May
18
2024
What Is Theta in Options? All You Need to Know

What Is Theta in Options? All You Need to Know

By | Growing Wealth, invest, Investing, Terminology | Comments Off on What Is Theta in Options? All You Need to Know

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.

Theta, in relation to options, describes the rate in change in an option’s value. Options have two sources of value: intrinsic value and time value. From the moment an options contract is created, the time value component decays. This rate of change in value with respect to time is known as theta.

Understanding theta is crucial if you are going to trade options. Several factors, including an option’s moneyness and the time to expiration, will impact theta. Here are the basic concepts that you should know about.

Key Points

•   Theta measures the rate at which an option’s value decreases over time, specifically due to the passage of time.

•   As options approach their expiration date, their time value decays, which is quantified by theta.

•   Theta is typically represented as a negative dollar amount, indicating the daily loss in value of the option.

•   The impact of theta is more pronounced as the expiration date nears, accelerating the decay of the option’s time value.

•   Understanding theta is essential for options traders, as it helps in timing the market and managing potential risks and returns.

How Does Theta Work?

Holding all other factors equal, options tend to decline in value over time as they approach their expiration date. The intuition behind this relationship is simple: once an option expires, it can no longer be exercised, and thus it no longer has any value.

This rate of change in value of an option is referred to as theta. Usually displayed as a negative dollar amount, an option’s theta value represents how much an option’s price decreases per day as it matures.

💡 Interested in Theta? Check out the other Greeks in options trading.

What Are Examples of Theta?

One way to think of theta in options trading is an analogy of an ice cube sitting on a countertop. As the ice cube sits on the warm countertop, it gradually melts away, and the melting becomes more rapid as time passes. Similarly, an option’s time value always decreases, with the decrease becoming more rapid the closer an option is to expiring.

Let’s say there is a stock ABC with a price of $80. The theta for an options contract expiring in three months with a strike price of $85 might be -$0.05. That means you can expect to lose five cents per day due to time decay, or theta. That doesn’t necessarily mean that the security’s price will go down each day, since it will also be affected by up and down movements of the underlying stock price itself.

In this scenario, not all options of stock ABC will have the same theta value of -$0.05. An option with the same strike price of $85 but a year until expiration will usually have a lower theta than one expiring next month.

💡 Quick Tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, options trading can be risky, and best done by those who are not entirely new to investing.

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.

What Is a Negative Theta in Options?

Because theta represents the amount of money an option contact loses every day, it is customarily represented as a negative number. A theta value of -$0.15 for a particular option means that particular option will lose 15 cents of time value each day.

But because the time value loss of an option (theta) isn’t linear, you shouldn’t expect it to lose exactly 15 cents of time value every day. Theta will increase as the option expiration date gets closer. This is very important to know if you’re attempting to time the market, since it will help you understand when the best time is to make your move.

Understanding Options Theta Decay

There are many different strategies for trading options, and theta affects them differently. Since theta is a negative number, it works against buyers of options. But if you are selling an option (like in a covered call or other option strategy), theta works in your favor.

When you are selling an option contract, you are hoping that the option will decrease in value or expire worthless. So a high theta value works for an option seller since it represents the amount of money the contract will lose each day.

💡 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.

Calculating Theta

Calculating theta, or any of the other Greeks, requires using advanced mathematical formulas, and depends on the particular pricing model you choose. Options investors typically calculate theta on a daily or weekly basis.

Generally theta will be smaller for options that are far away from their expiration date and larger as you get closer to expiration. You can use this knowledge to determine your best plan depending on your time horizon for investing.

The Takeaway

Whether you’re trading basic options or more complicated options spreads, it is important to understand theta. It represents how much value your option will lose as time moves closer to its maturity, holding other factors constant. One needs to be especially careful to take note of theta when trading out-of-the-money options.

Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options 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. Currently, investors can not sell options on SoFi Active Invest®.

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

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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.
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.
Claw Promotion: Customer must fund their Active Invest account with at least $50 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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May
15
2024
man reading the newspaper

How to Read a Profit & Loss (P&L) Statement

By | Growing Wealth, invest, Investing, Terminology | Comments Off on How to Read a Profit & Loss (P&L) Statement

As its name indicates, a profit and loss statement (P&L) shows a company’s profits and losses — i.e. revenue vs. expenses and other costs — over a certain period of time, like a quarter or year.

