Time decay is the loss of an option’s value as it gets closer to expiration. Time decay accelerates, meaning the time value declines more quickly, as the expiration date gets closer because investors have less time to profit from the contract.

Financial Topics Archives

May

2024

Time Decay of Options: How It Works & Its Importance

By Brian Nibley | Growing Wealth, invest, Investing | Comments Off

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

Time decay, as it relates to options trading, has to do with an option contract’s loss of value as it nears its expiration date. There are numerous variables in the mix when it comes to time decay, but knowing the basics of what the terms means, and how it can affect an investment strategy, can be important for investors.

Key Points

• Time decay refers to the reduction in an option’s value as its expiration date approaches.

• The rate of time decay is represented by theta, which accelerates as expiration nears.

• Options lose more value in the final month before expiration due to increased time decay.

• Intrinsic and extrinsic values are key components in options pricing, affected by time decay.

• Understanding time decay is crucial for options traders to manage potential profits and losses effectively.

What Is Time Decay?

Time decay is the loss of an option’s value as it gets closer to expiration. An option’s time value refers to the extent to which time factors into the value — or the premium — of the option. Time decay accelerates, or declines more quickly, as the expiration date gets closer because investors have less time to exercise the contract.

For options traders, understanding the power of time decay is important whether you’re buying call options or put options. Here are the basics you need to know.

Recommended: Options Trading: A Beginner’s Guide

How Time Decay Works

The rate of change in the time value of an option is known as theta. For traders who buy options with the intention of holding them until expiration, theta usually isn’t of great concern. That’s because traders who hold contracts until the expiry date are hoping that the underlying security moves so far in their favor that the reward in terms of intrinsic value will outweigh any loss in extrinsic value.

But traders who want to close their options position prior to expiration may be more concerned about time decay. Because the security will have less time to move in their favor, the potential profit from intrinsic value is reduced, and the potential loss of extrinsic value becomes greater.

While both intrinsic and extrinsic value are important for options traders of all kinds, the type of options trading strategy a trader is using can influence which factors they put more emphasis on.

Understanding Options Pricing

Time decay isn’t a difficult concept, but it does require a quick refresher about how options are traded and priced.

Four of the main variables that impact the price of an option are:

1. The underlying price and strike price

2. Time left until expiration

3. Implied volatility

4. Time decay

The underlying price, strike price, and expiration date of the options contract are the main factors that determine its intrinsic value, while implied volatility and time decay are the factors that determine its extrinsic value.

• Intrinsic value. An option’s intrinsic value refers to the option’s value at the time of expiration, which depends on the price of its underlying security relative to the strike price of the contract. In other words, whether the option is in the money, out of the money, or at the money.

• Extrinsic value. Extrinsic value refers to how time can impact the option’s value, i.e. its premium. As the expiration date of the options contract approaches, there’s less time for an investor to profit from the option, so time decay or theta, accelerates and the option loses value.

Interest rates can also affect options prices, but this is more of a macro factor that doesn’t have to do with the specific contract itself.

Thus, time value represents the added value an investor has to pay for an option above the intrinsic value. Options are sometimes referred to as depreciating or wasting assets because they tend to lose value over time, since the closer the option is to expiration, the faster its time value erodes.

Finally, user-friendly options trading is here.*

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*Check out the
OCC Options Disclosure Document.

How to Calculate Time Decay

The rate of an option’s time decay is measured by theta.An option with a theta of -0.05 (theta is expressed as a negative value) would be expected to fall about $0.05 each day until expiration, but this would likely accelerate during the days and weeks leading up to the expiry date.

Greek values like theta are constantly changing, and can therefore be one of the most difficult factors to take into account when trading options.

Example of Time Decay of Options

Imagine an investor is thinking about buying a call option with a strike price of $40. The current stock price is $35, so the stock has to rise by at least $5 per share for the option to be in the money. The expiration date is two months in the future, and the contract comes with a $5 premium.

Now imagine a similar contract that also has a strike price of $40 but an expiration date that is only one week away and comes with a premium of just $0.50. This contract costs much less than the $5 contract because the stock would have to gain almost 15% in value in one week to make the trade profitable, which is unlikely.

Thus, the extrinsic value of the second option contract is lower than the first, because of time decay.

How Does Time Decay Impact Options?

Option time decay is pretty straightforward in principle. Things can be more complicated in practice, but in general, options lose value over time. The more time there is between now and the expiry date of the option, the more extrinsic value the option will have. The closer the expiry date is to the current date, the more time decay will have taken effect, reducing the option’s value.

The basic idea is that because there’s less time for a security to move one way or the other, options become less valuable the closer they get to their expiration dates. This isn’t a linear process though. The rate of time decay accelerates over time, with the majority of decay occurring in the final month before expiration.

