After exercising a put option, can I still hold my option contract in order to sell it at a lower price?A:
Once a put option contract has been exercised, that contract does not exist anymore. A put option grants you the right to sell a stock at a specified price at a specific time. The holder of a put option expects the price of the underlying stock to decline. When the price of that stock goes down, the holder of the put option has two choices: a) sell the put option for profit, or b) exercise the option. You cannot exercise the option and then sell it at the same time; it has to be one or the other.
When a put option is in-the-money, depending on the rules of the brokerage firm you are using, instructions are submitted to your broker or it is automatically exercised. If the option is exercised, the holder buys the stock at its current price and sells the same stock at its exercise price. For example, if the put option contract for stock A specifies the exercise price at $10 at a specific date, and the actual price on that date is $8, the option holder exercises the contract by buying stock at $8 and selling it for $10 to get a $2 profit. When that option contract is exercised, it no longer exists.
To learn more, see our Options Basics Tutorial.
This question was answered by Chizoba Morah.
Are Stocks With Large Daily Volume Less Volatile?A:
Stock volatility refers to a drastic decrease or increase in value experienced by a given stock within a given period. There is a relationship between the volume of a traded stock and its volatility. When a stock is purchased in large quantities, the stock price or value goes up sharply, but if the stock is sold in large quantities a few minutes later, the price or value of the stock experiences a sharp decrease. In other words, volatility occurs when there is an imbalance in trade orders for a particular stock.
For example, if all or a majority of the trade orders for a particular stock are sell orders with little or no buy orders, then the stock's value will sharply decrease. So, the relationship between a stock's trading volume and its chances of volatility depends on the types of trading orders that are being received. If the stock's traded volume is high, but there is a balance of orders, then the volatility is low.
There are many reasons why volatility might occur in the stock market. Some of those reasons are:
- Unexpected earnings results: If a company reports earnings that are better than expected, then there will be a lot of buy orders and the stock value increases. However, if the earnings report is lower than expected, then the stock value will go down.
- Company or industry news: If there is good or bad news from a company or the industry, then there is an increase in volatility for the company's stock or the stocks of companies in that industry.
Also, stocks that trade at very low volumes, which are far less liquid than those with higher average volumes, can have a higher volatility than their higher-volume counterparts. In relatively illiquid stocks, any trading that is performed can have a drastic effect on the stock price because so few orders are placed. It is almost always safer to trade stocks with higher average trading volumes than stocks that are considered to be illiquid. (See also: Tips For Investors In Volatile Markets.)
This question was answered by Chizoba Morah.
- Unexpected earnings results: If a company reports earnings that are better than expected, then there will be a lot of buy orders and the stock value increases. However, if the earnings report is lower than expected, then the stock value will go down.
Are We In A Bull Market Or A Bear Market?A:
The Wall Street Journal and other media outlets often use 20% thresholds to label traditional uptrends and downtrends, stating a new bear market has begun when an index or other security falls 20% off its peak. Conversely, they announce the start of a new bull market when an index or other security rises 20% off its low. This logical approach can produce great controversy at times because a financial instrument that sells off from 20 to 1 in a bear market will enter a media-sanctioned bull market when a bounce gains 20-cents, lifting the instrument to 1.20 while marking a 20% rally off the low.
In the simplest definition, rising price signifies a bull market while falling price signifies a bear market. With this in mind, you might think it would be easy to determine what type of market we're grinding through at any point in time. However, it's not as easy as it looks because bull-bear observations depend on the time frames being examined. For example, an investor looking at a 5-year price chart will form a different opinion about the market than a trader looking at a 1-month price chart.
[There are many ways to measure bull and bear markets but quantitative methods rely on technical analysis concepts. Investopedia's Technical Analysis Course will show you how to identify technical patterns, trends, signals, and indicators that determine price behavior and how to apply them to make money in bull and bear markets.]
Let's say the stock market has been rising for the last two years, allowing an investor to argue that its engaged in a bull market. However, the market has also been pulling back for the last three months. Another investor could now argue that it's topped out and entered a new bear market. In sum, the first argument arises from looking at two years of data while the second arises from looking at three months of data. In truth, both points of view may be correct, depending on the viewer's particular interests and objectives
In reality, markets form trends in all time frames, from 1-minute to monthly and yearly views. As a result, bull and bear market definitions are relative rather than absolute, mostly dependent on the holding period for an investment or position intended to take advantage of the trend. In this scheme, day traders attempt to profit from bull markets that may last less than an hour while investors apply a more traditional approach, holding positions through bull markets that can last a decade or more.
Bottom line: there's no perfect way to label a bull or bear market and it's easier to focus on specific time frames or by considering the sequence of peaks and valleys on the price chart. Charles Dow applied this method with his classic Dow Theory, stating that higher highs and higher lows describe an uptrend (bull market) while lower highs and lower lows describe a downtrend (bear market). He took this examination one step further, advising that bull and bear markets aren't "confirmed" until major benchmarks, the Dow Industrial and Railroad Averages in his era, make new highs or new lows in tandem.
Can a stock lose all its value? How would this affect a long or short position?A:
The answer to the first part of this question is pretty straightforward: Yes, stocks are able to lose all their value in the market. Now, we don't want to scare you off investing in stocks, or investing in general. However, we would be lying if we told you that stocks carry no risk (although some carry more than others).
