260 million shares. Consequently, GE’s stock price is considered fairly volatile.

Practical Tips for Trading and Investing in Floating Stocks

Low-float stocks can be highly volatile and their price can go up and down in minutes or even seconds. This volatility could eliminate a significant chunk of an investor’s portfolio. Of course, low-float stocks could also present substantial profit opportunities with potentially big gains. But they are risky.

Low-float stocks are typically appealing to those who are hoping to make larger gains in a short amount of time, such as day traders.

To successfully trade low-float stocks, investors should look at technical indicators and also follow the news. Watching the market every day is critical since the prices of these stocks can change so quickly.

Whether you’re investing in low-float stocks or any stock, remember that diversifying your portfolio is important and can help mitigate risk and potentially increase your returns, studies show.

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

Is a Low-Float Stock Good for Day Trading?

A low-float stock could potentially lead to big profits for day traders if the stock is in high demand. However, these stocks can be very risky since they are volatile. If demand drops, a trader could lose large sums.

How Does a Stock’s Float Affect Its Liquidity?

Stocks with a higher float have more liquidity, which can make it easier for investors to buy and sell them. Low-float stocks have less liquidity, which could make it more challenging to buy or sell them.

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

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

SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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Dec
21
2023
What Are Securities in Finance? How Security Trading Works

What Are Securities in Finance? How Securities Trading Works

By | Growing Wealth, invest, Investing | Comments Off on What Are Securities in Finance? How Securities Trading Works

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.

A security is any financial instrument with a fungible value (meaning a value that’s essentially equal) that investors can trade. Common securities include stocks, bonds, and index and mutual funds, as well as options and other derivatives that derive their value from other assets. Most securities trade on financial exchanges, and all play a role in aiming to build wealth for individuals, companies, and other investors.

What are securities in finance and how do they work? Here’s a glimpse inside the world of securities in trading.

What is a Security?

A security is a tradable investment vehicle that traders can buy and sell on financial exchanges or other platforms. In general, investors earn money by buying securities at a low price and selling them at a higher one.

Securities in finance have some monetary value; buyers and sellers determine their value when trading them. Securities vary in nature – stocks, for example, represent ownership in a company, while bonds are essentially loan vehicles where borrowers pay lenders interest for their loan money.

Here are some common security categories.

Equity Securities

This type of securities in finance includes stocks and stock funds. Typically traded on exchanges, the price of equity securities rise or fall depending on the economy, the performance of the underlying company that offers the stock (or companies in the fund), and the sector that company or fund operates. Individual stocks may also pay dividends to investors who own them.


💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.

Debt Securities

This group includes bonds and other fixed-income vehicles where lenders borrow money from investors and pay an interest rate (i.e., the price for borrowing) on the investment principal. Bond issuers may include states, local and municipal governments, companies, and banks and other financial institutions. Typically, debt securities pay investors a specific interest rate paid usually twice per year until a maturity date, when the bond expires.

Some common debt securities include:

•   Treasury bills. Issued by the U.S. government, T-Bills are considered among the safest securities.

•   Corporate bonds. These are bonds issued by companies to raise money without going to the equity markets.

•   Bond funds. These allow investors to get exposure to the bond market without buying individual bonds.

Derivatives

This group of securities includes higher-risk investments like options trading and futures which offer investors a higher rate of return but at a higher level of risk.

Derivatives are based on underlying assets, and it’s the performance of those assets that drive derivative security investment returns. For example, an investor can buy a call option based on 100 shares of ABC stock, at a specific price and at a specific time before the option contract expires. If ABC stock declines during that contract period, the call option buyer has the right to buy the stock at a reduced rate, thus locking in gains when the stock price rises again.

Derivatives allow investors to place higher-risk bets on stocks, bonds, and commodities like oil or gold, and currencies. Typically, institutional investors, such as pension funds or hedge funds, are more active in the derivative market than individual investors.

Hybrid Securities

A hybrid security combines two or more distinct investment securities into one security. For example, a convertible bond is a debt security, due to its fixed income component, but also has characteristics of a stock, since it’s convertible.

Hybrid securities sometimes act like debt securities, as when they provide investors with a floating or fixed rate of return, as bonds normally do. Hybrid securities, however, may also pay dividends like stocks and offer unique tax advantages of both stocks and bonds.


💡 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.

How Security Trading Works

Securities often trade in open financial exchanges where investors can buy or sell securities with the goal of making a financial profit.