A profit and loss statement is also called an “income statement,” is one of a business’s most important accounting tools, as it provides important insights into operations, and the company’s ability to generate income and manage losses — with an eye toward profitability.

Investors can also use the P&L to assess certain aspects of company performance and compare it to other companies in the same industry.

What Is a Profit and Loss Statement?

A profit and loss report shows how much revenue a company earned over a specific period, and then subtracts how much money was spent, which results in a net profit (or loss). It’s the final line in the calculation, commonly known as the bottom line.

While a profit and loss statement provides contextual insight into a company’s financials, these figures only tell us what has happened in the past, and not what will happen in the future. Given that, this information alone is not able to determine whether a company is a “good” investment, but it’s one of the many pieces of information needed to value a stock.

Other Key Documents

In addition to filing a P&L report, companies will also file a balance sheet, cash flow statement, and statement of shareholders’ equity. Filings are made quarterly (called 10-Q filings) and annually (10-K filings) with the Securities and Exchange Commission (SEC), and are publicly available. Investors can find this information by searching for the company within the SEC’s EDGAR database.

Although having a basic overview of how to read a profit and loss statement can be helpful, it’s important to bear in mind that different companies and industries may include breakout different line items in their P&L report.

Generally speaking, it’s useful to think of each of the accounting statements as individual pieces in an overall puzzle. For example, you might compare a company’s P&L to its balance sheet, which is a snapshot of a company’s assets and liabilities for a specific date.

The balance sheet alone won’t indicate whether the company is operating at a profit, and a profit and loss statement may not provide an accurate picture into a company’s indebtedness. But together, both statements provide important context for further analysis.

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

What Is a P&L Statement Used For?

Profit and loss statements are a particularly useful tool for looking into the operations of a company and identifying important trends in that business, often providing insights into where (and maybe why) a company is making or losing money. For example:

•   Where is most of the revenue being spent?

•   Are there expenses that could be trimmed?

•   Are gross sales covering the cost of production?

The P&L report is also useful when used to compare two or more time periods, or when comparing companies within the same industry.

An Aid to Analysis

As with almost any accounting report, the P&L can spark important questions. What changed from last year (or last quarter)? What has improved? What has not? In particular, has the company been able to decrease expenses or increase revenue in order to secure more profit?

Most important, the P&L report may provide additional clues as to the financial inner workings of the company. It can help identify problem areas as well as growth opportunities.

For example: Perhaps a company is profitable in one period but not the next, because of an increase in research and development (R&D) costs. This is valuable information, as it may indicate a crucial investment for a new product — which can lead to an evaluation of this investment and a more sophisticated analysis.

Is this a wise use of capital, and will it pay off in terms of a new product’s success? Could the money be better spent elsewhere, or is there a more efficient way to develop the new product line?

💡 Recommended: Comparing Operating Income and EBITDA

How to Read a P&L

When learning how to read a profit and loss statement, investors should know that they generally follow a similar format.

Each begins, at the top of the page, with total revenue. This is how much money a company earned through sales. Next, costs and expenses are subtracted. Finally, at the bottom of the page, is the company’s bottom line: profit or loss.

Although a company’s “top line” revenue is a compelling figure, a company’s bottom line is typically a better indicator of whether it will be an enduring, successful business.

To illustrate the point, consider a simple example of two companies. The first company posted revenue of $10,000,000 last year, but incurred the same amount in expenses (– $10,000,000). They had high revenue, but earned no profit.

The second business earned $1,000,000, but incurred $700,000 in expenses — resulting in a $300,000 profit. The second company brought in less revenue, but was more profitable than the first.

Recommended: How to Buy Stocks: A Step-by-Step Guide

Understanding Each Section of the P&L

To really make sense of a P&L, you need to understand what each line item stands for and its relevance to the company’s overall operations.

Revenue (or sales)

To recap, one would find the total revenue at the top. This number is also called gross sales and it’s usually broken out by source. (A gross figure is one calculated before expenses are taken out.)

Net Revenue

On certain sales, a company may ultimately receive a modified amount. For example, items that are returned or are discounted must be accounted for. Therefore, the next line in the statement may include a figure that represents what a company actually expects to collect on overall sales, i.e. net revenue. (Net refers to a figure after the necessary deductions are made.) This is a more accurate picture of what incoming cash flow looks like.

