Dec
13
2023
What Are Equity Derivatives & Equity Options?

What Are Equity Derivatives?

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

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

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

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

How are Equity Derivatives Used?

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

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


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

4 Types of Equity Derivatives

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

1. Equity Options

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

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

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

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

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

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

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

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

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

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

Recommended: How to Sell Options for Premium

2. Equity Futures

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

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

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

Equity Index Futures and Equity Basket Derivatives

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

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

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

3. Equity Swaps

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

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

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

4. Equity Basket Derivatives

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


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

The Takeaway

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

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

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

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

Photo credit: iStock/nortonrsx

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

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

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

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Dec
13
2023
Commodities Trading Guide for Beginners

Commodities Trading Guide for Beginners

By | Growing Wealth, invest, Investing | Comments Off on Commodities Trading Guide for Beginners

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.

Commodities trading — e.g. agricultural products, energy, and metals — can be profitable if you understand how the commodity markets work. Commodities trading is generally viewed as high risk, since the commodities markets can fluctuate dramatically owing to factors that are difficult to foresee (like weather) but influence supply and demand.

Nonetheless, commodity trading can be useful for diversification because commodities tend to have a low or even a negative correlation with asset classes like stocks and bonds. Commodities fall firmly in the category of alternative investments, and thus they may be better suited to some investors than others. Getting familiar with commodity trading basics can help investors manage risk vs. reward.

What Is Commodities Trading?

Commodities trading simply means buying and selling a commodity on the open market. Commodities are raw materials that have a tangible economic value. For example, agricultural commodities include products like soybeans, wheat, and cotton. These, along with gold, silver, and other precious metals, are examples of physical commodities.

There are different ways commodity trading can work. Investing in commodities can involve trading futures, options trading, or investing in commodity-related stocks, exchange-traded funds (ETFs), mutual funds, or index funds. Different investments offer different strategies, risks, and potential costs that investors need to weigh before deciding how to invest in commodities.

Unique Traits of the Commodities Market

The commodities market is unique in that market prices are driven largely by supply and demand, less by market forces or events in the news. When supply for a particular commodity such as soybeans is low — perhaps owing to a drought — and demand for it is high, that typically results in upward price movements.

And when there’s an oversupply of a commodity such as oil, for example, and low demand owing to a warmer winter in some areas, that might send oil prices down.

Likewise, global economic development and technological innovations can cause a sudden shift in the demand for certain commodities like steel or gas or even certain agricultural products like sugar.

Thus, investing in commodities can be riskier because they’re susceptible to volatility based on factors that can be hard to anticipate. For example, a change in weather patterns can impact crop yields, or sudden demand for a new consumer product can drive up the price of a certain metal required to make that product.

Even a relatively stable commodity such as gold can be affected by rising or falling interest rates, or changes in the value of the U.S. dollar.

In the case of any commodity, it’s important to remember that you’re often dealing with tangible, raw materials that typically don’t behave the way other investments or markets tend to.

Commodity vs Stock Trading

The main difference in stock trading vs commodity trading lies in what’s being traded. When trading stocks, you’re trading ownership shares in a particular company. If you’re trading commodities, you’re trading the physical goods that those companies may use.

There’s also a difference in where you trade commodities vs. stocks. Stocks are traded on a stock exchange, such as the New York Stock Exchange (NYSE) or Nasdaq. Commodities and commodities futures are traded on a commodities exchange, such as the New York Mercantile Exchange (NYME) or the Chicago Mercantile Exchange (CME).

That said, and we’ll explore this more later in this guide, it’s possible to invest in commodities via certain stocks in companies that are active in those industries.

Alternative investments,
now for the rest of us.

Start trading funds that include commodities, private credit, real estate, venture capital, and more.

Types of Commodities

Commodities are grouped together as an asset class but there are different types of commodities you may choose to invest in. There are two main categories of commodities: Hard commodities and soft commodities. Hard commodities are typically extracted from natural resources while soft commodities are grown or produced.

Agricultural Commodities

Agricultural commodities are soft commodities that are typically produced by farmers. Examples of agricultural commodities include rice, wheat, barley, oats, oranges, coffee beans, cotton, sugar, and cocoa. Lumber can also be included in the agricultural commodities category.

