Are Cryptocurrencies Financial Instruments?

GAAP standards do not consider Bitcoin and other cryptocurrencies financial instruments. Those rules view cryptocurrency as an intangible asset, with no physical substance, rather than a financial asset.

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Q: What Is a Financial Instrument?

Financial instruments are agreements involving the exchange of an asset with a monetary value for another asset. These agreements involve multiple parties, such as individuals, corporations, or government entities.

Oct

2023

What Is a Financial Instrument? Types & Asset Classes Explained

By Rebecca Lake | Growing Wealth, invest, Investing | Comments Off

A financial instrument is simply a contract between entities that represents the exchange of money for a certain asset. Financial instruments include most types of investments: cash, stocks, bonds, mutual funds, exchange-traded funds (ETFs), certificates of deposit (CDs), loans, derivatives, and more.

Financial instruments facilitate the movement of capital through the markets and the broader economic system. While this may take different forms, the flow of capital remains a central feature.

What Is a Financial Instrument?

Generally Accepted Accounting Principles (GAAP) defines a financial instrument as cash; evidence of an ownership interest in a company or other entity; or a contract. A financial instrument confers either a right or an obligation to the holder of the instrument, and is an asset that can be created, modified, traded, or settled.

Investors can trade financial instruments on a public exchange. The New York Stock Exchange (NYSE) is an example of a spot market in which investors can trade equity instruments for immediate delivery.

💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.

Financial Instrument vs Security

A security is a type of financial instrument with a fluctuating monetary value that carries a certain amount of risk for the individual or entity that holds it. Investors can trade securities through a public exchange or over-the-counter market.

The federal government regulates securities and the securities industry under a series of laws, including the Securities Act of 1933, the Securities Exchange Act of 1934, and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

All securities are financial instruments but not all financial instruments are securities.

Like financial instruments, securities fall into different groups or categories. The four types of securities include:

• Equities. Equities represent an ownership interest in a company. Stocks and mutual funds are examples of equity securities.

• Debt. Debt refers to money lent by investors to corporate or government entities. Corporate and municipal bonds are two examples of debt securities.

• Derivatives. Derivatives are financial contracts whose value is tied to an underlying asset. Futures and stock options are derivative instruments.

• Hybrid. Hybrid securities combine aspects of debt and equity. Convertible bonds are a type of hybrid instrument.

Types of Financial Instruments

Financial instruments are not all alike. There are different types of financial instruments in different asset classes. Certain financial instruments are more complex in nature than others, meaning they may require more knowledge or expertise to handle or trade.

1. Cash Instruments

Cash instruments are financial instruments whose value fluctuates based on changing market conditions. Cash instruments can be securities traded on an exchange, such as stocks, or other types of financial contracts.

For example, a certificate of deposit account (CD) is a type of cash instrument. Loans also fall under the cash instrument heading as they represent an agreement or contract between two parties where money is exchanged.

2. Derivative Instruments

Derivative instruments or derivatives draw their value from an underlying asset, and fluctuate based on the changing value of the underlying security or benchmark.

As mentioned, options are a type of derivative instrument, as are futures contracts, forwards, and swaps.

3. Foreign Exchange Instruments

Foreign exchange instruments are financial instruments associated with international markets. For example, in forex trading investors trade currencies from different currencies through global exchanges.

Asset Classes of Financial Instruments

Financial instruments can also be broken down by asset class.

4. Debt-Based Financial Instruments

Companies use debt-based financial instruments as a means of raising capital. For example, say a municipal government wants to launch a road improvement project but lacks the funding to do so. They may issue one or more municipal bonds to raise the money they need.

Investors buy these bonds, contributing the capital needed for the road project. The municipal government then pays the investors back their principal at a later date, along with interest.

5. Equity-Based Financial Instruments

Equity-based financial instruments convey some form of ownership of an entity. If you buy 100 shares of stock in XYZ company, for example, you’re purchasing an equity-based instrument.

Equity-based instruments can help companies raise capital, but the company does not have to pay anything back to investors. Instead, investors may receive dividends from the stock shares they own, or realize profits if they’re able to sell those shares for a capital gain.

Are Commodities Financial Instruments?

Commodities such as oil or gas, precious metals, agricultural products and other raw materials are not considered financial instruments. A commodity itself, such as pork or copper, doesn’t direct the flow of capital.

That said, there are certain instruments whereby commodities are traded, including stocks, exchange-traded funds, and futures contracts.

A futures contract represents an agreement to buy or sell a certain commodity at a specific price at a future date. So, for example, an orange grower might sell a futures contract agreeing to sell a certain amount of their crop for a set price. An orange juice company could then buy a contract to purchase oranges at X price.

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.

💡 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.

Uses of Financial Instruments

Investors and businesses may use financial instrument for the following purposes:

1. As a Means of Payment

You already use financial instruments in your everyday life. When you write a check to pay a bill or use cash to buy groceries, you’re exchanging a financial instrument for goods and services.

Likewise, business entities may charge purchases to a business credit card. They’re borrowing money from the credit card company and paying it back at a later date, often with interest.

2. Risk Transfer

Investors use financial instruments to transfer risk when trading options and other derivative instruments, such as interest rate swaps. With options, for example, an investor has the option to buy or sell an underlying asset at a specified price on or before a predetermined date. A contract exists between the individual who writes the option and the individual who buys it. This type of financial instrument allows an investor to speculate about which way prices for a particular security may move in the future.

