Aug

2023

Determining Your Business Valuation: 7 Valuation Methods

How to Value a Business: Seven Valuation Methods

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

Business valuation refers to the process of determining the economic value of a business. There are different business valuation methods that can be used to establish a business’s worth. Understanding how to value a company can be helpful for investors and business owners, but creditors and potential buyers may need to value a company as well.

What Is a Business Valuation?

Business valuation means determining what a business is worth. Again, there are different scenarios where the valuation of a business becomes important. For instance, business owners may be interested in knowing what their business is worth if:

• They hope to sell it to a new owner

• A merger with another business is in the works

• They’re creating an employee stock purchase plan (ESPP)

• They’re working on a succession plan that includes a buy-sell agreement

• They plan to apply for loans or lines of credit using business assets as security

• They need it for tax purposes

• The business is being sued

• It’s required for the division of assets in a divorce proceeding

• Determining an IPO price

•Valuing shares in an equity crowdfunding round

Venture capitalists and angel investors may also be interested in how a company is valued if they’re planning to invest before an IPO.

💡 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.

How Are Companies Valued?

The business valuation process involves a detailed look at the company and its key financial characteristics. A professional business appraiser or an accountant that holds an Accredited in Business Value designation (ABV) typically completes a business valuation. These professionals have specially trained in calculating the valuation of a business. There are also business valuation software programs available that you can use to estimate your company’s value yourself.

Finding the valuation of a business can involve a number of factors, including:

• Ownership structure

• Company management

• Combined value of company assets

• Combined total of company liabilities

• Cash flow

• Revenues

• Projected earnings

That’s a general explanation of how business valuation works. To understand the valuation of a company at an individual level, it helps to know more about the different business valuation methods that can be used.

7 Business Valuation Methods

There’s more than one way to approach how to value a business. The method chosen reflects the reasons for determining a business valuation in the first place. For example, the methods used for company valuation ahead of an IPO may be very different from the valuation methods used for an existing company.

It can be helpful to use multiple business valuation methods when evaluating the same business. This makes it possible to see how the numbers compare, based on different metrics. Here are some of the most common ways the valuation of a company can be determined.

1. Market Capitalization

Market capitalization is a simplified way to find the valuation of a business, based on its stock share price. To find market capitalization, you’d multiply a company’s stock share price by the number of shares outstanding.

For example, if a company has 100 million shares outstanding priced at $10 each, its market capitalization value is $1 billion. Market cap is a fluid number, as share pricing can change day to day or even hour to hour.

Investors might use a company’s market capitalization when choosing stocks to invest in. For instance, if those interested in adding large-cap companies to your portfolio then they’d look for ones that have a market valuation of $10 billion or more. On the other hand, investors interested in small-cap companies would look for those with a valuation under $2 billion.

2. Asset-Based Valuation

The asset-based valuation method determines the value of a company based on its assets. Specifically, this involves looking at a business’s balance sheet and subtracting total liabilities from total assets. For example, if a company has $10 million worth of assets and $3 million worth of liabilities, its valuation would be $7 million.

This valuation method offers a fair market value of a company or business using assets as the key metric. It’s also referred to as a book value.

Businesses can use asset-based valuation to get an estimate of current value or what the business would be valued at after a liquidation event. Using the liquidation-based approach, the business’s value is measured by any net cash remaining after all assets are sold and liabilities are paid off.

3. Discounted Cash Flow Method

The discounted cash flow method for finding a company valuation estimates the value of an asset today using projected cash flows. Business owners use this business valuation method when they expect cash flow to fluctuate in the future.

A discounted cash flow method for finding the valuation of a business includes four elements:

• Time period for analyzing cash flows

• Cash flow projections

• A discount rate, which represents a projected rate of return from a hypothetical investment

• Estimated future growth

Discounted cash flow can help businesses get a sense of what their business is worth now, based on future cash flows. This can be helpful for businesses that are considering making investments in growth and want to gauge the estimated return on that investment.

4. Earnings Multiplier Business Valuation

With the earnings multiplier method, you’re finding the valuation of a business as measured by its current share price and earnings per share (EPS) ratio. Earnings per share represents the profit per common share compared to the company’s profits as a whole.