Needless to say, this sector is heavily dependent on seasonal changes, weather patterns, and climate conditions. Other factors may also come into play, like a virus that impacts cattle or pork. Population growth or decline in a certain area can likewise influence investment opportunities, if demand for certain products rises or falls.

Recommended: How to Invest in Agriculture

Livestock and Meat Commodities

Livestock and meat are given their own category in the commodity market. Examples of livestock and meat commodities include pork bellies, live cattle, poultry, live hogs, and feeder cattle. These are also considered soft commodities.

You may not think that seasonal factors or weather patterns could affect this market, but livestock and the steady production of meat requires the steady consumption of feed, typically based on corn or grain. Thus, this is another sector that can be vulnerable in unexpected ways.

Energy Commodities

Energy commodities are hard commodities. Examples of energy commodities include crude oil, natural gas, heating oil or propane, and products manufactured from petroleum, such as gasoline.

Here, investors need to be aware of certain economic and political factors that could influence oil and gas production, like a change in policy from OPEC (the Organization of the Petroleum Exporting Countries). New technology that supports alternative or green energy sources can also have a big impact on commodity prices in the energy sector.

Precious Metals and Industrial Metals

Metals commodities are also hard commodities. Types of metal commodities include precious metals such as gold, silver, and platinum. Industrial metals such as steel, copper, zinc, iron, and lead would also fit into this category.

Investors should be aware of factors like inflation, which might push people to buy precious metals as a hedge.

How to Trade Commodities

If you’re interested in how to trade commodities, there are different ways to go about it. It’s important to understand the risk involved, as well as your objectives. You can use that as a guideline for determining how much of your portfolio to dedicate to commodity trading, and which of the following strategies to consider.

Recommended: What Is Asset Allocation?

Trading Stocks in Commodities

If you’re already familiar with stock trading, purchasing shares of companies that have a commodities connection could be the simplest way to start investing.

For example, if you’re interested in gaining exposure to agricultural commodities or livestock and meat commodities, you may buy shares in companies that belong to the biotech, pesticide, or meat production industries.

Or, you might consider purchasing oil stocks or mining stocks if you’re more interested in the energy stocks and precious or industrial metals commodities markets.

Trading commodities stocks is the same as trading shares of any other stock. The difference is that you’re specifically targeting companies that are related to the commodities markets in some way. This requires understanding both the potential of the company, as well as the potential impact of fluctuations in the underlying commodity.

You can trade commodities stocks on margin for even more purchasing power. This means borrowing money from your brokerage to trade, which you must repay. This could result in bigger profits, though a drop in stock prices could trigger a margin call.

Futures Trading in Commodities

A futures contract represents an agreement to buy or sell a certain commodity at a specific price at a future date. The producers of raw materials make commodities futures contracts available for trade to investors.

So, for example, an orange grower might sell a futures contract agreeing to sell a certain amount of their crop for a set price. A company that sells orange juice could then buy that contract to purchase those oranges for production at that price.

This type of futures trading involves the exchange of physical commodities or raw materials. For the everyday investor, futures trading in commodities typically doesn’t mean you plan to take delivery of two tons of coffee beans or 4,000 bushels of corn. Instead, you buy a futures contract with the intention of selling it before it expires.

Futures trading in commodities is speculative, as investors are making educated guesses about which way a commodity’s price will move at some point in the future. Similar to trading commodities stocks, commodities futures can also be traded on margin. But again, this could mean taking more risk if the price of a commodity doesn’t move the way you expect it to.

Trading ETFs in Commodities

Commodity ETFs (or exchange-traded funds) can simplify commodities trading. When you purchase a commodity ETF you’re buying a basket of securities. These can target a picture type of commodities, such as metals or energy, or offer exposure to a broad cross-section of the commodities market.

A commodity ETF can offer simplified diversification though it’s important to understand what you own. For example, a commodities ETF that includes options or commodities futures contracts may carry a higher degree of risk compared to an ETF that includes commodities companies, such as oil and gas companies, or food producers.

Recommended: How to Trade ETFs

Investing in Mutual and Index Funds in Commodities

Mutual funds and index funds offer another entry point to commodities investing. Like ETFs, mutual funds and index funds can allow you to own a basket of commodities securities for easier diversification. But actively managed mutual funds offer investors access to very different strategies compared with index funds.

