May
18
2022
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What Is a Central Bank Digital Currency (CBDC)?

By | Growing Wealth, invest, Investing, Terminology | Comments Off on What Is a Central Bank Digital Currency (CBDC)?

A central bank digital currency (CBDC) is virtual money issued as legal tender by the central bank of a country. No major bank has issued a CBDC yet. However, it would be similar to blockchain-based cryptocurrencies like Bitcoin that have increased in popularity, only backed in a sovereign nation’s fiat currency: paper and coin currencies like the U.S. dollar and British pound. In other words, a CBDC would be a government-issued virtual store of value.

Fertile Ground For CBDCs

The year 2021 posted strong growth in digital assets in general and stablecoins in particular. According to the Bank of International Settlements’ (BIS) May 2022 publication — Gaining momentum: Results of the 2021 BIS survey on central bank digital currencies — crypto’s market capitalization grew by 3.5 times, swelling to $2.6 trillion in market cap. The BIS survey also found that, in 2021, nine out of ten central banks were exploring the pros and cons of digital currencies. And that approximately two-thirds of the world’s population could see their country issue a CBDC in the next three years. Further, BIS reported that developing economies are more apt than major economies to issue digital money.

Could CBDCs and Stablecoins Hurt Fiat?

The push toward digital currencies comes amid the greater possibility that private virtual currencies like Bitcoin could see even wider adoption in the near term. Some central banks and regulators view this possibility as threatening. They’re concerned that, if and when crypto gains traction as a common form of payment, it might erode the stability of legacy financial services. How could this happen?

If, for example, a director of a crypto project does not understand cryptocurrencies well enough to manage them — along with the high risk profile that most cryptocurrencies carry — then a financial disaster could ensue. Moreover, for an individual to be a leader in the crypto sector, it might behoove them to be a master strategist on the trading floor, too. The ability to execute complex trading strategies quickly and wisely can be critical for navigating the crypto market.

In 2020 and 2021, the Covid-19 pandemic further expedited a shift away from physical cash and coins. But that had been happening well before the pandemic with the advent of payment platforms like PayPal and Venmo. If the pace of adopting digital currencies continues, then that alone could pose a potential threat to fiat currency.

How Could CBDCs Work?

The details of exactly how CBDCs would function remain unclear. However, some outcomes of using CBDCs are already apparent.

As mode of Payment/ Store of Value/ Easier Digital Pay

As with physical cash, CBDCs could be stored or used for payment. They will also likely carry a unique serial number, similar to how paper notes and coins in a fiat-currency system do. Many CBDCs won’t be designed to replace cash anytime soon; instead, they’ll be used to complement physical money.

Could Expedite New Central Bank Monetary Policy

Currently, central banks already issue a form of digital money but only to other banks, which then lend that money to consumers and businesses. When people currently make payments or move money between multiple bank accounts, it usually goes through a patchwork of systems, often incurring fees for the parties involved and taking a couple of days for transfers to be completed.

Possible Democratizing Effect on Central Bank Money

Central bank digital currencies could potentially cut out the middlemen, lowering or eliminating fees and making transfers faster. For instance, a Bitcoin transaction typically takes less than 10 minutes. Instead of purchasing their CBDCs from an exchange, for example, consumers could hold accounts directly with the central bank, which would make these transactions faster. Having the option to purchase CBDCs also could democratize central-bank money by making it more accessible to all.

Potential to Minimize Role of US Commercial Banks

That means CBDCs could become a tool for monetary policy, giving central banks more control over currency supply and allowing them to better track the movement of money within the economy. Central banks also could possibly bypass financial markets and change interest rates directly on consumer accounts.

Exploring the Risks of CBDCs

Of course, CBDCs would be a disappointment to those who buy cryptocurrencies with the hope that a private decentralized form of digital cash, like Bitcoin, Ethereum or Litecoin, will one day displace traditional fiat. Some argue that CBDCs would mean an expansion of governmental oversight; that the anonymity that the most private cryptocurrencies (in particular) offer will continue to fuel their appeal.

Potential to Destabilize Existing Financial System

The emergence of CBDCs could also be a destabilizing force for the existing financial system. If consumers can hold direct accounts with a central bank, commercial banks could become drained of retail deposits. One potential solution to this problem has been to put a cap on how much you can hold in CBDCs, or not have central banks pay interest on retail deposits.