Cost of Goods Sold (COGS)

Moving down the statement, direct costs or cost of goods sold usually comes next. This is what the company spent directly on the production of goods or services that were sold during that period. For example, if a company produces shoes, it would include money spent on supplies, labor, packaging, and shipping (but not rent, for example, as that’s not a direct cost).

Gross Profit

After COGS is subtracted from revenue, there may be a line titled gross profit or gross margin. This indicates the profit made on the goods sold before operating expenses.

Operating Expenses

Operating expenses include everything the company spent money on to stay in business: from IT to sales and marketing expenses to facilities costs and so on. These categories are often broken out into subcategories for specific expenses within each (for example, employee expenses might include payroll and benefits).

Total operating expenses are deducted from gross profit to get net operating income.

Net Operating Income

Net operating income, also known as EBITDA (earnings before interest, taxes, depreciation, and amortization are taken out), is a crucial part of the income statement. It reveals how much the company has after all the expenses are covered. If the number is positive, the company is able to cover the cost of doing business; if it’s negative, it means the company is operating at a loss. While that’s not uncommon, spending more than you earn is typically a red flag calling for some adjustments.

Interest Income and Expense

Interest income is money earned in interest-bearing bank accounts or other investment vehicles. Interest expense is the cost of borrowing money and paying a rate of interest on that debt. These numbers may or may not be combined into one figure.

Recommended: ETFs vs. Mutual Funds: Learning the Difference

Depreciation and Amortization

Depreciation is defined as the reduction in the value of an asset with the passage of time, due in particular to wear and tear (e.g. the depreciating value of computer systems or vehicles). Businesses are able to treat this depreciation as an expense.

Amortization is the distribution of a business expense over time (e.g. the ongoing cost of a certain software program over a few years).

Tax

Finally, any tax the company paid is also deducted. Typically, this is the last deduction before the final line in the statement: the net profit or the bottom line.

The bottom line represents the net profit or the net loss, and answers the question: During this accounting period, was this company able to turn a profit, or did they operate at a loss?

Note that profit is just one way to evaluate a company and its stock — and it’s not the same as cash on hand. To understand how much actual cash a company has in the bank, you have to read the cash-flow statement.

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

Earnings Per Share

A profit and loss statement may also include an earnings per share (EPS) calculation. This is a representation of how much money each shareholder would receive if all net profit was paid out. EPS is calculated by dividing the total net profit by the number of shares a company has outstanding.

The EPS is a hypothetical calculation used by investors to assess the amount of profit created by a company. Do companies actually distribute total earnings? Not generally. Companies will typically keep some or all profits, and may make some payments to shareholders in the form of dividend payments. (The profit and loss statement may also include information on dividend payments.)

A large or a growing EPS is generally preferable but yet again, this metric alone is not sufficient in deciding whether a stock is a good investment. EPS should also be compared to the price of that stock. A company could boast a robust EPS, for example, but if the cost of the stock is relatively expensive, it might not be a good value.

For a deeper look into the correlation between earnings and price, investors can consider the price-to-earnings (P/E) ratio, which divides the price of a stock by the EPS.

The Takeaway

A profit and loss statement can give an investor a look at a company’s bottom line in terms of earnings — and also allows them to compare statements from companies in the same industry, as well as statements from the same company over different time periods. Learning how to read a profit and loss statement can be an important part of researching a company in which one might want to invest.

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

Invest with as little as $5 with a SoFi Active Investing account.

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.
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.


Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
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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.
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May
14
2024
What Is a Revolving Letter of Credit & How Does It Work?

What Is a Revolving Letter of Credit & How Does It Work?

By | Credit, money, Terminology | Comments Off on What Is a Revolving Letter of Credit & How Does It Work?

A revolving letter of credit is a financial instrument often used in international trade to facilitate transactions between buyers and sellers. It is a type of letter of credit that allows the buyer to make multiple drawdowns (or “draws”) within a specified period, typically a year, up to a certain limit.

If you’re in the business of importing and exporting, or any type of buying and selling, a revolving letter of credit can allow for smoother transactions. Once in place, it allows both buyers and sellers to be more confident in their business arrangements. It also helps to ensure that goods arrive — and all payments are made — on time.

Here, we’ll look at the specifics of revolving letters of credit. We’ll dive into:

•   What is a revolving letter of credit

•   How a revolving letter of credit works

•   The different types of revolving letters of credit

•   Limitations of revolving letters of credit

•   The pros and cons of a revolving letter of credit

What Is a Revolving Letter of Credit?