To calculate the earnings multiplier, you divide the market value per share by the earnings per share. So if a stock is worth $10 and earnings per share are $2, the earnings multiplier would be 5. That means that it would take five years of earnings at the current rate to get to the stock price. You can compare this data point to other companies in the same industry to get a sense of how its value compares to its peers.

The earnings multiplier method can be helpful for comparing the valuation of a company to its competitors. Essentially, what it tells you is how expensive a company’s stock is relative to the earnings per share it’s reporting.

Businesses can use the earnings multiplier approach to compare a company’s current earnings to projected future earnings. This method for how to value a business may be considered to be more accurate than methods that rely on revenues or assets alone.

5. Return on Investment (ROI) Valuation Method

Return on investment refers to the return an investor can expect from placing their capital into a specific investment vehicle. In terms of business valuation methods, this option bases value on what type of ROI an investor could receive from putting money into the business.

This type of valuation method might be useful for newer businesses that are trying to attract the attention of venture capitalist or angel investors. Using the ROI method, it’s possible to provide investors with a tangible number to use as the basis for estimating what type of return they could get on their money.

The formula for ROI-based valuation is simple:

ROI = (Current value investment – Cost of investment)/ Cost of investment

Similar to market capitalization this can be a very simple way to get an estimate of a company’s value.

6. Times-Revenue Method

The times-revenue method for business valuation helps find the value of a company on a range. This method applies a multiplier to the revenues generated over a set time period. The multiplier chosen depends on the industry the company or business belongs to and/or overall market conditions.

Compared to other valuation methods, the times-revenue method is not as precise since the multiplier used may be different each time the calculations are run. It also looks at revenues, rather than profits, which may paint a truer picture of a company’s value. This method of valuation can, however, be helpful for newer businesses that aren’t generating consistent revenues or profits yet.

7. IPO Valuation Methods

Some of the business valuation methods included so far are best for established businesses that are publicly traded on an exchange. In the case of a private company that’s preparing to launch an IPO, valuation requires additional strategies, since there’s no stock price to use.

When finding the valuation of a business for an IPO, the IPO underwriting team can use several strategies, including:

• Comparing the company to similar companies

• Looking at precedent transactions, such as mergers and acquisitions

• Running financial models, including a discounted cash flow analysis

If you’re interested in IPO investing, it’s helpful to understand how an IPO’s price is set. Pricing matters because if it’s too low, the company may not realize its goals for raising capital. If it’s too high, it may put off investors. Accurate valuation and pricing also comes into play during the IPO lock-up period, in which early stage investors are prohibited from selling their shares initially.

💡 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

Knowing how to value a company matters if you own a business but it can be just as important for retail investors. If you’re a value investor, for instance, your strategy may revolve around finding the hidden gem companies, undervalued by the market as a whole.

Investing is, in many ways, all about value. Again, that’s what makes business valuation so critical to investors and business owners alike. In fact, as an investor, you are a business owner – remember to keep that in mind. And knowing how businesses are valued can help further your understanding of the markets at large.

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

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

Photo credit: iStock/SeventyFour

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Aug

2023

Guide to Reading an S-1 Statement

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

An S-1 statement is a type of registration form that companies, hoping to go public, need to file with regulators in order to issue stocks on public exchanges. It’s an important document, and one that is combed through by many prospective investors prior to an IPO.

For investors who may be interested in IPO investing, learning the ins and outs of an S-1 statement is paramount.

What Is an S-1 Form?

An S-1 statement is the registration form companies must file with the Securities Exchange Commission (SEC) to issue new securities. As such, it’s a necessary document for any company preparing for an initial public offering (IPO) to list on a national exchange, such as the Nasdaq or the New York Stock Exchange.

The form serves as an introduction for companies hoping to raise money from the investing public, in which they essentially lay out their business plan. That includes explaining its current business model, its place in the current competitive landscape, as well as introducing managers and sharing a short prospectus for the stock itself. The form also includes the company’s methodology for formulating the stock price, and disclosures about how the company expects its IPO to impact the stocks of any existing public companies.

Thoroughly reading an S-1 is a great way for investors to research a company directly, rather than gathering information from third-party sources.