💡 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.

The Takeaway

If you think about it, the time value of an option is similar to other things that have a value which is time dependent. A fresh loaf of bread, a new car, a newly built home — these items would have an intrinsic value, but you might also pay a premium when they’re at full value.

As time passes, though, consumers will pay less for loaf of bread that isn’t fresh — or a car or home that’s older — because time has eroded some of the value. Similarly, as an option gets closer to its expiration date, it too loses value owing to the effects of time decay or theta.

SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.

With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.

Explore SoFi’s user-friendly options trading platform.

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.

For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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.

¹Claw Promotion: Probability of Member receiving $1,000 is a probability of 0.026%; If you don’t make a selection in 45 days, you’ll no longer qualify for the promo. Customer must fund their account with a minimum of $50.00 to qualify. Probability percentage is subject to decrease. See full terms and conditions.

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May

2024

Callable Bonds (or Redeemable Bonds), Explained

By Paulina Likos | Growing Wealth, invest, Investing | Comments Off

Table of Contents

What Is a Callable Bond?
How Do Callable Bonds Work?
Types of Callable Bonds
Callable Bond Example
Interest and Callable Bonds
Pros and Cons of Callable Bonds

Callable bonds give issuers the option to redeem the bond before it matures. They’re also referred to as redeemable bonds. Bond investors lend their money to entities or issuers for a certain period of time and in return investors receive interest on the principal. These entities typically return the borrowed principle to the bond investors by the bond’s maturity date.

An exception to this process of bond investing is using callable bonds, which allows the issuer to pay off its loans early by buying back its bonds before they reach their date of maturity. You can define a callable bond as one with a built-in call option.

Key Points

• Callable bonds allow issuers the option to redeem the bond before its maturity date.

• These bonds can be advantageous for issuers during periods of falling interest rates, allowing them to refinance at lower rates.

• Investors receive higher interest rates on callable bonds to compensate for the risk of early redemption.

• The value of callable bonds is influenced by changes in interest rates, with their desirability decreasing as interest rates fall.

• There are various types of callable bonds, including optional redemption, sinking fund redemption, and extraordinary redemption bonds.

What Is a Callable Bond?

Callable bonds, also referred to as redeemable bonds, allow the issuer the right, but not the obligation, to redeem the bond before it reaches its maturity date. The entity that issues callable bonds has the right to prepay, or in other words, the bond is callable before its maturity date.

Issuers may use callable bonds when they expect interest rates to fall. That way, they can redeem their bonds and issue new ones at a lower coupon rate, reducing their overall interest expenses.

How Do Callable Bonds Work?

When the issuer calls the bond, it pays investors the call price or the face value of the bond, along with the accrued interest to date. After that, the issuer no longer has to make payments on the bond.

Businesses may prefer callable bonds, since they have built-in flexibility that could lower costs in the future. For example, if market rates are 5% when a company first issues its bonds but they drop to 2.5%, a bond issuer paying 5% would call their bonds and get new ones at 2.5%.

Some bonds have call protection which forbids the issuer to buy it back for a certain period of time. During this period, the company can not call their bonds. However, at the end of this period, the issuer can redeem the bond at its specified call date.

Callable bond prices correlate to interest rates, since falling interest rates make callable bonds less valuable.

Finding the Value of Callable Bonds

The main difference between a non-callable bond and a callable bond is that a callable bond has the call option feature. This feature impacts the calculation of the value of the bond. To find the value of callable bonds, take the bond’s coupon rate and add 1 to it.

For example, a callable bond with a 7% coupon would be 1.07. Next, raise 1.07 to the number of years until the bond is callable. If the bond is callable in two years, you would raise 1.07 to the power of two, which would be 1.1449. Then, multiply that number by the bond’s par value or face value.

If the bond’s par value is $10,000, you would multiply $10,000 by 1.1449 to get 11,449, which is the value of the callable bond.

Recommended: How to Buy Bonds: A Guide for Beginners

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Types of Callable Bonds

Bonds have different types of issuers. Municipalities and corporations both may issue callable bonds. Here’s a look at three common types of callable bonds.

1. Optional Redemption Callable Bonds

Some municipal bonds have a redeemable option 10 years after the issue of the bond was issued. However, bonds with higher yields might have a protection or waiting period according to the bond’s maturity date. For example, a five-year bond might not be able to be recalled until two years after it is issued.

2. Sinking Fund Redemption Callable Bonds

This requires the issuer to recall a certain amount or all of the bonds according to a fixed schedule. A sinking fund is money that a company reserves on the side to pay off a bond.

