Aug
19
2023
Examining How Student Loan Deferment Works

Examining How Student Loan Deferment Works

By | Debt Payoff, Fresh Out of School, Student Loans, student_loan | No Comments

With mass student loan forgiveness blocked by the Supreme Court, you may be curious about what other forgiveness or deferment options are available for students with federal — or private — student loans.

Federal loans do allow you to stop or reduce your payments in some circumstances, such as financial hardship, for up to three years — which is known as deferment. Deferment on private student loans varies by lender, and not all lenders offer it.

One thing you generally don’t want to do — simply stop making payments on your student loan. Whether your loans are federal or private, this puts you at risk of default, which can have a number of negative consequences.

Read on to learn more about student loan deferment, including what it is, how it works, its pros and cons, plus some alternative ways to get student debt relief.

What Is Student Loan Deferment?

Student loan deferment allows qualified applicants to reduce or stop making payments on their loans for up to three years. If you have a subsidized federal loan, no interest accrues during the deferment period. If you have an unsubsidized federal loan, interest will accrue and will be added to the loan amount (or capitalized) at the end of the deferment period.

Deferments are available on federal loans including Direct Loans, FFEL Program loans, and Perkins Loans.

Private student loans may or may not offer deferment options to borrowers. If you have questions about your private student loan, you’ll want to check in with your lender directly.

How Does Student Loan Deferment Work?

If you have a federal student loan and are no longer in school at least half-time, you will need to apply to defer payments on your student loan. This usually involves submitting a request to your student loan servicer. You will also likely need to provide documentation to show that you meet the eligibility requirements for the deferment (more on eligibility requirements below).

If you have an unsubsidized federal student loan and are granted deferment, interest will continue to accrue during the deferral period. You will have the option to either pay the interest as it accrues or allow it to accrue and be capitalized (added to your loan principal balance) at the end of the deferment period.

Deferments are available on federal loans including Direct Loans, FFEL Program loans, and Perkins Loans.

If a private lender offers deferment, they will likely have their own forms and requirements.

Why Defer Student Loans

Applying for deferment may make sense if you are facing short-term difficulty paying your student loans, since a deferment can provide you with the opportunity you need to stay afloat financially. And, if you have a subsidized loan, deferment won’t make your loan any more expensive in the long run.

Deferring student loans also won’t directly impact your credit score.

Why Not Defer Student Loans

If you’re able to stay on top of your loan payments, then deferment likely doesn’t make sense. If you think that you may have long-term difficulty making your monthly loan payments, deferment may not be the best option either.

If you have an unsubsidized federal loan, interest will continue to accrue during deferment. At the end of the deferment period, this interest will be capitalized on the existing loan amount (or the principal loan value). Moving forward, interest will be calculated based on this new total. So essentially, you are accruing interest on top of interest, which can significantly increase the amount of interest owed over the life of the loan.

Pros and Cons of Student Loan Deferment

Student loan deferment can help borrowers who are struggling financially, but it may not be the right choice for everyone. Here are some pros and cons to consider when evaluating deferment options for federal student loans.

Pros

 Cons
Borrowers are able to temporarily suspend or lower the monthly payments on their student loans. On most federal student loans, interest continues to accrue. This may significantly increase the total cost of borrowing over the life of the loan.
Borrowers may qualify for deferment for periods of up to three years. Because interest may continue to accrue during deferment, other options like income-driven repayment plans, may be more cost- effective in the long term.

Types of Student Loan Deferment

For federal student loans, there are a few different deferment options . Here are the details on some of the most common reasons borrowers apply for deferment.

In-School Deferment

Students who are enrolled at least half-time in an eligible college or career program may qualify for an in-school deferment. If you are enrolled in a qualifying program at an eligible school, this type of deferment is generally automatic. If you find the automatic in-school deferment doesn’t kick in when you are enrolled at least half-time in an eligible school, you can file an in-school deferment request form .

Unemployment Deferment

Those currently receiving unemployment benefits, or who are actively seeking and unable to find full-time work, may be able to qualify for unemployment deferment. Borrowers can receive this deferment for up to three years.

Economic Hardship Deferment

This type of deferment may be an option for those borrowers who are receiving merit-tested benefits like welfare, who work full time but earn less than 150% of the poverty guidelines for your state of residence and family size, or who are serving in the Peace Corps.

Economic hardship deferments may be awarded for a period of up to three years.

Military Deferment

Members of the U.S. military who are serving active duty may qualify for a military service deferment. After a period of active duty service, there is a grace period in which borrowers may also qualify for federal student loan deferment.

Cancer Treatment Deferment

Individuals who are undergoing treatment for cancer may qualify for deferment. There is also a grace period of six months following the end of treatment.

Other Types of Deferment

There are other situations and circumstances in which borrowers might be able to apply for deferment. Some of these include starting a graduate fellowship program, entering a rehabilitation program, or being a parent borrower with a Parent PLUS Loan whose child is enrolled in school at least half-time.

Consequences of Defaulting on Federal Student Loans

If you simply stop making payments as outlined in your loan’s contract, you risk defaulting on your student loan. Default timelines vary for different types of student loans.