Recommended: What Is an IPO? Everything Investors Need to Know

💡 Quick Tip: If you’re opening a brokerage account for the first time, consider starting with an amount of money you’re prepared to lose. Investing always includes the risk of loss, and until you’ve gained some experience, it’s probably wise to start small.

Where Can You Find S-1 Filings?

The S-1 form, like all SEC forms, is publicly available. You can typically find it by going to the “investor relations” section of a company’s Web site, or by searching on the SEC’s EDGAR (Electronic Data Gathering, Analysis, and Retrieval) system.

The EDGAR system is free and publicly available. It allows you to search by company, or even by form type. So, for example, you could look for all the S-1 registrations for a given period.

💡 Quick Tip: Keen to invest in an initial public offering, or IPO? Be sure to check with your brokerage about what’s required. Typically IPO stock is available only to eligible investors.

How to Read An S-1: Section Breakdown

There are several different sections of the S-1 form that contain helpful information for analyzing a stock.

The Box

The beginning of the form consists of a section often called “The Box,” which summarizes the major highlights of the document. The Box usually includes the following information about the company:

• Background information

• Industry information

• Competitive strengths

• Business strategies

• Risks

• Financial data

• Description of securities it plans to sell in its IPO

The box is where the company will try to tell its life story, its plan for the future, and why it is a worthwhile investment. It is, in some ways, a pitch to prospective investors. As such, it can be surprisingly non-technical, without some of the financial and legal jargon that can make financial statements so difficult to read.

Management’s Discussion & Analysis (MD&A)

This is where the company explains and offers context around the financial statements that appear in other sections of the S-1 registration.

This usually includes operating performance metrics, as well as how different business segments performed. This is also where management often elaborates on some of the risk factors that affect or will affect the company. Sometimes, a company will also use the MD&A as a place to share their long-term outlook.

Selected Consolidated Financial Data

This is the section where you’ll get to the numbers that matter, where the company shares a condensed statement of its income, balance sheet and cash flow.

Those statements present a quarter-by-quarter illustration of the company’s financials over the previous two years, showing its growth, capital expenditures, and other trends in the business. While those numbers may well tell a story on their own, they may be worth perusing with the commentary and background of the MD&A in mind.

Description of Capital Stock & Underwriting

While the other sections tell you what the company is, what it does, and how it’s doing, this one gets to the main point of the S-1 – what the company is selling, namely, its stock.

This section is where investors can dig in to understand the security that will be making its debut. It includes details of shareholder rights, such as its voting and conversion rights. It also lists the investment banks that the company has hired to sell its IPO shares to large investors.

Description of Capital Stock & Underwriting even gives a preview of the IPO itself, disclosing the stock’s offering price, the number of shares the company plans to sell, and the total proceeds that the company hopes to raise in the IPO.

Recommended: How Are IPO Prices Set?

Executive Compensation

This is the section that discloses how much senior management makes in salary and other compensation, and can give investors a sense of the net worth and motivation of the leadership.

Related Party Transactions

This is where investors get a glimpse into who the company is working with. It’s a chance to connect the dots, and see who’s backing the company. The Related Party section is where a company has to disclose any transaction with a private equity firm, or a family member.

The Footnotes

Seasoned investors are also close readers of the footnotes of an S-1. This is where the most interesting little details are sometimes buried.

The Takeaway

Filing an S-1 is a key part of the IPO process. Reading an SEC S-1 filing can help investors understand what to expect about an IPO. Every company approaches their S-1 registration differently. Each company will provide different degrees of disclosure, and they will use the format of the S-1 to present that information in the way they believe will benefit them.

Reading through the document can feel like a chore, but if you’re at all interested in IPO investing, it’s a worthwhile investment of time. If you feel like you’re in over your head, though, you may want to speak with a financial professional to try and get caught up.

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/insta_photos

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.

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.

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.

SOIN0723039

Aug

2023

Capital Markets Explained

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

Capital markets are markets for capital, where businesses and other organizations can find financial resources to help them grow. The capital markets are also where financial securities like stocks and bonds are generated, which is critical for investors of all stripes to understand.

The capital markets play a key role in the economy, and there are also a wide variety of them. Again, this can all be critical for investors to understand, especially if they’re in the early stages of building their portfolios.

What Are Capital Markets?