3. Extraordinary Redemption Callable Bonds

Extraordinary redemption is when the issuer recalls the bond before maturity if certain specified events in the bond contract occur such as a business scenario that impacts bond revenue.

Callable Bond Example

A callable bond with a par value of $1,000 and a 5% coupon rate issued on January 1, 2022 has a maturity date of January 1, 2030. The annual interest payments investors would receive is $50. This bond has a protection feature which doesn’t allow the issuer to recall the bond until January 1, 2026, but after that date, the bond can be redeemed.

The issuer believes interest rates will decrease within the next four years and decides to recall the bond on January 1, 2026. If the investor bought the callable bond through their broker at its $1,000 par value, and the issuer chooses to redeem it when the protection period expires in 2026, they would calculate the value of the callable bond as follows:

• Take the coupon rate and add 1 to it, to make 1.05.

• Next, multiply 1.05 to the fourth power since the issuer will hold on to it for four years.

• This calculation will yield 1.2155.

• Next, multiply 1.255 by the bond’s par value of $1,000 to get $1,215, the value of the callable bond.

Interest and Callable Bonds

From the perspective of the callable bond issuer, falling interest rates are an opportunity to recall your bonds and lower your interest rate. While the investor is compensated at the outset with a higher yield or coupon rate for investing in callable bonds, they must be aware of the added risks associated with this investment.

If interest rates stay the same or increase, there’s a lower chance the issuer will recall its bonds. But if investors believe interest rates will drop prior to the bond’s maturity date, they should be compensated for this additional risk. The investor must determine if the higher yield from callable bonds is worth the risk of investment because the call feature is an advantage to the issuer, not the investor.

💡 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.

Pros and Cons of Callable Bonds

Like any other investment, callable bonds have benefits and risks. It’s important to keep in mind the pros and cons of investing in callable bonds when considering a long-term investing strategy.

Callable bonds are financial instruments that may carry more risk for investors than noncallable bonds (bonds only paid out at maturity) because there is the chance of the bond being called prior to it reaching maturity.

Pros	Cons
Companies issue callable bonds at higher interest rates to compensate for the risk of early redemption. This means the possibility of greater investment returns.	If an issuer calls its bonds early as a result of lower interest rates, bond investors risk not being able to find bonds with lower coupon rates. This could pose a challenge for income-seeking investors who want a reliable stream of passive income from bond investing.
One of the benefits of callable bonds is the option to call the bond early. Instead of waiting until the bond reaches maturity, the issuer can recall the bond earlier to suit their financial business needs.	Callable bond investors who pay a premium, or more than a bond’s face value risk only getting back the face value of the bond. This means the investor would lose their money on the premium they already paid.
Callable bonds have benefits that mostly favor the issuer. When interest rates fall, the company can redeem the bonds early and issue new bonds at a lower rate to save on interest payments.	Another risk is the bond’s maturity. The longer it takes for the bond to mature, the greater the likelihood for the bond to be called early, especially if there is a change in interest rates. Investing in bonds with a shorter maturity date carries lower interest rate risk.

The Takeaway

Again, callable bonds give issuers the option to redeem the bond before it matures. They’re also referred to as redeemable bonds. Callable bond investors lend their money to entities or issuers for a certain period of time and in return investors receive interest on the principal.

Some investors might consider buying callable bonds as one way to diversify an investment portfolio or to achieve higher yield, however, it’s important for investors to keep the risks associated with this investment top of mind. In an environment where interest rates are falling, callable bonds may not work for long-term investors looking for income.

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¹Opening and funding an Active Invest account gives you the opportunity to get up to $3,000 in the stock of your choice.

FAQ

Are callable bonds a good investment?

Callable bonds may be a good investment depending on an investor’s strategy, risk tolerance, and time horizon, but the overriding interest rate environment may also determine how good of an investment they are as well.

What does it mean if a bond is callable?

If a bond is callable, it means that bonds can be redeemed or paid off by their issuer before they reach their maturity date.

What is the call rule on a callable bond?

The call rule on callable bonds refers to the ability of a bond to be redeemed or repaid by its issuer prior to its maturity date.

What happens to callable bonds when interest rates rise?

When interest rates rise, callable bonds are less likely to be called, though there are no guarantees.

Are callable bonds cheaper?

Generally, callable bonds tend to be less expensive than normal bonds because of the call option, which are of value to their issuer, and may lead to a relative discount for the buyer.

Do callable bonds have higher yields?

Callable bonds do tend to have higher yields, but often not greatly so, and there’s no guarantee that the yields would be higher than those of other types of bonds.

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.

For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

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.