Stocks, for example, are listed on global stock exchanges and investors can purchase them during market trading hours. Exchanges are highly regulated and expected to comply with strict fair-trading mandates. For example, U.S.-based stock exchanges like the New York Stock Exchange or Nasdaq must adhere to the rules and regulations laid out by Congress and enforced by the U.S. Securities and Exchange Commission (SEC).

Each country has their own rules and regulations for fair and compliant securities trading, including oversight of stocks, bonds, derivatives, and other investment vehicles. Debt instruments, like bonds, usually trade on secondary markets while stocks and derivatives are traded on stock exchanges.

There are many ways for investors to engage in security trading. A few of the most common ones include:

Brokerage Accounts

Once an investor opens a brokerage account with a credentialed investment firm, they can start trading securities.

All a stock or bond investor has to do is fill out the required forms and deposit money to fund their investments. Investors looking to invest in higher-risk derivatives like options, futures, or currencies may have to fill out additional documentation proving their credentials as educated, experienced investors. They may also have to make larger cash deposits, as trading in derivatives is more complex and has more potential for risk.

Some investors with brokerage accounts can engage in margin trading, meaning that they trade securities using money borrowed from the broker.

Retirement Accounts

By opening a retirement account, through work or a bank or brokerage account, investors can invest in a range of securities, including stocks, mutual and index funds, bonds and bond funds, and annuities.

The type of securities you have access to will depend on the type of retirement account that you have. Workplace plans such as 401(k)s typically have fewer investment choices (but higher limits for tax-advantaged contributions) than Individual Retirement Accounts.

The Takeaway

There are many different types of securities that investors may purchase as part of their portfolio. Choosing which securities to invest in will depend on several factors, including your financial goals, current financial picture, and risk tolerance.

A great way to start building a portfolio of securities is by opening a brokerage account on the SoFi Invest® investment platform. Securities on the platform include stocks and exchange-traded funds.

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

What are the four types of securities?

The four types of securities are: equity securities (such as stocks), debt securities (such as bonds), derivatives (such as higher-risk investments like options trading), and hybrid securities (such as convertible bonds).

What is a securities investment?

A securities investment is an investment in a security such as stocks, bonds, or derivatives. A security is a tradable type of investment that traders can buy and sell.

What’s the difference between securities and shares?

Stocks, also known as equity shares, are a type of security. The term “securities” refers to a range of different investments, one of which is stocks, or shares.

Photo credit: iStock/paulaphoto

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.

SOIN1023179

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Dec
21
2023
What Is Margin Debt & How Does It Affect the Stock Market?

What Is Margin Debt?

By | Growing Wealth, invest, Investing | Comments Off on What Is Margin Debt?

Margin debt refers to the funds investors can borrow from a brokerage firm to purchase securities. Margin debt is basically a loan from a broker that must be backed with collateral (cash and other securities), and paid back with interest.

Margin is not available with a cash-only brokerage account, where a trader simply buys the securities they want and cover the full amount using the funds in their account. Margin accounts are available only to investors who qualify, owing to the high-risk nature of margin trading.

Margin Debt Definition

In order to understand what margin debt is and how it works, it helps to review the basics of margin accounts.

What Is a Margin Account?

With a cash brokerage account, an investor can only buy as many investments as they can cover with cash. If an investor has $10,000 in their account, they can buy $10,000 of stock, for example.

A margin account, however, allows qualified investors to borrow funds from the brokerage to purchase securities that are worth more than the cash they have on hand.

In this case, the cash or securities already in the investor’s account act as collateral, which is why the investor can generally borrow no more than the amount they have in cash. If they have $10,000 worth of cash and securities in their account, they can borrow up to another $10,000 (depending on brokerage rules and restrictions), and place a $20,000 trade.

Recommended: What Is Margin Trading?

Margin Debt, Explained

In other words, when engaging in margin trading an investor generally can only borrow up to 50% of the value of the trade they want to place, though an individual brokerage firm has license to impose stricter limits. Although the cash and securities in the account act as collateral for the loan, the broker also charges interest on the loan, which adds to the cost — and to the risk of loss.

Margin debt is high-risk debt. If an investor borrows funds to buy securities, that additional leverage enables them to place much bigger bets in the hope of seeing a profit. The risk is that if the trade moves against them they could lose all the money they borrowed, plus the cash collateral, and they would have to repay the loan to their broker with interest — on top of any brokerage fees and investment costs.

