InvestGen Archives | Page 40 of 83

Aug

2023

Eurex Exchange: European Futures and Options Market

What Is the Eurex?

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

If you’re thinking about trading futures and options, it’s important to understand the exchanges where such transactions take place. The Eurex Exchange — the shorter name for the European Futures and Options Market — is one of the largest derivatives markets in the world.

Here’s what you need to know about the Eurex.

Defining Eurex Exchange

What exactly is the Eurex definition? The Eurex Exchange facilitates the European-based derivatives market, handling digital trading volume and contract settlement for global traders in 700 markets across the world. Large volumes traded on the Eurex include common stock indexes and more complex securities, such as derivatives, which are securities that derive their price from their underlying assets.

Eurex is one of several global derivatives exchanges, including the Chicago Board Options Exchange.

💡 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.

History of the Eurex

The Eurex Exchange was co-founded in 1988 by Deutsche Börse AG and the SIX Swiss Exchange and was billed as one of the largest and one of the first all-electronic trading exchanges. That partnership lasted until 2012, when Deutsche Börse AG bought out SIX Swiss and now stands as the sole owner of the Eurex.

Headquartered in Frankfurt, Germany, the exchange has nine offices spread across the globe, in Chicago, London, Paris, Tokyo, Hong Kong, Singapore, Leipzig, Eschborn, Zurich, and Frankfurt (headquarters). That makes it easier for the Eurex to trade in non-European bourses and thus gives the Eurex a thoroughly global presence.

Understanding Eurex Exchange and What It Does

The Eurex definition is this: The Eurex Exchange is an international exchange that facilitates trading for European-based derivatives. The Eurex products include European stocks, bonds, and stock indexes. The Eurex also handles clearing (the timely transfer of funds) and contract settlements.

The Eurex Exchange network is totally electronic, and it’s widely considered one of the best in the world.

The Eurex’s Trading Technology and Management

Eurex launched as an all-digital trading exchange at a time when manual “open cry” trading still remained the primary way of doing business. At that time, buyers and sellers would gather in closed areas (called “trading pits” in Wall Street lingo) and shout trade orders to market makers, who would gather the trades and execute them on behalf of traders.

In strictly electronic trading, buyers and sellers execute options and futures contracts from thousands of miles away via a digital-based trading platform. That also provides increased liquidity for traders. Since Eurex is 100% automated, market investors have quick access to a wide array of investment products, making it easier to move in and out of volatile positions in fast-moving markets.

Rolled out in 2013, the Eurex’s trademark T7 trading platform handles all the exchange’s electronic derivative trading volume, connecting traders from 35 countries who execute about seven million futures and options trading contracts for each daily trading session.

That makes Eurex one of the most widely used derivatives trading platforms in the world for listed and over-the-counter futures and options trading.

💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

Eurex Exchange Products

Eurex offers a wide range of trading options, including various Euro-based debt instruments, common Euro-based stocks and stocks indices, along with its mainstay futures and options derivative trading products.

Here’s a list of the exchange’s most widely-traded investment vehicles.

• Stock derivatives, including more than 1,000 futures and approximately 900 options

• Interest rate derivatives, including fixed-income, money market, and interest rate swaps

• Equity index derivatives, including derivatives from 12 primary European index, such as EURO STOXX and MSCI

• Dividend-based derivatives, including singles stocks and indexes

• Volatility derivatives

• Exchange-traded fund derivatives

• Foreign currency (FX) derivatives

• Commodity-based derivatives

• Property/real estate derivatives

The exchange recently launched a platform for trading digital assets.

Recommended: The Black-Scholes Model, Explained

The Takeaway

The Eurex is an important exchange that global derivatives traders use to execute their strategy. Individual investors can typically access the exchange through their brokers.

However, it’s not necessary to invest on the Eurex or trade derivatives in order to build a portfolio, especially for beginning investors. For instance, individuals could instead set up an investment account if they don’t already have one, and start exploring assets that could help them achieve their financial goals and make sense for their situation.

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/Halfpoint

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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

Aug

2023

What Is a Money Purchase Pension Plan (MPPP)? How Is It Different From a 401(k)?