Most federal student loans enter default when payments are roughly nine months, or 270 days, past due. Federal Perkins loans can default immediately if you don’t make any scheduled payment by its due date.

•   Immediately owing the entire balance of the loan

•   Losing eligibility for forbearance, deferment, or federal repayment plans

•   Losing eligibility for federal student aid

•   Damage to your credit score, inhibiting your ability to qualify for a car or home loan or credit cards in the future

•   Withholding of federal benefits and tax refunds

•   Garnishing of wages

•   The loan holder taking you to court

•   Inability to sell or purchase assets such as real estate

•   Withholding of your academic transcript until loans are repaid

Consequences of Defaulting on Private Student Loans

The consequences for defaulting on private student loans will vary by lender but could include repercussions similar to federal student loans, and more, including:

•   Seeking repayment from the cosigners of the loan (if there are any cosigners)

•   Calls, letters, and notifications from debt collectors

•   Additional collection charges on the balance of the loan

•   Legal action from the lender, such as suing the borrower or their cosigner

To avoid these negative consequences, one option for borrowers struggling to pay federal student loans is deferment.

Who Is Eligible for Student Loan Deferment?

To be granted a deferment on federal loans, borrowers need to meet certain criteria.

You may be eligible if you’re:

•   Enrolled at least part-time in college, graduate school, or a professional school

•   Unable to find a full-time job or are experiencing economic hardship

•   On active military duty serving in relation to war, military operation, or response to a national emergency

•   In the 13-month period following active duty

•   Enrolled in the Peace Corps

•   Taking part in a graduate fellowship program

•   Experiencing a medical hardship

•   Enrolled in an approved rehabilitation program for the disabled

Borrowers who re-enroll in college or career school part-time may find that their federal student loans automatically go into in-school deferment with a notification from their student loan provider.

Loans may also keep accruing interest during deferment — depending on what kind of federal student loans the borrower holds. Borrowers are still responsible for paying interest if they have a:

•   Direct Unsubsidized (Stafford) Loan

•   Direct PLUS Loan

If you don’t pay the interest during the deferment period, the accrued amount is added to your loan principal, which increases what you owe in the end.

Recommended: Student Loan Deferment in Grad School

What if You Have Private Student Loans?

Private lenders aren’t required to offer deferment options, but some do. For example, some might allow you to temporarily stop making payments if you:

•   Lose your job

•   Experience financial hardship

•   Go back to school

•   Have been accepted into an internship, clerkship, fellowship, or residency program

•   Face high medical expenses

Typically, even while a private student loan is in deferment, the balance will still accrue interest. This means that in the long term, the borrower will pay a larger balance overall, even after the respite of deferment.

In most cases, even with accrual of interest, deferment is preferable to defaulting. Borrowers with private loans could contact the lender to ask what options are available.

The Limits of Student Loan Deferment

Keep in mind that deferment is not a panacea. By definition, it’s temporary. Federal student loan borrowers will ultimately need to go back to making payments once they are no longer deferment-eligible. For example, a borrower’s deferral might end if they leave school, even if their ability to pay has not improved.

Federal loans can only be deferred due to unemployment or financial hardship for up to three years. With private loans, there may not be an option to defer at all, and if it is an option, the limit may be no more than a year.

Other Options for Reducing Federal Student Loan Payments

Besides student loan deferment, you have other choices if you can’t afford the total cost of your monthly payments. Here’s a look at some alternatives to deferment.

Income-Driven Repayments

For a longer-term solution, you may want to consider signing up for an income-driven repayment plan.

If you qualify, you may be able to reduce your monthly payment based on your income. Enrolling in an income-driven repayment plan won’t have a negative impact on your credit score or history. On certain income-driven repayment plans, student loan balances can be forgiven after 20 or 25 years, depending on the payment plan that the borrower is eligible for.

With an income-driven repayment plan, your monthly payment is based on your total discretionary income. That means if you change jobs, or see a significant increase in your paycheck, you’ll be expected to pay a higher monthly bill on your student loan payment.

Forbearance

Student loan forbearance is another way to suspend or lower your student loan payments temporarily during times of financial stress, typically for up to 12 months. Generally, forbearance is not as desirable as deferment, since you will be responsible for accrued interest when the forbearance period is over no matter what type of federal loan you have.

When comparing deferment vs. forbearance, you’ll want to keep in mind that there are two types of forbearance for federal student loan holders: general and mandatory.

General student loan forbearance is sometimes called discretionary forbearance. That means the servicer decides whether or not to grant your request. People can apply for general forbearance if they’re experiencing:

•   Financial problems

•   Medical expenses

•   Employment changes

General forbearance is only available for certain student loan programs, and is only granted for up to 12 months at a time. At that point, you are able to reapply for forbearance if you’re still experiencing difficulty. General forbearance is available for:

•   Direct Loans

•   Federal Family Education Loan (FFEL) Program loans

•   Perkins Loans

Mandatory forbearance means your servicer is required to grant it under certain circumstances. Reasons for mandatory forbearance include:

•   Serving in a medical residency or dental internship

•   The total you owe each month on your student loan is 20% or more of your gross income

•   You’re working in a position for AmeriCorps

•   You’re a teacher that qualifies for teacher student loan forgiveness

•   You’re a National Guard member but don’t qualify for deferment

Similar to general forbearance, mandatory forbearance is granted for up to 12 month periods, and you can reapply after that time.