As mentioned, capital markets refer to entities that offer funding to businesses, organizations and other entities that need capital. Capital market instruments are financial securities, including stocks and bonds. Most capital markets are located in the world’s financial centers, such as London, New York, Singapore and Hong Kong.

The entities that supply the capital consist of financial institutions, corporate treasurers, commercial banks, pension plans, life insurance companies, charitable foundations, and other asset managers. The entities that go to the capital markets to acquire capital include companies, nations, states, municipalities, banks, among others.

💡 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 Types of Capital Markets?

There are a wide range of capital markets. The most common capital markets are stock markets, where investors exchange capital for equity stakes in a given company, and the bond market, where investors exchange capital for a right to agreed-upon debt repayments from a company, a state, or another entity.

Stock markets are probably the most well-known of the capital markets. They are capital markets because it’s where companies go to acquire the capital they need to grow, and where investors go to find opportunities for their capital to grow. Companies acquire capital in the stock markets through an initial public offering (IPO) when they sell fractional ownership stakes in themselves to investors.

Recommended: A Brief History of the Stock Market

Bond markets, on the other hand, are not as popular or as well understood by the general public. For one thing, the bond market doesn’t have a central exchange. Instead, they sell over the counter. And most of the people who trade in this OTC market are professional traders, such as pension funds, investment banks, hedge funds, and asset managers.

The bond market is a capital market because it is where companies, states, and other entities go to raise money by offering their debt in the form of a bond. In a bond issuance, investors pay for the right to receive repayment, along with the interest rate offered in the bond.

Stock and bond markets are one way to divide up the capital markets. But there are other so-called hybrid securities such as preferred stocks, convertible bonds, convertible preference shares and other sophisticated securities that companies sell to raise capital. And they also trade in the capital markets.

Primary Market vs. Secondary Market

Capital markets are also commonly divided into primary and secondary markets. The primary markets are where the entities who need capital sell stakes in themselves in the form of a stock IPO, or take on debt by selling bonds directly to investors. It is where issuers sell “new” securities, and where investors buy them.

The other side of the capital markets are the secondary markets. This is where investors buy and sell the stocks and bonds that have already been issued.

While the New York Stock Exchange and the Nasdaq are different stock exchanges where companies hold their IPOs, they are much better known to investors because of their roles as the secondary markets where investors buy and sell shares of companies. The issuers of stocks typically only play a role in the secondary markets when they conduct a share buyback.

Capital Markets vs. Financial Markets vs. Money Markets

While capital markets overlap with financial markets, the two are not synonymous.

Financial markets are a broader category that includes any venue in which people and institutions trade any financial asset, including securities, currencies, derivatives, commodities and contracts. Capital markets specifically refer to the places where companies and other entities go to raise funding.

Capital markets are also distinct from money markets in that the money market is where investors trade short-term debt. The money markets also have a wide variety of participants, such as corporations, banks, governments and financial institutions.

In the money market, they lend and borrow for terms as short as a single night, all the way up to a year. The capital markets, on the other hand, consist of trade in longer-term stocks and bonds.

Capital Markets vs. Other Funding Sources

When a company, a state or another entity needs to raise money, they have a few options. They can borrow money from a bank, or another institution. And a private company can even sell a stake to a private equity investor, a venture capital firm, or an angel investor. Those funding mechanisms come with less scrutiny and draw less attention. So what advantages do the capital markets offer?

If a company wants to access large-scale funding from the capital markets, it can issue stocks or bonds. To issue stocks to sell to the institutions that offer funding through the capital markets, the company will have to conduct an IPO.

IPOs and Capital Markets

A company will usually consider an IPO when it has grown in size and matured as an organization. From a size perspective, one common time to consider an IPO is when a unicorn company has reached a valuation of $1 billion, though many companies go public before this point.

As a company grows, many early-stage investors, including company founders, will look to the public markets as a way to cash out their investments.

The maturity of the company is also important, as it will need to have internal procedures and dedicated professionals to take on the kind of scrutiny and regulatory compliance that the Securities and Exchange Commission (SEC) demands of publicly traded companies.

Many companies will choose to conduct an IPO to raise capital in amounts that simply aren’t available through private investors. The public capital market creates the opportunity for millions of investors to buy stakes in the company.