By Rebecca Lake | invest, Investing, Preparing for Retirement | Comments Off

A money purchase pension plan or MPPP is an employer-sponsored retirement plan that requires employers to contribute money on behalf of employees each year. The plan itself defines the amount the employer must contribute. Employees may also have the option to make contributions from their pay.

Money purchase pension plans have some similarities to more commonly used retirement plans such as 401(k)s, pension plans, and corporate profit sharing plans. If you have access to a MPPP plan at work, it’s important to understand how it works and where it might fit into your overall retirement strategy.

What Is a Money Purchase Pension Plan?

Money purchase pension plans are a type of defined contribution plan. That means they don’t guarantee a set benefit amount at retirement. Instead, these retirement plans allow employers and/or employees to contribute money up to annual contribution limits.

Like other retirement accounts, participants can make withdrawals when they reach their retirement age. In the meantime, the account value can increase or decrease based on investment gains or losses.

Money purchase pension plans require the employer to make predetermined fixed contributions to the plan on behalf of all eligible employees. The company must make these contributions on an annual basis as long as the plan is maintained.

Contributions to a money purchase plan grow on a tax-deferred basis. Employees do not have to make contributions to the plan, but they may be allowed to do so, depending on the plan. The IRS does allow for loans from money purchase plans but it does not permit in-service withdrawals.

💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

What Are the Money Purchase Pension Plan Contribution Limits?

Each money purchase plan determines what its own contribution limits are, though the amount can’t exceed maximum limits set by the IRS. For example, an employer’s plan may specify that they must contribute 5% or 10% of each employee’s pay into that employee’s MPPP plan account.

Annual money purchase plan contribution limits are similar to SEP IRA contribution limits. For 2023, the maximum contribution allowed is the lesser of:

• 25% of the employee’s compensation, OR

• $66,000

The IRS routinely adjusts the contribution limits for money purchase pension plans and other qualified retirement accounts based on inflation. The amount of money an employee will have in their money purchase plan upon retirement depends on the amount that their employer contributed on their behalf, the amount the employee contributed, and how their investments performed during their working years. Your account balance may be one factor in determining when you can retire.

Rules for money purchase plan distributions are the same as other qualified plans, in that you can begin withdrawing money penalty-free starting at age 59 ½. If you take out money before that, you may owe an early withdrawal penalty.

Like a pension plan, money purchase pension plans must offer the option to receive distributions as a lifetime annuity. Money purchase plans can also offer other distribution options, including a lump sum. Participants do not pay taxes on their accounts until they begin making withdrawals.

The Pros and Cons of Money Purchase Pension Plans

Money purchase pension plans have some benefits, but there are also some drawbacks that participants should keep in mind.

Pros of Money Purchase Plans

Here are some of the advantages for employees and employers who have a money purchase plan.

• Tax benefits. For employers, contributions made on behalf of their workers are tax deductible. Contributions grow tax-free for employees, allowing them to put off taxes on investment growth until they begin withdrawing the money.

• Loan access. Employees may be able to take loans against their account balances if the plan permits it.

• Potential for large balances. Given the relatively high contribution limits, employees may be able to accumulate account balances higher than they would with a 401(k) retirement plan, depending on their pay and the percentage their employer contributes on their behalf.

• Reliable income in retirement. When employees retire and begin drawing down their account, the regular monthly payments through a lifetime annuity can help with budgeting and planning.

Disadvantages of Money Purchase Pension Plan

Most of the disadvantages associated with money purchase pension plans impact employers rather than employees.

• Expensive to maintain. The administrative and overhead costs of maintaining a money purchase plan can be higher than those associated with other types of defined contribution plans.

• Heavy financial burden. Since contributions in a money purchase plan are required (unlike the optional employer contributions to a 401(k)), a company could run into issues in years when cash flow is lower.

• Employees may not be able to contribute. Depending on the terms of a plan, employees may not be able to make contributions to the plan. However, if the employer offers both a money purchase plan and a 401(k), employees could still defer part of their salary for retirement.

💡 Quick Tip: Want to lower your taxable income? Start saving for retirement with a traditional IRA. The money you save each year is tax deductible (and you don’t owe any taxes until you withdraw the funds, usually in retirement).

Money Purchase Pension Plan vs 401(k)

The main differences between a pension vs 401(k) have to do with their funding and the way the distributions work. In a money purchase plan, the employer provides the funding with optional employee contribution.