Another Option to Consider: Refinancing

Depending on your personal financial circumstances, another long-term solution could be student loan refinancing. This involves applying for a new loan with a private lender and using it to pay off your current student loans. Qualifying borrowers may be able to secure a lower interest rate or the option to lengthen their loan’s term and reduce monthly payments. Note that lengthening the repayment period may lower monthly payments but will generally result in paying more interest over the life of the loan.

Refinancing could be a good option for borrowers with strong credit and a solid income, among other factors. Unlike an income-driven repayment plan, your monthly payment wouldn’t change based on your income. If you aren’t able to qualify for student loan refinancing on your own, you may be able to apply for refinancing with a cosigner.

Either way, you’ll want to keep in mind that refinancing federal student loans with a private lender means you no longer have access to any federal borrower protections or payment plans. So, if you are taking advantage of things like income-driven payment plans or deferment, you likely don’t want to refinance. But for other borrowers, student loan refinancing might be a useful solution.

If you have more than one student loan, refinancing could also simplify your repayment process.

The Takeaway

If you take out a federal student loan and at some point need to pause or reduce your payments, you may be able to qualify for deferment, forbearance, or an income-driven repayment plan. Each option has its pros and cons.

If you’re considering a private student loan (or refinancing your federal loans), keep in mind that private loans don’t come with government-sponsored protections like forbearance and deferment don’t apply. However, private lenders may offer hardship and deferment programs of their own.

If you’ve exhausted all federal student aid options, no-fee private student loans from SoFi can help you pay for school. The online application process is easy, and you can see rates and terms in just minutes. Repayment plans are flexible, so you can find an option that works for your financial plan and budget.

Cover up to 100% of school-certified costs including tuition, books, supplies, room and board, and transportation with a private student loan from SoFi.

Deferment FAQ

How long can you defer student loans for?

Depending on the type of deferment you are enrolled in, federal loans can be deferred for up to three years. Private student loans may not offer an option to defer payments, and if they do, the limit will be set by the individual lender.

Why would you defer student loans?

Deferment can be helpful if you are facing a temporary financial hurdle, because they allow you to pause or reduce your payments for a period of time.

Are there any reasons not to defer student loans?

Most loans will continue to accrue interest during periods of deferment. When the deferment is over, this accrued interest is then capitalized on the loan. This means it’s added to the existing value of the loan. Moving forward, interest is charged based on this new total. This can significantly impact the total amount of interest that a borrower has to pay over the life of a loan.

SoFi Student Loan Refinance
If you are a federal student loan borrower, you should consider all of your repayment opportunities including the opportunity to refinance your student loan debt at a lower APR or to extend your term to achieve a lower monthly payment. Please note that once you refinance federal student loans you will no longer be eligible for current or future flexible payment options available to federal loan borrowers, including but not limited to income-based repayment plans or extended repayment plans.


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SoFi Private Student Loans
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Aug
18
2023

How to Trade the Bullish Harami Candlestick Pattern

By | Growing Wealth, invest, Investing | Comments Off on How to Trade the Bullish Harami Candlestick Pattern

The bullish harami pattern consists of two candlesticks and is a sign of a potential bullish turn on a stock. When a downtrend has been in place, a harami can offer traders clues that an upward trend is forming.

Other technical analysis tools should be used alongside observation of the bullish harami pattern for better confirmation. The pattern is useful when analyzing assets other than stocks, for example, the bullish harami pattern is also applicable to cryptocurrency charts.

Period 1 of a bullish harami is a long bearish candle, often after a series of down days. Period 2’s candlestick has a smaller body, sometimes even a doji (a candle with little to no body due to opening and closing prices being very close.

What Is a Bullish Harami Pattern?

A bullish harami candlestick pattern indicates a bottom may be forming. This two-day candlestick pattern is a signal that a bullish reversal might be taking shape.

You can learn more about candlestick charts on SoFi Invest.

bullish-harami

Period 1’s candle is a large red body (or black depending on your candlestick chart settings) which is bearish. It might be a bearish marubozu, a candle with no wicks — that means the opening price is the high of the day and the closing price is the low of the day. Period 1’s candle could also have small wicks.

An upper wick is price action above the opening price and closing price. A lower wick is trading activity below the opening and closing price.

Period 2 features a small green (or white) body. This candle is contained within period 1’s candle. This is also known as an inside day pattern. Period 2’s trading action includes a gap higher at the open and a closing price that is slightly higher than the opening price. The upper and lower wicks should be within the body of the first day’s candle.

Day 2 is often a minor increase in price that might seem unimportant, but the pause in the prior downtrend is taken as a signal of bearish exhaustion. Some traders further limit the size of period 2’s candle such that the candle body is no larger than 25% of period 1’s candle.

As with most candlestick patterns, it is important to know the context of the larger trend. With a bullish harami candlestick pattern, the existing trend is bearish.

A bullish harami is just one of many bullish technical indicators.

On the flip side, a bearish harami candlestick pattern happens after a bullish trend, and can indicate the start of a new bearish trend.

