Intrinsic Value and Time Value of Options, Explained

Intrinsic Value and Time Value of Options, Explained


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.

Intrinsic value and time value are two major determining factors of the value of an options contract. An option’s intrinsic value is the payoff the buyer would receive if they exercised the option right away. In other words, the intrinsic value is how profitable the option would be, based on the difference between the contract’s strike price and the market value of the underlying security.

An option’s time value is not quite as straightforward. Time value is based on a formula that includes the expected volatility of the underlying asset, as well as the amount of time until the option contract expires.

What Is the Intrinsic Value of an Option?

An investor who purchases an options contract may be buying the right, but not the obligation, to buy or sell the option’s underlying asset at an agreed-upon price, known as the strike price. Options are considered derivatives, because they are tied to the value of the underlying security. The contract may allow the investor to purchase or sell a security at that strike price at any point up until the contract expires.

There are two main kinds of options: calls and puts. The purchaser of a call option buys the right (but not the obligation) to purchase the underlying asset at a given price until a particular date.

The buyer of a put option purchases the right (but not the obligation) to sell the underlying asset at a given price until a particular date.

Important terms: In the Money, At the Money, Out of the Money

There are a few more key terms to know as it relates to options: in the money, at the money, and out of the money.

In the Money

An option is considered to be “in the money” if the investor could sell it at that moment for a profit. For a call option, that means that the price of the underlying asset is higher than the strike price specified in the options contract. For a put option to be in the money, the price of the underlying asset would have to be lower than the strike price in the contract.

At the Money

If an option is “at the money,” the price of the underlying security is equal to the strike price in the contract, and it’s not considered profitable. If an option is “out of the money,” e.g. above the market price for a call option or below the market price for a put option, the contract is also not profitable.

Out of the Money

If an option is not profitable when it expires, then it expires with no value, except for the premium. In those instances, the buyer takes a loss on the premium they paid to enter into the options contract, while the seller, or writer, of the contract collects the premium.

Recommended: Popular Options Trading Terminology to Know

Formula for the Intrinsic Value of an Options Contract

Time to get down to the math! Here are the formulas for calculating intrinsic values of call and put options.

To calculate the intrinsic value of a call option:

Call Option Intrinsic Value=Underlying Stock’s Current Price – Call Strike Price​

To calculate the intrinsic value of a put option:

Put Option Intrinsic Value=Put Strike Price – Underlying Stock’s Current Price

Example of Intrinsic Value

Imagine that hypothetical XYZ stock is selling at $48.00. A call option for XYZ with a strike price of $40 would have an intrinsic value of $8.00 ($48 – $40 = $8). So in theory, the option holder could exercise the option to buy XYZ shares at $40, then immediately sell them for a $8.00 profit in the market. Another way to phrase it: The contract would be in the money at $8.

But what if the strike price is higher than the $48.00 market price of XYZ stock? Let’s say the call option strike is $50 ($48 – $50 = –$2.00. The option would be considered out of the money and worth zero, because the intrinsic value of an option can never be negative.

What if it’s a put option? In this scenario, with an underlying price of $48.00 for XYZ stock, a put option with a strike price of $44.00 would have an intrinsic value of zero ($44 – $48 = –$4.00), again because the value of an option cannot fall below zero.

But a put option with a strike price of $50 would be considered in the money, and have an intrinsic value of $2 ($50 – $48 = $2).

While intrinsic value as a term sounds all encompassing, it isn’t. Investors should remember when calculating options strategies that an option’s intrinsic value does not include the premium the investor has to pay in order to buy the options contract in the first place. To get a better sense of the profit of an options trade, it’s important to include that initial premium, along with any other trading commissions and fees charged by the broker.

💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.

What Is the Time Value of an Option?

When an investor buys an option, they pay in the form of a premium, or fee. When they do, that premium is typically based on the option’s intrinsic value, plus its extrinsic value. While higher volatility can result in higher premiums, time value plays a large role as well.The opportunity for an option to be profitable over time is, in essence, its time value.