3. To Store Value

Businesses often use financial instruments in this way. For example, say you default on a credit card balance. Your credit card company can write off the amount as a bad debt and sell it to a debt collector. Meanwhile, businesses with outstanding invoices they’re awaiting payment on can use factoring or accounts receivables financing to borrow against their value.

4. To Raise Capital

Companies may issue stocks or bonds in order to get access to capital that they can invest in their business. In this case, the financial instruments could be a means of raising capital for one party and a store of value for the other.

Importance of Financial Instruments

Financial instruments are central to not only the stock market, but also the financial and economic system as a whole. They provide structures and legal obligations that facilitate the regulated exchange of capital via investing, lending and borrowing, speculation and growth.

In short, financial instruments keep the financial markets moving, and they also help businesses to keep their doors open and allow consumers to manage their finances, plan for the future, and invest with the hope of future gains.

For example, you may also have a savings account that you use to hold your emergency fund, an Individual Retirement Account (IRA) that you use to save for retirement and a taxable brokerage account for trading stocks. Your checking account is one of the basic tools you might use to pay bills or make purchases.

You might be paying down a mortgage or student loans while occasionally using credit cards to spend. All of these financial instruments allow you to direct the flow of money from one place to another.

The Takeaway

Financial instruments are integral to every aspect of the financial world, and they also play a significant part in business transactions and day-to-day financial management. If you trade stocks, invest in an IRA, or write checks to your landlord, then you’re contributing to the movement of capital with various financial instruments. Understanding the different types of financial instruments is the first step in becoming a steward of your own money.

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

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

Photo credit: iStock/Love portrait and love the world

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.

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at [email protected]. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.

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

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.

SOIN0723141

Oct

2023

Guide to Options Trading for Beginners

By Inyoung Hwang | Growing Wealth, invest, Investing | Comments Off

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

An option is a financial instrument whose value is tied to an underlying asset; this is known as a derivative. Instead of buying an asset, such as company stock, outright, an options contract allows the investor to potentially profit from price changes in the underlying asset without actually owning it.

Because options contracts may be much cheaper to come by than the underlying asset, trading options can offer investors leverage that may result in significant gains if the market moves in the right direction. But options are very risky, and also can result in steep losses. That’s why investors must meet certain criteria with their brokerage firm before being able to trade options.

What Is Options Trading?

Knowing how options trading works requires understanding what an option is, and what the advantages, disadvantages, and risks of options trading may be.

What Are Options?

Buying an option is simply purchasing a contract that represents the right but not the obligation to buy or sell a security at a fixed price by a specified date.

• The options buyer (or holder) has the right, but not the obligation to buy or sell a certain asset, like shares of stock, at a certain price by a specific date (the expiration date of the contract). Buyers pay a premium for each options contract; this is the total price of the option.

• The options seller (or writer), who is on the opposite side of the trade, has the obligation to buy or sell the underlying asset at the agreed-upon price, aka the strike price, if the options holder exercises their contract.

Options buyers and sellers may use options if they think an asset’s price will go up (or down), to offset risk elsewhere in their portfolio, or to increase the profitability of existing positions. There are many different options-trading strategies.

💡 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.

Why Are Options Called Derivatives?

An option is considered a derivative instrument because it is based on the underlying asset: An options holder doesn’t purchase the asset, just the options contract. That way, they can make trades based on anticipated price movements of the underlying asset, without having to own the asset itself.

In stock options, one options contract typically represents 100 shares.

Other types of derivatives include futures, swaps, and forwards. Options that exist for futures contracts, such as the S&P 500 index or oil futures, are also popular derivatives.

What is the difference between trading using margin vs. options? Having a margin account does offer investors leverage for other trades (e.g. trading stocks). But while a brokerage may require you to have a margin account in order to trade options, you can’t purchase options contracts using margin. That said, an options seller (writer) might be able to use margin to sell options contracts.

Recommended: What Are Derivatives?

What Are Puts and Calls?

There are two main types of options: calls vs. puts.

Call Options 101

When purchased, call options give the options holder the right to buy an asset.

Here’s how a call option might work. The options buyer purchases a call option tied to Stock A with a strike price of $40 and expiration three months from now. Stock A is currently trading at $35 per share.

If Stock A appreciates to a value higher than $40 per share, the option holder may choose to exercise the contract, or sell their option for a premium. If the value of Stock A goes up, the value of the call option should, all else being equal, also go up.

The opposite would also be true. If shares of Stock A go down, the value of the call should, all else being equal, go down.

If the options holder wanted to exercise their call option, with American-style options they have until the expiration date to do so (with European-style options, the option must be exercised on the expiration date). When they exercise, they can buy 100 shares at the strike price.

Put Options 101

Meanwhile, put options give holders the right to sell an asset at a specified price by a certain date.

Here’s how a put trade might work. A trader buys a put option tied to Stock B with a strike price of $45 and expiration three months from now. Stock B is currently trading at $50 per share.

If the price of Stock B falls to $44, below the strike price, the options holder can exercise the put. Alternatively, the value of the option would likely also rise in this scenario, as owners of Stock B might look to lock in profits and sell shares before the stock falls further. A scenario like that may give the option holder the choice of selling the option itself for a profit.

What Is the Put-Call Ratio?