To help you understand why a stock can lose all its value, we should review how stock price is determined. Specifically, the value of a stock is determined by the basic relationship between supply and demand. If a lot of people want a stock (demand is high), then the price will rise. If a lot of people don't want a stock (demand is low), then the price will fall. (For a deeper look into supply and demand and other economic concepts, check out the Economics Basics Tutorial.)
If a stock's demand sinks dramatically, it will lose much (if not all) of its value. The main factor determining the demand for a stock is the quality of the company itself. If the company is fundamentally strong, that is, if it is generating positive income, its stock is less likely to lose value.
So, although stocks carry some risk, it would not be accurate to say that a loss in a stock's value is completely arbitrary. There are other factors that drive supply and demand for companies. (If you want to learn more, take a look at the Stock Basics Tutorial.)
The effects of a stock losing all its value will be different for a long position than for a short position. Someone holding a long position (owns the stock) is, of course, hoping the investment will appreciate. A drop in price to zero means the investor loses his or her entire investment – a return of -100%.
Conversely, a complete loss in a stock's value is the best possible scenario for an investor holding a short position in the stock. Because the stock is worthless, the investor holding a short position does not have to buy back the shares and return them to the lender (usually a broker), which means the short position gains a 100% return. Bear in mind that if you are uncertain about whether a stock is able to lose all its value, it is probably not advisable to engage in the advanced practice of short selling securities. Short selling is a speculative strategy and the downside risk of a short position is much greater than that of a long position. (You can check out our Short Selling Tutorial to explore this concept further.)
To summarize, yes, a stock can lose its entire value. However, depending on the investor's position, the drop to worthlessness can be either good (short positions) or bad (long positions).
Can a stop-loss order protect a short sale?A:
The quick and simple answer to this question is yes.
The major difference between a stop-loss order used by an investor who holds a short sale and one used by an investor with a long position is the direction of the stop's execution. The individual with the long position wants the price of the asset to increase and would be negatively affected by a sharp decrease. The individual with the short sale wants the price of the asset to decrease and would be negatively affected by a sharp increase. To protect against a sharp rise in asset price, the short seller can set a buy-stop order, which turns into a marketable order when the execution price is reached. Conversely, the individual who holds the long position can set a sell order to be triggered when the asset hits the execution price.
For example, if a trader is short selling 100 shares of ABC Company at $50, he or she might set a buy-stop order at $55 to protect against a move above this price level. If the stock rallies to $55, the stop would be triggered, buying the 100 shares near the current price. A word of caution: in a fast moving market the buy-stop order could be triggered at a substantially higher price than $55.
Another way that a short seller can protect against a large price increase is to buy an out-of-the-money call option. If the underlying asset rallies, the trader can exercise his or her option to buy the shares at the strike price and deliver them to the lender of the shares used for the short sale.
(To learn more about short sales, see our Short Selling Tutorial. For more on stop-loss orders, read The Stop-Loss Order - Make Sure You Use It.)
Can an option be exercised on the expiration date?A:
The use of options has increased dramatically over the years as a way to profit from or hedge against the volatile movements of stock prices. Not only can options be traded with stock as the underlying asset, they are also traded on foreign currency, interest rates and various indexes.
There are two kinds of stock options, American and European. American options can be exercised any time up to and including the expiration date of the option. However, European options can only be exercised on the date of expiration. Expiration dates follow three cycles, January, February and March. The January cycle is comprised of the first month of each quarter (January, April, July and October); the February cycle consists of the second month of each quarter (February, May, August and November); and the March cycle consists of the final month of each quarter (March, June, September and December).
Beyond the difference between American and European options, there are also more specific terms regarding expiration. Because expiration dates are usually identified just by a month, a specific date is identified within the expiration month that is used as an exact deadline. This deadline, for both types of options, is the Saturday following the third Friday of the expiration month. An investor normally has until 4:30pm Central time on the third Friday of the month to instruct his or her broker to exercise an option.
To learn more about options, see the Options Basics Tutorial, The Four Advantages Of Options and Trading A Stock Versus Stock Options Parts I and Part II.
Can an Option Have a Negative Strike Price?A:
The simple answer is that, at least when it comes to exchange traded options, an option can't have a negative strike price.
Remember that an option gives the holder the right, but not the obligation, to buy or sell an underlying security at a set price (strike price) before a set date in time. If the strike price were to be negative, it would mean that it would cost you a negative amount to buy or sell a security. If it was a call option on a stock with a strike price of -$5, it would mean that if you exercised the option you would receive $5 for each share you bought. This would mean that no matter what happened to the price of the underlying security, the option holder would exercise the option.
The strike price of an option should be related to the price of its underlying security. In most cases, the price of these securities can never be negative, so there is no reason to have an option with a negative strike price.
However, this doesn't necessarily mean that you couldn't have an option with a negative strike price. The reason for this is that an option is simply a contract between two parties. A contract is completely customizable and could even have an option with a negative strike price. (See also: Options Basics Tutorial.)
Can I improve credit score with utility bill?The bad news for consumers is that, typically, utility bills only appear on a credit report when they're delinquent. In most states, providers aren't obligated to regularly report payment histories to the major credit bureaus; in fact, there are significant disincentives for doing so. In addition to being expensive, reporting to credit agencies makes the utility company subject to the Fair Credit Reporting Act. Most don't bother with the potential legal fallout.