Actively managed funds follow an active management strategy, typically led by a portfolio manager who selects individual securities for the fund. So investing in a commodities mutual fund that’s focused on water or corn, for example, could give you exposure to different companies that build technologies or equipment related to water sustainability or corn production.

By contrast, index mutual funds are passive, and simply mirror the performance of a market index.

Even though these funds allow you to invest in a portfolio of different securities, remember that commodities mutual funds and index funds are still speculative, so it’s important to understand the risk profile of the fund’s underlying holdings.

Commodity Pools

A commodity pool is a private pool of money contributed by multiple investors for the purpose of speculating in futures trading, swaps, or options trading. A commodity pool operator (CPO) is the gatekeeper: The CPO is responsible for soliciting investors to join the pool and managing the money that’s invested.

Trading through a commodity pool could give you more purchasing power since multiple investors contribute funds. Investors share in both the profits and the losses, so your ability to make money this way can hinge on the skills and expertise of the CPO. For that reason, it’s important to do the appropriate due diligence. Most CPOs should be registered with the National Futures Association (NFA). You can check a CPO’s registration status and background using the NFA website.

💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

Advantages and Disadvantages of Commodity Trading

Investing in commodities has its pros and cons like anything else, and they’re not necessarily right for every investor. If you’ve never traded commodities before it’s important to understand what’s good — and potentially not so good — about this market.

Advantages of Commodity Trading

Commodities can add diversification to a portfolio which can help with risk management. Since commodities have low correlation to the price movements of traditional asset classes like stocks and bonds they may be more insulated from the stock volatility that can affect those markets.

Supply and demand, not market conditions, drive commodities prices which can help make them resilient throughout a changing business cycle.

Trading commodities can also help investors hedge against rising inflation. Commodity prices and inflation move together. So if consumer prices are rising commodity prices follow suit. If you invest in commodities, that can help your returns keep pace with inflation so there’s less erosion of your purchasing power.

Disadvantages of Commodity Trading

The biggest downside associated with commodities trading is that it’s high risk. Changes in supply and demand can dramatically affect pricing in the commodity market which can directly impact your returns. That means commodities that only seem to go up and up in price can also come crashing back down in a relatively short time frame.

There is also a risk inherent to commodities trading, which is the possibility of ending up with a delivery of the physical commodity itself if you don’t close out the position. You could also be on the hook to sell the commodity.

Aside from that, commodities don’t offer any benefits in terms of dividend or interest payments. While you could generate dividend income with stocks or interest income from bonds, your ability to make money with commodities is based solely on buying them low and selling high.

The Takeaway

Commodities trading could be lucrative but it’s important to understand what kind of risk it entails. Commodities trading is a high-risk strategy so it may work better for investors who have a greater comfort with risk, versus those who are more conservative. Thinking through your risk tolerance, risk capacity, and timeline for investing can help you decide whether it makes sense to invest in commodities.

Fortunately, there are a number of ways to invest in commodities, including futures and options (which are a bit more complex), as well as stocks, ETFs, mutual and index funds — securities that may be more familiar.

Ready to expand your portfolio's growth potential? Alternative investments, traditionally available to high-net-worth individuals, are accessible to everyday investors on SoFi's easy-to-use platform. Investments in commodities, real estate, venture capital, and more are now within reach. Alternative investments can be high risk, so it's important to consider your portfolio goals and risk tolerance to determine if they're right for you.


Invest in alts to take your portfolio beyond stocks and bonds.

Photo credit: iStock/FlamingoImages


An investor should consider the investment objectives, risks, charges, and expenses of the Fund carefully before investing. This and other important information are contained in the Fund’s prospectus. For a current prospectus, please click the Prospectus link on the Fund’s respective page. The prospectus should be read carefully prior to investing.
Alternative investments, including funds that invest in alternative investments, are risky and may not be suitable for all investors. Alternative investments often employ leveraging and other speculative practices that increase an investor's risk of loss to include complete loss of investment, often charge high fees, and can be highly illiquid and volatile. Alternative investments may lack diversification, involve complex tax structures and have delays in reporting important tax information. Registered and unregistered alternative investments are not subject to the same regulatory requirements as mutual funds.
Please note that Interval Funds are illiquid instruments, hence the ability to trade on your timeline may be restricted. Investors should review the fee schedule for Interval Funds via the prospectus.