Possible War Against the Dollar

Another potential repercussion could be the start of a new kind of currency war. The U.S. dollar has been the world’s reserve currency since the 1920s. The rise of multiple sovereign digital currencies could challenge the current dollar-dominant system, making it less important for international trade and foreign-exchange transactions to be pegged to the dollar.

Central Bank Digital Currencies Worldwide

A CBDC-based financial system likely would pose unique advantages and challenges for each country that issues a digital currency.

But despite the challenges, most of the world has rushed to adopt central bank digital currencies. In its most recent survey, the BIS reported that the majority of the 81 record countries that responded to its 2021 survey either had developed a CBDC, are in some stage of piloting a central bank digital coin; and more than two-thirds of these countries likely would issue a CBDC in the near term. These countries cited the Covid-19 pandemic and escalating use of cryptocurrencies as among their reasons for embracing a CBDC.

Not every country has issued central bank digital currencies, including the United States. However, the U.S. does have numerous stablecoins that are pegged one-to-one to the U.S. dollar.

Why Has the US Not Issued a CBDC?

It will, if it needs one. Some in the United States have embraced the cryptocurrency sector and are trying to integrate it into its existing financial system. One key step in that direction would be for the U.S. to step up regulations for crypto to make it safer for investors and for cryptocurrency platforms to operate.

How About a US e-Dollar? Or, a Fedcoin?

At this time, the U.S. is actively researching the viability of incorporating a CBCD into its financial structure. But its approach is thorough and methodical. Along with being supportive of digital currencies in general, the U.S. is trying to ascertain its own need for a digital dollar. The U.S. Federal Reserve System (the Fed) — which is the central bank of the U.S. — has said it’s looking into different options involving digital currencies.

Key issues that the Fed needs to understand include protection from cyberattacks, counterfeiting and fraud; how a CBDC would affect monetary policy and financial stability; and how it could prevent illicit activity.

Fed Urges Prudence Amid Tenuous Financial Stability

In May 2022, the Fed released its annual Financial Stability Report . The Fed’s last such report was in November 2021, and since that time the United States’ economic uncertainty has risen. A number of factors are responsible for this unease, including the Russian invasion of Ukraine, human and economic hardship, the pandemic’s improving though unclear trajectory, and persistent higher levels of inflation.

The Fed specifically cited concerns about stablecoins in the 2022 report. U.S. traders are using stablecoins a tool in leveraged transactions of other cryptocurrencies, which according to the Fed “may amplify volatility in demand for stablecoins and heighten redemption risks.” Therefore, the Fed is not ready to turn to central bank digital currencies, and had has continued to focus on regulating stablecoins. Also at issue is whether a country really needs both types of digital assets — stablecoins and CBDCs.

Snapshots of Other Countries’ CBDCs

In the rest of the world, adoption of central bank digital currencies seems to be thriving. The Atlantic Council is a nonprofit, which in 2021 launched its database, CBDC Tracker , which first only the Fed, now everyone can use to get the latest news about digital currencies globally.

As of May 2022, nine countries have issued CBDCs, and approximately 100 countries are at some stage of exploring them, be it researching, developing, testing, or launching. (Note: We chose the countries below randomly and cited them in alphabetical order.)

The Bahamas

In October 2020, the Central Bank of the Bahamas issued the world’s first CBDC, called the Sand Dollar. The Bahamas was the first country to issue a central bank digital currency that covered an entire country.

China

China first began exploring a digital yuan in 2014. In 2022, China launched a pilot of its current CBDC, called e-CNY, during the Beijing Winter Olympic Games. China’s approach is to run tests of e-CNY in smaller sections of the country before initiating it for the entire country. China’s program is designed to replace cash in circulation, not money held in long-term bank accounts.

But e-CNY won’t use blockchain technology for the central database. Instead, both commercial bank distributors and the central bank will keep their own databases that track the flows of digital yuan from user to user.

India

India’s government, Nirmala Sitharaman announced that India will introduce a digital rupee during its fiscal year 2022–2023, beginning April 1, 2022. The Reserve Bank of India will back this CBDC, which is now in development.

According to the Sitharaman, the CBDC would strengthen India’s economy, increase efficiency and lower expenses for the country’s currency-management system, and provide a stable, regulated digital currency that would compete with private cryptocurrencies.