However, if you're significantly behind on your bills, a gas, electric or phone provider may send your account to a collection agency that could – and likely will – forward the information to one or more of the credit bureaus.
Of course, paying your bills on time will help your credit, insofar as the absence of "negative" items improves your score. But if you're looking to build your credit score, simply paying your gas, electric or phone bill on time usually won't do the trick. A more effective approach is to obtain a secured or unsecured credit card and use it responsibly. (You can bet these lenders report to all three credit bureaus – they usually do.)
Can I make money using put options when prices are going up?A:
It seems counterintuitive that you would be able to profit from an increase in the price of an underlying asset by using a product that is most often associated with gaining from falling prices. However, as you'll see with the two methods below, it is possible.
A put option gives the purchaser the right to sell the underlying at the agreed upon strike price, regardless of how far the price declines. For this right, the trader pays a premium, which in turn is kept by the writer of the option if the price of the asset closes above the strike price at expiration. Looking at this transaction from the perspective of the option writer rather than that of the purchaser, it becomes apparent that when an option trader has a bullish outlook on a security, he or she can collect a premium by selling put options and keep the premium when the options expire worthless.
The downside to using this strategy is the amount of risk associated with holding a short position in a put option. Therefore, this strategy should only be attempted by traders who understand all the risks, so that the likelihood of significant losses is reduced. (To learn more about this strategy, see Introduction To Put Writing.)
One method of avoiding the risk associated with a short put option is to implement a strategy known as a bull put spread. This strategy is created by selling one put option and buying another with a lower strike price. In this case, the lower put option protects the trader from large declines in the price of the underlying because the gains from a move below the strike help offset the losses the trader incurs when the original holder of the long position exercises his or her options. This strategy also has a limited profit potential equal to the difference between the amount collected from selling the option and the price paid to acquire the other option. Profiting from an increase in the price of an underlying asset by using a product that is associated with declining prices may seem attractive, but it is extremely important that you have a good understanding of the risks and payoffs associated with both of these strategies before you incorporate them into your trading.
For further reading on put options, see Trading The QQQQ With In-The-Money Put Spreads.
Can I trade a currency when its main market is closed?A:
In the forex market, currencies from all over the world can be traded at all times of the day. The forex market is very liquid, and the increased availability of advanced technology and information processing has only increased the number of participants.
Although markets in many foreign countries are closed at the time when North American markets are open, trading on foreign currencies can still take place. While the majority of trading on a particular currency occurs when its main market is open, many other banks around the world hold foreign currencies, enabling them to continue to be traded at times when the main market is closed. For example, the North American markets are open when the Japanese markets are closed, but North American traders are still able to buy and sell Japanese yen through their brokerages and banks. However, the market for Japanese yen is more liquid at times when the Japanese market is open.
Certain currencies have very low rates of demand for exchange purposes. As a result, these currencies can be difficult to trade and can usually only be traded in specific banks. Because currency trading does not take place on a regulated exchange, there is no assurance that there will be someone who will match the specifications of your trade. However, the major currencies of the world, such as the American dollar, the euro and the Japanese yen, are the most widely available.
For further reading, see Getting Started In Forex, A Primer On The Forex Market, Wading Into The Currency Marketand Common Questions About Currency Trading.
Can Sallie Mae loans be forgiven?Sallie Mae (Student Loan Marketing Association) loans issued by SLM Corporation (SLM) similar to other private loans, cannot be forgiven. As of 2017, there is no option for private student loan forgiveness, but there are options for public student loan forgiveness. If a person needs relief from his Sallie Mae loans, there are options other than forgiveness. Note: When we say "Sallie Mae loan," we are referring to a loan that originates with the agency; Sallie Mae also administrates federal direct student loans (confusing, we know).
Talk to the Lenders
The first step is to speak directly with the lender. Sallie Mae, for example, has forbearance options for those needing it. By using this option, a person is able to temporarily pause loan payments without facing delinquency. A loan can only be in forbearance for up to 12 months.
Refinancing/Consolidating the Sallie Mae Loan
By consolidating multiple loans, a person is often able to get a better interest rate. Doing so not only means lower monthly payments (obviously), but it also saves a lot of money over the entire life of the consolidated loan, reducing long-term financial stress.
Private student loans can only be refinanced or consolidated with other private loans, and public loans with other public loans. Unfortunately, Sallie Mae no longer offers private loan consolidation. Students can still consolidate their Sallie Mae and other private loans through a private financial institution. In that case, the consolidated loan and resulting payment plan are managed by that institution.
Public loans administered through Sallie Mae can be consolidated with other student federal loans. The agency used to allow student-borrowers to apply for the consolidation of federal loans directly, but this is no longer the case: They now have to apply directly to the U.S. Department of Education's Federal Student Aid division. Sallie Mae can continue to manage the new Federal Consolidation Loan, if the borrower wishes.
Look at Federal Student Loan Repayment Options
Sallie Mae loans can't be refinanced, either. However, for those who have both private and public student loans, it is possible to use the special programs offered to give relief to federal loans, and then apply those savings to the Sallie Mae loan. Some people in this situation apply for a federal income-based repayment plan and use the extra capital to pay off the Sallie Mae loan. These options are also available for federal consolidated loans.