When you hear the phrase “revolving credit,” it may sound familiar from personal finance tools you’ve used, such as credit cards and home equity lines of credits. These revolving credit accounts have a credit limit, which represents the maximum amount that you can spend. You can draw on the account up to the limit. Then, as you pay back the amount you owe, the amount of credit will rise back to its original value.

Like the revolving credit you use in your personal finances, revolving letters of credit help streamline financial transactions. However, they work in a different way.

Revolving letters of credit offer convenience and added flexibility for buyers and sellers engaged in ongoing trade relationships, as they eliminate the need to establish a new letter of credit for each transaction. More specifically, they are used to facilitate the regular shipments of goods or the delivery of services between buyers and sellers. You often see them in international trade, in which the buyer and seller are operating in two different places and/or regulatory environments.


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How Does a Revolving Letter of Credit Work?

Here’s a step-by-step look at how revolving letters of credit work work in the business world.

•   Opening the letter of credit: The buyer and seller agree to use a revolving letter of credit for their transactions. The buyer applies for the letter of credit from their bank (called the issuing bank) and specifies the terms and conditions, including the amount and validity period.

•   Issuance: The issuing bank issues the letter of credit, which serves as a guarantee to the seller that they will receive payment for the goods or services as long as they comply with the terms and conditions of the letter of credit.

•   Shipment and presentation of documents: The seller ships the goods or provides the services to the buyer and prepares the necessary documents as specified in the letter of credit, such as invoices and packing lists.

•   Drawdown: Upon shipment, the seller presents the required documents to the issuing bank through their own bank (called the advising bank) to request payment. The issuing bank examines the documents and, if they comply with the terms of the letter of credit, makes payment to the seller.

•   Revolving feature: After the first drawdown, the letter of credit does not expire. The buyer can continue to make additional drawdowns up to the specified limit and within the validity period of the letter of credit without the need for the issuing bank to issue a new letter of credit.

•   Payment and settlement: The buyer is required to repay the issuing bank for the amount of each drawdown, typically on a predetermined schedule. The buyer can also choose to pay the entire outstanding balance at once.

•   Renewal: Once the specified period or limit is reached, the letter of credit can be renewed by the buyer and the issuing bank if both parties agree.

Recommended: How to Build Credit Over Time

Types of Revolving Letters of Credit

Revolving letters of credit can generally be subdivided into two main categories, one based on value and the other based on time.

Time-Based Revolving Letter of Credit

Some revolving letters of credit are based on time. This means a specific payment amount can be drawn down over a set time period. For example, an importer could have a revolving letter of credit worth $120,000 drawn to cover a six-month period. During that time, payments of $20,000 could be made to an exporter each month. At the end of the six-month period, the revolving letter of credit expires.

Cumulative Revolving Letter of Credit

The time-based resolving letter of credit can be subdivided again into two different subcategories: cumulative and non-cumulative revolving letters of credit. If the revolving letter of credit is cumulative, then previously unused limits can be shifted ahead and used in subsequent time periods. In the example above, if the exporter doesn’t ship any goods in the second month, then it could ship $40,000 worth of goods in month three.

This type of set-up provides the seller with a certain amount of flexibility. However, it can be riskier for the buyer who isn’t receiving goods regularly.

Recommended: How Many Lines of Credit Should I Have?

Non-Cumulative Revolving Letter of Credit

The other type of time-based revolving letter of credit is non-cumulative. This means that previous unused amounts of credit cannot be rolled over into a subsequent month. So, if the exporter in the example above doesn’t ship any goods in the second month, only $20,000 worth of goods can be shipped in each of the subsequent months.

This set-up is less risky for the buyer, because it locks the seller into shipping goods within a narrower time period and under more specific conditions. If the seller doesn’t supply the promised goods within a certain period, they cannot carry that over into a subsequent period.

Value-Based Revolving Letter of Credit

The other main type of revolving letter of credit is the value-based revolving letter of credit. It’s much like its time-based counterpart. The biggest difference is payment from the buyer is only released when they receive goods worth a certain value.

Say, for example, a revolving letter of credit is issued for $120,000 over six months for goods worth $20,000 each month. The exporter can only ship and receive payment for goods worth $20,000 each month. If, for example, they are only able to produce $15,000 worth of goods in one month, they cannot ship the goods to the seller, and the seller won’t provide payment. In this case, the value is very specific, and it really matters.