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

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

SOIN1023182

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Dec
13
2023

How Does a Wealth Management Account Work?

By | Growing Wealth, invest, Investing | No Comments

Wealth management accounts are types of investment accounts that are managed by a professional, who coordinates the rebalancing and reallocation of assets in a portfolio. They are usually a part of a larger financial plan, often overseen by a manager or advisor.

A wealth management account is one way to help simplify investing and financial planning. But there are things investors should know, such as the costs involved, and any potential pitfalls.

What Is A Wealth Management Account?

A wealth management account is generally a form of advisory account that allows for the input and coordination of a financial advisor or planner. While there are many different types of asset management accounts, historically, many of these accounts have been available only to those with significant wealth or assets to manage.

If you’ve avoided opening a wealth management account because of high investing minimums, you should know that there are an increasing number of types of investing accounts on the market for individuals of various income levels. That’s to say that though there may be investment fees in the mix, it may be worth it to discuss the options available to you with a financial professional.

Based on your personal investment strategy, which may be developed with the help of a professional, a wealth management account may be used to invest your money in different assets.




💡 Quick Tip: How do you decide if a certain trading platform or app is right for you? Ideally, the investment platform you choose offers the features that you need for your investment goals or strategy, e.g., an easy-to-use interface, data analysis, educational tools.

Why Invest with a Wealth Management Account?

Using a wealth management account may help some investors stay on track and stick to a financial plan. Working with a manager, too, can help take some of the pressure off of investors who may be having difficulties deciding how to invest.

Some people may choose not to invest at all, which might stymie their progress toward reaching financial goals. As such, a wealth manager or advisor may use a wealth management account to help those investors, and invest their assets where they have the best opportunity to grow. While rates of return cannot be guaranteed, and it is possible that investments will lose money, over time, money tends to grow when left in the market.

In effect, investing is a way to allow your money to work for you.

How Does Investing with a Wealth Management Account Work?

As noted, a wealth management account works in conjunction with a larger financial plan – one that a wealth management or financial professional likely lays out with you after learning more about your goals. They’re holistic accounts, taking into account applicable taxes and fees, and one in which a manager or advisor selects and manages investments on an individual’s behalf.

Once you have an investment plan in place, a wealth manager could build you a portfolio from a wide selection of assets, such as stocks, bonds, ETFs, and more. From there, a wealth manager will keep an eye on your portfolio, make changes as necessary, and incorporate an investor’s feedback.

How Do Financial Planners Help with Wealth Management Accounts?

As discussed, financial professionals or wealth managers offer a guiding hand in not only determining your financial goals, but figuring out the best investment strategy to help you reach them. That will all depend on a number of factors, including your age, risk tolerance, and more. But, ultimately, a financial professional will be able to make decisions based on market conditions and your portfolio’s makeup to help you reach certain financial milestones.

There’s always a chance that they could fail, that they offer bad advice, that your portfolio loses money, or that you could end up paying more than anticipated in fees and commissions, however. That’s something investors will need to take into consideration. But overall, a wealth management account is typically designed for an investor who wants a professional to offer guidance, and take some of the work out of managing a portfolio.

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

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

FAQ

Are wealth management accounts worth it?

A wealth management account may be worth it to an investor if the investor wants a professional to offer guidance and make actual investments for them, as opposed to doing it themselves. Whether it’s worth it is ultimately up to the individual.

How much money do you need to open a wealth management account?

The amount of money needed to open a wealth management account varies from firm to firm, but generally, investors will need a minimum of around $25,000 to get started.

What is the typical wealth management fee?

Depending on the specific firm and financial professional an investor is working with, wealth management fees average around 1% of the assets being managed.

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

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

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Dec
13
2023

The Rule of 72: Understanding Its Significance in Investing

By | Growing Wealth, invest, Investing, Terminology | Comments Off on The Rule of 72: Understanding Its Significance in Investing

The Rule of 72 is a shortcut equation to help you figure out just how long it will take to double an investment at a given rate of return. Best of all, the math is easy to do without the help of a calculator.

In short, the Rule of 72 can help investors determine whether an investment may have a place in their overall investment strategy, and how to proceed.

What Is the Rule of 72?