The more time an investor in an options contract has, the better their chances of being able to exercise that option in the money, simply because the underlying security has a greater chance of moving in the desired direction. Longer time periods come with greater possibility for profit.

Conversely, as an options contract gets closer to expiring, its value goes down. The reason is that there is less time for the security underlying the options contract to make profitable moves.

One rule of thumb is that an option loses a third of its value during the first half of its life, and two-thirds during the second half. This phenomenon is known as the time decay of options. It’s a critical concept for options investors because the closer the option gets to expiration, the more the underlying security must move to impact the price of the option.

The intrinsic value of the option plays a role in how fast the time value of an option decays. An in-the-money option faces less dramatic time decay, because the elimination of time value takes the overall value of the option to the level of its intrinsic value. But for an out-of-the-money option, time decay is more dramatic, since the option will be entirely worthless if it expires out of the money.

Formula for the Time Value of an Options Contract

The formula for the time value of an options contract is as such:

Time Value=Option Price−Intrinsic Value

How Does Volatility Impact Time Value?

Another important factor that can impact time value is the volatility of the underlying asset.

Stocks with higher volatility typically have the potential for greater price movements — and thus related options may have a higher probability of expiring in the money. That’s one reason why time value, as reflected by the option’s premium, is typically higher when the underlying asset is more volatile.

With stocks and other assets that have lower volatility and therefore are not expected to show big price fluctuations, the time value and the option premium is likely to be lower.

Volatility, as every investor knows, cuts both ways. It can help generate gains or lead to losses.

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

How Can Intrinsic and Time Value Help Traders?

When calculating the value of the options contracts that they’re buying and selling, intrinsic value and time value can be vital to help traders gauge the potential risks and rewards of the options trade. While the intrinsic value is easy to assess, it only tells part of the story. Traders need to understand the extrinsic or time value of options as well in order to gauge how profitable the option is likely to be.Investors use this deeper understanding to inform which options trading strategies they use.

When it comes to the profitability of an options trade, investors also need to take into account the premiums they pay to buy an option, along with related commissions and fees. There are also other factors that play a role in the pricing of an options contract, such as the option’s implied volatility. This is the aspect of options pricing that takes into account the market sentiment as to the future volatility of an option’s underlying security, and can have a major influence on the price of an option as well.

💡 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.

The Takeaway

Understanding how options are priced is a complicated business, and knowing the two main components — intrinsic value and time value — is essential. While intrinsic value is simply the tangible face value of the contract — because it’s the amount the buyer would receive if they exercised the option right now — time value is a more complex calculation.

The time value of an option, expressed as its premium, is part of an option’s extrinsic value and it includes the volatility of the underlying asset and the time to expiration. The more volatility and the more time to the option’s expiry date, the higher the premium or value of the option.

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.

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/Moyo Studio

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

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

Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
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.
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Private Equity vs Venture Capital

Venture capital and private equity funds are two different ways that companies, funds or individuals invest in other companies. While the two types of funds share some similarities, there are also key differences that you’ll want to be aware of. While many private equity and venture capital funds are privately held, some are open to individual investors.

A private equity fund might use its managerial, technological or other expertise to invest in one specific company, hoping to turn it around and improve its profitability. That would allow the fund to sell their investment for a healthy return. Venture capital firms often invest in early-stage companies or startups. They provide capital funds to these companies in exchange for a portion of the company’s equity.

Key Points

•   Private equity and venture capital are two ways that people, funds or companies invest in other companies.

•   Private equity funds often invest in a small number or even just one company at a time, usually a mature company.

•   Venture capital funds generally invest in many different companies that are early in their journey to profitability.

•   While many private equity and venture capital funds are privately held, there are some that are publicly traded and open to individual investors.

What Is Private Equity?