With a 401(k), employees fund accounts with elective salary deferrals and option employer contributions. For both types of plans, the employer may implement a vesting schedule that determines when the employee can keep all of the employer’s contributions if they leave the company. Employee contributions always vest immediately.

The total annual contribution limits (including both employer and employee contributions) for these defined contribution plans are the same, at $66,000 for 2023. But 401(k) plans allow for catch-up contributions made by employees aged 50 or older. For 2023, the total employee contribution limit is $22,500 with an extra catch-up contribution of $7,500.

Both plans may or may not allow for loans, and it’s possible to roll amounts held in a money purchase pension plan or a 401(k) over into a new qualified plan or an Individual Retirement Account (IRA) if you change jobs or retire.

Employees may also be able to take hardship withdrawals from a 401(k) if they meet certain conditions, but the IRS does not allow hardship withdrawals from a money purchase pension plan.

Here’s a side-by-side comparison of a MPPP and a 401(k):

	MPPP Plan	401(k) Plan
Funded by	Employer contributions, with employee contributions optional	Employee salary deferrals, with employer matching contributions optional
Tax status	Contributions are tax-deductible for employers, growth is tax-deferred for employees	Contributions are tax-deductible for employers and employees, growth is tax-deferred for employees
Contribution limits (2023)	Lesser of 25% of employee’s pay or $66,000	$22,500, with catch-up contributions of $7,500 for employees 50 or older
Catch-up contributions allowed	No	Yes, for employers 50 and older
Loans permitted	Yes, if the plan allows	Yes, if the plan allows
Hardship withdrawals	No	Yes, if the plan allows
Vesting	Determined by the employer	Determined by the employer

The Takeaway

Money purchase pension plans are a valuable tool for employees to reach their retirement goals. They’re similar to 401(k)s, but there are some important differences.

Whether you save for retirement in a money purchase pension plan, a 401(k), or another type of account the most important thing is to get started. The sooner you begin saving for retirement, the more time your money will have to grow through the power of compounding returns.

Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

Easily manage your retirement savings with a SoFi IRA.

FAQ

Here are answers to some additional questions you may have about money pension purchase plans.

What is a pension money purchase scheme?

A money purchase pension plan or money purchase plan is a defined contribution plan that allows employers to save money on behalf of their employees. These plans are similar to profit-sharing plans ,and companies may offer them alongside a 401(k) plan as part of an employee’s retirement benefits package.

Can I cash in my money purchase pension?

You can cash in a money purchase pension at retirement in place of receiving lifetime annuity payments. Otherwise, early withdrawals from a money purchase pension plan are typically not permitted, and if you do take money early, taxes and penalties may apply.

Is final salary pension for life?

A final salary pension is a defined benefit plan. Unlike a defined contribution plan, defined benefit plans pay out a set amount of money at retirement, typically based on your earnings and number of years of service. Final salary pensions can be paid as a lump sum or as a lifetime annuity, meaning you get paid for the remainder of your life.

Photo credit: iStock/ferrantraite

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

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Aug

2023

What is a Futures Contract? Definition & How Futures Work

Futures Contracts: What They Are and How They Work

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

Futures contracts are a type of financial derivative that investors use to speculate on the price of a security at a forthcoming date. These typically trade on separate futures exchanges, which allow for higher volumes of trading.

Futures are a type of derivative, and trading futures and other options contracts requires an advanced level of trading and market knowledge. That said, investors would do well to know the basics of futures contracts, so that they can determine whether they have a place in their investing strategy.

What Is a Futures Contract?

Futures contracts, or futures, are legal agreements to either buy or sell a given security, commodity, or asset at a specific time in the future, for a previously agreed-upon price. For investors, they offer access to commodities and other markets they might not be able to access otherwise. They can also act as a way to protect against volatility.

One important feature of a future contract is that both buyers and sellers can execute the contract regardless of the current market price of the underlying asset when the contract expires.

Investors use futures contracts when they believe that the underlying security will go up or down by a certain amount of time over a fixed period of time. The futures contract buyer enters a legal agreement to buy the underlying asset at the contract’s expiration date. On the other side of the trade, the futures contract seller agrees to deliver the underlying security at the agreed-upon price, when the contract expires.