First, a student can elect for graduated repayment, which is a loan that has lower monthly payments initially, which increase gradually over a 10-year period.
Students can opt for an income-based repayment plan. This plan caps monthly payments at a discretionary income level of 10% or 15% (depending if your loan originated before or after July 2014). However, to be eligible for this type of plan, students must prove financial hardship.
A student who has an outstanding loan balance of more than $30,000 is eligible for an extended repayment plan. This plan extends the life of the loan to 25 years, with monthly payments based on a low fixed or graduated repayment amount.
Also, some lenders allow for unemployment protection that puts payments on pause if a person loses his or her job.
For related reading, see "'My Student Loans Will Be Forgiven by the Government': Really?"
Can you short sell stocks that are trading below $5? My broker says that I can't.A:
Short selling can be very risky for both the investor and the broker. Brokers will often tell investors that only stocks above $5 can be sold short. Although this may be true for your particular brokerage firm, it is not a requirement set by the Financial Industry Regulatory Authority or the SEC.
Most brokerage firms will have a "short list," which details all securities the firm allows investors to short sell without any extra requirements. If you are looking to short sell a security that isn't on this list, your broker will have to call into the securities lending department to see if the brokerage has enough of the particular security for you to short sell. This list and the securities available for short selling will vary across different brokerages, and it is completely up to your brokerage to decide whether it will assist you in short selling a security.
For more on short selling, take a look at our Short Selling Tutorial.
Continuous compounding versus discrete compoundingA:
Discrete compounding and continuous compounding are closely related terms. An interest rate is discretely compounded whenever it is calculated and added to the principal at specific intervals (such as annually, monthly or weekly). Continuous compounding uses a natural log-based formula to calculate and add back accrued interest at the smallest possible intervals.
Interest can be compounded discretely at many different time intervals. The number of and distance between compounding periods is explicitly defined with discrete compounding. For example, interest that compounds on the first day of every month is discrete.
There is only one way to perform continuous compounding – continuously. The distance between compounding periods is so small (smaller than even nanoseconds) that it is mathematically equal to zero.
Compounding is still considered to be discrete if it occurs every minute or even every single second. If it isn't continuous, it's discrete. Simple interest is considered discrete as well.
Calculating Discrete Compounding
If the interest rate is simple – no compounding takes place – then the future value of any investment can be written as: Future Value = principal x ((1 + (interest rate) x (time period)); or, more simply, as FV = P(1+rt)
When interest is compounded discretely, its formula is: FV = P (1+ r/m)^mt, where t is the term of the contract (in years) and m is the number of compounding periods per year.
Calculating Continuous Compounding
Continuous compounding introduces the concept of the natural logarithm. This is the constant rate of growth for all naturally growing processes. It's a figure that developed out of physics.
The natural log is typically represented by the letter e. To calculate continuous compounding for an interest-generating contract, the formula needs to be written as: FV = P*e^(rt).
Debit card versus credit cardDebit cards and credit cards work in similar ways. Both carry the logo of a major credit card company, such as Visa or MasterCard, and can be swiped at retailers to purchase goods and services. The key difference between the two cards is where the money is drawn from when a purchase is made. When a consumer uses a debit card, the money comes directly from his checking account. When he uses a credit card, the purchase is charged to a line of credit for which he is billed later.
Consider two customers who each purchase a television from a local electronics store at a price of $300. One uses a debit card, and the other uses a credit card. The debit card customer swipes his card, and his bank immediately places a $300 hold on his account, effectively earmarking that money for the television purchase and preventing him from spending it on something else. Over the next one to three days, the store sends the transaction details to the bank, which electronically transfers the funds to the store.
The other customer uses a traditional credit card. When he swipes it, the credit card company automatically adds the purchase price to his card account's outstanding balance. He has until his next billing due date to reimburse the company, by paying some or all of the amount shown on his statement.
With most credit card companies, the customer has 30 days to pay before interest is charged on the outstanding balance, though in some cases, interest starts accruing right away. Interest rates on credit cards are notoriously high (they are key way the credit card companies make money). Savvy consumers avoid paying it by settling their balance in full each month.
The Debt Instrument Difference
By definition, all credit cards are debt instruments. Whenever someone uses a credit card for a transaction, the card holder is essentially just borrowing money from a company, because the credit card user is still obligated to repay the credit card company.
Debit cards, on the other hand, are not debt instruments because whenever someone uses a debit card to make a payment, that person is really just tapping into his or her bank account. With the exception of any related transaction costs, the debit user does not owe money to any external party: The purchase was made his or her own available funds.
However, the distinction between debt and non-debt instruments becomes blurred if a debit card user decides to implement overdraft protection. In this case, whenever a person withdraws more money than what is available in his or her bank account, the bank will lend the person enough money to cover the transaction. The bank account-holder is then obligated to repay the account balance owed and any interest charges that apply to using the overdraft protection.
Overdraft protection is designed to prevent embarrassing situations, such as bounced checks or declined debit transactions. However, this protection does not come cheaply; the interest rates charged by banks for using overdraft protection are as high, if not higher, than the ones associated with credit cards. Therefore, using a debit card with overdraft protection can result in debt-like consequences.