Private equity refers to investing in companies that are not publicly traded. Unlike investing in public equities (such as by purchasing index funds or shares of stock of companies listed on a public stock exchange), private equity investors put their money into privately-held companies.

While you might not think of private companies as having shares of stock in the same way that publicly-traded companies do, most incorporated companies do have shares of stock. A small company might only have a hundred or even less shares, all owned by the initial founders of the company.

A private company that is more established, on the other hand, might have hundreds of thousands or even millions of shares owned by a wide variety of people. The stock of private companies might be owned by the founders, employees or other private equity investors.

💡 Quick Tip: While investing directly in alternative assets often requires high minimum amounts, investing in alternative funds through a mutual fund or ETF generally involves a low minimum requirement, making them accessible to retail investors.

Alternative investments,
now for the rest of us.

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


What Is Venture Capital?

Venture capital refers to investors and money that is invested into early-stage companies in the hope that they will generate an above-average return on investment. Venture capital investing usually refers to funds or individuals that give money to early-stage companies, but the investment can also be via managerial or technical expertise.

Venture capital money is often invested over a series of “rounds.” Initially there might be an “angel” round or “seed” round, and then Series A, B, C and so on. In each round, companies receive funding from venture capital investors in exchange for a percentage of the company’s stock, at an agreed-upon valuation.

Generally, the earlier the round of venture capital investment, the lower the valuation. This allows the earliest investors to potentially have the highest return on investment, since they also carry the largest amount of risk.

Venture capital and private equity may serve as examples of alternative investments for certain investors.

Key Differences Between Private Equity and Venture Capital

While private equity and venture capital both refer to companies or funds that invest in companies, there are a few key differences that you’ll want to be aware of:

Private Equity Venture Capital
Generally invests in already established companies Often invests in early-stage companies and/or startups
Often purchase entire companies and work to improve their profitability Purchase a portion of the companies they invest in
Generally invest more money and focus on fewer companies Firms tend to spread their money around — investing relatively fewer amounts of money in more investments

Advantages and Disadvantages

When you compare private equity vs. venture capital investing, there are a few similarities as well as advantages or disadvantages to investing in both.

In most cases, comparing the advantages and disadvantages of venture capital vs. private equity depends on your own specific situation or goal. What might be an advantage for one investor could be a disadvantage for an investor with a different risk tolerance or financial profile.

One potential advantage of investing in private equity is that private equity firms often concentrate their money in a small number of firms. This might allow the private equity investors to concentrate their expertise into improving the profitability of those companies. However, some might consider this a disadvantage, since you might lose some or most of your investment if the company is not able to turn things around.

Similarly, venture capital investors typically invest in a number of startups and early-stage companies. One advantage of investing in this manner is that you may see outsized returns if the company succeeds. However, a related disadvantage is that many companies in these early stages do not succeed, potentially wiping out your entire investment.

In that sense, it’s a high-risk, high-potentialy-reward area of investment.

Common Misconceptions

One common misconception about private equity vs. venture capital is that only investors with significant net worth can invest in these fields. While it is true that most actual private equity and venture capital investors are those with access to significant amounts of capital, there are also many private equity or venture capital funds that sell shares of the funds themselves to retail investors.

This may allow even regular individual investors to take part in investing in venture capital or private equity.

💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.

The Takeaway

Private equity and venture capital funds are two different ways that companies invest in other companies. While they share a lot of similarities, there are also some key differences. One big difference is that generally, private equity funds invest more money in fewer companies while venture capital funds often invest (relatively) smaller sums of money in many companies.

While most private equity and venture capital funds are privately held, there are some that are publicly traded and open to individual investors.

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 in alts to take your portfolio beyond stocks and bonds.

FAQ

Is private equity better than venture capital?

Private equity (PE) and venture capital (VC) are two forms of investing in other companies, and when comparing the difference between VC and PE, it isn’t really the case that one is better than the other. Instead, it will depend on your own specific financial situation and/or risk tolerance. You can also consider alternative investments to both private equity and venture capital.