A stock’s put-call ratio is the number of put options traded in the market relative to calls. It is one measure that investors look at to determine sentiment toward the shares. A high put-call ratio indicates bearish market sentiment, whereas a low one signals more bullish views.

💡 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.

Options Trading Terminology

• The strike price is the price at which the option holder can exercise the contract. If the holder decides to exercise the option, the seller is obligated to fulfill the contract.

• With American-style options the expiration is the date by which the contract needs to be exercised. The closer an option is to its expiration, the lower the value of the contract. That is what’s called the time value.

• Premiums reflect the value of an option; it’s the current market price for that option contract.

• Call options are considered in the money, when the shares of the underlying stock trade above the strike price. Put options are in the money when the underlying shares are trading below the strike price.

• Options are at the money when the strike price is equal to the price of the asset in the market. Contracts that are at the money tend to see more volume or trading activity, as holders look to exercise the options.

• Options are out of the money when the underlying security’s price is below the strike price of a call option, or above the strike price of a put option. For example, if shares of Stock C are trading at $50 each and the call option’s strike price is $60, the contracts are out of the money.

For an out-of-the-money put option, the shares of Stock C may be trading at $60, while the put’s strike price is $50, so therefore, not yet exercisable.

“The Greeks” in Options Trading

Traders use a range of Greek letters to gauge the value of options. Here are some of the Greeks to know:

• Delta measures the impact of the price of the underlying asset on the option’s value.

• Beta measures how much a single stock moves relative to the overall stock market.

• Gamma tracks the sensitivity of an option’s Delta.

• Theta is the sensitivity of the option to time.

• Vega is the sensitivity of the option to implied volatility.

• Rho is the sensitivity of the option to interest rates.

How to Trade Options

The market for stock options is typically open from 9:30am to 4pm ET, Monday through Friday, while futures options can usually be traded almost 24 hours.

This is how you may get started trading options:

1. Pick a Platform

Log into your investment account with your chosen brokerage.

2. Get Approved

Your brokerage may base your approval on your trading experience. Trading options is riskier than trading stocks because losses can be steeper. That’s why not all investors should trade options.

3. Place Your Trade

Decide on an underlying asset and options strategy and place your trade.

4. Manage Your Position

Monitor your position to know whether your options are in, at or out of the money.

Basic Options Trading Strategies

Options offer a way for holders to express their views of an asset’s price through a trade. But traders may also use options to hedge or offset risk from other assets that they own. Here are some important options trading strategies to know:

Long Put, Long Call

In simple terms, if the buyer purchases an option — be it a put or a call — they are ‘long’. A long put or long call position means the holder owns a put or call option.

• A holder with a long call strategy effectively locks in a lower purchase price for the underlying asset in case it increases in value.

• A holder with a long put strategy effectively locks in a higher sales price for the underlying asset in case it decreases in value.

Covered and Uncovered Calls

If an options writer sells call options on a stock or other underlying security they also own outright, the options are referred to as covered calls. The selling of options helps the writer generate an additional stream of income while committing to sell the shares they own for the predetermined price if the option is exercised.

Uncovered calls, or naked calls, also exist, when options writers sell call options without owning the underlying asset. However, this is a much riskier trade since the exercising of the option would oblige the options seller to buy the underlying asset in the open market, in order to sell the stock to the option buyer.

Note that the seller wants the option to stay out of the money so that they can keep the premium (which is how the seller makes money).

Spreads

Option spread trades involve buying and selling an equal number of options for the same underlying asset but at different strikes or expirations.

A bull spread is a strategy in which a trader expects the price of the underlying asset to appreciate.

A bearish spread is a strategy in which a trader expects a decline in the price of the underlying asset.

Horizontal spreads involve buying and selling options with the same strike prices but different expiration dates. Vertical spreads are created through the simultaneous buying and selling of options with the same expiration dates but different strike prices.

Straddles and Strangles

Strangles and straddles in options trading allow traders to profit from a move in the price of the underlying asset, rather than the direction of the move.

In a straddle, a trader buys both calls and puts with the same strike prices and expiration dates. The options buyer would pocket a profit if the asset price posts a big move, regardless of whether it rises or falls.

In a strangle, the holder also buys both calls and puts but with different strike prices.

Pros & Cons of Options Trading

Like any other type of investment, or investment strategy, trading options comes with certain advantages and disadvantages that investors should consider before going down this road.

Pros of Options Trading

• Options trading is complex and involves risks, but for experienced investors who understand the fundamentals of the contracts and how to trade them, options can be a useful tool to make investments while putting up a smaller amount of money upfront.

• The practice of selling options to collect income can also be a way for writers who are seeking income to collect premiums consistently. This was a popular strategy particularly in the years leading up to 2020 as the stock market tended to be quiet and interest rates were low.

• Options can also be a useful way to protect a portfolio. Some investors offset risk with options. For instance, buying a put option while also owning the underlying stock allows the options holder to lock in a selling price, for a specified period of time, in case the security declines in value, thereby limiting potential losses.

Cons of Options Trading

• A key risk in trading options is that losses can be outsized relative to the cost of the contract. When an option is exercised, the seller of the option is obligated to buy or sell the underlying asset, even if the market is moving against them.

• While premium costs are generally low, they can still add up. The cost of options premiums can eat away at an investor’s profits. For instance, while an investor may net a profit from a stock holding, if they used options to purchase the shares, they’d have to subtract the cost of the premiums when calculating the stock profit.