For this reason, among others, margin accounts are considered to be more appropriate for experienced investors, since trading on margin means taking on additional costs and risks. It’s also why only certain investors can open margin accounts.


💡 Quick Tip: When you trade using a margin account, you’re using leverage — i.e. borrowed funds that increase your purchasing power. Remember that whatever you borrow you must repay, with interest.

How Margin Debt Works

Traders can use margin debt for both long and short selling stocks. The Federal Reserve Board’s Regulation T (Reg T) places limitations on the amount that a trader can borrow for margin trades. Currently the limit is 50% of the initial investment the trader makes. This is known as the initial margin.

In addition to federal regulations, brokerages also have their own rules and limitations on margin trades, which tend to be stricter than federal regulations. Brokers and governments place restrictions on margin trades to protect investors and financial institutions from steep losses.

Recommended: Regulation T (Reg T): All You Need to Know

Example of Margin Debt

An investor wants to purchase 2,000 shares of Company ABC for $100 per share. They only want to put down a portion of the $200,000 that this trade would cost. Due to federal regulations, the trader would only be allowed to borrow up to 50% of the initial investment, so $100,000.

In addition to this regulation, the broker might have additional rules. So the trader would need to deposit at least $100,000 into their account in order to enter the trade, and they would be taking on $100,000 in debt. The $100,000 in their account would act as collateral for the loan.

What Is Maintenance Margin?

The broker will also require that the investor keep a certain amount of cash in their account at all times for the duration of the trade: this is known as maintenance margin. Under FINRA rules, the equity in the account must not fall below 25% of the market value of the securities in the account.

If the equity drops below this level, say because the investments have fallen in value, the investor will likely get a margin call from their broker. A margin call is when an investor is required to add cash or forced to sell investments to maintain a certain level of equity in a margin account.

If the investor fails to honor the margin call, meaning they do not add cash or equity into their account, the brokerage can sell the investor’s assets without notice to cover the shortfall.

Managing Interest Payments on Margin Debt

There’s generally no time limit on a margin loan. An investor can keep margin debt and just pay off the margin interest until the stock in which they invested increases to be able to pay off the debt amount.

The brokerage typically takes the interest out of the trader’s account automatically. In order for the investor to earn a profit or break even, the interest rate has to be less than the growth rate of the stock.

Increase your buying power with a margin loan from SoFi.

Borrow against your current investments at just 10%* and start margin trading.

*For full margin details, see terms.

Advantages and Disadvantages of Margin Debt

There are several benefits and drawbacks of using margin debt to purchase securities such as stocks, bonds, mutual funds, or exchange-traded funds (ETFs).

Advantages

•   Margin trading allows a trader to purchase more securities than they have the cash for, which can lead to bigger gains.

•   Traders can also use margin debt to short sell a stock. They can borrow the stock and sell it, and then buy it back later at a lower price.

•   Traders using margin can more easily spread out their available cash into multiple investments.

•   Rather than selling stocks, which can trigger taxable events or impact their investing strategy, traders can remain invested and borrow funds for other investments.

Recommended: How to Invest in Stocks

Disadvantages

•   Margin trading is risky and can lead to significant losses, making it less suitable for beginner investors.

•   The investor has to pay interest on the loan, in addition to any other trading fees, commissions, or other investment costs associated with the trade.

•   If a trader’s account falls below the required maintenance margin, let’s say if a stock is very volatile, that will trigger a margin call. In this case the trader will have to deposit more money into their account or sell off some of their holdings.

•   Brokers have a right to sell off a trader’s holdings without notifying the trader in order to maintain a certain balance in the trader’s account.


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

Is High Margin Debt a Market Indicator?

What is the impact of high margin debt on the stock market, historically? There is an uneasy relationship between margin debt and market performance. Over the years elevated levels of margin debt have been associated with financial instability and market crashes.

For example, the widespread use of margin trading during the 1920s meant that the market was overleveraged, and the excessive reliance on debt contributed to the calamitous stock market crash that led to the Great Depression in the 1930s.

Different Perspectives on Margin Debt Levels

Today, some traders view margin debt as one measure of investor confidence in the markets because investors feel bullish about buying.

However, high margin debt can also be a sign that investors are chasing stocks, creating a cycle that can lead to greater volatility. If investors’ margin accounts decline, it can force brokers to liquidate securities in order to keep a minimum balance in these accounts.