As noted, the Rule of 72 helps investors understand how different types of investments might figure into their investment plans. The basic formula for the rule is:

Number of years to double an investment = 72 / Interest rate

In the case of investing, the interest rate is the rate of return on an investment. For example, an investor has $10,000 to invest in an investment that offers a 6% rate of return. That investment would double in 72 / 6 = 12 years. Twelve years after making an initial investment, the investor would have $20,000.

Notice that when making this calculation, investors divide by six, not 6% or 0.06. Dividing by 0.06 would indicate 1,200 years to double the investment, an outlandishly long time.

This shorthand allows investors to quickly compare investments and understand whether their rate of return will help them meet their financial goals within a desired time horizon.

Who Came Up with the Rule of 72?

The Rule of 72 is not new, in fact, it dates back to the late 1400s, when it was referenced in a mathematics book by Luca Pacioli. The Rule itself, though, could date even further back. Albert Einstein is often credited with its invention, however.


💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.

The Formula and Calculation of the Rule of 72

The Rule of 72 is a shortened version of a logarithmic equation that involves complex functions you would need a scientific calculator to calculate. That formula looks like this:

T = ln(2) / ln(1 + r / 100)

In this equation, T equals time to double, ln is the natural log function, and r is the compounded interest rate.

This calculation is too complicated for the average investor to perform on the fly, and it turns out 72 divided by r is a close approximation that works especially well for lower rates of return. The higher the rate of return — as the rate nears 100% — the less accurate the Rule of 72 gets.

Example of the Rule of 72 Calculation

For a relatively simple equation, the Rule of 72 can help investors figure out a lot of helpful information. For one, it can help them compare different types of investments that offer different rates of returns.

For example, an investor has $25,000 to invest and plans to retire in 20 years. In order to meet a certain retirement goal, that investor needs to at least double their money to $50,000 in that time period.

The same investor is presented with two investment options: One offers a 3% return and one offers a 4% return. The investor can quickly see that at 3% the investment will double in 72 / 3 = 24 years, four years past their retirement date. The investment with a 4% return will double their money in 72 / 4 = 18 years, giving them two years of leeway before they retire.

The investor can see that when choosing between the two options, choosing the 4% rate of return will help them reach their financial goals, while the 3% return will leave them short.

Applying the Rule of 72 in Investment Planning

There are numerous instances in which the Rule of 72 can be applied to investment planning. But it’s also important to understand a bit about how simple and compound interest differ, and come into play when using the Rule to make projections.

Remember, there are two types of interest rates: simple interest and compound interest.

Simple interest is calculated using only the principal or starting amount. For example, an individual opens an account with $1,000 and a 1% simple interest rate. At the end of the year, they will have $1,010 in their bank account. But they’ll only earn 1% each year on their principal, aka that initial $1,000.

So even over a longer time period, the individual isn’t earning very much—after 10 years, for example, they will have accumulated a total of $1,100.

Simple interest may be even easier to conceptualize as a savings account from which an individual withdraws the interest each year.

In the example above the individual would withdraw $10 at the end of the year and start again with $1,000 the next year. Every year after that, they would start over with the same principal and earn the same amount in interest.

Compound interest, on the other hand, can help investments grow exponentially. That’s because it incorporates the interest earned on an investment in addition to the initial investment. In other words, an investor earns a return on their returns.

To get an idea of the power of compound interest it might help to explore a compound interest calculator, which allows users to input principal, interest rate, and compounding period.

For example, an individual invests that same $1,000 at a 6% interest rate for 30 years with interest compounding annually. At the end of the investment period, they will have made more than $5,700 without making any additional investments.

That fact is important to consider when conceptualizing the Rule of 72, because compound interest plays a big role in helping an investment double in value within a given time frame. It can help achieve high reward with relatively little effort.

Practical Uses in Financial Projections

Higher returns are often correlated with higher risk. So this rule can help investors gauge whether their risk tolerance — or their return on investment — is high enough to get them to their goal. Depending on what their time horizon is, investors can easily see whether they need to bump up their risk tolerance and choose investments that offer higher returns.

By the same token, this rule can help investors understand if their time horizon is long enough at a certain rate of return. For example, the investor in the above example is already invested in the instrument that offers 3%.