Debt and collection agencyA:
If your debt is significantly delinquent – usually 90 days or more past due – your lender may decide to either assign or sell your debt to a third-party debt collection agency. Sometimes collection agencies sell entire portfolios of debt accounts to each other. If your debt is purchased by another debt collection agency, the date opened on the account is the date purchased from the original (or previous) creditor. In this sense, the previous account is written off by the selling creditor, and a new collection account is opened.
This does not mean that your delinquency is wiped clean, however. The original delinquency date – when you missed your last payment – must remain the same. It does not matter how many times the debt account changes hands. Your credit history is not altered, and the statute of limitations on credit reporting or on legal collection practices does not reset.
This does not mean that nothing has changed, however. If your debt is moving from an original lender to a third-party debt collector, this new creditor's collection efforts are regulated through the Fair Debt Collection Practices Act (FDCPA). The FDCPA is designed to protect you from unscrupulous or abusive debt collection techniques and generally only applies to third-party agencies.
Collectors cannot legally restart the clock on the statute of limitations (seven to 10 years, depending on the debt) through any re-aging techniques or through the sale to a different debt collector. The Federal Trade Commission has shut down the operations of collection agencies for attempts to re-age debts. For more on this topic, see "When Does the Statute of Limitations Clock Start on My Debts?"
Difference between delinquency and defaultA:
Delinquency and default are both loan terms representing different degrees of the same problem: missing payments. A loan becomes delinquent when you make payments late (even by one day) or miss a regular installment payment or payments. A loan goes into default – which is the eventual consequence of extended delinquency – when the borrower fails to keep up with ongoing loan obligations or doesn't repay the loan according to the terms laid out in the promissory note agreement (such as making insufficient payments). Loan default is much more serious, changing the nature of your borrowing relationship with the lender, and with other potential lenders as well.
Loan delinquency is commonly used to describe a situation in which a borrower misses its due date for a single scheduled payment for a form of financing, like student loans, mortgages, credit card balances or automobile loans. There are consequences for delinquency, depending on the type of loan, the duration and the cause of the delinquency.
For example, assume a recent college graduate fails to make a payment on his student loans by two days. His loan remains in delinquent status until he either pays, defers or forebears his loan.
On the other hand, a loan goes into default when a borrower fails to repay his loan as scheduled in the terms of the promissory note he signed when he received the loan. Usually, this involves missing several payments over a period. There is a time lapse that lenders and the federal government allow before a loan is officially placed in default status. For example, most federal loans are not considered in default until after the borrower has not made any payments on the loan for 270 days, according to the Code of Federal Regulations.
Consequences of Delinquency and Default
In most cases, delinquency can be remedied by simply paying the overdue amount, plus any fees or charges resulting from the delinquency. Normal payments can begin immediately afterward. In contrast, default status usually triggers the remainder of your loan balance to be due in full, ending the typical installment payments set forth in the original loan agreement. Rescuing and resuming the loan agreement is often difficult.
Delinquency adversely affects the borrower's credit score, but default reflects extremely negatively on it and on his consumer credit report, which makes it difficult to borrow money in the future. He may have trouble obtaining a mortgage, purchasing homeowners insurance and getting approval to rent an apartment. For these reasons, It is always best to take action to remedy a delinquent account prior to reaching default status.
The distinction for default and delinquency is no different for student loans than for any other type of credit agreement, but the remedial options and consequences of missing student loan payments can be unique. The specific policies and practices for delinquency and default depend on the type of student loan that you have (certified versus non-certified, private versus public, subsidized versus unsubsidized, etc).
Nearly all student debtors have some form of federal loan. When you default on a federal student loan, the government stops offering assistance and begins aggressive collection tactics. Student loan delinquency may trigger collection calls and payment assistance offers from your lender. Responses to student loan default may include withholding of tax refunds, garnishing of your wages and the loss of eligibility for additional financial aid.
There are two primary financial options made available to student debtors to help avoid delinquency and default: forbearance and deferment. Both options allow payments to be delayed for a period of time, but deferment is always preferable because the interest on your federal student loans is actually paid by the federal government until the end of the deferment period. Forbearance continues to credit interest to your account, although you do not have to make any payments on it until the forbearance ends. Only apply for forbearance if you do not qualify for a deferment.
Do I own a stock on the trade date or settlement date?A:
When buying shares, there are two key dates involved in the transaction. First is the trade date, which marks the date the buy order is executed in the market or exchange. Second is the settlement date, which marks the date and time the transfer of shares is made between buyer and seller. The settlement date, not the trade date, establishes a legal transfer of ownership from the seller to the buyer. While different rules govern various jurisdictions around the world, its commonly agreed that ownership is transferred when the funds are given in exchange for the security, which happens on the settlement date.
[Day traders must use margin accounts because settlements don't occur in time for cash accounts. But these aren't the only regulations that day traders must follow. Investopedia's Become a Day Trader Course provides an in-depth overview of day trading, with over five hours of on-demand video, exercises, and interactive content.]
However, there is little differentiation between the two dates because it is likely that ownership will be transferred without complication or conflict after the trade date. Upon execution of the buy order on the trade date, both buyer and seller incur a legal obligation to finalize the transaction. The buyer is obligated to provide the necessary funds (cash) to pay the seller and the seller is obligated to have or obtain the adequate number of shares to transfer to the owner.