Which is the riskier option?

Both private equity and venture capital carry some level of risk. In one manner of speaking, venture capital is riskier, since many of the early-stage companies that they invest in will not succeed. However, most venture capital funds mitigate that risk by investing in many different companies. One successful investment may pay off the losses of tens or even hundreds of unsuccessful venture capital investments.

Are there private equity or venture capital funds available to buy?

Many private equity and venture capital firms are targeted towards investors with significant assets and/or a high net worth. However, there are some funds that are publicly traded and thus available to individual investors. Make sure that you do your own research before investing in any one particular private equity or venture capital fund.


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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.


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

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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Private Credit vs. Private Equity: What’s the Difference?

Private credit and private equity investments offer investors opportunities to build their portfolios in substantially different ways. With private credit, investors make loans to businesses and earn returns through interest. Private equity represents an ownership stake in a private company or a public company that is not traded on a stock exchange.

Each one serves a different purpose, which can be important for investors to understand.

What Does Private Credit and Private Equity Mean?

Private equity and private credit are two types of alternative investments to the stocks, bonds, and mutual funds that often make up investor portfolios. Alternative investments in general, and private equity or credit in particular, can be attractive to investors because they can offer higher return potential.

However, investors may also face more risk.

💡 Quick Tip: While investing directly in alternative assets often requires high minimum amounts, investing in alts through a mutual fund or ETF generally involves a low minimum requirement, making them accessible to retail investors.

Alternative investments,
now for the rest of us.

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


Private Credit Definition

Private credit is an investment in businesses. Specifically, an investor or group of investors extends loans to private companies and delisted public companies that need capital. Investors collect interest on the loan as it’s repaid. Other terms used to describe private credit include direct lending, alternative lending, private debt, or non-bank lending.

Who invests in private credit? The list can include:

•   Institutional investors

•   High-net-worth individuals

•   Family offices or private banks

Retail investors may pursue private credit opportunities but they tend to represent a fairly small segment of the market overall. Private credit investment is expected to exceed $3.5 trillion globally by 2028.

Private Equity Definition

Private equity is an investment in a private or delisted public company in exchange for an ownership share. This type of investment generates returns when the company is sold, or in the case of a private company, goes public.

Similar to private credit, private equity investments are often the domain of private banks, or high-net-worth individuals. Private equity firms can act as a bridge between investors and companies that are seeking capital. Minimum investments may be much higher than the typical mutual fund buy-in, with investors required to bring $1 million or more to the table.

Private equity is often a long-term investment as you wait for the company to reach a point where it makes sense financially to sell or go public. One difference to note between private equity and venture capital lies in the types of companies investors target. Private equity is usually focused on established businesses while venture capital more often funds startups.

What Are the Differences Between Private Credit and Private Equity?

Private credit and private equity both allow for investment in businesses, but they don’t work the same way. Here’s a closer look at how they compare.

Investment Returns

Private credit generates returns for investors via interest, whereas private equity’s goal is to generate returns for investors after selling a company (or stake in a company) after the company has grown and appreciated, though that’s not always the case.

With private credit, returns may be more predictable as investors may be able to make a rough calculation of their potential returns. Private equity returns are less predictable, as it may be difficult to gauge how much the company will eventually sell for. But there’s always room for private equity returns to outstrip private credit if the company’s performance exceeds expectations. However, it’s important to remember that higher returns are not guaranteed.

Risk

Investing in private credit carries liquidity risk, in that investors may be waiting several years to recover their original principal. That risk can compound for investors who tie up large amounts of capital in one or two sectors of the market. Likewise, changing economic conditions could diminish returns.

If the economy slows and a company isn’t able to maintain the same level of revenue, that could make it difficult for it to meet its financial obligations. In a worst-case scenario, the company could go bankrupt. Private credit investors would then have to wait for the bankruptcy proceedings to be completed to find out how much of their original investment they’ll recover. And of course, any future interest they were expecting would be out the window.