The majority of futures contracts on a futures exchange are standardized by date and price, to allow for higher trading volumes and simpler transactions.

Investors can buy futures contracts to make money — or to hedge against losses — resulting from the price increases or decreases in stocks and commodities like oil, as well as other financial instruments.

💡 Quick Tip: In order to profit from purchasing a stock, the price has to rise. But an options account offers more flexibility, and an options trader might gain if the price rises or falls. This is a high-risk strategy, and investors can lose money if the trade moves in the wrong direction.

How Do Futures Contracts Work?

In a futures contract, the purchaser gets to buy a given asset at a predetermined price. That can help protect against big price swings up or down, making them popular not only with investors, but with companies that rely on commodities that experience sudden price changes.

Example of a Futures Contract

An airline, for example, might buy an oil futures contract to lock in the price of the oil that it will need to buy in order to get its jets off the ground in the coming months. Purchasing the futures contract allows the airline to guard against the financial harm of a sudden rise in the price of fuel. The risk to the airline, however, is that oil prices will go down – in which case, it will miss out on those lower prices.

On the other side of this hypothetical transaction is a fuel distributor, which has millions of gallons of oil in its inventory. It would sell the oil futures contract as a way of maintaining a steady market for its oil in the coming months. That’s because the airline buying the futures contract must buy the fuel at the agreed-upon price on the dates specified in the contract. That removes some risk for the oil distributor, but it also creates a risk if oil prices climb before the futures contract expires. Should that happen, the oil distributor will still have to sell the oil at the lower price specified in the futures contract.

To stay with this example, in the futures contract, the airline and the oil distributor will set and agree upon the terms, specifically the price of the oil and the expiration date upon which the contract expires. In this contract, the distributor agrees to sell 1,000 barrels of oil at $50 per barrel, in exactly 90 days. If the price of oil in 90 days is $75 per barrel, then the airline will have gotten a good deal. If a barrel of oil falls to $35, then the oil supplier will have protected itself against the price declines.

What’s the Difference Between Futures and Options?

Futures and options are both derivative contracts. However, futures contracts oblige the buyer or seller to complete the deal at the contract’s expiration, while options contracts give traders the right but not always the obligation to execute the contract when it expires.

Recommended: 10 Important Options Trading Strategies

Both futures and options share some of the same trading terminology. For example, both investors in both types of derivatives will need to consider its bid-ask price. The bid price is the highest price a buyer will pay for the contract, while the ask price is what the seller will accept.

Investors can also purchase options on future contracts. In a call option on a future, the buyer has the right to buy a futures contract at a specific price at a specific future date. In a put option, the buyer has the right to sell the futures contract at a specific price at a specific date.

Futures Contracts Pros & Cons

Futures trading can be a profitable strategy, but it also has some drawbacks that investors should consider.

Benefits of Futures Contracts

• Futures contracts act as a hedge against the risks related to price volatility.

• Most futures markets are highly liquid, allowing traders to buy and sell when they want.

• Futures may give investors access to commodities, and other markets not normally accessible to everyday investors.

• Futures contract pricing is determined by adding the cost of carrying the underlying asset to its spot price.

Downsides of Futures Contracts

• Futures contracts can be a high risk investment. In some cases, a futures contract can lose all of its value and trade at $0 when it expires.

• Futures contracts can reduce or eliminate potential gains from price swings in the underlying securities or assets.

• Futures contracts themselves are often highly volatile, with their prices fluctuating wildly.

• You may have to pay high commission charges on high-volume trades.

How Investors Use Futures Contracts

But not everyone who buys an oil futures contract plans to take delivery of the oil it represents. Retail investors also use futures as a way to protect their investments against volatility. Those futures investors who buy and sell the contracts to make money off the price changes that the contracts themselves undergo.

To go back to the example of an oil futures contract, an investor owns a contract, and the price of oil rises, allowing the contract owner to buy oil for less than the market price. The investor will be able to sell that contract for more than they purchased it for. The investor will then sell the contract on the futures market.

Other investors use futures contracts related to other commodities, including corn, soybeans and wheat. But there are also futures markets where investors can buy futures contracts that offer them the ability to bet on the future of currencies, individual stocks or stock indices like the S&P 500 or 10-year Treasury bills. Investors may choose to buy futures, rather than the securities themselves, to reduce their volatility exposure.