Nevertheless, there are two ways in which the settlement can fail. The first is a long fail, in which the buyer lacks adequate funds to pay for the purchased shares. A short fail can also occur; which happens when the seller does not have the security on the settlement date.
The time frame between the trade date and settlement date differs from one security to another, due to varying settlement rules. For bank certificates of deposit (CDs) and commercial paper, the settlement date is the same day as the trade or transaction date. Mutual funds, options, government bonds and government bills are settled one day after the trade date, while the settlement date for foreign exchange spot transactions, U.S. equities and municipal bonds occurs two days after the trade date. This is commonly referred to as "T +2".
To read more, see The Nitty-Gritty Of Executing A Trade.
Do Stop or Limit Orders Protect You Against Gaps?A:
Many are hesitant to invest in the stock market because of the large gaps in prices. It is not uncommon to see a stock that closed the previous session at $55 open the next trading day at $40. This kind of volatility can result in massive losses, but this is the risk that investors take when trying to make money in the stock market.
Regardless of the type of order placed, gaps are events that cannot be avoided. For example, assume you hold a long position in company XYZ. It is trading at $55, and you place a stop-loss order at $50. Your order will be entered once the price moves below $50, but this does not guarantee that you will be taken out at a price near $50. If XYZ's stock price gaps lower and opens at $40, your stop-loss order will turn into a market order and your position will be closed out near $40—rather than $50, like you had hoped. On the other hand, if you decided to enter a limit order to sell at $50 (instead of the stop-loss discussed above) and the stock opened the next day at $40, your limit order would not be filled and you would still hold the shares.
Mind the Gap
As you can see, if you are worried about a gap down in price, you may not want to rely on the standard stop-loss or limit order as protection. As an alternative, you can purchase a put option, which gives the purchaser the right but not the obligation to sell a specific number of shares at a predetermined strike price. Put options can be valuable when there is depreciation of the underlying stock price in relation to the strike price.
Holding a put option is a good strategy for traders who are worried about losses from large gaps because a put option guarantees that you will be able to close the position at a certain price. However, they do come with certain challenges, most specifically costs associated with long-term protection against gaps and the ever present issue of timing. Ultimately, though, put options are probably the surest way to mitigate gap risk, although it requires a level of sophistication and experience to get the timing right. (See also: The Basics of Order Entry, Understanding Order Execution and Options Basics.)
Does a negative alpha automatically mean I should sell?A:
Investors and analysts use numerous technical indicators to assess the relative risk associated with a given stock. Optimal risk management involves assessing an investment's risk and profitability potential from all angles, including its performance relative to that of the broader market. Consistent underperformance may be an indicator of limited growth potential or inefficient business practices.
One of the most popular metrics for comparing a company's performance to that of the wider market is alpha. In its essence, alpha reflects the degree to which a stock's returns meet or exceed the returns generated by the market. A stock with an alpha of zero performs in line with the market. A positive alpha indicates the security is outperforming the market, while a negative alpha indicates the security fails to generate returns at the same rate as the broader sector. By definition, a stock with a negative alpha is underperforming, but does this mean you should sell as soon as this metric dips below zero?
Consistent underperformance can be a huge red flag. However, by using market returns as the baseline for performance evaluation, alpha assumes that the risk level of the individual security, called company-specific risk, is comparable to that of the market, called systematic risk. For this reason, alpha is more useful in the context of portfolio analysis because the distribution of investment capital over several different securities allows for diversification. Optimal diversification can completely negate company-specific risk, making the overall risk of the portfolio equal to the risk of the market. Because this kind of diversification is impossible with single-security investments, alpha is a less accurate reflection of performance.
Alpha is just one metric that should be analyzed when creating an investment strategy. As with any other indicator, it is important to take a comprehensive view of an investment's relative risk rather than basing decisions on one value alone. In single-security investments, a negative alpha isn't necessarily a signal to sell if the security is still generating returns. In portfolio management, a negative alpha indicates that your investments aren't optimally diversified.
Does Advertisers provide good financing?When an advertisement says "financing available," it means that the seller is going to give you a loan on an item that you purchase. Making use of seller financing means that you're buying on credit. You do not have to pay for the item on the spot, but you are billed periodically by the seller for a portion of the cost, plus interest charges. Consumers commonly use financing when purchasing big ticket items like cars, jewelry, major appliances and furniture.
An important point to note is that when retailers or dealers advertise financing, the interest rate that they quote is not necessarily the one that applies to you. Sometimes, the rate you actually end up paying is affected by your geographical location, credit history, term of loan and the condition of the item being purchased. Generally, new items are less expensive to finance (i.e., lower interest rates) than used items.
There are pros and cons to using the seller's financing program. The pros are that it's often fast, convenient and competitive, and if you do not meet the rigid requirements of traditional lenders, there is a good chance that you can obtain financing from a seller. The cons associated with seller financing are that there are sometimes higher interest rates and down payment requirements than those at traditional lending institutions.
If you have to take out a loan to make a purchase, there are other options. You can go to your bank, your local credit union or family and friends. There may be particular upside to using a financial institution that you already have a relationship with, in the shape of special rates or accommodations for account-holders and clients.
Does inflation favor lenders or borrowers?Inflation can benefit either the lender or the borrower, depending on the circumstances.