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What Does a Bullish Harami Pattern Tell Traders?

A bullish harami pattern tells traders to be on guard against a quick change in trend. For bears, that means it might be prudent to cover short positions. For bulls, this type of harami candlestick pattern can be a signal to get long.

Before putting on big positions, the wise trader reviews other technical indicators for confirmation of a change in trend. Momentum tools such as oscillators, moving average crossovers, and subsequent bullish candlestick patterns can help confirm the predicted bullish reversal.

The crucial aspect of a bullish harami pattern is period 2’s gap up in price and higher close. A small body, sometimes a doji, shows indecision on a price chart. It indicates that bearish momentum could be slowing and perhaps the bulls are ready to take charge.

If period 2’s candle is a doji, traders refer to the pattern as a bullish harami cross. The “cross” refers to the doji candlestick.

Example of a Bullish Harami Pattern

It can be helpful to use an example of a stock’s price action to show how a bullish harami pattern works.

While the harami candlestick formation is frequently used and offers a favorable reward/risk ratio, it does not guarantee profits. It’s important to know the existing price trend and use other trading tools for better results.

Initially, you want to identify that a downtrend was in place before the harami pattern appeared. Let’s say a stock was trading at $100 one year ago, and it closed at $30 on the most recent trading day. You can use other technical tools like moving averages to help confirm the bearish price trend.

Next, look for clues that the bears are losing their stranglehold on the security — that could be seen with a bullish hammer or other candlestick patterns. This is not a requirement, but it can be a telltale signal that a reversal is not far off. What’s important is that a bearish trend is in place before day 1’s candle.

In our example, let’s say day 1’s candle opens with a small gap down to $29. Intraday price action is bearish. The stock closes at $26, near the low of the day. Bears are excited as a downward price trend seems to be continuing. The stock’s sentiment is likely very bearish.

Day 2 opens with a minor gap higher to $27. The low of the day and high of the day are tight — between $26.50 and $27.50. The stock settles up on the day at $27.20. That is also slightly above the opening price.

The entire session’s trading activity is within day 1’s range.

While other candlestick patterns require a third day to help confirm a reversal in trend, a bullish harami pattern does not. Traders use the two-day candlestick pattern to identify a bullish price reversal.

Other technical indicators, like the relative strength index, can be used to show that the market is in an oversold condition.

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Does the Bullish Harami Pattern Work?

When researching stocks, technical analysis is used to help traders improve their chances of making profits over time. One indicator is never a sure thing, though.

It is helpful to analyze price action around the harami and to use other tools to spot key areas of support and resistance.

A bullish harami pattern has advantages and disadvantages. Let’s describe those.

Benefits of the Bullish Harami Pattern

An upshot to the bullish harami is that it can offer early long entry points when a bullish trend begins. That means the risk to reward ratio can be very favorable.

Moreover, it is an easy pattern to identify on a price chart.

Drawbacks of the Bullish Harami Pattern

There are some limitations, however.

You should not use the harami in isolation. You also must know the prevailing price trend when looking for a bullish harami pattern.

Finally, you should have a grasp of momentum indicators to help support the case for a bullish reversal.

How to Trade a Bullish Harami Pattern

You trade the bullish harami pattern by spotting a small bullish candlestick after a long bearish candle within an existing downtrend. You can use momentum oscillators and other technical indicators to help confirm a bullish reversal is taking shape.

A buy order can be executed after period 2’s candlestick. A trader might place a stop loss order below the low price over the 2-day harami pattern.

Since a new bullish trend pattern may be developing, look for multiple upside price targets to take profits based on prior support and resistance levels.

Bullish Harami Pattern in Crypto

Bullish harami candlestick patterns can be found on several timeframes and across many assets. It is a popular indicator among cryptocurrency traders. The tight risk range can lead to attractive risk-to-reward ratios.

A downside with crypto markets, since they trade 24/7, is that it is rare to see a price gap, so that is a limiting factor, but it can make the pattern even more important when it does appear on a crypto chart. Some traders also make allowances for no gap in price between periods, with all other factors in place.

The Takeaway

The bullish harami is a two-day candlestick pattern indicating a prior bearish trend could be reversing. A bullish harami candlestick pattern could signal that a bottom may be close, and that a bullish trend might be taking shape.

Period 1 of the pattern features a large bearish session with downward price action.

Period 2’s candle has a small body often with minor upper and lower wicks. The bullish harami candlestick pattern is used to spot signs of bearish exhaustion.

An upshot to the bullish harami is that it can offer early long entry points when a bullish trend begins. That means the risk to reward ratio can be very favorable, but this does have its limitations, and is best used by experienced investors when considering their goals.

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Aug
18
2023

Dividend Discount Model (DDM): Formula & Examples

By | Growing Wealth, invest, Investing | Comments Off on Dividend Discount Model (DDM): Formula & Examples

The Dividend Discount Model (DDM) is a fundamental quantitative valuation tool used to help determine the intrinsic value of a stock. There are several variations of the model based on future cash flow assumptions of owning a stock.

The goal is to determine a stock’s fair value, then compare it to the market price. If a stock is found to be undervalued via the DDM, then an investor might buy shares. If the formula finds a stock is overvalued compared to the market price, it could be a candidate for a short sale.