With private equity investments, perhaps the biggest risk to investors is also that the company closes shop or goes bankrupt before it can be sold but for a different reason. In a bankruptcy filing, the company’s creditors (including private credit investors) would have the first claim on assets. If nothing remains after creditors have been repaid, private equity investors may walk away with nothing.

The nature of the company itself can add to your risk if there’s a lack of transparency around operations or financials. Privately-owned companies aren’t subject to the same federal regulation or scrutiny as publicly-traded ones so it’s important to do thorough research on any business you’re thinking of backing.

Ownership

A private credit investment doesn’t offer any kind of ownership to investors. You’re not buying part of the company; you’re simply funding it with your own money.

Private equity, on the other hand, does extend ownership to investors. The size of your ownership stake can depend on the size of your investment.

Investor Considerations When Choosing Between Private Credit and Private Equity

If you’re interested in private equity or private credit, there are some things you may want to weigh before dividing in. Here are some of the most important considerations for adding either of these investments to your portfolio.

•   Can you invest? As mentioned, private credit and equity are often limited to accredited investors. If you don’t meet the accredited investor standard, which is defined by income and net worth, these investments may not be open to you.

•   How much can you invest? If you are an accredited investor, the next thing to consider is how much of your portfolio you’re comfortable allocating to private credit or equity.

•   What’s your preferred holding period? When evaluating private credit and private equity, think about how long it will take you to realize returns and recover your initial investment.

•   Is predictability or the potential for higher returns more important? As mentioned, private credit returns are typically easy to estimate if you know the interest rate you’re earning. However, returns may be lower than what you could get with private equity, assuming the company performs well.

Here’s one more question to ask: how can I invest in private equity?

These investments may not be available in a standard brokerage account. If you’re looking for private credit opportunities you may need to go to a private bank that offers them. When private equity is the preferred option, a private equity firm is usually the connecting piece for those investments.

When comparing either one, remember to consider the minimum initial investment required as well as any fees you might pay.

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

The Takeaway

Private credit and private equity can diversify a portfolio and help you build wealth, though not in the same way. Comparing the pros and cons, assessing your personal tolerance for risk and ability to invest in either can help you decide if alternative investments might be right for you.

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

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

FAQ

Why do investors like private credit?

Private credit can offer some unique advantages to investors, starting with predictable returns and steady income. The market for private credit continues to grow, meaning there are more opportunities for investors to add these types of investments to their portfolios. Compared to private equity, private credit carries a lower degree of risk.

How much money do you need for private equity?

The minimum investment required for private equity can vary, but it’s not uncommon for investors to need $100,000 or more to get started. In some instances, private equity investment minimums may surpass $1 million, $5 million, or even $10 million.

Can anyone invest in private credit or private equity?

Typically, no. Private credit and private equity investments most often involve accredited investors or legal entities, such as a family office. It’s possible to find private credit and private equity investments for retail investors, however, you may need to meet the SEC’s definition of accredited to be eligible.


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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.


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

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What is the Greenshoe Option? Definition & How it Works

What is the Greenshoe Option? Definition & How it Works

The greenshoe option allows underwriters involved with IPOs to sell more shares than initially agreed upon: usually up to 15% more. That can occur if there is enough investor demand to purchase the shares.

Because IPO share prices can be volatile, the greenshoe option is an important tool that can help underwriters stabilize the price of a newly listed stock to protect both the company and investors.

Understanding the Greenshoe Option

Also called the over-allotment option, the greenshoe provision is part of an underwriting agreement between an underwriter and a company issuing stock as part of an IPO, or initial public offering. The greenshoe option is the only type of price stabilization allowed by the Securities and Exchange Commission (SEC).

The SEC allows this because it increases competitiveness and efficiency of IPO fundraising. It gives underwriters the ability to stabilize security prices by increasing the available supply. It is the responsibility of an underwriter to help sell shares, build a market for a new stock, and use the tools at their disposal to launch a successful initial public offering.