For many companies, the day of its IPO represents the beginning of a new stage of growth. In addition to the funds raised in an IPO, the credibility and transparency of being a publicly traded company can make it easier and less expensive to borrow money in the future.

Bond Issuance and Capital Markets

To access public funding through a bond issue, a company or another entity will start by discussing its need for capital with an investment bank. The bank will do some research to see if the borrower meets the requirements for the bond market.

If the borrower doesn’t have a rating from a bond-rating agency, the bank will help the borrower get in touch with the right rating agencies.

Once the terms of the bond are agreed upon, and the rating assigned to it, the bank sets up meetings with institutional investors. If they respond positively, then the bonds go to the investors who agreed to buy it over the course of the meetings leading up to the issuance date.

💡 Quick Tip: If you’re opening a brokerage account for the first time, consider starting with an amount of money you’re prepared to lose. Investing always includes the risk of loss, and until you’ve gained some experience, it’s probably wise to start small.

The Takeaway

The term capital markets encompasses any place where companies, countries, states or other entities go to obtain capital from investors. While the term capital markets is a familiar one, it is sometimes confused with other types of markets.

Understanding the basics of capital markets is very important for investors, as they will be interacting with numerous capital markets throughout their investing journeys. While you may not end up thinking about capital markets on a day to day basis, some background knowledge is helpful.

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/Ivan Pantic

SOIN0723040

Aug

2023

What Are Index Options?

By Brian Nibley | Growing Wealth, invest, Investing | Comments Off

While stock options derive their value from the performance of a single stock, index options are derivatives of an index. Indexes can have a narrow focus on a specific market sector or they can contain a broader mix of stocks. They’re listed on U.S. option exchanges and regulated by the Securities and Exchange Commission (SEC).

Like stock options, the prices of index options fluctuate according to factors like the value of the underlying security, volatility, time left until expiration, strike price, and interest rates. Unlike stock options, there is no underlying asset with index options, they’re simply bets on the direction that an index will move.

What Is An Index Call Option?

An index call option is a financial derivative that represents a bullish bet on the underlying index. An investor who buys an option of this kind believes that the index in question will rise in value. If the index appreciates, so too will the call option.

Before getting too far into the weeds when it comes to trading index options, it may be a good idea to make sure you have a solid understanding of what it means to trade options in a broader sense. It can be a confusing segment of the financial market.

💡 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.

What Is An Index Put Option?

An index put option is a bearish bet on the underlying index. An investor who buys this derivative believes that its underlying index will decline in value.

Differences Between Index Options and Stock Options

In addition to the existence of an underlying security, there are several key differences between trading index options and trading stock options. It’s important for investors to understand these differences.

Trading Hours

Broad-based indexes stop trading at 4:15 PM Eastern Time while stock options and narrow-based index options end their trading fifteen minutes earlier, at 4:00 PM ET. When significant news drops after the market closes, this could impact the prices of narrow-based index options and stock options.

Broad-based indexes are less likely to be affected, however, because they tend to include more sectors in their baskets of securities.

Recommended: When Is the Stock Market Closed?

Settlement Date and Style

While stock options use the American-style of exercise, meaning options holders can exercise at any point leading up to expiration, most index options have European-style exercise (with some exceptions). That means the trader can’t exercise the option until their expiration date. However, traders can still close out their index option positions by buying or selling throughout the life of the contract.

As for settlement date, stock index options usually have their last trading day on the Thursday before the third Friday of the month, with determination of the settlement value coming on Friday. Stock options, by contrast, have their last trading day on the third Friday of the month, with settlement being determined on Saturday.

Settlement Method

When settling stock options, the underlying stock changes hands upon the exercise of the contract. However, traders of index options settle their contracts in cash.

That’s because of the number of securities involved. For example, an investor exercising a call option based on the S&P 500 would have to buy shares of all the stocks in that index.

What Are Options Trading Levels?

Some options trading strategies are simple and come with relatively low investment risk. But there are other ways to use options that can get rather complicated and come with substantial risk.

To make sure that investors are aware of the bets they are making and the risks involved, brokerages have something called options trading levels. Brokerages have enacted these levels to protect themselves from liability if new investors lose large amounts of money in a short period when trading options they don’t understand.