The DDM has some shortcomings, and other valuation tools can be used in conjunction with it to help improve the accuracy of your fundamental analysis.

Additionally, traders can combine this fundamental analysis with technical analysis tools to determine optimal entry and exit points when buying and selling shares.

What Is the Dividend Discount Model (DDM)

The DDM uses a discounted cash flow approach to valuing a stock. The idea is that a stock’s value is simply the present value of future dividends when discounted back to the present. This equity valuation technique looks closely at the cash flows of a stock including future dividend payments and the sale of the stock itself at some future date.

You can think of it as a bottom-up investing approach. The dividend discount model is used to find stocks that are either under- or overvalued compared to the market price. Thus, it is used to find long and short ideas using fundamental analysis and equity valuation.

To better understand the DDM, it’s helpful to know how business fundamentals, and fundamental stock analysis, works.

When a firm earns profits, it can either retain those earnings or pay them out as dividends. The DDM can work best with companies that pay out a large proportion of its profits as dividends. The DDM does not work as well on firms that do not distribute dividends or on companies that pay very little out to shareholders.

The dividend discount model formula is also based on the notion of the time value of money, which says that a dollar today is worth more than a dollar in the future. For this reason, firms that have big dividends today are generally thought to be worth more than those that defer them to the future (per the calculation).

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Dividend Discount Model vs Discounted Cash Flow Model

The Dividend Discount Model (DDM) is closely related to the Discounted Cash Flow Model (DCF) but has distinct differences.

The DDM focuses on the cash flows associated with holding a stock, including dividends and cash received upon a stock sale.

The DCF model examines the cash flows in a company and determines the overall market value of the company. Cash flows include profits, depreciation, changes in accounts receivable, changes in accounts payable, etc. As you might imagine a DCF calculation is extremely detailed and requires some financial and accounting acumen to perform accurately.

Both models require determining future cash flows and forecasting the future requires a mix of art and science to develop accurate valuations.

Dividend Discount Model Formulas

There are several dividend discount model formulas. Each is based on the nature of future dividend distributions from the company to shareholders.

Gordon Growth Model

The Gordon Growth Model (GGM) is one of the most popular versions of the DDM. It is named after American economist Myron Gordon, who first developed the valuation technique. The GGM is also a rather straightforward spin on the DDM since it assumes a stock will pay dividends at a constant rate into perpetuity.

You might use the GGM when analyzing very stable businesses that have steady cash flows and a track record of consistent dividend payouts. Big, blue-chip companies and utility stocks are good examples. The GGM is expressed as:

Gordon Growth Model

Where:

•   V0 = The current stock price

•   D1 = The dividend payment one period from now

•   r = The required rate of return on the stock

•   g = The constant growth rate of the company’s dividends into perpetuity

Be aware that the model is extraordinarily sensitive to the dividend growth rate used.

One-Period Dividend Discount Model

The one-period DDM is used less frequently than the popular Gordon Growth Model. It is useful when an investor wants to calculate a stock’s fair value in order to trade it after one period (often one year). Since it is a one-period look, a single dividend is used along with the proceeds of the sale of the stock. Those are the only two cash inflows.

One-Period-Dividend-Discount-Model

Where:

•   V0 = The current stock price

•   D1 = The dividend payment one period from now

•   P1 = The stock price one period from now

•   r = The required rate of return on the stock

Multi-Period Dividend Discount Model

In contrast to the one-period DDM, the multi-period formula assumes that an investor plans to hold a stock over a period that features many dividend payments.

What makes this variation of the DDM tough is that you forecast several future dividends. There is no guarantee that a firm’s payout policy will match your forecast. Like other DDM models, a final return of capital is assumed — the sale price of the stock at the end of the holding period.

Multi-Period-Dividend-Discount-Model

Each future dividend is discounted back to the present using a discount rate that is typically the firm’s estimated cost of equity.

Variable Growth DDM or Non-Constant Growth

You can get even more complex with the variable growth version of the dividend discount model formula. With this approach, you can divide growth into several stages.

Perhaps a firm will grow rapidly over the first year, slow down in year two, then finally transition into a steady grower into perpetuity. Some argue this is a more realistic way to value a stock versus other models. The variable growth DDM assumes non-constant growth by commonly using a two-stage or three-stage approach. Of course, even more stages can be applied.

Zero Growth DDM

A final approach is the zero growth dividend discount model. This is actually the simplest of all DDM variations. It is the same calculation you would use when valuing a perpetuity or preferred stock. It’s simply:

current-stock-price

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Dividend Discount Model Example

Let’s perform an example using the most common DDM method: the Gordon Growth Model.

Suppose a company pays a current annual dividend of $5 (D0) and will grow it at a steady rate of 3% per year into perpetuity. Shares currently trade at $60. We will also assume we used the Capital Asset Pricing Model to find the firm’s 10% estimated cost of equity. Here’s how the DDM would look:

dividend-discount-model-example

Since we found the stock’s intrinsic value to be significantly higher than the market price, we might buy shares with the thought that eventually the market will realize how valuable the stock is and the price will move towards our valuation.