The greenshoe option got its name when the Green Shoe Manufacturing Company was issued the first over-allotment options in 1919.

💡 Quick Tip: Access to IPO shares before they trade on public exchanges has usually been available only to large institutional investors. That’s changing now, and some brokerages offer pre-listing IPO investing to qualified investors.

How Does a Greenshoe Option Work?

During the IPO process, stock issuers set limits on how many shares they will sell to investors during an IPO. With a greenshoe option, the IPO underwriter can sell up to 15% more shares than the set amount.

IPO underwriters want to sell as many shares as they can because they earn on commission as a percentage of IPO sales.

All of the details about an IPO sale and underwriter abilities appear in the prospectus filed by the issuing company before the sale. Not every company allows their investment banker to use the greenshoe option. For instance, if they only want to raise a specific amount of capital, they wouldn’t want to sell any more shares than necessary to raise that money.

There are two ways an underwriter can over allot sales:

At the IPO Price

If the IPO they are underwriting is doing well, investors are buying IPO shares and the price is going up, the underwriter can use the greenshoe option to purchase up to 15% more stock from the issuing company at the IPO price and sell that stock to investors at the higher market price for a profit.

A Break Issue

Conversely, if an IPO isn’t doing well, the underwriter can take a short position on up to 15% of the issued stock and buy back shares from the market to stabilize the price and cover their position.

The underwriter then returns those additional shares to the issuing company. This is known as a “break issue.” When an IPO isn’t performing well, this can reduce consumer confidence in the stock, and result in investors either selling their shares or refraining from buying them.

The greenshoe option helps the underwriter stabilize the stock price and reduce stock volatility.

Types of Greenshoe Options

There are three types of greenshoe options an underwriter might choose to use depending on what happens after an IPO launches. These options are:

Full Greenshoe

If the underwriter can’t buy back any shares before the stock price increases, this is known as a full greenshoe. In this case, the underwriter buys shares at the current offering price.

Partial Greenshoe

In a partial greenshoe scenario, the underwriter only buys back some of the stock inventory they started with in order to increase the share price.

Reverse Greenshoe

The third option for underwriters is to purchase shares from market investors and sell them back to the stock issuer if the share price has dipped below the original offering price. This is similar to a put option in stock trading.

Recommended: How Are IPO Prices Set?

Greenshoe Option Examples

Here’s an example of how a greenshoe option might work in real life.

Once the IPO company owners, underwriter, and clients determine the offering or initial price of the newly issued shares, they’re ready to be traded on the public market. Ideally, the share price will rise above offering, but if the shares fall below the offering price the underwriter can exercise the greenshoe option (assuming the company had approved it in the prospectus).

To control the price, the underwrite can short up to 15% more shares than were part of the original IPO offering.

Let’s say a company’s initial public offering is going to be 10 million shares. The underwriters can sell up to 15% over that amount, or 1.5 million more shares, thus giving underwriters the ability to increase or decrease the supply as needed — adding to liquidity and helping to control price stability.

💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.

What the Greenshoe Option Means for IPO Investors

The greenshoe option is an important tool for underwriters that can help with the success of an IPO and bring additional funds to the issuing company. It reduces risk for the issuing company as well as investors. It can maintain IPO investor confidence in a newly issued stock which helps to build a long-term group of shareholders.

Although buying IPO stocks can be very profitable, stock prices don’t always increase and sometimes they can be volatile. It’s important for investors to research a company, look at the IPO prospectus, understand what the stock lock-up period and greenshoe options are before deciding to buy.

The Takeaway

Buying shares in IPOs can be a great way to invest in companies right when they go public. Although IPO investing comes with some risks, and IPO stock can be volatile, investment banks and companies going public use tools such as the greenshoe option to minimize volatility.