If a brokerage believes an investor faces a low risk of potentially blowing up their whole account through complex options trading, they’ll assign that investor a higher options trading level. Higher options levels open up a user’s account to additional investment strategies, enabling them to trade different types of options.

Most brokerages have four or five trading levels. Reaching all but the highest level usually involves little more than answering some questions and taking a quiz to test an investor’s knowledge.

Options Trading Level 1

This is the lowest level and most often only allows a user to trade the simplest options like covered calls and protective puts. A covered call is when an investor writes an out-of-the-money call option on stocks they own, and a protective put is when an investor buys put options against stocks they own.

These strategies require the trader to hold shares of the underlying stock, making these trades less risky than many others. There is also only one option leg to worry about, which makes executing the trade much simpler in practice.

Options Trading Level 2

Level 2 comes with the right to buy calls and puts. The difference between level 2 and level 1 is that traders at level 2 can make directional bets. Most new traders begin their accounts at this level.

Options Trading Level 3

At level 3, more complex strategies start to come into play. This level usually brings with it the ability to trade debit spreads. Though complicated to execute, debit spreads still limit risk since the trader’s loss is limited to the cash paid to buy the necessary options.

Options Trading Level 4

Level 4 provides traders the ability to trade credit spreads, and is sometimes included in level 3 (in which case the brokerage would have only 4 levels). A credit spread works like a debit spread, although the trader will receive a premium.

Calculating potential losses becomes more complicated at this level. It is here that novice traders can wind up accidentally exposing themselves to tremendous risk.

Options Trading Level 5

Level 5 brings with it the highest risk, allowing traders to write call options and put options without owning shares of the underlying stock. These trades expose investors to potentially unlimited losses and should be avoided by all but the most experienced options traders.

The most important requirement of level 5 is that an investor keeps adequate cash as margin in their account. That way, if an options trade moves against the investor, the broker can take cash to cover the losses created by the bad trade.

Recommended: What Are Naked Options?

What Happens to Index Options On Expiry?

Most index options have European-style exercise, meaning traders can only execute them upon expiration. Investors should conduct the appropriate research to learn which type of exercise their index options have before making a trade.

Upon expiration, the Options Clearing Corporation (OCC) assigns the option to one or more Clearing Members who have short positions in the same options. The Clearing Members then assign the option to one of their customers.

The index option writer must then pay the settlement amount in cash. Settlement usually occurs on the business day following the exercise.

💡 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 To Trade Index Options

Trading index options may be one type of investment to consider as part of a diversified portfolio. For the most part, trading index options works like trading any other option. The big difference is that the underlying security will be an index, rather than stock.

Here are a few basic steps that investors can follow to begin trading index options.

• Get your brokerage account authorized for options trading

• Get familiar with how the options chains look in your brokerage account

• Study different option trading strategies and pick one appropriate for your level of expertise

• Enter an option trade using the trading screens of your account

• Monitor your option trades and make a plan for closing out positions to either lock in profits or cut losses.

The Takeaway

Index options are similar to stock options, in some ways, in that they are financial derivatives. They are rooted in indexes, though, which are focused on a segment or portion of the overall market. Trading options and index options, though, is a high-level activity, and may not be for all investors.

Index investing with index options could appeal to investors looking to hedge their portfolios with different types of investments. If an investor holds a lot of positions within a particular index, or perhaps an index fund or other low-fee ETFs, put options for that index could serve as a hedge, for example.

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/kate_sept2004

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.
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SOIN0723036

Aug

2023

Beginners Guide to Understanding Support and Resistance

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

Support and resistance are price levels that traders look at when they’re applying technical analysis to their investing. “Support” is where the price of an asset tends to stop falling and “resistance” is where the price tends to stop climbing.

While support and resistance levels are rarely the sole indicators used to determine when to buy or sell, they can provide helpful clues to estimating when a price trend may pause or reverse. That can be critical for investors to know and understand as they fine-tune their strategies.

What Is Support and Resistance?

As noted, support and resistance are price levels used by traders and investors. Specifically, they’re used as a part of what is called technical analysis, which involves looking at a number of technical indicators that describe how a stock is performing – and trying to determine what it may do in the future.