• Because options expire within a specific time window, there is only a short period of time for an investor’s thesis to play out. Securities like stocks don’t have expiration dates.

Advantages and Disadvantages of Options Trading
Pros	Cons
Additional income	Potential outsized losses
Hedging portfolio risk	Premiums can add up
Less money upfront than owning an asset outright	Limited time for trades to play out

The Takeaway

Options are derivative contracts on an underlying asset (an options contract for a certain stock is typically worth 100 shares). Options are complex, high-risk instruments, and investors need to understand how they work in order to avoid steep losses.

When an investor buys a call option, it gives them the right but not the obligation to buy the underlying asset by the expiration date. When an investor buys a put option, it gives them the right but not the obligation to sell the underlying asset by the expiration date.

The contracts work differently for options sellers/writers.

The seller or writer of a call option has the obligation to sell the underlying asset at the agreed strike price to the options holder, if the holder chooses to exercise the option on or before the expiration.

The seller of a put option has the obligation to buy the shares of the underlying asset from the put option holder at the agreed strike price.

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

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

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

SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at [email protected]. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.

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

SOIN0423010

Oct

2023

What is the Capital Asset Pricing Model (CAPM)?

By Brian O'Connell | Growing Wealth, invest, Investing | Comments Off

The Capital Asset Pricing Model (CAPM) is an investment assessment formula that shines a light on the relationship between the systematic risk in a security and its estimated return. Investors use the CAPM to determine whether an investment’s expected return is the same as its risk-free return, and to determine an asset’s expected returns.

CAPM Defined

The Capital Asset Pricing Model makes the process of measuring investment return and risk more efficient, to determine whether a particular asset offers an acceptable rate of return.

CAPM is especially helpful when an investor faces significant investment risk, such as when trading equity options. The formula helps the investor determine whether the transaction has an acceptable measure of risk. By using CAPM, the investor is able to accurately assess if the potential investment return on a security is worth taking on.

Evaluating the fair value of a security is an ongoing endeavor, as investment risk factors and other variables change all the time. When those risks shift (think interest rate changes, company management changes, or a geopolitical crisis erupts, among other potential threats), investors can still use the capital asset pricing model to weigh an investment against constant risk and return variables.

Investors can factor market impactors, like interest rate flows, currency valuations, and stock market cycles, among other issues, into their CAPM analysis to better weigh risk versus return. Basically, the bigger the chance of risk, the more important CAPM becomes to investors weighing that risk against potential returns.

💡 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.

What Is the CAPM Formula?

CAPM can help evaluate an investment’s viability in a time of significant market angst, by measuring three important barometers in an investment equation – risk-free return, the market risk premium, and the investment beta.

Let’s take a look at how CAPM is calculated with all three factors included.

The (capital asset pricing model) CAPM formula is represented as below:

Expected Rate of Return = Risk-Free Premium + Beta * (Market Risk Premium) Ra = Rrf + βa * (Rm – Rrf)

The calculation reflects a series of financial metrics, which taken together can offer a balanced look at a potential investment’s risk and return, with the aforementioned metrics front and center.

Risk-Free Return (Rrf)

This metric represents the value given to an investment (like a stock or commodity trading, for example) that provides return with no risk. U.S. Treasury bond, backed by the full faith and credit of the United States government, are a good example of risk-free return in action.

Since the U.S. government guarantees the bonds, and there is virtually zero chance of the U.S. defaulting on its debt obligations, Treasuries are considered among the safest investments available. That’s a big reason why risk-free return value reflects the yield delivered by a 10-year U.S. government bond.

The Market Risk Premium (Rm-Rrf)

This financial metric represents the return an investor earns – or anticipates earning – from owning a more risk-abundant portfolio. The MPA is an important component of CAPM, as it enables an investor to assess risk and decide if the market premium rate is superior to an investment in a risk-free investment like U.S. bonds.

The Beta (Ba)

Wall Street analysts rely on beta to weigh the volatility of a given security against a broader market.

For instance, an investor looking to buy 100 shares of an emerging biotech company can use beta to evaluate that investment and see how it may perform if the broader stock market turns volatile. In that scenario, that biotech stock’s beta may be 13%, which means it would trigger a 130% variation from any significant (based on the exact calculation) of any shift in the broader stock market. Beta is always equal to 1 in any market evaluation equation, meaning it’s parallel to any potential shifts in a broader market

CAPM Formula Explained

Factoring in each component to the CAPM equation, the resulting formula looks like this:

Expected return = Risk-free rate + (beta x market risk premium).

The risk-free component focuses on the time value of money, or the concept that a cash amount in present form is potentially higher than the same amount of cash down the road, primarily because of money’s current earnings potential. A CAPM formula may also factor in excess risks taken on by an investor.

Next, beta is assessed to figure out just how much risk is on the table relative to the broader market. For instance, if ABC stock offers more risk than the broader market, its beta is higher than 1 (one). A beta that is lower than 1 assumes the investment will curb portfolio risk, which may make a security more palatable to risk-averse investors.

With the beta calculated, beta is multiplied by the market risk premium, and the result (value) is added into the investment’s risk-free rate to provide the security’s estimated rate of return.

In conducting a CAPM exercise, the investor must acknowledge some level of risk in any investment, primarily in two ways.

• Loss is always possible, as common market securities like stocks, commodities, funds, or currencies may lose money, making them a depreciation risk.