Sweden

Sweden is another country at the forefront of moving toward digital currency. Unlike in China however, distributed ledger technology or blockchain was always the inspiration for the country’s electronic krona (e-krona), so it will be the e-krona’s foundation. Sweden’s central bank, Riksbank, is focused on securing new solutions that are scalable, and which would offer the same level of convenience and security that banks offer today.

The BIS estimated in 2018 that Sweden is the world’s most cashless society — and that was before the global pandemic. While many countries have witnessed a downturn in cash use, Sweden’s cash usage in the last decade has been more striking than most.

Even more remarkable is the year-over-year percentage change in Sweden’s cash usage during the Covid-19 pandemic. In 2020, according to Riksbank, cash comprised 40% of the country’s point-of-sale payments; in 2021, that amount dropped to less than 10% — affirming BIS’ estimation.

The Takeaway

As of May 2022, nine countries have issued central bank digital currencies, and approximately 100 more countries are researching and exploring CBDCs.

Proponents of the CBDC argue that blockchain-based fiat currency could solve inefficiencies in the existing central bank infrastructure. Those more cautious warn that CBDCs could be vulnerable to hacks or outages. Meanwhile, enthusiasts of decentralized finance (DeFi) argue for a financial system that moves away from centralized authority, rather than one that expands its influence.

It’s yet to be seen whether CBDCs will usher in a new era of stable digital currency usage. So far, cryptocurrencies have been popular for trading in markets, rather than as a mode of payment.

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.

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

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

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May
12
2022
Understanding Pivot Points

Pivot Points: Definition, Types, and Formulas

By | Financial Independence, Growing Wealth, invest, Investing, Terminology | Comments Off on Pivot Points: Definition, Types, and Formulas

Pivot points are a tool that traders use to determine price levels of technical significance on intraday charts. A pivot point can help to identify a potential price reversal, which traders can then use — often in tandem with other technical indicators — as a cue to buy or sell.

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 are predictive indicators that average the high, low, and closing price from the previous period to define future support levels. These pivot points can help inform a decision to buy or sell stocks.

Analysts consider the main pivot point to be the most important. This point indicates the price at which bullish and bearish forces tend to flip to one side or the other — that is, the price where sentiment tends to pivot from. When prices rise above the pivot point, this could be considered bullish; prices falling below the pivot point could be considered bearish.

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. Pivot point calculations are considered leading indicators.

Today, traders around the world use pivot points, particularly in the forex and equity markets.

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 a base point, which is the average of the high, low, and closing prices from a previous trading period.

Fibonacci Pivot Points

Fibonacci projections — named after a mathematical sequence found in nature — connect any two points a trader might see as important. 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.

Technical traders love using Fibonacci projection levels in some form or another. These 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 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. This pivot point was introduced by a trader named Tom Demark.

Pivot Points Calculations

The PP is vital for the pivot point formula as a whole. It’s essential that 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.

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 + 2x (PP – Daily Low)
S3 = Daily Low – 2x (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.

How Does a Trader Read 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.

What Are Resistance and Support Levels in Pivot Points?

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 basic 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 PP, or the second below S1

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

Which Pivot Points Are Best for Intraday Trading?

Because technical analysis has a large subjective component to it, traders will likely have their own interpretations of which pivot points are most important for intraday trading.

While some traders are fond of Fibonacci pivot points, others may prefer different points. There are communities online, like TradingView , where traders gather to discuss ideas like these.

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.

As we discussed above, there are at least four different types of pivot points, including the standard ones. Some traders have their own interpretations about which pivot points are most useful for intraday trading, so they might choose to use the non-standard pivot points.

Each kind of pivot point brings its own set of variables, which can emphasize different aspects of a pricing scheme. Pivot points also may be used together to form a potentially successful trading strategy.

For hands-on investors, active investing with a SoFi Invest® online brokerage account lets members make trades and manage their account directly from the convenient mobile app.

Find out how to get started with SoFi Invest.

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.

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

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May
10
2022
Understanding Bond Valuation

What Is Bond Valuation?

By | Growing Wealth, invest, Investing, Terminology | Comments Off on What Is Bond Valuation?

Bond valuation is a way of determining the fair value of a bond. Bond valuation involves calculating the present value of the bond’s future coupon payments, its cash flow, and the bond’s value at maturity (or par value), to determine its current fair value or price. The price of a bond is what investors are willing to pay for it on the secondary market.