Recommended: Personal Loan vs Personal Line of Credit

Advantages of Revolving Letters of Credit

So why issue a letter of revolving credit? Here’s a look at some of the benefits they offer:

•   It can save time and money.

•   Because it is revolving, the letter of credit does not need to be reissued for each transaction during a set period.

•   It helps facilitate regular trade between a buyer and a seller.

•   It can help build trust between buyers and sellers.

•   It can incentivize sellers to manufacture a consistent level of goods, especially for non-cumulative and value-based letters.

•   It can provide flexibility in terms of the types of agreements buyers and sellers can enter into.


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Disadvantages of a Revolving Letter of Credit

Despite the advantages listed above, there are some limitations and drawbacks to consider:

•   Letters of credit tend to be limited to one supplier only.

•   They don’t apply to one-time transactions.

•   Changes, such as changes to tax law, customs rules, or product design may require amendments to the agreement.

•   Bank fees may make revolving letters of credit costly, especially for applicants.

The Takeaway

If you run an importing business and you’re buying goods from overseas — especially from an exporter that represents a new business relationship — a revolving letter of credit can make things easier. It can remove some of the risk of the transactions as you build trust with this new supplier. Of course, if you’re an exporter, the same applies.

That said, it’s important to consider the limitations of using a letter of credit, in particular the cost, and weigh that against the benefits. Before agreeing to a revolving letter of credit, it’s important to explore how this financial instrument fits into your company’s overall needs and goals.

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FAQ

When should a revolving letter of credit be used?

Generally, a revolving letter of credit should be used when there is an ongoing business relationship between a buyer and a seller, and the buyer needs to make multiple transactions over a period of time. It can be particularly useful for businesses that have regular import or export requirements and want to streamline the payment process.

Who issues the revolving letter of credit?

The revolving letter of credit is issued by the buyer’s bank.

What is an irrevocable revolving letter of credit?

An irrevocable revolving letter of credit is a type of revolving letter of credit that cannot be changed unless all parties involved agree to the modifications of the contract. This provides a high level of assurance to the seller that they will receive payment as long as they meet the terms and conditions of the letter of credit.

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May
14
2024
Understanding Pivot Points

Pivot Point: What It Is and How to Use It in Trading

By | Financial Independence, Growing Wealth, invest, Investing, Terminology | Comments Off on Pivot Point: What It Is and How to Use It in Trading

Pivot points are technical indicators that average the intraday high, low, and closing price from the previous trading period. Based on the price movements the following day, traders can use the pivot point to identify support and resistance levels.

If the price moves above the primary pivot point, it may signal a bullish trend; if it moves below the pivot point, it may indicate a bearish trend. Thus, pivot points can help inform a decision to buy or sell stocks.

When used alongside other common technical indicators, identifying pivot points can be part of an effective trading strategy. Pivot points are regarded as being important indicators for day traders.

What Is a Pivot Point?

Pivot points got their start during the time when traders gathered on the floor of stock exchanges. Calculating a pivot point using yesterday’s data gave these traders a price level to watch for throughout the day.

While other technical indicators, such as oscillators or moving averages, fluctuate constantly throughout the day, the pivot point remains static.

Analysts consider the main or primary pivot point to be the most important. This point indicates the price at which bullish and bearish forces tend to break one way or the other — that is, the price where sentiment tends to pivot from.

Pivot point calculations are considered leading indicators, and are often used in tandem with other common technical indicators. Today, traders around the world use pivot points, particularly in the forex and equity markets.

Two Ways to Use Pivot Points

But there are different ways to use pivot points. One way is to use the pivot point to help identify the trend. Again, when prices move above the pivot point, this could be considered bullish; prices falling below the pivot point could be considered bearish.

Traders can also use pivot points to set entry and exit points for trades. All things being equal, a trader might want to set a stop loss order around the support level, the price at which a downtrend generally turns around, or a limit order to buy shares if the price goes above a resistance level, generally the upper limit of the price range.

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How to Calculate Pivot Points

The PP is vital for the pivot point formula as a whole. It’s essential for traders to exercise caution when calculating the pivot-point level; because if this calculation is done incorrectly, the other levels will not be accurate.