• The higher level of risk in a specific security often correlates to a higher potential investment return, as history shows that specific investments carry more risks and more rewards than others (stock options and future.

Advantages to Capital Asset Pricing Model

The chief advantages to the capital asset pricing model are that it’s relatively simple and easy to use, it takes systemic risk into consideration, it has a wide range of potential uses (when other models may not do the trick, for instance), and for that reason, is often seen as a superior model to others, such as the WACC formula.

Problems with the CAPM

While the CAPM is an extremely useful tool for investors, it does have some drawbacks. One such drawback is the reliance on the risk-free rate and the beta. As such, CAPM must be constantly recalculated in order to remain useful. It also does not account for transaction costs such as taxes and fees, which could make a potential investment less favorable than the model shows.

Efficient Frontiers and the Capital Asset Pricing Model

In theory, if an investor adhered perfectly to CAPM all of their investments would exist on the efficient frontier, meaning that all returns justify the risks taken. The efficient frontier is the optimal baseline for a portfolio, Since every investment comes with some risk, it’s important to make sure that the returns correspond to the level of risk.

CAPM and the Security Market Line (SML)

The security market line, or SML, is a graphical representation of the CAPM formula, and shows expected returns for a security. Specifically, it shows the relationship between beta and expected return. When used in conjunction with the CAPM formula, investors can use the SML to try and get a sense of whether a prospective investment offers a good enough expected return when all risks are taken into account.

Practical Value of the CAPM

Many investors probably wonder if, when it comes down to it, CAPM has much practical value. While that will ultimately depend on the individual investor, it may be fair to say that the CAPM has value in that it’s widely used, and can give investors a broad or general idea of the risks and potential returns involved with a single investment. Again, it’s not the only model or formula that does that – but can be yet another tool that an investor can have in their analytical tool box.

The Takeaway

CAPM can help investors understand how the risk and return of a given investment relate to each other. Having the answer to that question can help investors make more knowledgeable portfolio decisions on an ongoing basis.

CAPM is also a fairly high-level investing concept, and one that many investors may never use or encounter. That’s not to say it doesn’t have its uses – but if you feel that it’s over your head or too advanced, you can always consult with a financial professional for guidance.

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 some of the assumptions built into the CAPM model?

A few assumptions built into the CAPM model are that all investors are naturally risk-averse, that investors are evaluating investments within the same time period, and that investors have unlimited capital to borrow at a relatively risk-free rate of return.

What are alternatives to the CAPM?

Some alternatives to the CAPM include arbitrage pricing theory, or APT, and the Fama-French Model. There are others out there, too, which may or may not be perfect substitutes or alternatives to the CAPM.

What is the International Capital Asset Pricing Model (ICAPM)?

The International Capital Asset Pricing Model, or ICAPM, is more or less an extension of the CAPM, and incorporates or includes international investments.

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Oct

2023

Understanding the Different Stock Order Types

By Austin Kilham | Growing Wealth, invest, Investing | Comments Off

There are several ways to execute stock trades, from the common and relatively simple market order, to more complex stop orders and timing instructions. Each type of order is a tool tailored to specific situations and needs of an investor or trader, and can result in a different outcome.

It’s important to understand the types of order in the stock market thoroughly to know when and how to use them. That way you’ll be able to know which order will best help you reach your goals as you buy and sell stocks.

Stock Order Types Explained

Different types of stock orders have different outcomes for investors. The best stock order type for you will depend on your investing style and risk appetite. You’ll need to understand each of them, particularly if you’re working with a self-directed brokerage account.

Recommended: 50 Investment Terms Decoded

Here’s a look at the different types of stock orders:

Market Order

Market orders are one of the most common types of trade you’ll encounter. A market order is an order to buy or sell a security as soon as possible at its current price. These types of orders make sense when you want to get a transaction done as quickly as possible.

A market order is guaranteed to be carried out, or executed. Investors buying stocks with a market order will pay an amount at or near the “ask” price. Sellers will sell for a price at or near the “bid” price.

However, while you’re guaranteed that your order will execute, you do not get a guarantee on the exact price. In volatile markets, stock prices may move quickly, deviating from the last quoted price, although.

For example, if you put in an order to buy a stock at an ask price of $50 per share, but many other buy orders are executed first, your market order may execute at a higher price as demand rises.

Recommended: What Is a Market-On-Open Order (MOO)?

Limit Order

Limit orders are another common type of stock orders. They are orders to buy or sell stock at a specific price or better within a certain time period. There are two basic types of limit orders:

• Buy limit orders can only be executed at the limit price or lower. For example, say you want to buy shares in a company only when prices hit $40. By placing a limit order for that amount, you can ensure your order only executes when that price, or a lower price, is reached.

• A sell limit order executes when stock hits a certain price or higher. For example, if you don’t want to sell your stock until it hits $40 or more, a sell limit will ensure that you own the stock until it hits that price.

Stop Order

In addition to the more commonly used market orders and limit orders, brokerage firms may also allow investors to use special orders and trading instructions, such as the stop order, also known as a stop-loss order. Stop orders are orders to buy or sell a stock when it reaches a predetermined price, known as the stop price. Stop orders help investors lock in profits and limit losses.

You enter a buy stop order at a price that is above current market price, which can help protect profit, especially if you are selling short. On the other hand, a sell stop order is an order to sell a stock at a price below the current market price, which can help you limit their losses.