It can be helpful for investors to look at whether total margin debt has been increasing year over year, rather than focusing on current margin debt levels. FINRA publishes total margin debt levels each month.

Jumps in margin debt do not always indicate a coming market drop, but they may be an indication to keep an eye out for additional signs of market shifts.

Recommended: 5 Bullish Indicators for Stocks

The Takeaway

Margin trading and the use of margin debt — i.e. borrowing funds from a broker to purchase securities — can be a useful tool for some investors, but it isn’t recommended for beginners due to the higher risk of using leverage to place trades. Margin debt does allow investors to place bigger trades than they could with cash on hand, but profits are not guaranteed, and steep losses can follow.

Thus using margin debt may not be the best strategy for investors with a low appetite for risk, who should likely look for safer investment strategies.

If you’re an experienced trader and have the risk tolerance to try out trading on margin, consider enabling a SoFi margin account. With a SoFi margin account, experienced investors can take advantage of more investment opportunities, and potentially increase returns. That said, margin trading is a high-risk endeavor, and using margin loans can amplify losses as well as gains.

Get one of the most competitive margin loan rates with SoFi, 10%*

Photo credit: iStock/PeopleImages

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.

*Borrow at 10%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
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.

SOIN1023157

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Dec
13
2023
What Is a Forward Contract? Futures vs Forwards, Explained

What Is a Forward Contract?

By | Growing Wealth, invest, Investing | Comments Off on What Is a Forward Contract?

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.

A forward contract, also referred to as a forward, is a type of customizable derivative contract between a buyer and a seller that sets the sale of an asset at a specific price on a specific future date. Like all derivatives, a forward contract is not an asset itself, but a contract representing the potential future trade of an underlying asset.

Forward contracts are similar to options, as discussed below, but there are some key differences that investors will need to know if they plan to use forwards as a part of their investing strategy.

How Do Forward Contracts Work?

Forwards are similar to options contracts in that they set a specific price, amount, and expiration date for a trade, but they are different because most options give traders the right, but not the obligation, to trade. With forwards contracts the transaction must take place on the expiration date.

Unlike futures contracts, another type of derivative, forwards are only settled once on their expiration date. The ability to customize forwards makes them popular with investors, since the buyer and seller can set the exact terms they want for the contract. Many other types of derivative contracts have preset contract terms.

There are four main aspects and terms that traders should understand and consider before entering into a forward contract. These components are:

•   Asset: This refers to the underlying asset associated with the forward contract.

•   Expiration Date: This is the date that the contract ends, and this is when the actual trade occurs between the buyer and seller. Traders will either settle the contract in cash or through the trade of the asset.

•   Quantity: The forward contract will specify the number of units of the underlying asset subject to the transaction.

•   Price: The contract will include the price per unit of the underlying asset, including the currency in which the transaction will take place.

Investors trade forwards over the counter instead of on centralized exchanges. Since the two parties custom create the forwards, they are more flexible than other types of financial products. However, they carry higher risk due to a lack of regulation and third party guarantee.


💡 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.

Recommended: What Are Over-the-Counter (OTC) Stocks?

What’s the Difference Between Forward and Futures Contracts?

Futures and forwards have many similarities in that they are both types of investments that specify a price, quantity, and date of a future transaction. However, there are some key differences for traders to know, including:

•   Futures are standardized options contracts traded on centralized exchanges, while forwards are customized contracts created privately between two parties.

•   Futures are settled through clearing houses, making them less risky and more guaranteed than forwards contracts, which are settled directly between the two parties. Parties involved in futures contracts almost never default on them.

•   Futures are marked to market and settled daily, meaning that investors can execute a strategy to trade them whenever an exchange is open. Forwards are only settled on the expiration date. Because of this, forwards don’t usually include initial margins or maintenance margins like futures do.

•   It’s more common for futures to be settled in cash, while forwards are often settled in the asset.

•   The futures market is highly liquid, making it easy for investors to buy and sell whenever they want to, whereas the forwards market is far less liquid, adding additional risk.

Forward Contract Example

Let’s look at an example of a forward contract. If an agricultural company knows that in six months they will have one million bushels of wheat to sell, they may have concerns about changes in the price of wheat. If they think the price of wheat might decline in six months, they could enter into a forward contract with a financial institution that agrees to purchase the wheat for $5 per bushel in six months time in a cash settlement.

By the time of the expiration date, there are three possibilities for the wheat market:

1.    The price per bushel is still $5. If the asset price hasn’t changed in six months, no transaction takes place between the agricultural company and the financial institution and the contract expires.