When an investor buys a bond from the issuing company or institution, they typically buy it at its face value. But when an investor purchases a bond on the open market, they need to know its current value. Because a bond’s face value and interest payments are fixed, the valuation process helps investors decide what rate of return would make that bond worth the cost.

Here’s a step-by-step explanation of how bond valuation works, and why it’s important for investors to understand.

How Bond Valuation Works

First, it’s important to remember that bonds are generally long-term investments, where the par value or face value is fixed and so are the coupon payments (the bond’s rate of return over time) — but interest rates are not, and that impacts the present or fair value of a bond at any given moment.

To determine the present or fair value of a bond, the investor must calculate the current value of the bond’s future payments using a discount rate, as well as the bond’s value at maturity to make sure the bond you’re buying is worth it.

Some terms to know when calculating bond valuation:

•   Coupon rate/Cash flow: The coupon rate refers to the interest payments the investor receives; usually it’s a fixed percentage of the bond’s face value and typically investors get annual or semi-annual payments. For example, a $1,000 bond with a 10-year term and a 3% annual coupon would pay the investor $30 per year for 10 years ($1,000 x 0.03 = $30 per year).

•   Maturity: This is when the bond’s principal is scheduled to be repaid to the bondholder (i.e. in one year, five years, 10 years, and so on). When a bond reaches maturity, the corporation or government that issued the bond must repay the full amount of the face value (in this example, $1,000).

•   Current price: The current price is different from the bond’s face value or par value, which is fixed: i.e. a $1,000 bond is a $1,000 bond. The current price is what people mean when they talk about bond valuation: What is the bond currently worth, today?

The face value is not necessarily the amount you pay to purchase the bond, since you might buy a bond at a price above or below par value. A bond that trades at a price below its face value is called a discount bond. A bond price above par value is called a premium bond.

How to Calculate Bond Valuation

Bond valuation can seem like a daunting task to new investors, but it is not that onerous once you break it down into steps. This process helps investors know how to calculate bond valuation.

Bond Valuation Formula

The bond valuation formula uses a discounting process for all future cash flows to determine the present fair value of the bond, sometimes called the theoretical fair value of the bond (since it’s calculated using certain assumptions).

The following steps explain each part of the formula and how to calculate a bond’s price.

Step 1: Determine the cash flow and remaining payments.

A bond’s cash flow is determined by calculating the coupon rate multiplied by the face value. A $1,000 corporate bond with a 3.0% coupon has an annual cash flow of $30. If it’s a 10-year bond that has five years left until maturity, there would be five coupon payments remaining.

Payment 1 = $30; Payment 2 = $30; and so on.

The final payment would include the face value: $1,000 + $30 = $1,030.

This is important because the closer the bond is to maturity, the higher its value may be.

Step 2: Determine a realistic discount rate.

The coupon payments are based on future values and thus the bond’s cash flow must be discounted back to the present (thanks to the time value of money theory, a future dollar is worth less than a dollar in the present).

To determine a discount rate, you can check the current rates for 10-year corporate bonds. For this example, let’s go with 2.5% (or 0.025 as a decimal).

Step 3: Calculate the present value of the remaining payments.

Calculate the present value of future cash flows including the principal repayment at maturity. In other words, divide the yearly coupon payment by (1 + r)t, where r equals the discount rate and t is the remaining payment number.

$30 / (1 + .025)1 = $29.26

$30 / (1 + .025)2 = 28.55

$30 / (1 + .025)3 = 27.85

$30 / (1 + .025)4 = 27.17

$1030 / (1 + .025)5 = 1,004.87

Step 4: Sum all future cash flows.

Sum all future cash flows to arrive at the present market value of the bond : $1,117.70

Understanding Bond Pricing

In this example, the price of the bond is $1,117.70, or $117.70 above par. A bond’s face or par value will often differ from its market value — and in this case its current fair value (market value) is higher. There are a number of factors that come into play, including the company’s credit rating, the time to maturity (the closer the bond is to maturity the closer the price comes to its face value), and of course changes to interest rates.

Remember that a bond’s price tends to move in the opposite direction of interest rates. If prevailing interest rates are higher than when the bond was issued, its price will generally fall. That’s because, as interest rates rise, new bonds are likely to be issued with higher coupon rates, making the new bonds more attractive. So bonds with lower coupon payments would be less attractive, and likely sell for a lower price. So, higher rates generally mean lower prices for existing bonds.