When a stock’s price reaches the stop order price, the stop order becomes a market order. Like a market order, the stop price is not a guaranteed price. Fast moving markets can cause the execution price to be quite different.

Stop-Limit Order

Stop-limit orders are a sort of hybrid between stop orders and limit orders. Investors set a stop price, and when a stock hits that price, the stop order becomes limit order, executed at a specific price or better.

Stop-limit orders help investors avoid the risk that a stop order will execute at an unexpected price. That gives them more control over the price at which they’ll buy or sell.

For example, say you want to buy a stock currently priced at $100 but only if it shows signs that it’s on a clear upward trajectory. You could place a stop-limit order with a stop price of $110 and a limit of $115. When the stock reaches $110, the stop order becomes a limit order, and it will only execute when prices reach $115 or higher.

💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.

Trailing Stop Loss Order

Investors who already own stocks and want to lock in gains may use these relatively uncommon orders. While stop-loss orders help investors buy or sell when a stock hits a certain stop price, trailing stop loss orders put guardrails around an investment.

For example, if you buy a stock at $100 per share, you might put a trailing stop loss order of 10% on the stock. That way, if, at any time, the stock’s share price dips below 10%, the brokerage will execute the order to sell.

Bracket Order (BO)

Bracket orders are similar to stop-loss orders in that they’re designed to help investors or traders lock in their profits or gains. They effectively create an order “bracket” with two orders: A buy order with a high-side sell limit, and a sell order with a low-side limit.

With a bracket order set up and in place, an order will execute when a security’s value goes outside of the predetermined range, either too high or too low.

Timing Instructions

Investors use a set of tools, known as timing instructions, to modify the market orders and limit orders and tailor them to more specific needs.

Day Orders

If an investor does not specify when an order will expire, the brokerage enters it as a day order. At the end of the trading day, it expires. If at that point, the brokerage has not executed the trade, it will have to be reentered the following day.

Good ‘Til Canceled (GTC)

A GTC order allows investors to put a time restriction on an order so that it lasts until the completion or cancellation of an order. Brokerage firms typically place a time limit on how long a GTC order can remain open.

Immediate or Cancel (IOC)

IOC orders allow investors to ask that the brokerage execute the buying or selling of stock immediately. It also allows for partial execution of the order. So, if an investor wants to buy 1,000 shares of a company but it’s only possible to buy 500 shares immediately, these instructions will alert the broker to buy the shares available. If the broker can not fulfill the order, or any portion of the order, immediately, the broker will cancel it.

Fill-Or-Kill (FOK)

Unlike IOC orders, fill-or-kill orders do not permit partial execution. The brokerage must execute the order immediately and in its entirety, or cancel it.

All-Or-None (AON)

Similar to FOKs, all-or-none orders require the complete execution of the order. However, AONs do not require immediate execution, rather the order remains active until the broker executes or cancels it.

💡 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).

Which Order Type Is Best?

The type of order or special instructions you use when buying and selling stock depends on your goals with the transaction. Most beginner investors probably only need to execute market orders and perhaps limit orders.

Those trying to execute more complicated trades in shorter time frames, such as professional traders, may be more likely to use stop orders and special timing instructions.

The Takeaway

There are numerous types of stock orders, including limit orders, stop orders, bracket orders, and more. Investors and traders can use each individually or in concert to execute their strategy, though beginner investors likely won’t dig too far into their order tool kit when learning to navigate the markets.

Before using any of trade orders or timing instructions it’s critical to understand their function and to think carefully about how and whether they apply to your specific needs. Using the right order for your situation can potentially help you reduce risk and protect your portfolio, no matter how many stocks you own.

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 is the safest type of stock order to use?

The stock order type that is all but guaranteed to execute per an investor’s desires is a market order, which executes immediately and at a given price. Other order types depend on specific conditions dictated by the investor and the market.

What is the difference between stop-loss vs stop-limit orders?

The main difference between a stop-loss order and a stop-limit order is that a stop-loss order guarantees to execute a market order if the stock hits the stop price, while a stop-limit order triggers a limit order when the assigned value is reached.

What is a standard stop-loss rule?

An example of a more or less standard stop-loss rule would be setting the stop-loss order parameters at 2% of the buy price, which would mean that an investor is not putting more than 2% of their initial investment at risk.

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Sep

2023

What Is a Bear Market? Characteristics and Causes, Explained

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

A bear market is defined as a broad market decline of 20% or more from recent highs, which lasts for at least two months. Although bear markets make for dramatic headlines, the truth is that bull markets tend to last much longer — the average bear market typically ends within a year.

While most investors know the difference between a bull and a bear market, it’s important to know some of the characteristics of bear markets in order to understand how different market conditions may impact your portfolio and your investment choices.

What Is a Bear Market?

Investors and market watchers generally define a bear market as a drop of 20% or more from market highs. So when investors refer to a bear market, it usually means that multiple broad market indexes, such as the Standard & Poors 500 Index (S&P 500), Dow Jones Industrial Average (DJIA), and others, fell by 20% or more over at least two months.

To be sure, 20% is a somewhat arbitrary barometer, but it’s a common enough standard throughout the financial world.

The term bear market can also be used to describe a specific security. For example, when a particular stock drops 20% in a short time, it can be said that the stock has entered a bear market.