Interpreting DDM Results

Interpreting the results from the dividend discount model is straightforward, but it is getting to the output that can be tricky. The inputs to the calculation are often subjective and can change over time, so any interpretation should be taken with a grain of salt.

Dividends can be hard to forecast accurately, and valuations are sensitive to the growth and discount rates chosen. The analyst must also be open to the possibility that market forces can cause an over- or under-valued stock to further drift from intrinsic value.

How Investors Can Use DDM

The dividend discount model, and all its variations, can be used to calculate a stock’s fair value. In practice, that fair value is then compared to the market price.

Investors can choose to go long shares when they determine that a company’s intrinsic value is above the market price. They can also short shares if the DDM valuation method determines that a stock is overvalued compared to the market price.

The dividend discount model can be used to value stocks in different sectors to see which might be the best investment.

The use of the DDM is based on fundamental analysis and the notion that stock values ultimately revert to their intrinsic worth based on the present value of future cash flows.

Investors can use the DDM along with other valuation techniques to help form a better mosaic of a company’s value. Moreover, technical analysis indicators could be used for more precise buy and sell price points.

The Takeaway

The dividend discount model formula is one of the most widely used equity valuation techniques. Its premise is that firms pay out a large proportion of their profits as dividends to equity holders, thus an intrinsic value can be calculated using those predictable future cash flows.

There are several variations of the DDM based on the profile of a firm’s future dividends. There are drawbacks to the DDM, and using other valuation methods can help an analyst determine if a stock is over- or under-valued.

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

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.

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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Aug
18
2023

The Heston Model: Defined & Explained with Calculations

By | Growing Wealth, invest, Investing | Comments Off on The Heston Model: Defined & Explained with Calculations

The Heston model is an options pricing model developed to address some of the shortcomings in the Black-Scholes model when pricing European options. In contrast to the Black-Scholes model, the Heston model uses stochastic, not constant, volatility as a key variable to determine option prices.

Developed by mathematician Steve Heston in 1993, this model is thought to be more real-world in nature since implied volatility percentages change during an option’s life. However, the Heston model is just one of many option valuation techniques to consider.

What Is the Heston Model?

The Heston model is used to gauge the value of options. The main difference between this and other models is how volatility is treated. The Heston model for option pricing assumes that volatility is stochastic, or random. That simply means that volatility is treated as a variable, in contrast to other models that assume constant or local volatility.

Option prices are made up of several variables — often referred to as the Greeks. It is important to understand price inputs in order to know how to trade options. Volatility is a major piece of the price of an option. The higher the implied volatility, the more valuable the option is. The Heston approach accounts for this by assuming there is a relationship between a stock’s price and its volatility.

💡 Quick Tip: In order to profit from purchasing a stock, the price has to rise. But an options trading 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.

How Does the Heston Model Work?

By assuming that volatility is random, many traders believe the Heston option pricing model works better than the Black-Scholes model since it captures the true nature of volatility. The Heston approach is considered a superior model to the Black-Scholes, too. The downside is that it can be more complicated to calculate. Moreover, it can only be used on European options — those that can be exercised only at expiration.

Like other option pricing models, the Heston method attempts to determine the time value piece of an option’s total value. Intrinsic value is straightforward to figure out since it is just the difference between the stock price and strike price. Intrinsic value and time value comprise an option’s total worth.

Heston Model Pros and Cons

The Heston option pricing model has several advantages and disadvantages. By incorporating variable volatility characteristics, an options trader can have more confidence in the Heston model’s output reflecting observed market behavior versus other valuation techniques. The Heston model achieves increased accuracy by considering correlations between the price of a stock and its volatility. It also assumes that volatility exhibits mean reversion.

Additionally, Heston’s approach yields a closed-form solution that can simplify what is a complex mathematical equation.

The Heston model has its limitations. For one thing, the output is only as good as the variables you assume. This model is also thought to be ill-equipped to price options close to expiration due to instances when implied volatility might be extremely high.

Perhaps the biggest downside is its complexity versus Black Scholes and the binomial options pricing model.

Pros

 Cons
Incorporates more realistic market conditions such as changing volatility levels Only useful on European-style options
Prices options considering the price and maturity variables on volatility Only as good as the inputs used
Yields a closed-form solution that can be used to compare an option’s value to its market price Considered not an accurate gauge to price short-term options with high volatility

Heston vs Black-Scholes Model

Understanding the differences between the Heston model and the Black-Scholes model can help you determine which might work best when you trade options.

Heston Model

 Black-Scholes Model
Assumes that volatility is random Assumes that volatility is constant
Incorporates a relationship between a stock’s price and its volatility Does not incorporate correlations between a stock’s price and volatility
Can be used in a variety of market conditions Prices options under one set of volatility parameters

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.

Heston Model Formula Explained

The Heston volatility model includes several mathematical inputs. Knowing these can help you find the right strategies for trading options. Understanding the model inside and out can arm you with the quantitative armor other traders might not possess.