¹Claw Promotion: Probability of Member receiving $1,000 is a probability of 0.026%; If you don’t make a selection in 45 days, you’ll no longer qualify for the promo. Customer must fund their account with a minimum of $50.00 to qualify. Probability percentage is subject to decrease. See full terms and conditions.

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May

2024

Investing in Options vs Stocks: Trading Differences to Know

Buying Options vs Stocks: Trading Differences to Know

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

Stocks and options are two of the most popular investment types that investors might include in their portfolio. There are reasons to invest in each, and they both come with their own risks, timelines, pros, and cons.

When deciding whether to invest in stocks vs. options, or any type of security or asset, it’s important to consider your personal investing goals, experience, risk tolerance, and investing horizon.

Key Points

• Options are derivatives that provide the right, but not the obligation, to buy or sell a stock at a set price before a certain date.

• Stocks represent shares of ownership in a company, potentially offering dividends and voting rights.

• Options can offer high leverage, allowing significant exposure to stock price movements without full investment in the stock.

• The value of options can decrease rapidly over time due to time decay, especially as expiration approaches.

• Stocks can be held indefinitely, providing potential for long-term gains, whereas options have an expiration date limiting their lifespan.

What Are the Differences Between Options and Stocks?

	Stocks	Options
Common types of Investors	Beginners and long-term investors	Experienced and active traders
Potential Downsides	Risks, Taxes, Fees	Risks, Costs, Complexity
Type of Investment	Equity	Derivative

Options

Options, or stock options, are a type of derivative investment. Rather than buying shares of a company, options contracts give buyers the right, but not the obligation, to buy or sell shares at a specified price, (known as the strike price in options terminology,) at a specified time in the future.

A call option gives the buyer the right, but not the obligation, to buy a stock at a specified price, at a specified time in the future. The options investor does not have any ownership of the company’s shares unless they choose to exercise the option and buy the shares.

A put option gives the buyer the right, but not the obligation, to sell a stock at a specified price, at a specified time in the future.

Over the time period of the option, the contract gets exponentially less valuable. This is known as time decay.

Investors may exercise their right to buy or sell a stock, or sell their option position to make a potential profit. Options trading strategies can get complicated, involving buying and selling multiple options on the same underlying security.

Recommended: A Guide to Options Trading

Stocks

Stocks are portions of ownership in companies, also known as shares. Investors can buy shares in companies and become fractional owners of that company in proportion to the number of outstanding shares that company has. For instance, if a company has 100,000 shares and an investor buys 10,000, they own 10% of the company.

Investors who purchase stocks typically hope to buy them at a lower price then sell them later at a higher price to make a profit. There are also other ways investors can earn profits on stocks. For instance, some stocks pay out dividends to owners. Every month, quarter, or year, an investor can earn money based on the number of shares they own.

Recommended: How to Start Investing in Stocks

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.

5 Key Differences in Stocks vs Options

Both stocks and options are popular investments, and there can be a place for both of them in a diversified portfolio. Here’s a look at some of of the differences to keep in mind when it comes to trading options vs. stocks:

1. Risk

Both stocks and options have associated risks. For stocks, the risk is that the value of the security will fall lower than the investor expected. For options, there are additional risks, including the risk that they could exacerbate losses or could expire without being exercised.

2. Ownership

When an investor buys stock, they become partial owners of that company. When they buy options, they do not.

3. Quantities

When buying stock, the number of shares an investor buys is the total number they have, and they can purchase any number of shares, including fractional shares. When buying options, each contract represents 100 shares of stock.

4. Timeline

Options are contracts that are only valid for a certain period of time until the expiration date. They lose value over time until they are worthless when the contract expires. When an investor buys stock, they can hold it as long as they want.

5. Time Commitment

Investors can buy stock and hold onto it without doing much additional work, whereas options traders are often more hands-on and prefer an eye on the market for the duration of the contract.

💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.

When to Consider Trading Stocks

There are several reasons to consider trading stocks, depending on your goals, timeline, and risk tolerance. Like any asset, stocks come with their share of risks and downsides. Some of the pros and cons of stocks include:

Pros

It can be relatively easy to start investing in stocks. There are several other benefits as well:

• Investors don’t have to sell their stocks on any particular date, so they can choose the best time to sell.

• Some stocks pay out dividends to investors.

• Stocks are easier to research than options since they have market history.

• Being an owner of a company may allow investors to vote on certain corporate issues that can affect their investment.

• Stocks typically have more liquidity than options, meaning it’s easier for traders to buy and sell them at any given time.

Cons

Like all securities, there are risks involved with investing in stocks. Those include:

• Whether you buy and sell stocks quickly as a day trading strategy, or hold onto them for years, you will need to pay short or long-term capital gains taxes if you sell for a profit.

• While trading stocks can be very profitable, it’s generally considered a long-term strategy.