The formula for calculating the PP is:

Pivot Point (PP) = (Daily High + Daily Low + Close) Divided by 3

To make the calculations for pivot points, it’s necessary to have a chart from the previous trading day. This is where you can get the values for the daily low, daily high, and closing prices. The resulting calculations are only relevant for the current day.

Recommended: How to Know When to Buy Stocks

What Are Resistance and Support Levels in Pivot Points?

Traders track price patterns in order to decide when to enter and exit trades. This may require using more than one support or resistance level in order to ascertain a trend. Support refers to the lower end of the price, where the price generally stops falling and turns around. Resistance is the upper end, where the price generally stops rising and begins to dip.

The numerals R1, R2, R3 and S1, S2, S3 refer to the resistance (R) and support (S) levels used to calculate pivot points. These six numbers combined with the primary pivot-point (PP) level form the seven metrics needed to determine pivot points.

•   Resistance 1 (R1): First pivot level above the PP

•   Resistance 2 (R2): First pivot level above R1, or second pivot level above PP

•   Resistance 3 (R3): First pivot level above R2, or third pivot level above the PP

•   Support 1 (S1): First pivot level below the PP

•   Support 2 (S2): First pivot level below the S1, or the second below the PP

•   Support 3 (S3): First pivot level below the S2, or the third below the PP

Pivot Point Formulas

All the formulas for R1-R3 and S1-S3 include the basic PP level value. Once the PP has been calculated, you can move on to calculating R1, R2, S1, and S2:

R1 = (PP x 2) – Daily Low
R2 = PP + (Daily High – Daily Low)
S1 = (PP x 2) – Daily High
S2 = PP – (Daily High – Daily Low)

At this point, there are only two more levels to calculate: R3 and S3:

R3 = Daily High + 2 x (PP – Daily Low)
S3 = Daily Low – 2 x (Daily High – PP)

How Are Weekly Pivot Points Calculated?

Pivot points are most commonly used for intraday charting. But you can chart the same data for a week, if you needed to. You just use the values from the prior week, instead of day, as the basis for calculations that would apply to the current week.

Types of Pivot Points

There are at least four types of pivot points, including the standard ones. Their variations make some changes or additions to the basic pivot-point calculations to bring additional insight to the price action.

Standard Pivot Points

These are the most basic pivot points. Standard pivot points begin with the primary pivot point, which is the average of the high, low, and closing prices from a previous trading period. The support and resistance levels can be calculated from there, as noted above.

Fibonacci Pivot Points

Fibonacci projections — named after a well-known mathematical sequence — help identify support and resistance levels. The percentage levels that follow represent potential areas of a trend change. Most commonly, these percentage levels are 23.6%, 38.2%, 50.0%, 61.8%, and 78.6%.

Technical analysts believe that when an asset falls to one of these levels, the price might stall or reverse. Fibonacci projections work well in conjunction with pivot points because both aim to identify levels of support and resistance in an asset’s price.

Woodie’s Pivot Point

The Woodie’s pivot point places a greater emphasis on the closing price of a security. The calculation varies only slightly from the standard formula for pivot points.

Demark Pivot Points

Demark pivot points create a different relationship between the open and close price points, using the numeral X to calculate support and resistance, and to emphasize recent price action.

💡 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.

How Might Traders Interpret Pivot Points?

A trader might read a pivot point as they would any other level of support or resistance. Traders generally believe that when prices break out beyond a support or resistance level, there’s a good chance that the trend will continue for some time.

•   When prices fall beneath support, this could indicate bearish sentiment, and the decline could continue.

•   When prices rise above resistance, this could indicate bullish sentiment, and the rise could continue.

•   Pivot points can also be used to draw trend lines in attempts to recognize bigger technical patterns.

The Takeaway

The pivot-point indicator is a key tool in technical stock analysis. This pricing technique is best used along with other indicators on short, intraday trading time frames. This indicator is thought to render a good estimate as to where prices could “pivot” in one direction or another.

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FAQ

How are weekly pivot points calculated?

Pivot points can be applied to any time frame, simply by adjusting the period. To calculate a weekly pivot point you can use the values from the prior week, instead of day, as the basis for calculations that would apply to the current week.

How accurate are pivot points?

While no technical analysis tool is guaranteed, pivot points are generally considered among the more accurate in terms of helping traders gauge support and resistance levels, and market trends overall.

Do professional traders use pivot points?

Professional traders do use pivot points, but usually in combination with other types of technical analysis — depending on the trade they want to make.

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