Here is the full Heston model formula:

Heston model formula

Where:

•   St = specific asset price at time t

•   r = the risk-free interest rate, often a short-term Treasury rate

•   √Vt = volatility (standard deviation) of the asset

•   σ = volatility of volatility

•   θ = long-run price variance

•   k = reversion rate to the long-term price variance

•   dt = indefinitely small positive time increment

•   W1t = Brownian motion of the asset price

•   W2t = Brownian motion of the asset’s price variance

Note that the two Brownian motions are negatively correlated. For example, a drop in the asset price will see an increase in volatility. The two Brownians are related by the following equation:

Brownian equation

Where ρ is the correlation.

In his original paper describing this model, Heston provided default parameters for the equations above which include:

•   St = 100

•   r = 0

•   Vt = 0.01

•   σ = 0.1

•   θ = 0.01

•   k = 2

•   ρ = 0

•   Option maturity = 0.5 year

Further calibration of the model requires advanced mathematical analysis.

Other Option Pricing Models

The Heston option pricing is just one of many approaches to consider. Let’s outline several of the most common methods you might use to price options.

Binomial Model

The binomial model uses an iterative approach using several periods to value American-style options. It follows a binomial pricing tree, which can be useful in illustrating how option prices change from one period to another. This method is considered intuitive and is used more often than Black-Sholes.

Risk-Neutral Probability

The risk-neutral approach to option pricing assumes that risk is not considered. This method can help a trader assess the true value of an option outside of market risk conditions.

Monte Carlo Simulation

Monte Carlo simulations are sometimes used to gauge the value of options. This method utilizes computer simulations to create thousands of potential outcomes. Option values can be calculated based on the probability-weighted computer output.

Monte Carlo simulation is used to generate realistic market conditions which can be useful for options traders as they attempt to assess how an option value will fluctuate over time. However, it can be time-consuming and costly to run these complex programmatic scenarios.

The Takeaway

The Heston model prices options using stochastic (random) volatility to more accurately model options pricing behavior. The more well-known Black-Scholes option pricing model assumes that implied volatility remains constant.

Some traders believe that the Heston model approach works better to incorporate practical, real-world conditions. Still, there are many techniques to price options for you to consider when you trade.

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

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

With SoFi, user-friendly options trading is finally here.

FAQ

What is the Heston model used for?

The Heston Model is used for pricing European options. It uses stochastic volatility to arrive at pricing outcomes, helping traders value options. If a trader determines that an option is over- or under-valued, they might sell or buy the option, then hold it through expiration or trade out of the position before expiration. It is important to remember that European options, unlike American options, cannot be exercised early.

Is the Heston model better than Black-Scholes?

It’s hard to conclude that the Heston stochastic volatility model is better than the more widely known Black-Scholes model. In contrast to Black-Scholes, the Heston model assumes that volatility can change. The Heston model can be more useful to traders since it assumes implied volatility, an important variable for options pricing, increases as options become more in-the-money or out-of-the-money. While the Heston model is considered to be more accurate, it comes with increased computational complexity or in layman’s terms…it’s slower.

What does stochastic local volatility mean?

Local volatility is a basic application of the Black-Scholes model. It accounts for the requirement to price-in skewness into option values. Stochastic volatility contrasts local volatility in that the former can produce a more real-world forward volatility profile. It’s thought that stochastic volatility can overprice options while local volatility and the Black-Scholes method might underprice options.

Photo credit: iStock/FG Trade

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.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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Aug
18
2023

Guide to Barrier Options

By | Growing Wealth, invest, Investing | Comments Off on Guide to Barrier Options

Barrier options are complex derivative products that have payoffs based on whether an underlying asset crosses a pre-specified price threshold.

There are several types of barrier options, and they are used to hedge a portfolio or simply to speculate on an underlying asset’s price change, much like regular call and put options. But due to the restriction of the barrier, premiums tend to be lower when initiating the trade.

What Is a Barrier Option?

Barrier options are just like regular options with the inclusion of an additional barrier to the regular option payoff.

Beginners start trading options with purchases of simple puts and calls. Options trading quickly turns complex as you dive into writing options, combination strategies, and exotic options.

In contrast to barrier options, plain-vanilla options typically have some value as the asset approaches and then crosses the strike price. Before an option is in the money, the value is known as time or extrinsic value.

Once an option is in the money, the option price is a combination of intrinsic value and extrinsic value.

A barrier option’s payoff (or lack thereof) is predicated by the underlying asset crossing some barrier price determined upon option initiation. Once the barrier is crossed, the nature of the option changes.

In some cases, the option is “normal” but after crossing the barrier it becomes worthless forever, simply by crossing the barrier. Other barrier options begin as worthless (or close to it), but revert to a normal option once they cross the barrier, even if they later cross the barrier again.

These products can be used to develop simple or complex strategies in options trading.

💡 Quick Tip: If you’re an experienced investor and bullish about a stock, purchasing call options (rather than the stock itself) can allow you to take the same position, with less cash outlay. It is possible to lose money trading options, if the price moves against you.

How Barrier Options Work

First, recognize that a barrier option is an exotic option — it comes with added rules and features compared to the more common American-style and European-style flavors. A barrier option is also path-dependent, much like non-exotic options, in that its value is determined by changes in the underlying asset’s market price.

A key feature of a barrier option is when it can be exercised. Depending on the barrier option pricing terms, its value activates or becomes worthless at that crossover price.