2.    The price per bushel has increased. Let’s say the price of wheat is now $5.20 per bushel. In this case the agricultural producer must pay the financial institution $0.20 per bushel, the difference between the current price market and the price set in the contract, which was $5. So, the agricultural producer must pay $200,000.

3.    The price per bushel has decreased. Let’s say the price is now $4.50. In this case the financial institution must pay the agricultural producer the difference between the spot price and the contract price, which would be $500,000.

Pros and Cons of Trading Forwards

Forwards can be useful tools for traders, but they also come with risks and downsides.

Pros of Trading Forwards

There are several reasons that investors might choose to use a forward:

•   Flexibility in the terms set by the contract

•   Hedge against future losses

•   Useful tool for speculation

•   Large market

Cons of Trading Forwards

Investors who use forwards should be aware that there are risks involved with these financial products. Those include:

•   Risky and unpredictable market

•   Not as liquid as the futures market

•   OTC trading means a higher chance of default and no third party guarantees or regulations

•   Details of contracts in the market are not made known to the public

•   Contracts are only settled on the expiration date, making them riskier than futures contracts that are marked-to-market regularly

Who Uses Forward Contracts?

Typically, institutional investors and day traders use forwards more commonly than retail investors. That’s because the forwards market can be risky and unpredictable since traders create the contracts privately on a case-by-case basis. Often the public does not learn the details of agreements, and there is a risk that one party will default.

Institutional traders often use forwards to lock in exchange rates ahead of a planned international purchase. Traders might also buy and sell contracts themselves instead of waiting for the trade of the underlying asset.

Traders also use forwards to speculate on assets. For instance, if a trader thinks the price of an asset will increase in the future, they might enter into a long position in a forward contract to be able to buy the asset at the current lower price and sell it at the future higher price for a profit.

How Do Investors Use Forwards?

Traders use forwards to hedge against future losses and avoid price volatility by locking in a particular asset price or to speculate on the price of a particular asset, such as a currency, commodity, or stock. Forwards are not subject to price fluctuations since buyers and sellers have agreed to a predetermined price.

The trader buying a forward contract is taking a long position, and the trader selling is going into a short position. This is similar to options traders who buy calls and puts. The long position profits if the price of the underlying asset goes up, and the short position profits if it goes down.

Locking in a future price can be very helpful for traders, especially for assets that tend to be volatile such as currencies or commodities like oil, wheat, precious metals, natural gas.

Recommended: Why Is It Risky to Invest in Commodities?

The Takeaway

Forward contracts are a common way for institutional investors to hedge against future volatility or protect against losses. However, they’re risky securities that may not be the best investment for most retail investors.

Given the specialized nature of forwards contracts (and other types of options), the risks may outweigh the potential rewards for many investors. As such, it may be a good idea to consult a financial professional before dabbling with forwards, or incorporating them into a larger investing strategy.

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

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

Photo credit: iStock/fizkes

SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Dec
13
2023
What Are Equity Derivatives & Equity Options?

What Are Equity Derivatives?

By | Growing Wealth, invest, Investing | Comments Off on What Are Equity Derivatives?

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.

Equity derivatives are trading instruments based on the price movements of underlying asset equity. These financial instruments include equity options, stock index futures, equity index swaps, and convertible bonds.

With an equity derivative, the investor doesn’t buy a stock, but rather the right to buy or sell a stock or basket of stocks. To buy those rights in the form of a derivative contract, the investor pays a fee, more commonly known as a premium.

How are Equity Derivatives Used?

The value of an equity derivative goes up or down depending on the price changes of the underlying asset. For this reason, investors sometimes buy equity derivatives — especially shorts, or put options — to manage the risks of their stock holdings.

Investors buy the rights (or options) to buy or sell an asset via a derivative contract, as mentioned.


💡 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.

4 Types of Equity Derivatives

Generally, there are four types of equity derivatives that investors should familiarize themselves with: Equity options, equity futures, equity swaps, and equity basket derivatives.

1. Equity Options

Equity options are one form of equity derivatives. They allow purchasers to buy or sell a given stock within a predetermined time period at an agreed-upon price.

Because some equity derivatives offer the right to sell a stock at a given price, many investors will use a derivatives contract like an insurance policy. By purchasing a put option on a stock or a basket of stocks, can purchase some protection against losses in their investments.