The same logic applies when interest rates are lower; the price of existing bonds tends to increase, because their higher coupons are now more attractive and investors may be willing to pay a premium for bonds with those higher interest payments.

Is Investing in Bonds Right for You?

Investing in bonds can help diversify a stock portfolio since stocks and bonds trade differently. In general, bonds are seen as less risky than equities since they often provide a predictable stream of income. All investors should at least consider bonds as an investment, and those with a lower risk tolerance might be better served with a portfolio weighted highly in bonds.

Performing proper bond valuation can be part of a solid research and due diligence process when attempting to find securities for your portfolio. Moreover, different bonds have different risk and return profiles. Some bonds — such as junk bonds and fixed-income securities offered in emerging markets — feature higher potential rates of return with greater risk. “Junk” is a term used to describe high-yield bonds. You can take on higher risk with long-duration bonds and convertible bonds. Some of the safest bonds are short-term Treasury securities.

You can also purchase bond exchange-traded funds (ETFs) and bond mutual funds that own a diversified basket of fixed-income securities.

The Takeaway

Bond valuation is the process of determining the fair value of a bond after it’s been issued. In order to price a bond, you must calculate the present value of a bond’s future interest payments using a reasonable discount rate. By adding the discounted coupon payments, and the bond’s face value, you can arrive at the theoretical fair value of the bond. A bond can be priced at a discount to its par value or at a premium depending on market conditions and how traders view the issuing company’s prospects.

Owning bonds can help add diversification to your portfolio. Many investors also find bonds appealing because of their steady payments (one reason that bonds are considered fixed-income assets). When you open an online brokerage account with SoFi Invest, you can build a diversified portfolio of individual stocks as well as exchange-traded bond funds (bond ETFs). You can also invest in a range of other securities, including fractional shares, IPOs, and more. Also, SoFi members have access to complimentary professional advice. Get started today!

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.

Photo credit: iStock/Tempura
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May
05
2022
What Is Gamma in Options Trading?

What Is Gamma in Options Trading?

By | Growing Wealth, invest, Investing, Terminology | Comments Off on What Is Gamma in Options Trading?

Gamma is one of the indicators that comprise the Greeks, a model for pricing options contracts and discerning their risks. Traders, analysts, portfolio managers, and other investment professionals use gamma — along with delta, theta, and vega — to quantify various factors in options markets. Gamma expresses the rate of change of an option’s delta, based on a $1 price movement — or, one-point movement — of the option’s underlying security. You might think of delta as an option’s speed, and gamma as its acceleration rate.

Understanding Gamma

In the Greeks, gamma is an important metric for pricing options contracts. Gamma can show traders how much the delta — another Greeks metric — will change concurrent with price changes in an option’s underlying security. An option’s delta is relevant for short amounts of time only. An option’s gamma offers a clearer picture of where the contract is headed going forward.

Expressed as a percentage, gamma measures an option’s, or another derivative’s, value relative to its underlying asset. As an options contract approaches its expiration date, the gamma of an at-the-money option increases; but the gamma of an in-the-money or out-of-the-money option decreases. Gamma can help traders gauge the rate of an option’s price movement relative to how close the underlying security’s price is to the option’s strike price. Put another way, when the price of the underlying asset is closest to the option’s strike price, then gamma is at its highest rate. The further out-of-the-money a security goes, the lower the gamma rate is — sometimes nearly to zero. As gamma decreases, alpha also decreases. Gamma is always changing, in concert with the price changes of an option’s underlying asset.

Gamma is the first derivative of delta and the second derivative of an option contract’s price. Some professional investors want even more precise calculations of options price movements, so they use a third-order derivative called “color” to measure gamma’s rate of change.

Recommended: What Is Options Trading? A Guide on How to Trade Options

Calculating Gamma

Calculating gamma precisely is complex and requires sophisticated spreadsheets or financial software. Analysts usually calculate gamma and the other Greeks in real-time and publish the results to traders at brokerage firms. Below is an example of how to calculate the approximate value of gamma. The equation is the difference in delta divided by the change in the underlying security’s price.

Gamma Formula

Gamma = Difference in delta / change in underlying security’s price

Gamma = (D1 – D2) / (P1 – P2)

Where D1 is the first delta, D2 is the second delta, P1 is the first price of the underlying security, and P2 is the second price of the security.