• It can be emotionally challenging to watch the market, and one’s portfolio, go up and down in value over months or years.

• Making a big profit on stocks can require a large upfront investment.

• When investing in stocks, traders risk losing all the money they put in.

• Stocks of certain companies are very expensive, making it difficult for smaller traders to even buy one.

When to Consider Trading Options

Like stocks or any investment, options come with their share of risks and downsides. Some of the main pros and cons of trading options are:

Pros

Options trading can be complicated, but there can be significant upside potential. Benefits include:

• Options may be an inexpensive way to participate in the market.

• Options provide investors with leverage. Essentially the investor has some control and access to shares.

• Options can help hedge against market volatility.

Cons

Since fewer traders buy and sell options than stocks, there can be lower liquidity making it difficult to get out of an options contract. Other drawbacks include:

• If an investor buys a stock option, they must pay a premium to enter into the contract. If the stock doesn’t move the way they hope it will and they choose not to exercise the option, they lose that premium they had put in.

• Options lose value over time.

• Trading options may require more ongoing management than stocks.

💡 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.

The Takeaway

Stocks and options are two popular types of investments traders use to earn profits and build a diversified portfolio. Depending on your investment strategy, you might invest in a combination of the two. Note that both have their own associated risks and potential benefits.

Options trading, however, is typically something that experienced investors delve into, and often requires traders to actively invest, rather than leave their portfolios idle. If you’re interested in options, it may be a good idea to speak with a financial professional for guidance.

Explore SoFi’s user-friendly options trading platform.

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

May

2024

What Is Excess Margin & How Do You Use It?

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

The excess margin in a trading account indicates how much available funds it contains above the required minimum amounts. Knowing your excess margin helps determine how many securities you can trade on margin, as well as how much you can withdraw from your account to use for other purposes.

In other words, knowing your excess margin helps an investor get a better idea of their overall buying power, which can be critical in guiding investing decisions.

Key Points

• Excess margin in a trading account indicates available funds above the required minimum.

• It provides a gauge of overall buying power, influencing investment decisions.

• Excess margin can be used as collateral for margin loans or withdrawn.

• A Special Memorandum Account holds the excess margin from a trading account.

• Understanding and managing excess margin is crucial to maintaining account standing and leveraging investment strategies.

What Is Excess Margin?

Excess margin is a trading account‘s equity above the legal minimum required for a margin account, or the amount of equity above the broker’s maintenance margin requirement.

Excess margin is generated from cash or securities a trader deposits in a margin account above required levels. Excess margin can be used as collateral for margin loans, or it may be withdrawn from the account. It is important to monitor your excess margin ratio so you can keep your account in good standing.

Special Memorandum Account

A special memorandum account (SMA) is where excess margin generated from a margin trading account is held. Trading margin is also sometimes called usable margin, available margin, or “free” margin — but to be clear, “free” margin isn’t free in the sense that it doesn’t involve interest charges or fees, it’s “free” in that it’s not tied up in a current position.

Excess margin, on the other hand, is only the margin above the required minimum.

Understanding Trading Margin Excess

Trading margin excess tells you how much buying power you have, but no trader should feel compelled to use all of it just because it is there. Excess cash margin can be thought of as funds left over after you have taken positions during the trading day. You can use excess margin to buy new positions or add to an existing holding.

Understanding how to trade excess margin requires a grasp of how margin accounts work. A margin account allows you to borrow from a broker if you meet initial margin requirements. You will need the greater of either the $2k minimum margin requirement or 50% of the security’s purchase price in your account to buy on margin. For example, if you were to purchase 10 shares of a stock trading at $30, 50% is $1,500.

Since that is less than $2,000, you’ll need to deposit $2,000 in order to purchase the 10 shares on margin. On the other hand, if you wanted to purchase 10 shares of a stock selling for $50, 50% is $2,500 — and you would need to deposit $2,500, not $2,000, in order to make your purchase on margin.In the United States, Regulation T set by the Federal Reserve states that a trader with a margin account can borrow up to 50% of the purchase price of a stock (assuming the stock is fully marginable).

There are also maintenance margin requirements set at 25% by the Financial Industry Regulatory Authority (FINRA) — your equity relative to your account value must not fall below that threshold. Finally, a broker might set stricter margin requirements than the governing authorities.

The value of assets in a margin account that exceeds these requirements is the excess margin deposit. Since you are trading with leverage, the maintenance margin excess amount indicates how much is left that you can borrow against — it is not actual cash remaining in your account. According to FINRA, maintenance margin excess is the amount by which the equity in the margin account exceeds the required margin.