Pros and Cons of Barrier Options

Barrier options work like puts and calls, but they feature more restrictions than standard American or European options. That leads to advantages and disadvantages for both the holder and seller of a barrier option.

Barrier options’ pricing terms often dictate how and when traders of these derivatives might use them in their trading strategies.

In general, there is less risk for the barrier option seller and more restrictions put on the owner. Both parties, however, should be aware that there is less liquidity in barrier option markets compared to more actively traded standard options markets.

Pros

 Cons
Lower option premiums means a cheaper way to trade for option buyers Less chance to exercise due to restrictive terms (for the holder)
Reduced risk to the option writer Poor liquidity versus plain vanilla puts and calls
Can be more customized than standard options Added complexity makes barrier options tougher to understand for new traders

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.

Knock-In and Knock-Out Barrier Options

Knock-in and knock-out barrier options are the two common types of barrier options. Knock-in options are unable to be exercised until the underlying security crosses a trigger point, deemed the barrier price.

Knock-out options can be exercised immediately, but they turn inactive (worthless) at the time of breaching the barrier price. It can be helpful to see how these products work via barrier options examples.

Knock-In

Knock-In Option Example

Let’s say you buy a knock-in barrier call option featuring a strike price of $100 and a barrier of $110 while the underlying security trades at $90. The option is not exercisable until the underlying asset’s price climbs above the $110 barrier.

The option owner pays a premium but that premium is lower than for a regular call. Why?

Two reasons:

1.    The barrier option won’t be immediately exercisable and is worth close to zero until the underlying asset crosses the barrier price.

2.    The barrier price typically exceeds the strike price for calls and is below the strike price for puts. That means the likelihood to have any intrinsic value is lower because the option must first breach the barrier. A regular option has intrinsic value once it exceeds the strike price.

However, after the barrier is breached the barrier option will trade like any other standard call option with a strike of $100, no matter what the price does subsequent to breaching the barrier. If the barrier is not broken, the seller keeps the premium.

Knock-in barrier options are broken down further into up-and-in or down-and-in options.

The call above is an up-and-in barrier option example, the asset price must move up for the option to be exercisable. Down-and-in means the price must move down to the barrier before it is exercisable and typically is used for barrier put options.

Knock-Out

Knock-Out Option Example

For a knock-out barrier option, we’ll assume you bought an up-and-out call option with a barrier of $50 and a strike of $40 while the underlying asset trades at $35. If the asset rallies to $50, the option will cease to exist and be worth nothing.

A knock-out option is worthless even if the underlying asset’s price touches the barrier price for only a moment before falling back.

The call above is immediately exercisable and will always trade at a lower price than a regular call. Why?

Reasons include:

1.    If the underlying asset is far from the barrier, the option will be cheaper than a regular option as it is still at some small risk of breaching the barrier and being worthless.

2.    As the underlying asset moves closer to the barrier the option will move towards zero as the risk of crossing the barrier increases dramatically.

Knock-out barrier options are broken down further into up-and-out or down-and-out options. The difference is which way the price must move to breach the barrier and become worthless.

As you can see, barrier options pricing puts a spin on the usual calls and puts you might be familiar with.

Types of Barrier Options

Beyond knock-in and knock-out options, there are a few other barrier option types to learn about.

Rebate Barrier Options

Rebate barrier options have provisions that allow the holder to retain some value of the option contract even if the barrier price is not reached. It might be a percentage of the premium paid from the execution of the trade.

This might be seen as a less risky version of barrier options as it is not an all-or-nothing approach.

Turbo Warrant Barrier Options

Turbo warrant barrier options are traded more actively in overseas markets. They are a category of down-and-out options and feature high leverage.

While they can be risky, turbo warranty barrier options are also less volatile than other types.

Parisian Option

Both time and price are key variables with Parisian barrier options. They work similarly to Asian options. They are different in that the underlying security’s price must not only cross the barrier but stay above that price for a predetermined time period before the contract is in effect.

The Takeaway

Barrier options offer traders another means to hedge a portfolio or speculate on an underlying asset. This type of option is exotic, meaning it is more complex than plain vanilla puts and calls.

With barrier “in” options, the call or put does not go into effect until a barrier price level is hit while “out” options are active until the barrier price is touched.

Barrier options give investors more flexibility and customization at a cheaper price, but they can be more restrictive and less liquid than other options.

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

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

With SoFi, user-friendly options trading is finally here.

FAQ

Are barrier options American or European?

Barrier options are complex exotic options different from the two common styles of options: American and European. While American-style options can be exercised at any time, before and at expiration, and while European-style options can be exercised only at expiration, barrier options are exercisable only after the barrier price is reached.

How are barrier options valued?

Barrier options have a path-dependent value since their worth is based on the underlying asset’s price movements. It is only when the underlying price crosses the barrier price that the option has value and can be exercised. If that predetermined barrier option price is never reached, then the option is worthless with a typical knock-out option. Knock-in options are non-exercisable until they reach the barrier price.

Can you replicate barrier options?

Some strategies can replicate the structure and payoff profile of barrier options. Many of these analyses were performed by academics over recent decades. The goal is often to produce sound portfolio hedging techniques.

Photo credit: iStock/nensuria

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.

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

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