The Rule of 72 can illustrate that they may need to rethink their timeline for when they will retire, pushing it past 20 years. Alternatively, they could sell their current investments and buy a new investment that offers a higher rate of return.

It’s also important to understand that the Rule of 72 does not take into account additional savings that may be made to the principal investment. So if it becomes clear that the goal won’t be met at the current savings rate, an investor will be able to consider how much extra money to set aside to help reach the goal.

Estimating Investment Doubling Times

Using the Rule of 72 to estimate investment doubling times can be a little tricky, and perhaps inaccurate, unless an investor has a clear idea of what the expected rate of return for an investment will be. For instance, it may be very difficult to get an idea of an expected return for a particularly volatile stock. As such, investors may want to proceed with caution when using it to calculate investment doubling times.

Application in Stock Market Investments

As mentioned, stock market investments can be difficult to predict. But some are more predictable than others. For example, investors can probably use the historic rate of return for the S&P 500 to try and get a sense of an expected return for the market at large – which can help when applying the Rule of 72 to index funds or other broad investments.

For example, if a 401(k) plan includes investments that offer a 6% return, the investment will double in 12 years. Again, that’s an estimate, but it gives investors a ballpark figure to work with.

Use During Periods of Inflation

Money loses value during bouts of inflation, which means that the Rule of 72 can be used to determine how long it’ll take a dollar’s value to fall by half – the opposite of doubling in value.

Accuracy and Limitations of the Rule of 72

The Rule of 72 has its place in the investing lexicon, but there are some things about its accuracy and overall limitations to take into consideration.

Is the Rule of 72 Accurate?

Perhaps the most important thing to keep in mind about the Rule of 72’s accuracy is that it’s a derivation of a larger, more complex operation, and therefore, is something of an estimate. It’s not perfectly accurate, but will get you more of a “ballpark” figure that can help you make investing decisions.

Situations Where the Rule is Most Accurate

The Rule of 72 is only an approximation and depending on what you’re trying to understand there are a few variations of the rule that can make the approximation more accurate.

The rule of 72 is most accurate at 8%, and beyond that at a range between 6% and 10%. You can, however, adjust the rule to make it more accurate outside the 6% to 10% window.

The general rule to make the calculation more accurate is to adjust the rule by one for every three points the interest rate differs from 8% in either direction. So, for an interest rate of 11%, individuals should adjust from 72 to 73. In the other direction, if the interest rate is 5%, individuals should adjust 72 to 71.

Comparisons and Variations on the Rule

There are a few alternatives or variations of the Rule of 72, too, such as the Rule of 73, Rule of 69.3, and Rule of 69.

Rule of 72 vs. Rule of 73

The basic difference between the Rule of 72 and the Rule of 73 is that it’s used to estimate the time it takes for an investment’s value to double if the rate of return is above 10%. The Rule of 73 is only a slight tweak to the rule of 72, using different figures in the calculation.

Rules of 72, 69.3, and 69

Similarly to the Rule of 73, some people prefer to use the Rule of 69.3, especially when interest compounds daily, to get a more accurate result. That number is derived from the complete equation ln(2) / ln(1 + r / 100). When plugged into a calculator by itself, ln(2) results in a number that’s approximately 0.693147.

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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.

FAQ

What are flaws of the Rule of 72>

There are a few key drawbacks to using the Rule of 72, including the fact that it’s mostly accurate only for a certain subset of investments, it’s only an estimation, and that unforeseen factors can cause the rate of return for an investment to change, rendering it useless.

Does the Rule of 72 apply to debt?

Yes, the Rule of 72 can apply to debt, and it can be used to calculate an estimate of how long it would take a debt balance to double if it’s not paid down or off.

Who created the Rule of 72?

Albert Einstein often gets credit, but Italian mathematician Luca Pacioli most likely invented, or introduced the Rule of 72 to the popular world in the late 1400s.


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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.

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

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What Is the Coupon Rate of a Bond?

Understanding the Coupon Rate of a Bond

By | Growing Wealth, invest, Investing | Comments Off on Understanding the Coupon Rate of a Bond

A bond’s coupon rate represents the annual interest rate paid by the issuer, as determined by current market interest rates and based on the bond’s face value. Bond issuers typically pay coupon rates on a semiannual basis.