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Risks and Benefits of Excess Margin

An account is in good standing as long as it has margin levels above those set by regulators and the broker. There are dangers with trading excess margin securities, though. Since you trade with leverage in a margin account, there is the risk that your account value could drop dramatically if the market goes against you. Your account can be in good standing one day, but then face a margin call the next day.

If your account violates margin requirements, you will be faced with a margin call. To meet the call, you must deposit cash, deposit marginable securities, or liquidate securities you own. If you do not meet the call, your broker can perform a forced sale. In extreme cases, your account’s trading privileges can be suspended.

On the upside, there is potential to make larger profits by trading on margin. Returns are amplified by leverage. You can also benefit from declining share prices by short selling (it’s worth noting that margin requirements are different for short selling — 30% in most cases). There are other benefits when trading on margin so long as you maintain excess margin. You can use your margin account for loans by borrowing against your assets, often at a competitive interest rate. Margin trading also lets you diversify a concentrated portfolio.

Excess Margin Risks vs Benefits

Risks	Benefits
Trading with leverage can amplify losses	Trading with leverage can amplify returns
A broker can perform a forced sale if you face a margin call	Excess margin tells you how much money you can use for new purchases or to withdraw from the account
You can lose more than what you put in during extreme events	You can hold a diversified portfolio and short positions

What Is an Excess Margin Deposit?

An excess margin deposit is the collateral held in a margin account that is above required margin levels. When the value of your excess margin deposit drops under the required margin amount, you might face a margin call. An excess margin deposit is calculated as the difference between an account’s value and its minimum maintenance requirement. Required margin levels are often higher for equity and options trading accounts versus futures trading accounts.

Managing excess margin securities is important when trading. If you trade positions without understanding risk, then you are more likely to eventually get hit with a margin call. A way to manage excess margin is to trade securities and positions sizes that fit your risk and return preferences.

Excess Margin Deposit Example

An example helps illustrate what excess margin is. Let’s say your margin trading account has $50,000 of unmargined securities. The Reg T requirement dictates that your initial margin is $25,000 (a 50% margin requirement), so excess initial margin is $25,000. Assuming a 25% maintenance margin requirement, $12,500 of equity must be kept after opening the account.

With $25,000 of equity, there is $12,500 of excess margin above the 25% maintenance margin requirement. You can buy more securities with that amount or withdraw it to use for other purposes.

If the account value drops to $45,000, then your equity has fallen to $20,000 ($45,000 of stocks minus the $25,000 loan). Assuming the account has a 25% maintenance requirement, the account would need to have equity of at least $11,250 (25% of $45,000). With $20,000 of equity, the account meets the requirements and is in good standing.

The Takeaway

Excess margin is your margin trading account’s equity above all margin requirements. It is a balance that tells you how much more securities you can buy on margin. The excess cash margin also indicates how much you can pull from the account to use for other purposes.

Excess margin, conceptually, is related to an investor’s buying power, which is why it’s important to understand. There are also rules and regulations in the mix, such as Regulation T, which investors need to keep in mind, too, and risks related to margin calls.

Get one of the most competitive margin loan rates with SoFi, 10.50%*

FAQ

What happens if you go over margin?

If you go over margin, you might be faced with a margin call. A margin call happens when your excess margin deposit falls below zero. Satisfying a margin call involves depositing more cash or securities or liquidating existing holdings to bring the account’s excess margin ratio back within proper limits.

What is excess intraday margin?

Excess intraday margin is the amount of funds in a margin trading account above the intraday margin requirement. It is a balance that tells you how much money is in the account above an intraday margin requirement. Intraday margin is also referred to as day trading margin if you engage in pattern day trading. Note: There are different requirements for a pattern day trader.

Can margin trading put you in debt?

In extreme circumstances, trading excess margin securities can put you in debt due to positions losing value and margin interest being owed. Margin calls issued by brokers help to reduce this risk since the calls require the trader to deposit more funds into the account or liquidate existing holdings. If the trader does not act, the broker might automatically sell securities. If the trader has borrowed too much and market movements are drastically against the trader, equity can turn negative.

Photo credit: iStock/Geber86

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.

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

May

2024

Intrinsic Value and Time Value of Options, Explained

By Colin Dodds | Growing Wealth, invest, Investing | Comments Off

Intrinsic value and time value are two major determining factors of the value of an options contract. An option’s intrinsic value is the payoff the buyer would receive if they exercised the option right away. In other words, the intrinsic value is how profitable the option would be, based on the difference between the contract’s strike price and the market value of the underlying security.

An option’s time value is not quite as straightforward. Time value is based on a formula that includes the expected volatility of the underlying asset, as well as the amount of time until the option contract expires.

Key Points

• Intrinsic value of an option is the profit from exercising it immediately, based on the current market value versus the strike price.