If wages increase with inflation, and if the borrower already owed money before the inflation occurred, the inflation benefits the borrower. This is because the borrower still owes the same amount of money, but now he or she has more money in his or her paycheck to pay off the debt. This results in less interest for the lender if the borrower uses the extra money to pay his or her debt early.
Inflation can help lenders in several ways, especially when it comes to extending new financing. First, higher prices mean that more people want credit to buy big-ticket items, especially if their wages have not increased – new customers for the lenders. On top of this, the higher prices of those items earn the lender more interest. For example, if the price of a TV goes from $1,500 to $1,600 due to inflation, the lender makes more money because 10% interest on $1,600 is more than 10% interest on $1,500. Plus, the extra $100 and all the extra interest might take more time to pay off, meaning even more profit for the lender.
Second, if prices increase, so does the cost of living. If people are spending more money to live, they have less money to satisfy their obligations (assuming their earnings haven't increased). This benefits lenders because people need more time to pay off their previous debts, allowing the lender to collect interest for a longer period. However, the situation could backfire if it results in higher default rates.
Does the seller (the writer) of an option determine the details of the option contract?A:
The quick answer is yes and no. It all depends on where the option is traded. An option contract is an agreement between the buyer and the seller of the contract to buy or sell an underlying asset at a certain price, amount and time. These are referred to as the strike price, the contract size and the expiration date, respectively. Options are sold in two places: on option exchanges and over the counter.
Option exchanges are similar to stock exchanges in that trade happens through a regulated organization, such as the Chicago Board Option Exchange (CBOE). Exchange-traded options at the basic level are standardized; this means that each option has a set standard underlying asset, quantity per contract, price scale and expiration date. For example, when looking at a May05 MSFT 30.00 call option, the CBOE has standardized that each option contract represents 100 shares of MSFT common shares, the strike price is $30, and the contract expires on the third Friday of May. There is no customization at the basic level of option exchanges, and the terms of the contract are set out by the exchange.
Flexible exchange options (FLEX) allow for customization of the contract specifics of exchange-traded options; they are most often written by a clearing house. There are also exchange-specified rules that must be followed when creating a FLEX option; for example, the exercise date must differ from the exercise date of all other options and there may be a minimum size. This allows for some customization, which means an option contract writer can change some of the details of the contract.
Over the Counter
Options are also traded in the over-the-counter option market. Over-the-counter options are traded through a wide network of various brokers and dealers. This market allows for the complete customization of option terms, from the strike price to the expiration date. The price that is paid or received for the option is dependent on the price someone in the market is willing to sell for or pay, and this is determined by the terms of the option.
However, there is more risk in the over-the-counter market than in the exchange-traded market. In the over-the-counter market, the other party to the contract may not hold up his or her side of the agreement. This is unlike exchange-traded options, which are guaranteed by the clearing corporation to be exercisable, no matter what the other party to the option does.
For more information on options, please read the Options Tutorial.
How accurate is the forward rate in predicting interest rates?A:
Forward rates are extremely limited predictors of actual interest rates. This isn't particularly surprising, given the multitude of determinant factors for interest rates or the nature and use of forward rates. The imperfections of forward rate forecasts tend to be most glaring before the business cycle begins a boom or bust cycle.
The Determinants of Interest Rates
Generally speaking, interest rates depend on the supply and demand for interest-bearing financial instruments. There are three major influences on the supply and demand of interest rates: liquidity preference, the difference between the demand for past and future consumption, and the premium demanded for assuming market risk.
For example, if inflation is expected to increase in the future, individual and institutional investors may demand higher rates from their financial instruments. Businesses might increase offered interest rates on issues if they need more capital than is available to spend on future expansion.
Banks may raise interest rates if they want more deposits and lower them if they want less. The opposite is true for bank lending; rates increase if banks want to discourage borrowing and decrease if they want to encourage borrowing.
In modern mixed economies, interest rates are heavily influenced by central bank policy. Rates tend to fall when the Federal Reserve pursues expansionary monetary policy and contract when it pursues contractionary monetary policy.
Limits of Forward Rates
Because there are so many complex, uncertain and interconnected influences on interest rates, it is very hard to predict where rates will land in the future.
Most forward rate calculations tell investors a lot more about how spot rate curves are set today. Even though longer-term spot rates are adjusted based on future expectations, their accuracy is limited to the forecasting ability of present market actors (and Federal Open Market Committee (FOMC) policy or other artificial manipulations).
Forward rates are intended to coordinate futures contracts so that they are competitive with other financial market transactions. There is a component of future forecasting involved, but it is ancillary rather than primary.
How are Bollinger Bands® used in forex trading?A:
Bollinger Bands are popular with technical analysts and traders in all markets, including forex. Since traders of currency look for very incremental moves to profit, recognizing volatility and trend changes quickly is essential. Bollinger Bands help by signaling changes in volatility. For generally steady ranges of a security, such as many currency pairs, Bollinger Bands act as relatively clear signals for buying and selling. This can result in stop-outs and frustrating losses, though, so traders consider other factors when placing trades in relation to the Bollinger Bands.