How to Trade Futures Contracts

There are several steps to trading futures contracts.

1. Open a brokerage account

To trade futures contracts, the first thing you’ll need is a brokerage account. You may also need your broker to give approval for margin and options privileges in your account.

2. Set a trading strategy

Before jumping into the futures market, develop a strategy. That strategy could involve technical analysis based on market data, or fundamental analysis based on the investment’s underlying economic and financial trends.

Some investors even try out their strategy using hypothetical trades before they start trading with real money. This allows you to understand the risks of potential trades without actually losing money.

3. Research trades that make sense for your investment strategy

Most brokerages that offer futures trading have an online platform you can use to research specific securities and see futures contracts available to buy or sell.

4. Double-check the terms

Make sure that the contracts will do what you think. That means confirming the selling and purchase price of the contract, the expiration, and the fees.

5. Develop your skills

Whether doing it on paper, or with real money, you’ll want to refine your strategy over time. You may find that you make more profitable trades in a specific sector, for example, or need to work on staying calm as security prices rise and fall. Practice will allow you to improve, and get more out of the futures strategy you’ve developed.

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

The Takeaway

Futures contracts are a type of investment that can offer access to commodities markets, as well as a way to protect against volatility. They can be a helpful tool to some investors, but they’re also risky and can be an expensive way to invest.

Futures trading can be fun and profitable, but is incredibly risky. It’s also a high-level trading strategy, and one that may not be suited for beginning investors. If you’re curious about it, though, you may want to speak 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.

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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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Aug

2023

Implied Volatility: What It Is & What It’s Used for

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

Implied volatility (IV) is a metric that describes the market’s expectation of future movement in the price of a security. Implied volatility, also known by the symbol σ (sigma), employs a set of predictive factors to forecast the future changes of a security’s price.

Investors sometimes use implied volatility as a way to understand the level of market risk they face. They calculate the implied volatility of a security using either the Black-Scholes model or the Binomial model.

What Is Volatility?

Volatility, as it relates to investments, is the pace at which the market price of a security moves up or down during a given period. During times of high volatility, prices experience frequent, large swings.

💡 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.

What Is Implied Volatility?

Implied volatility is, in essence, a prediction, based on probability. While it shapes the price of an option, it does not guarantee that the price activity of the underlying security will indeed be as volatile, or as stable, as the expectation embedded in its implied volatility. While implied volatility isn’t a window onto the future, it does often correlate with the broader opinion that the market holds regarding a given security.

To express implied volatility, investors typically use a percentage that shows the rate of standard deviation over a particular time period. As a measure of market risk, investors typically see the highest implied volatility during downward-trending or bearish markets, when they expect equity prices to go down.

During bull markets on the other hand, investors implied volatility tends to go down as more investors believe equity prices will rise. That said, as a metric, implied volatility doesn’t predict the direction of the price swings, only that the prices are likely to swing.

How Implied Volatility Affects Options

So how does implied volatility affect options? When determining the value of an options contract, implied volatility is a major factor. Options implied volatility can also help options traders decide whether and when to exercise their option.

An investor buying options contracts has the right, but not the obligation, to buy or sell a particular asset at an agreed-upon price during a specified time period. Because IV options forecast the size of the price change investors expect a security to experience in a specific time span, it directly affects the price an investor pays for an option. It would not help them determine whether they want a call or a put option.

It can also help investors determine whether they want to charge or pay an options premium for a security. Options on underlying securities that have high implied volatility come with higher premiums, while options on securities with lower implied volatility command lower premiums.

Implied Volatility and Other Financial Products

Implied volatility impacts the prices of financial instruments other than options. One such instrument is the interest rate cap, a product aimed at limiting the increases in interest charged by variable-rate credit products.

For example, homeowners might purchase an interest rate cap to limit the risks associated with their variable-rate mortgages and adjustable-rate mortgage (ARM) loans. Implied volatility is a major factor in the prices that people pay for those caps.

How Is Implied Volatility Calculated?

There are two implied volatility formulas that investors typically use.