• Time value of an option reflects its potential profitability over time until expiration.

• The formula for intrinsic value involves subtracting the strike price from the current price of the underlying asset.

• Time value decreases as the option nears expiration, a concept known as time decay.

• Volatility of the underlying asset significantly impacts the time value, with higher volatility increasing the premium.

What Is the Intrinsic Value of an Option?

An investor who purchases an options contract may be buying the right, but not the obligation, to buy or sell the option’s underlying asset at an agreed-upon price, known as the strike price. Options are considered derivatives, because they are tied to the value of the underlying security. The contract may allow the investor to purchase or sell a security at that strike price at any point up until the contract expires.

There are two main kinds of options: calls and puts. The purchaser of a call option buys the right (but not the obligation) to purchase the underlying asset at a given price until a particular date.

The buyer of a put option purchases the right (but not the obligation) to sell the underlying asset at a given price until a particular date.

Important terms: In the Money, At the Money, Out of the Money

There are a few more key terms to know as it relates to options: in the money, at the money, and out of the money.

In the Money

An option is considered to be “in the money” if the investor could sell it at that moment for a profit. For a call option, that means that the price of the underlying asset is higher than the strike price specified in the options contract. For a put option to be in the money, the price of the underlying asset would have to be lower than the strike price in the contract.

At the Money

If an option is “at the money,” the price of the underlying security is equal to the strike price in the contract, and it’s not considered profitable. If an option is “out of the money,” e.g. above the market price for a call option or below the market price for a put option, the contract is also not profitable.

Out of the Money

If an option is not profitable when it expires, then it expires with no value, except for the premium. In those instances, the buyer takes a loss on the premium they paid to enter into the options contract, while the seller, or writer, of the contract collects the premium.

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*Check out the
OCC Options Disclosure Document.

Formula for the Intrinsic Value of an Options Contract

Time to get down to the math! Here are the formulas for calculating intrinsic values of call and put options.

Intrinsic value formula for a call option:

Call Option Intrinsic Value = Underlying Stock’s Current Price – Call Strike Price

Intrinsic value formula for a put option:

Put Option Intrinsic Value = Put Strike Price – Underlying Stock’s Current Price

Example of Intrinsic Value Calculation

Imagine that hypothetical XYZ stock is selling at $48.00. A call option for XYZ with a strike price of $40 would have an intrinsic value of $8.00 ($48 – $40 = $8). So in theory, the option holder could exercise the option to buy XYZ shares at $40, then immediately sell them for a $8.00 profit in the market. Another way to phrase it: The contract would be in the money at $8.

But what if the strike price is higher than the $48.00 market price of XYZ stock? Let’s say the call option strike is $50 ($48 – $50 = –$2.00. The option would be considered out of the money and worth zero, because the intrinsic value of an option can never be negative.

What if it’s a put option? In this scenario, with an underlying price of $48.00 for XYZ stock, a put option with a strike price of $44.00 would have an intrinsic value of zero ($44 – $48 = –$4.00), again because the value of an option cannot fall below zero.

But a put option with a strike price of $50 would be considered in the money, and have an intrinsic value of $2 ($50 – $48 = $2).

While intrinsic value as a term sounds all encompassing, it isn’t. Investors should remember when calculating options strategies that an option’s intrinsic value does not include the premium the investor has to pay in order to buy the options contract in the first place. To get a better sense of the profit of an options trade, it’s important to include that initial premium, along with any other trading commissions and fees charged by the broker.

What Is the Time Value of an Option?

When an investor buys an option, they pay in the form of a premium, or fee. When they do, that premium is typically based on the option’s intrinsic value, plus its extrinsic value. While higher volatility can result in higher premiums, time value plays a large role as well.The opportunity for an option to be profitable over time is, in essence, its time value.

The more time an investor in an options contract has, the better their chances of being able to exercise that option in the money, simply because the underlying security has a greater chance of moving in the desired direction. Longer time periods come with greater possibility for profit.

Conversely, as an options contract gets closer to expiring, its value goes down. The reason is that there is less time for the security underlying the options contract to make profitable moves.

One rule of thumb is that an option loses a third of its value during the first half of its life, and two-thirds during the second half. This phenomenon is known as the time decay of options. It’s a critical concept for options investors because the closer the option gets to expiration, the more the underlying security must move to impact the price of the option.

The intrinsic value of the option plays a role in how fast the time value of an option decays. An in-the-money option faces less dramatic time decay, because the elimination of time value takes the overall value of the option to the level of its intrinsic value. But for an out-of-the-money option, time decay is more dramatic, since the option will be entirely worthless if it expires out of the money.