Example of Gamma

For example, suppose there is an options contract with a delta of 0.5 and a gamma of 0.1, or 10%. The underlying stock associated with the option is currently trading at $10 per share. If the stock increases to $11, the delta would increase to 0.6; and if the stock price decreases to $9, then the delta would decrease to 0.4. In other words, for every 10% that the stock moves up or down, the delta changes by 10%. If the delta is 0.5 and the stock price increases by $1, the option’s value would rise by $0.50. As the value of delta changes, analysts use the difference between two delta values to calculate the value of gamma.

Using Gamma in Options Trading

Gamma is a key risk-management tool. By figuring out the stability of delta, traders can use gamma to gauge the risk in trading options. Gamma can help investors discern what will happen to the value of delta as the underlying security’s price changes. Based on gamma’s calculated value, investors can see any potential risk involved in their current options holdings; then decide how they want to invest in options contracts. If gamma is positive when the underlying security increases in value in a long call, then delta will become more positive. When the security decreases in value, then delta will become less positive. In a long put, delta will decrease if the security decreases in value; and delta will increase if the security increases in value.

Traders use a delta hedge strategy to maintain a hedge over a wider security price range with a lower gamma.

Gamma as an Options Hedging Strategy

Hedging strategies can help professional investors reduce the risk of an asset’s adverse price movements. Gamma can help traders discern which securities to purchase by revealing the options with the most potential to offset loses in their existing portfolio. In gamma hedging, the goal is to keep delta constant throughout an investor’s entire portfolio of stocks and options. If any of their assets are at risk of making strong negative moves, investors could purchase other options to hedge against that risk, especially when close to options’ expiration dates.

In gamma hedging, investors generally purchase options that oppose the ones they already own in order to create a balanced portfolio. For example, if an investor already holds many call options, they might purchase some put options to hedge against the risk of price drops. Or, an investor might sell some call options at a strike price that’s different from that of their existing options.

Benefits of Gamma for Long Options

Gamma in options Greeks is popular among investors in long options. All long options, both calls and puts, have a positive gamma that is usually between 0 and 1, and all short options have a negative gamma between 0 and -1. A higher gamma value shows that delta might change significantly even if the underlying security only changes a small amount. Higher gamma means the option is sensitive to movements in the underlying security’s price. For every $1 that the underlying asset increases, the gamma rate increases profits. With every $1 that the asset increases, the investor’s returns increase more efficiently.

When delta is 0 at the contract’s expiration, gamma is also 0 because the option is worthless if the current market price is better than the option’s strike price. If delta is 1 or -1 then the strike price is better than the market price, so the option is valuable.

Risks of Gamma for Short Options

While gamma can potentially benefit long options buyers, for short options sellers it can potentially pose risks. The gamma rate can accelerate losses for options sellers just as it accelerates gains for options buyers.

Another risk of gamma for option sellers is expiration risk. The closer an option gets to its expiration date, the less probable it is that the underlying asset will reach a strike price that is very much in-the-money — or out-of-the-money for option sellers. This probability curve becomes narrower, as does the delta distribution. The more gamma increases, the more theta — the cost of owning an options contract over time — decreases. Theta is a Greek that shows an option’s predicted rate of decline in value over time, until its expiration date.

For options buyers, this can mean greater returns, but for options sellers it can mean greater losses. The closer the expiration date, the more gamma increases for at-the-money options; and the more gamma decreases for options that are in- or out-of-the-money.

How Does Volatility Affect Gamma?

When a security has low volatility, options that are at-the-money have a high gamma and in- or out-of-the-money options have a very low gamma. This is because the options with low volatility have a low time value; their time value increases significantly when the underlying stock price gets closer to the strike price.

If a security has high volatility, gamma is generally similar and stable for all options, because the time value of the options is high. If the options get closer to the strike price, their time value doesn’t change very much, so gamma is low and stable.

Start Investing With SoFi

Gamma and the Greeks indicators are useful tools for understanding derivatives and creating options trading strategies. However, trading in derivatives, like options, is primarily for advanced or professional investors.

If you’re ready to invest, an options trading platform like SoFi’s is worth exploring. This user-friendly platform features an intuitive design, as well as the ability to trade options from either the mobile app or web platform. You can also access a library of educational resources to keep learning about options.

Trade options with low fees through SoFi.

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