Recommended: How to Trade Options: A Beginner’s Guide

Not all put options are used as simple insurance against losses. Buying a put option on a stock is also called “shorting” the stock. And it’s used by some investors as a way to bet that a stock’s price will fall. Because a put option allows an investor to sell a stock at a predetermined price, known as a strike price, investors can benefit if the actual trading price of the stock falls below that level.

Call options, on the other hand, allow investors to buy a stock at a given price within an agreed-upon time period. As such, they’re often used by speculative investors as a way to take advantage of upward price movements in a stock, without actually purchasing the stock. But call options only have value if the price of the underlying stock is above the strike price of the contract when the option expires.

For options investors, the important thing to watch is the relationship between a stock’s price and the strike price of a given option, an options term sometimes called the “moneyness.” The varieties of moneyness are:

•   At-the-money (ATM). This is when the option’s strike price and the asset’s market price are the same.

•   Out-of-the-money (OTM). For a put option, OTM is when the strike price is lower than the asset’s market price. For a call option, OTM is when the strike price is higher than the asset’s market price.

•   In-the-money (ITM). For a put option, in-the-money is when the market price of the asset is lower than the option’s strike price. For a call option, ITM is when the market price of the asset is higher than the option’s strike price.

The goal of both put and call options is for the options to be ITM. When an option is ITM, the investor can exercise the option to make a profit. Also, when the option is ITM, the investor has the ability to resell the option without exercising it. But the premiums for buying an equity option can be high, and can eat away at an investor’s returns over time.

Recommended: How to Sell Options for Premium

2. Equity Futures

While an options contract grants the investor the ability, without the obligation, to purchase or sell a stock during an agreed-upon period for a predetermined price, an equity futures contract requires the contract holder to buy the shares.

A futures contract specifies the price and date at which the contract holder must buy the shares. For that reason, equity futures come with a different risk profile than equity options. While equity options are risky, equity futures are generally even riskier for the investor.

One reason is that, as the price of the stock underlying the futures contract moves up or down, the investor may be required to deposit more capital into their trading accounts to cover the possible liability they will face upon the contract’s expiration. That possible loss must be placed into the account at the end of each trading day, which may create a liquidity squeeze for futures investors.

Equity Index Futures and Equity Basket Derivatives

As a form of equity futures contract, an equity index futures contract is a derivative of the group of stocks that comprise a given index, such as the S&P 500, the Dow Jones Industrial Index, and the NASDAQ index. Investors can buy futures contracts on these indices and many others.

Being widely traded, equity index futures contracts come with a wide range of contract durations — from days to months. The futures contracts that track the most popular indices tend to be highly liquid, and investors will buy and sell them throughout the trading session.

Equity index futures contracts serve investors as a way to bet on the upward or downward motion of a large swath of the overall stock market over a fixed period of time. And investors may also use these contracts as a way to hedge the risk of losses in the portfolio of stocks that they own.

3. Equity Swaps

An equity swap is another form of equity derivative in which two traders will exchange the returns on two separate stocks, or equity indexes, over a period of time.

It’s a sophisticated way to manage risk while investing in equities, but this strategy may not be available for most investors. Swaps exist almost exclusively in the over-the-counter (OTC) markets and are traded almost exclusively between established institutional investors, who can customize the swaps based on the terms offered by the counterparty of the swap.

In addition to risk management and diversification, investors use equity swaps for diversification and tax benefits, as they allow the investor to avoid some of the risk of loss within their stock holdings without selling their positions. That’s because the counterparty of the swap will face the risk of those losses for the duration of the swap. Investors can enter into swaps for individual stocks, stock indices, or sometimes even for customized baskets of stocks.

4. Equity Basket Derivatives

Equity basket derivatives can help investors either speculate on the price movements or hedge against risks of a group of stocks. These baskets may contain futures, options, or swaps relating to a set of equities that aren’t necessarily in a known index. Unlike equity index futures, these highly customized baskets are traded exclusively in the OTC markets.


💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

The Takeaway

Equity derivatives are trading instruments based on the price movements of underlying asset equity. Options, futures, and swaps are just a few ways that investors can gain access to the markets, or hedge the risks that they’re already taking.

Investors interested in utilizing equity derivatives as a part of their larger investing strategy should probably do a lot of homework, as options and futures require a good amount of background knowledge to use effectively. It may also be worth speaking with a financial professional for guidance.

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

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

Photo credit: iStock/nortonrsx

SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

SOIN1023184

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