Black-Scholes Model

One of the most widely used methods of calculating implied volatility is the Black-Scholes Model. Sometimes known as the Black-Scholes-Merton model, the Black-Scholes model is named for three economists who developed the model in 1973.

It is a complex mathematical equation investors use as a way of projecting the price changes over time for financial instruments, including stocks, futures contracts, and options contracts. Investors use the Black-Scholes Model to forecast different securities and financial derivatives. When used to price options, it uses the following factors:

• Current stock price

• Options contract strike price

• Amount of time remaining until the option expires

• Risk-free interest rates

The Black-Scholes formula takes those known factors and effectively back-solves for the value of volatility.

The Black-Scholes Model offers a quick way to calculate European-style options, which can only be exercised at their expiration date, but the formula is less useful to accurately calculating American options, since it only considers the price at an option’s expiration date. With American options, the owner may exercise at any time up to and including the expiration day.

Recommended: The Black-Scholes Model, Explained

Binomial Model

Many investors consider the binomial option pricing model more intuitive than the Black-Scholes model. It also represents a more effective way of calculating the implied volatility of U.S. options, which can be exercised at any point before their expiration date.

Invented in 1979, the binomial model uses the very simple assumption that at any moment, the price of a security will either go up or down.

As a method for calculating the implied volatility of an options contract, the binomial pricing model uses the same basic data inputs as Black-Scholes, along with the ability to update the equation as new information arises. In comparison with other models, the binomial option pricing model is very simple at first, but becomes extremely complex as it accounts for multiple time periods.

By using the binomial model with multiple periods of time, a trader can use an implied volatility chart to visualize the changes in implied volatility of the underlying asset over time, and evaluate the option at each point in time. It also allows the trader to update those multi-period equations based on each day’s price movements, and new market news emerges.

The calculations involved in the binomial model can take a long time to complete, which makes it difficult for short-term traders to utilize.

💡 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).

What Affects Implied Volatility?

The markets fluctuate, and so does the implied volatility of any security. As the price of a security rises, that can change its implied volatility, which translates to changes in the premium it costs to buy an option.

Another factor that changes the implied volatility priced into an option is the time left until the option expires. An option with a relatively near expiration date will have lower implied volatility than one with a longer duration. And as an options contract grows closer to its expiration, the implied volatility of that option tends to fall.

Implied Volatility Pros and Cons

There are both benefits and drawbacks to be aware of when using implied volatility to evaluate a security.

Pros

• Implied volatility can help an investor quantify the market sentiment around a given security.

• Implied volatility can estimate the size of the price movement that a particular asset may experience.

• During periods of high volatility, implied volatility can help investors choose safer sectors or products.

Cons

• Implied volatility cannot predict the future.

• Implied volatility does not indicate the direction of the price movement a security is likely to experience.

• Implied volatility does not factor in or reflect the fundamentals of the underlying security, but is based entirely on the security’s price.

• Implied volatility does not account for unexpected adverse events that can affect the security, its price and its implied volatility in the future.

The Takeaway

Investors use implied volatility to predict the changes in security prices that increase the odds of success. It is a useful indicator but it has limitations, so investors may want to use it in connection with other types of analysis.

Volatility is a fairly high-level concept as it relates to the markets, and given that there are different types of volatility, it may be beyond most investors’ ability to properly use as a part of a larger strategy. That said, having a basic understanding of implied volatility can be useful for nearly all investors.

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

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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.

SOIN0723069

Aug

2023

What Is a Death Cross Pattern in Stocks? How Do They Form?

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

A death cross is the X-shape created when a stock’s or index’s short-term moving average descends below the long-term moving average, possibly signaling a sell-off. The death cross typically shows up on a technical chart when the 50-day simple moving average (SMA) of a stock or index peaks, drops, and then crosses below the 200-day moving average.

Because the 50-day SMA is more of a short-term indicator, it’s considered to be a more accurate indicator of potential volatility ahead than the 200-day SMA, which has averaged in 200 days worth of prices. That said, both the 50-day moving average and the 200-day are, by definition, lagging indicators. Meaning: They only capture what has already happened. Still, some death crosses have appeared to forecast major recessions — although they can also send false signals.

What Is a Death Cross, Exactly?

A death cross is based on a technical analysis of a security’s price. The short-term average dropping below the long-term average to create an X-shape is the “cross”; the “death” part of the name refers to the ominous signal that such a crossing may send for individual securities or overall markets.