Bear markets are usually associated with economic recessions, although this isn’t always the case. As economic activity slows, people lose jobs, consumer spending falls, and business earnings decline. As a result, many companies may see their share prices tumble or stagnate as investors pull back.

Why Is It Called a Bear Market?

There are a variety of explanations for why “bear” and “bull” have come to describe specific market conditions. Some say a market slump is like a bear going into hibernation, versus a bull market that keeps charging upward.

The origins of the term bear market may also have come from the so-called bearskin market in the 18th century or earlier. There was a proverb that said it is unwise to sell a bear’s skin before one has caught the bear. Over time the term bearskin, and then bear, became used to describe the selling of assets.

Characteristics of a Bear Market

There are two different types of bear markets:

• Regular bear market or cyclical bear market: The market declines and takes a few months to a year to recover.

• Secular bear market: This type of bear market lasts longer and is driven more by long-term market trends than short-term consumer sentiment. A cyclical bear market can happen within a secular bear market.

History of Bear Markets

The most recent U.S. bear market began in June 2022, largely sparked by rising interest rates and inflation. The bear market officially ended on June 8, 2023, lasting about 248 trading days, according to Dow Jones Market Data, and resulting in a market drop of about 25.4%.

Including the most recent bear market, the S&P 500 Index posted 12 declines of more than 20% since World War II. The table below shows the S&P 500’s returns from the highest point to the lowest point in a downturn. Bear markets average a decline of 34%, and generally last a little more than a year: about 400 days.

Recommended: What Is a Financial Crisis?

Bear markets have occurred as close together as two years and as far apart as nearly 12 years. A secular bear market refers to a longer period of lower-than-average returns; this could last 10 years or more. A secular bear market may include minor rallies, but these don’t take hold.

A cyclical bear market is more likely to last a few weeks to a few months and is more a function of market volatility.

Peak (Start)	Trough (End)	Return	Length (in days)
May 29, 1946	May 17, 1947	-28.78%	353
June 15, 1948	June 13, 1949	-20.57%	363
August 2, 1956	October 22, 1957	-21.63%	446
December 12, 1961	June 26, 1962	-27.97%	196
February 9, 1966	October 7, 1966	-22.18%	240
November 29, 1968	May 26, 1970	-36.06%	543
January 11, 1973	October 3, 1974	-48.20%	630
November 28, 1980	August 12, 1982	-27.11%	622
August 25, 1987	December 4, 1987	-33.51%	101
March 27, 2000	Sept. 21, 2001	-36.77%	545
Jan. 4, 2002	Oct. 9, 2002	-33.75%	278
October 9, 2007	Nov. 10, 2008	-51.93%	408
Jan. 6, 2009	March 9, 2009	-27.62%	62
February 19, 2020	March 23, 2020	-34%	33
June 2022	June 8, 2023	-25%	248
Average		-34%	401

Source: Seeking Alpha/Dow Jones Market Data as of June 8, 2023.

What Causes a Bear Market?

Usually bear markets are caused by a loss of consumer, investor, and business confidence. Various factors can contribute to the loss of consumer confidence, such as changes to interest rates, global events, falling housing prices, or changes in the economy.

When the market reaches a high, people may feel that certain assets are overvalued. In that instance, people are less likely to buy those assets and more likely to start selling them, which can make prices fall.

When other investors see that prices are falling, they may anticipate that the market has reached a peak and will start declining, so they may also sell off their assets to try and profit on them before the decline. In some cases panic can set in, leading to a mass sell-off and a stock market crash (but this is rare).

Is a Recession the Same as a Bear Market?

No. Bear market conditions can lead to recessions if the market slump lasts long enough. But this isn’t always the case. According to the National Bureau of Economic Research as reported in The New York Times, the U.S. has been in a recession only 14% of the time since World War II.

What Is a Bear Market Rally

Things can get tricky if there is a bear market rally. This happens when the market goes back up for a number of days or weeks, but the rise is only temporary. Investors may think that the market decline has ended and start buying, but it may in fact continue to decline after the rally. Sometimes the market does recover and go back into a bull market, but this is hard to predict.

If the bear market continues on long enough then it becomes a recession, which can go on for months or years. That said, it’s not always the case that a bear market means there will be a recession.

Once asset prices have decreased as much as they possibly can, consumer confidence begins to rise again, and people start buying. This reverses the bear market trend into a bull market, and the market starts to recover and grow again.

Example of a Bear Market

The most recent bear market occurred in June of 2022, when the S&P 500 closed 21.8% lower than its high on Jan. 3, 2022.

While the Nasdaq and the Dow showed a similar pattern in early 2022, the decline of those markets didn’t cross the 20% mark that signals official bear market territory.

Bear Market vs Bull Market

A bull market is essentially the opposite of a bear market. As consumer confidence increases, money goes into the markets and they go up.

A bull market is defined as a 20% rise from the low that the market hit in a bear market. However, the parameters of a bull market are not as clearly defined as they are for a bear market. Once the bottom of the bear market has been reached, people generally feel that a bull market has started.

Investing Tips During a Bear Market

There are a few different bear market investing strategies one can use to both prepare for a bear market and navigate through one.

1. Reduce Risky Investments

When preparing for a bear market, it’s a good idea to reduce riskier holdings such as growth stocks and speculative assets. One can move money into cash, gold, bonds, or other ‘safe’ investments to reduce the risk of losses if the market goes down.