Whether you’re curious about exploring IPOs, or interested in traditional stocks and exchange-traded funds (ETFs), you can get started by opening an account on the SoFi Invest® brokerage platform. On SoFi Invest, eligible SoFi members have the opportunity to trade IPO shares, and there are no account minimums for those with an Active Investing account. As with any investment, it's wise to consider your overall portfolio goals in order to assess whether IPO investing is right for you, given the risks of volatility and loss.


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/AzmanJaka

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.

Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. IPOs offered through SoFi Securities are not a recommendation and investors should carefully read the offering prospectus to determine whether an offering is consistent with their investment objectives, risk tolerance, and financial situation.

New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For SoFi’s allocation procedures please refer to IPO Allocation Procedures.


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

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

Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
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.

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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Stochastic Oscillator, Explained

Stochastic Oscillator Explained

A stochastic oscillator is a technical indicator that traders use to determine whether a given security is overbought or oversold. Traders will use a stochastic indicator, which is considered a momentum indicator, to compare a specific closing price of a security to a range of its prices over a certain time frame.

In other words, by using a stochastic chart traders can gauge the momentum of a security’s price with the aim of anticipating trends and reversals. A stochastic oscillator uses a range of 0 to 100 to determine if an asset is overbought (when the measurements are above 80) or oversold (when the measurement is below 20).

What Is a Stochastic Oscillator?

Let’s consider two main types of analysis that investors and traders commonly use when trading stocks: fundamental analysis and technical analysis.

Fundamental analysis incorporates earnings data, in addition to economic and market news, to predict how an asset’s price might move. Whereas technical analysis relies on various sets of data and indicators, such as price and volume, to identify patterns and trends.

The stochastic oscillator is a key tool in securities trading because it helps gauge how strong the momentum of the market is. Thus the stochastic oscillator, or sto indicator, is an indicator used in trading to assess trend strength.

History of the Stochastic Oscillator

Developed in the 1950s for commodities traders, the stochastic oscillator is now a common technical indicator that investors use to evaluate a variety of assets in many online investing platforms and price chart services.

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*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.

How Does a Stochastic Oscillator Work?

The stochastic oscillator has two moving lines, or stochastics, that oscillate between and around two horizontal lines. The primary “fast” moving line is called the %K and reflects with a specific formula, while the other “slow” line is a three-period moving average of the %K line.

The full stochastic oscillator is a line customized by the user that may combine the traits of the slow and fast stochastics.

Slow vs Fast Stochastics

A signal is generated when the “fast” %K line diverges above the “slow” line or vice versa. The two horizontal lines are often pre-set at 30 and 70, indicating oversold and overbought levels, respectively, but can be modified to other levels, such as 20 and 80, to reduce the risk of entering trades on false or premature signals.

The price is considered “overbought” when the two moving lines rise above the upper horizontal line and “oversold” when they fall below the lower horizontal line. The overbought line indicates price action that exceeds the top 20% (or 30%) of the recent price range over a defined period — typically 14-interval period. Conversely, the oversold line represents price levels that fit into the bottom 20% of the recent price range.

The stochastic oscillator is a form of stock technical analysis that calculates statistically opportune times for trade entries and exits. When both stochastics are above the ‘overbought’ line (typically 80) and the fast %K line crosses below the slow %D line, this may signify a time to exit a long position or initiate a short position.

Conversely, when both stochastics are below the oversold line (typically 20), and the %K line crosses above the %D line, this could signify a time to exit a short position or initiate a new long position.

The stochastic oscillator is especially useful among commonly day-traded assets such as low-float stocks that have limited amounts of shares and are more volatile.

However useful these stock indicators are for determining entry and exit points, most readers use them in connection with other tools. While a stochastic oscillator is useful for implementing an overall strategy, it does not assist with identifying the overall market sentiment or trend direction.

It is only when the trend or sideways trading range is well established that traders can safely and reliably use the stochastic oscillator to look for long entries in oversold conditions and shorts entries in overbought conditions.