Specifically, support and resistance levels can be plotted on a stock chart to try and create a visual representation of a stock’s value range – it doesn’t tell a trader everything, but sort of gives a visual as to the “range” a stock’s value sits within. In short, at the higher end of the range a stock may hit “resistance,” while at the lower end, it may find “support.” That’s not to say that values don’t break out of that range – they can and do – but support and resistance act more as a general guideline for traders.

💡 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.

Technical Analysis 101

Technical analysis is a type of trading method that uses price patterns to forecast future movement. It differs from fundamental analysis, which is based on using a company’s financials, like its earnings and revenue. Professional technical analysts are called Chartered Market Technicians or CMTs.

A general rule of thumb in investing is that past performance never guarantees future results. However, technical analysts believe that because of market psychology and sentiments like fear and greed, history tends to repeat itself. For instance, if an asset falls a certain amount, buyers tend to swoop in.

In addition to price levels and their historical patterns, technical analysts may look at volume, oscillators – such as the Stochastic Oscillator, and momentum.

Another aspect of technical analysis is that it can be self-fulfilling. If many investors and traders believe a certain price is important, they may use stop-loss orders at certain levels. That, in turn, makes it likely those points will trigger a reversal or pause in an asset’s direction.

How Do You Identify Support and Resistance Indicators?

The support level is typically a price point at which investors or traders expect a downward price trend to pause or reverse. A resistance level is the price point at which an upward price trend is expected to pause or reverse.

Here are some different ways in which support and resistance levels can be determined.

1. Round Numbers

Round numbers like $100, $500 or $10,000 can be levels at which investors, traders and analysts believe a price trend will hit support or resistance.

For instance, in a hypothetical example in the stock market, a company’s shares may climb steadily and struggle to surpass the $100 level. This may be driven more by market sentiment, as the market doesn’t believe the stock can consistently trade above that $100 level.

There could also be a more fundamental reason, such as the $100 level pushing the valuation – something like the stock’s price-to-earnings ratio – to a level the market believes is too expensive.

2. Buy and Sell Orders

Technical analysts may come up with support and resistance points by studying where buy and sell orders are congregated. In other words, they’re determining support and resistance levels by the volume of trades.

Investors, traders and analysts may have access to actual buy or sell order books. They could study price targets that bank research analysts set. They may also scour sources like social-media platforms to get a sense of where investors believe the stock may find a floor or hit a ceiling.

3. Historical Highs and Lows

A previous high or low for an asset may be deemed a level at which there’s support or resistance.

For instance, let’s say Company Y stock had months ago climbed to hit a price level but then reversed. If Company Y stock nears that level again, investors may believe that’s a resistance point where the shares may struggle again.

How to Trade Using Support and Resistance Levels

There are roughly four types of investors who may be using trade and resistance levels:

1. Investors who are long and waiting to buy at a support level,

2. Investors who are shorting a stock or asset and may close their position,

3. Investors on the sidelines and want to buy at a support price,

4. Investors on the sidelines and simply monitoring to learn more about the stock.

One common way investors and traders utilize support and resistance levels is through stop-loss orders. Stop-loss orders are in general popular when it comes to technical analysis trading. They involve placing an order with an investor’s brokerage account to buy or sell once an asset reaches a specific price.

Recommended: How to Open a Brokerage Account

Stop-loss orders are a way for investors to manage their portfolio without having to monitor their holdings every day.

For example, let’s say an investor believes $1,000 is a level of resistance for Company Z stock. They could set a stop-loss order to sell the stock at $1,000, which the brokerage firm will automatically execute once the shares hit that price.

💡 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.

The Takeaway

Support and resistance levels are price points at which investors and traders in a market expect trends to reverse or take a pause. Individuals can think about support and resistance levels as the potential floors and ceilings for price moves in an asset.

While there’s no guarantee support and resistance levels come true, it can be a helpful way to try to time the market or have specific price points to monitor. They may also use these prices to gauge whether the velocity of a price movement will slow down, pick up or reverse course.

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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Photo credit: iStock/Jay Yuno

SOIN0723030

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Beginners Guide to Understanding Support and Resistance

What Is Support and Resistance?

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How Do You Identify Support and Resistance Indicators?

1. Round Numbers

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How to Trade Using Support and Resistance Levels

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