These safe investments tend to perform better than stocks during a bear market. Types of stocks that tend to weather bear markets well include consumer staples and healthcare companies.

2. Diversify

Another investing strategy is diversification. Rather than having all of one’s money in stocks, distribute your investments across asset classes, e.g. precious metals, bonds, crypto, real estate, or other types of investments.

This way, if one type of asset goes down a lot, the others might not go down as much. Similarly, one asset may increase a lot in value, but it’s hard to predict which one, so diversifying increases the chances that one will be exposed to the upward trend, and you’ll see a gain.

3. Save Capital and Reduce Losses

During a bear market, a common strategy is to shift from growing capital into saving it and reducing losses. It may be tempting to try and pick where the market has hit the bottom and start buying growth assets again, but this is very hard to do. It’s safer to invest small amounts of money over time using a dollar-cost averaging strategy so that one’s investments all average out, rather than trying to predict market highs and lows.

4. Find Opportunities for Future Growth

However, in a broad sense if the market is at a high and assets are clearly overvalued, this may not be the best time to buy. And vice versa if assets are clearly undervalued it may be a good time to buy and grow one’s portfolio. A bear market can be a good time to identify assets that might grow in the next bull market and start investing in them.

5. Short Selling

A very risky strategy that some investors take is short selling in anticipation of a bear market. This involves borrowing shares and selling them, then hoping to buy them back at a lower price. It’s risky because there is no guarantee that the price of the shares will fall, and since the shares are borrowed, typically using a margin account, they may end up owing the broker money if their trade doesn’t work out as they hope.

Overall, it’s best to create a long-term investing strategy rather than focusing on short-term trends and making reactive decisions to market changes. It can be scary to watch one’s portfolio go down, especially if it happens fast, but selling off assets because the market is crashing generally doesn’t turn out well for investors.

The Takeaway

Bear markets can be scary times for investors, but even a prolonged drop of 20% or more isn’t likely to last more than a few months, according to historical data. In some cases, bear markets present opportunities to buy stocks at a discount (meaning, when prices are low), in the hope they might rise.

Also there are strategies you can use to reduce losses and prepare for the next bull market, including different types of asset allocation. The point is that whether the markets are considered bearish or bullish, any time can be a good time to invest.

If you’re looking to build a portfolio, no matter what the market, it’s easy when you set up an Active Invest account with SoFi Invest. The secure investing app lets you research, track, buy and sell stocks, ETFs, and other assets right from your phone or computer. You can easily move between different types of assets and you can set automated recurring investments if you want to put in a certain dollar amount each week or month. All you need is a few dollars to get started.

Start building a portfolio today.

FAQ

How long do bear markets last?

Bear markets may last a few months to a year or more, but most bear markets end within a year’s time. If they go on longer than that they typically become recessions. And while a bear market can end in a few months, it can take longer for the market to regain lost ground.

When was the last bear market?

The most recent bear market started in June of 2022, when the S&P 500 fell from record highs in January for more than two months.

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SoFi Invest®

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

What Is a Financial Instrument? Types & Asset Classes Explained

What Is a Financial Instrument?

Financial Instrument vs Security

Types of Financial Instruments

1. Cash Instruments

2. Derivative Instruments

3. Foreign Exchange Instruments

Asset Classes of Financial Instruments

4. Debt-Based Financial Instruments

5. Equity-Based Financial Instruments

Are Commodities Financial Instruments?

Uses of Financial Instruments

1. As a Means of Payment

2. Risk Transfer

3. To Store Value

4. To Raise Capital

Importance of Financial Instruments

The Takeaway

Guide to Options Trading for Beginners

What Is Options Trading?

What Are Options?

Why Are Options Called Derivatives?

What Are Puts and Calls?

Call Options 101

Put Options 101

What Is the Put-Call Ratio?

Options Trading Terminology

“The Greeks” in Options Trading

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How to Trade Options

1. Pick a Platform

2. Get Approved

3. Place Your Trade

4. Manage Your Position

Basic Options Trading Strategies

Long Put, Long Call

Covered and Uncovered Calls

Spreads

Straddles and Strangles

Pros & Cons of Options Trading

Pros of Options Trading

Cons of Options Trading

The Takeaway

What is the Capital Asset Pricing Model (CAPM)?

CAPM Defined

What Is the CAPM Formula?

Risk-Free Return (Rrf)

The Market Risk Premium (Rm-Rrf)

The Beta (Ba)

CAPM Formula Explained

Advantages to Capital Asset Pricing Model

Problems with the CAPM

Efficient Frontiers and the Capital Asset Pricing Model

CAPM and the Security Market Line (SML)

Practical Value of the CAPM

The Takeaway

FAQ

What are some of the assumptions built into the CAPM model?

What are alternatives to the CAPM?

What is the International Capital Asset Pricing Model (ICAPM)?

Understanding the Different Stock Order Types

Stock Order Types Explained

Market Order

Limit Order

Stop Order

Stop-Limit Order

Trailing Stop Loss Order

Bracket Order (BO)

Timing Instructions

Day Orders

Good ‘Til Canceled (GTC)

Immediate or Cancel (IOC)

Fill-Or-Kill (FOK)

All-Or-None (AON)

Which Order Type Is Best?

The Takeaway

FAQ

What is the safest type of stock order to use?

What is the difference between stop-loss vs stop-limit orders?

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