Recommended: 15 Technical Indicators for Stock Trading

What Is the Formula for a Stochastic Oscillator?

Below is the calculation for a standard 14-period stochastic indicator, but the time period can be adjusted for any time frame.

Calculation for %K:

%K = [(C – L14) / H14 -L14)] x 100

Key:

C = Latest closing price
L14 = Lowest low over the period
H14 = Highest high over the period

%K is sometimes referred to as the “fast stochastic”, whereas the “slow” stochastic indicator is defined as %D = 3-period moving of %K.

The general idea for this oscillator is that in an uptrending market prices will close near the indicator’s high, and in a downtrending market prices will close near the low. Trade signals are generated when the “fast” %K line crosses above or below the three-period moving average, or “slow” %D.

The Slow %K Stochastic Oscillator incorporates a slower three-interval period that provides a moderate internal smoothing of %K. If the %K smoothing period was set to one instead of three, it would result in the equivalent of plotting the ‘fast stochastic.’

💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.

Pros of the Stochastic Oscillator

There are several benefits to using the stochastic oscillator when evaluating investments.

Clear Entry/Exit Signals

The oscillator has a simple design and generates visual signals when it reaches an extreme level, which can help a trader determine when it’s time to buy or when to sell stocks.

Frequent Signals

For more active traders who trade on intraday charts such as the five, 10, or 15 minute time frames, the stochastic oscillator generates signals more often as price action oscillates in smaller ranges.

Easy to Understand

The oscillator’s fluctuating lines ranging from 0 to 100 are fairly clear for investors who know how to use them.

Available on Most Trading Platforms

The stochastic oscillator is a ubiquitous technical indicator found in many trading platforms, online brokerages, and technical chart services with similar configurations.

Recommended: How to Open a Brokerage Account

Cons of the Stochastic Oscillator

Despite its benefits, the stochastic oscillator is not a perfect tool.

Possible False Signals

Everyone’s strategy is different but depending on the time settings chosen, traders may misperceive a sharp oscillation as a buy or sell signal, especially if it goes against the trend. This is more common during periods of market volatility.

Doesn’t Measure the Trend or Direction

The stochastic oscillator calculates the strength or weakness of price action in a market, not the overall trend or direction.

How to Trade With the Stochastic Oscillator

Some traders find the stochastic oscillator indicator useful to identify trade entry and exit points, and help decide whether they’re bullish on a stock. The stochastic oscillator does this by comparing a particular closing price based on the user’s selected time frame to a range of the security’s highest and lowest prices over a certain period of time.

Traders can reduce the sensitivity of the oscillator to market fluctuations by adjusting the time frame and range of prices. The oscillator tends to trend around a mean price level because it relies on recent price history, but it also adjusts (with lag) when prices break out of price ranges.

The Takeaway

The stochastic oscillator is a popular technical trading indicator, which can help investors find trading opportunities, measure movements, and calculate valuations. After identifying the direction of a security’s trend, the stochastic oscillator can help determine when the security is overbought or oversold, thus identifying lower-risk trade-entry points.

The oscillator uses a complex formula to calculate recent price averages according to the user’s preset time frame and the most recent price to the average price ranges. The tool plots the final calculation on a scale of 0 to 100, 0 being extremely oversold and 100 being extremely overbought. While technical indicators are not trading strategies on their own, they are useful tools when properly incorporated into an overall trading strategy.

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

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

FAQ

Which is more accurate, RSI or Stochastic?

Relative strength index, or RSI, tends to be more useful for investors in trending markets, whereas Stochastics tend to be more helpful or reliable in non-trending markets.

What are the default indicator settings for Stochastic?

The default indicator settings for Stochastic Indicator are 5,3,3, though there are other commonly-used settings.

What is divergence in Stochastics?

Divergences are indications of a change, and can be used by traders or investors to try and determine whether a trend is getting weaker, stronger, or continuing.


Photo credit: iStock/alvarez

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

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

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

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