A death cross tends to form over the course of three separate phases. In the first phase, the rising value of a security reaches its peak as the momentum dies down, and sellers begin to outnumber buyers. That brings on the second phase, in which the price of the security begins to decline to the point where the actual death cross occurs.

That’s typically marked as being when the security’s 50-day moving average dips under the 200-day moving average.
That crossing alerts the broader market to a potential bearish, long-term trend, which brings about the third and final phase of the death cross. In this phase, the stock may continue to lose value over a longer period.

If the dip following the cross is short-lived, and the stock’s short-term moving average moves back up over its long-term moving average, then the death cross is usually considered to be a false signal.

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What Does the Death Cross Tell Investors?

The death cross has helped predict some of some of the worst bear markets of the past 100 years: e.g., in 1929, 1938, 1974, and 2008. Nonetheless, because it’s a lagging indicator, meaning that it only reveals a stock’s past performance, it’s not 100% reliable.

Another criticism of the death cross is that the pattern sometimes won’t show up until a security’s price has fallen well below its peak. In order to alter a death cross calculation to see the downtrend a little sooner, some investors say that a death cross occurs when the security’s trading price (not its short-term moving average), falls under its 200-day moving average.

For experienced traders, investors, and analysts, a death cross pattern for a stock is most meaningful when combined with, and confirmed by, other technical indicators.

When interpreting the seriousness of a death cross, experienced investors will often look at a stock’s trading volume. Higher trading volumes during a death cross tend to reveal that more investors are selling into the death cross, and thus buying into the downward trend of the stock.

Investors will also look to technical momentum indicators to see how seriously to take a death cross. One of the most popular of these is the moving average convergence divergence (MACD), which is based on the moving averages of 15, 20, 30, 50, 100, and 200 days, and is designed to give investors a clearer idea of where a stock is trading than one that’s updated second by second.

Death Cross vs Golden Cross: Main Differences

The opposite of a death cross is known as a golden cross. The golden cross indicator is when the 50-day moving average of a particular security moves higher than its 200-day moving average.

While the golden cross is broadly considered a signal of a bull market, it has some of the same characteristics as the death cross in that it’s essentially a lagging indicator. Experienced investors use the golden cross in conjunction with other technical indicators such as trading volume and MACD.

Is a Death Cross a Reliable Indicator?

Historically, the death cross indicator has an impressive track record as a barometer of the broader stock market, especially when it comes to severe downturns, as noted above.

The Dow Jones Industrial Average (DJIA) went through a death cross shortly before the crash of 1929. More recently, the S&P 500 Index underwent a death cross in May of 2008 – four months before the 2008 crash. In both instances, investors who stayed in the market faced extreme losses. But the Dow also experienced a death cross in March of 2020. And the markets quickly rebounded, and rose to new heights.

The fact is that broad-market death crosses happen frequently. Prior to 2020, the Dow has gone through five death crosses since 2010, and 46 death crosses since 1950. Yet the index has only entered a bear market 11 times since the 1950s. A death cross doesn’t necessarily bring significant losses, either.

Even more noteworthy is that the Dow continued falling after a death cross only 52% of the time since 1950. And when it did keep falling, its median decline after a month was only 0.9%.

For short-term traders, the death cross has less value than it does for investors with longer-term outlooks. As an indicator, the death cross – especially one that’s market-wide – can be especially valuable for long-term investors who hope to lock in their gains before a bear market begins.

How to Trade a Death Cross

The death cross is a significant indicator for some investors. But it’s important to remember that it only shows past trends. As an investor, it’s equally important to use the death cross in conjunction with other indicators such as the MACD and trading volume, as well as other news and information related to the security you’re investing in.

💡 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 Takeaway

Although the ominous-sounding death cross stock pattern is valued by some analysts and investors as a way to foretell a downturn in a certain security or even the broader market, it’s really not that reliable. The main elements of the death cross — a stock’s short-term moving average and long-term moving average — are lagging indicators that may or may not predict a bearish turn of events.

The typical investor may not use or even look for death crosses as a part of their strategy. But knowing, on a basic level, what the term refers to, and why it may be important to the markets, is a good idea.

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/goir

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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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