The coupon rate of a bond can tell an investor how much interest they can expect to collect on a yearly basis. The bond coupon rate is not the same as the bond yield, which investors who buy bonds on the secondary market use to estimate the total rate of return at maturity.

Investment-quality bonds can help with diversification in a portfolio while providing a consistent stream of interest income. Understanding the coupon rate and what it means is important when choosing bonds for your portfolio.

What Is the Coupon Rate?

Bonds represent a debt where the bond issuer borrows money from investors and agrees to pay interest at regular intervals in exchange for the use of their capital. Both governments and non-government entities, like corporations, may issue bonds to raise capital to fund various endeavors.

The coupon rate of a bond is usually a fixed interest rate, typically paid out twice per year. That said, there are some variable-rate bonds, as well as zero-coupon bonds (more on those below). Investors often use the term “coupon rate” when discussing fixed-income securities, including bonds and notes.

Recommended: How Does the Bond Market Work

The Role of Coupon Rates in Bond Investments

Investors can buy individual bonds, bond funds, or bond options, which are derivatives similar to stock options.

The coupon interest rate tells you what percentage of the bond’s face value, or par value, you’ll receive yearly. The rate won’t change during the life of the bond, which is why some bonds are worth more than others on the secondary market.

Coupon rates are typically lower for investment-grade bonds and higher for junk bonds, due to their higher risk.

Example of a Bond’s Coupon Rate

Assume you purchase a bond with a face value of $1,000. The bond has a coupon rate of 4%. This means that for each year you hold the bond until maturity, you’d receive $40, regardless of what you paid for the bond.

If you buy a bond on the secondary market, the story changes somewhat. That’s because bonds trade either at a premium to the par value (higher than the face value), or at a discount to par (lower than the face value). Because the coupon rate of the bond stays the same until maturity, it may represent a higher or lower percentage of the par value — this is called the yield.

History of the Term Coupon

Bond holders used to get literal coupons as a way of collecting their interest payments. This is no longer the case, as interest is paid on a set schedule to the investor directly.


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Calculating the Coupon Rate

The bond coupon rate formula is fairly simple:

Bond coupon rate = Total annual coupon payment/Face or par value of the bond x 100

To apply the coupon rate formula you’d need to know the face or par value of the bond and the annual interest or coupon payment. To find this payment, you’d multiply the amount of interest paid by the number of periodic payments made for the year. You’d then divide that by the par value and divide the result by 100.

Recommended: How to Buy Bonds: A Guide for Beginners

Step-by-Step Calculation of the Coupon Rate

Say you have a bond with a face value of $1,000, which pays $25 in interest to you twice per year.

•   To find the annual coupon payment you’d multiply $25 by two to get $50.

•   You’d then divide the $50 annual coupon payment by the $1,000 par value of the bond. 50 / 1000 = 0.05

•   Then multiply the result by 100 (0.05 x 100) to find that your bond has a coupon rate of 5%.

The Impact of Market Interest Rates on Coupon Rates

How is the coupon rate determined? This is where current market interest rates come into play.

How Interest Rate Fluctuations Affect Bonds

Interest rates can influence coupon rates. An interest rate is the rate a lender charges a borrower. Individual lenders determine interest rates, often based on movements in an underlying benchmark rate. When discussing bond coupon rates and interest rates, it’s typically in the context of changes to the federal funds rate. This is the rate at which commercial banks lend to one another overnight.

Movements in the federal funds rate directly influence other types of interest rates, including coupon rates and bond prices on the secondary market.

When interest rates rise, based on changes to the federal funds rate, that can cause bond prices to fall. When interest rates decline, bond prices typically rise. When bond prices change that doesn’t impact the coupon rate, which stays the same. But a bond’s price is an important consideration for investors who trade on the secondary market because it impacts the yield to maturity.

Strategies for Investors in a Changing Rate Environment

Bond prices can move up or down based on the coupon rate, relative to movements in interest rates.

When interest rates are higher than the bond’s coupon rate, that bond’s price may fall in order to offset a less attractive yield. If interest rates drop below the bond’s coupon rate, the bond’s price may rise if it becomes a more attractive investment opportunity.