Formula for the Time Value of an Options Contract

The formula for the time value of an options contract is as such:

Time Value = Option Price − Intrinsic Value

How Does Volatility Impact Time Value?

Another important factor that can impact time value is the volatility of the underlying asset.

Stocks with higher volatility typically have the potential for greater price movements — and thus related options may have a higher probability of expiring in the money. That’s one reason why time value, as reflected by the option’s premium, is typically higher when the underlying asset is more volatile.

With stocks and other assets that have lower volatility and therefore are not expected to show big price fluctuations, the time value and the option premium is likely to be lower.

Volatility, as every investor knows, cuts both ways. It can help generate gains or lead to losses.

How Can Intrinsic and Time Value Help Traders?

When calculating the value of the options contracts that they’re buying and selling, intrinsic value and time value can be vital to help traders gauge the potential risks and rewards of the options trade. While the intrinsic value is easy to assess, it only tells part of the story. Traders need to understand the extrinsic or time value of options as well in order to gauge how profitable the option is likely to be.Investors use this deeper understanding to inform which options trading strategies they use.

When it comes to the profitability of an options trade, investors also need to take into account the premiums they pay to buy an option, along with related commissions and fees. There are also other factors that play a role in the pricing of an options contract, such as the option’s implied volatility. This is the aspect of options pricing that takes into account the market sentiment as to the future volatility of an option’s underlying security, and can have a major influence on the price of an option as well.

💡 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.

The Takeaway

Understanding how options are priced is a complicated business, and knowing the two main components — intrinsic value and time value — is essential. While intrinsic value is simply the tangible face value of the contract — because it’s the amount the buyer would receive if they exercised the option right now — time value is a more complex calculation.

The time value of an option, expressed as its premium, is part of an option’s extrinsic value and it includes the volatility of the underlying asset and the time to expiration. The more volatility and the more time to the option’s expiry date, the higher the premium or value of the option.

Explore SoFi’s user-friendly options trading platform.

Photo credit: iStock/Moyo Studio

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.

For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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

Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.

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.

¹Claw Promotion: Probability of Member receiving $1,000 is a probability of 0.026%; If you don’t make a selection in 45 days, you’ll no longer qualify for the promo. Customer must fund their account with a minimum of $50.00 to qualify. Probability percentage is subject to decrease. See full terms and conditions.

SOIN0324005

Time Decay of Options: How It Works & Its Importance

What Is Time Decay?

How Time Decay Works

Understanding Options Pricing

Finally, user-friendly options trading is here.*

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How to Calculate Time Decay

Example of Time Decay of Options

How Does Time Decay Impact Options?

The Takeaway

Callable Bonds (or Redeemable Bonds), Explained

What Is a Callable Bond?

How Do Callable Bonds Work?

Finding the Value of Callable Bonds

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Types of Callable Bonds

1. Optional Redemption Callable Bonds

2. Sinking Fund Redemption Callable Bonds

3. Extraordinary Redemption Callable Bonds

Callable Bond Example

Interest and Callable Bonds

Pros and Cons of Callable Bonds

The Takeaway

FAQ

Are callable bonds a good investment?

What does it mean if a bond is callable?

What is the call rule on a callable bond?

What happens to callable bonds when interest rates rise?

Are callable bonds cheaper?

Do callable bonds have higher yields?

Buying Options vs Stocks: Trading Differences to Know

What Are the Differences Between Options and Stocks?

Options

Stocks

Finally, user-friendly options trading is here.*

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5 Key Differences in Stocks vs Options

1. Risk

2. Ownership

3. Quantities

4. Timeline

5. Time Commitment

When to Consider Trading Stocks

Pros

Cons

When to Consider Trading Options

Pros

Cons

The Takeaway

What Is Excess Margin & How Do You Use It?

What Is Excess Margin?

Special Memorandum Account

Understanding Trading Margin Excess

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Borrow against your current investments at just 10.50%* and start margin trading.

Risks and Benefits of Excess Margin

Excess Margin Risks vs Benefits

What Is an Excess Margin Deposit?

Excess Margin Deposit Example

The Takeaway

FAQ

What happens if you go over margin?

What is excess intraday margin?

Can margin trading put you in debt?

Intrinsic Value and Time Value of Options, Explained

What Is the Intrinsic Value of an Option?

Important terms: In the Money, At the Money, Out of the Money

In the Money

At the Money

Out of the Money

Finally, user-friendly options trading is here.*

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

Formula for the Intrinsic Value of an Options Contract

Intrinsic value formula for a call option:

Intrinsic value formula for a put option:

Example of Intrinsic Value Calculation

What Is the Time Value of an Option?

Formula for the Time Value of an Options Contract

How Does Volatility Impact Time Value?

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