When comparing coupon rates and bond prices, it’s important to understand the relationship between the bond’s face value and what it trades for on the secondary market. If a bond is trading at a price above its face value, that means it’s trading at a premium to par. Conversely, if a bond is trading at a price below its face value, that means it’s trading at a discount to par.

An investor who purchases a bond with the intent to hold it until it reaches maturity does not need to worry about bond price movements. Their end goal is to collect the annual interest payments and recover their principal on the assigned maturity date, making it a relatively safe investment as long as the issuer fulfills their obligation.

Investors looking to buy bonds and resell them before they mature, however, may pay attention to which way bond prices are moving relative to the coupon rate to determine whether selling would yield a profit or loss.

Understanding Coupon Rate vs. Yield

Coupon rate tells investors how much interest a bond will pay yearly until maturity. But there are other metrics for evaluating bonds, including yield to maturity and interest rates. Understanding the differences in what they measure matters when determining whether bond investments are a good fit and what rate of return to expect.

Coupon Rate vs. Yield to Maturity

A bond’s yield to maturity or current yield reflects the interest rate earned by an investor who purchases a bond at market price and holds on to it until it reaches maturity. A bond’s maturity date represents the date at which the bond issuer agrees to repay the investor’s principal investment. Longer maturity dates may present greater risk, as they leave more room for the bond issuer to run into complications that could make it difficult to repay the principal.

When evaluating yield to maturity of a bond, you’re looking at the discount rate at which the sum of all future cash flows is equal to the price of the bond. Yield to maturity can be quoted as an annual rate that’s different from the bond coupon rate. In figuring yield to maturity, there’s an assumption that the bond issuer will make coupon and principal payments to investors on time.

The coupon rate is the annual interest earned while yield to maturity reflects the total rate of return produced by the bond when all interest and principal payments are made.

Coupon Rate vs Interest Rate

While coupon rate and interest rate seem similar, they are distinct. The coupon rate is set by the issuer of the bond, and the amount paid to the bondholder is tied to the face value.

But the prevailing interest rate set by the government is what determines the coupon rate. If the central bank, i.e. the Federal Reserve, sets the interest rate at 6%, that will influence what lenders are willing to accept in the form of the coupon rate.

Also, the price of a bond on the secondary market hinges on the coupon rate. A higher-coupon bond is more desirable than a lower-coupon bond, so its price will be higher.


💡 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.

Variable-Rate and Zero-Coupon Bonds

Not all coupon rates are fixed. Investors can also consider whether buying variable-rate bonds or zero-coupon bonds might make sense.

Fixed vs. Variable Coupon Rates and Investment Impact

Although bonds typically offer fixed-income payments, some bonds do offer coupon rates that adjust periodically. For that reason these bonds are sometimes called floating-rate or adjustable-rate bonds.

In these cases, the coupon rate adjusts according to a formula that’s linked to an interest rate index such as the SOFR (Secured Overnight Financing Rate), the new benchmark in the U.S. that has largely replaced the LIBOR (London Interbank Offered Rate).

Although these are income-producing bonds, and there is always the possibility that they could offer a higher yield under the right conditions, they are not technically fixed-income instruments, which is something for investors to bear in mind. In addition they come with the risk of default.

Zero-Coupon Bonds Explained

Some bonds, called zero-coupon bonds, don’t pay interest at all during the life of the bond. The upside of choosing zero bonds is that by forgoing annual interest payments, it’s possible to purchase the bonds at a deep discount to par value. This means that when the bond matures, the issuer pays the investor more than the purchase price.

Zero-coupon bonds typically have longer maturity dates, which may make them suitable when investing for long-term goals. This type of bond may experience more price fluctuations compared to other types of bonds sold on the secondary market. Investors may still have to pay taxes on the imputed interest generated by the bond, though it’s possible to avoid that by investing in zero-coupon municipal bonds or other tax-exempt zero-coupon bond options.

The Takeaway

Investing in bonds can help you create a well-rounded portfolio alongside stocks, and other securities, which is why knowing the coupon rate of a bond is important. The coupon rate is the interest rate paid by the issuer, and it’s fixed for the life of the bond — which makes it possible to create a predictable income stream, whether you buy the bond at issuance or on the secondary market.

As you get closer to retirement, bonds can be an important part of your income and risk management strategy, whether you’re investing through an IRA, a 401(k), or a brokerage account.

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).


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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.

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

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

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