First, a trader must understand how Bollinger Bands are set up. There is an upper and lower band, each set at a distance of two standard deviations from the security's 21-day simple moving average. Therefore, the Bands show the volatility of the price in relation to the average, and traders can expect movements in price anywhere between the two bands. Forex traders can use the bands to place sell orders at the upper band limit and buy orders at the lower band limit. This strategy works well with currencies that follow a range pattern, but it can be costly to a trader if a breakout occurs.
Since Bollinger Bands measure deviation from the average, they react and change shape when price fluctuations increase or decrease. Increased volatility is nearly always a sign that new normals will be set, and traders can capitalize using Bollinger Bands. When the Bollinger Bands converge on the moving average, indicating lower price volatility, it is known as "the Squeeze." This is one of the most reliable signals given by Bollinger Bands, and it works well with forex trading. A Squeeze was seen in the USD/JPY currency pair on Oct. 31, 2014. News that the Bank of Japan would be increasing its stimulus bond buying policy sparked the trend change. Even if a trader did not hear about this news, the trend change could be spotted with the Bollinger Band Squeeze.
Sometimes reactions are not as intense, and traders can miss profits by setting orders directly on the upper and lower Bollinger Bands. Therefore, it is wise to determine entry and exit points near these lines to avoid disappointment. Another Forex trading strategy to work around this is to add a second set of Bollinger Bands placed only one standard deviation from the moving average, creating upper and lower channels. Then, buy orders are placed within the lower zone and sell orders in the upper zone, increasing execution probability.
There are several other specific strategies used in currency trading with Bollinger Bands, such as the Inside Day Bollinger Band Turn Trade and Pure Fade Trade. In theory, these are all profitable trades, but traders must develop and follow the methods exactly in order for them to pan out.
How are Donchian channels used when building trading strategies?A:
Donchian channels are used to show volatility, breakouts and potential overbought/oversold conditions for a security. The Donchian system uses adjustable bands that are set equal to the n-period's highest highs and lowest lows across a moving average. The upper and lower bounds of a Donchian channel can also form effective support and resistance levels, particularly when used in combination with other technical indicators.
Most Donchian trading systems use a four- or five-week moving average line. Basic Donchian channel analysis waits to spot the point where a security's price breaks through the upper or lower band, at which point the trader enters into a long or short position. For example, when the price exceeds the high of the previous four weeks, most go long and cover their short positions.
Donchian channels also make natural partners with another moving average indicator for a crossover strategy. The Donchian moving average middle line is likely to form the short-term average in these situations, although some have used a 20-day Donchian channel in conjunction with a five- or 10-day channel to exit a position before a consolidation eats into short-term profits.
The danger of incorporating Donchian channels into a trading strategy lies in their simplicity. It is very easy to spot a breakout from the upper or lower bounds, but these events are uninformative on their own. For example, a breakout might indicate the start of a long-term trend, or it may trigger a possible reversal. Donchian channels don't provide new information; they only allow the trader to visualize information that could easily be obtained other ways. They are best used as confirmation tools along with other tools of analysis.
How are interest rates related to open market operations?A:
Interest rates are indirectly affected by open market operations (OMOs). OMOs are a tool in monetary policy allowing a central bank to control the money supply in an economy. Under contractionary policy, a central bank sells securities on the open market, which reduces the amount of money in circulation. Expansionary monetary policy entails the purchase of securities and an increase in money supply. Changes to the money supply affect the rates at which banks borrow reserves from one another due to the law of supply and demand.
The federal funds rate is the interest rate at which banks borrow reserves from one another overnight to meet the reserve requirement. This is the interest rate that the Fed targets when conducting OMOs. Short-term interest rates offered by banks are based on the federal funds rate, so the Fed can indirectly influence interest rates faced by consumers and businesses by the sale and purchase of securities.
In 1979, the Fed began using OMOs as a tool under Chairman Paul Volcker. To combat inflation, the Fed began selling securities in an attempt to reduce the money supply. The amount of reserves shrank enough to push the federal funds rate as high as 20%. 1981 and 1982 saw some of the highest interest rates in modern history, with average 30-year fixed mortgage rates rising above 18%. Conversely, the Fed purchased over $1 trillion in securities in response to the 2008 recession. This expansionary policy, called quantitative easing, increased the money supply and drove down interest rates. Low interest rates helped stimulate business investment and demand for housing.
How are NDFs (non-deliverable forwards) pricedA:
The price of non-deliverable forward contracts, or NDFs, is commonly based on an interest rate parity formula used to calculate equivalent returns over the term of the contract based on the spot price exchange rate and interest rates for the two currencies involved, although a number of other factors can also affect the price.
NDFs are a foreign exchange agreement most commonly used when one of the currencies involved is not freely traded in the forex market and is thus considered "non-deliverable." They are most often used by companies seeking to hedge exposure to currency risk when transacting business in countries whose currency is not freely traded. NDFs are usually short-term contracts between two parties in which the difference between the spot price exchange rate on the contract settlement date and the previously agreed upon exchange rate is settled between the two parties for a notional amount of money. NDFs are typically priced and settled in U.S. dollars.
Pricing NFD contracts
Interest rates are the most common primary determinant of the pricing for NDFs. Most NDFs are priced according to an interest rate parity formula. This formula is used to estimate equivalent interest rate returns for the two currencies involved over a given time frame, in reference to the spot rate at the time the NDF contract is initiated. Other factors that can be significant in determining the pricing of NDFs include liquidity, counterparty risk and trading flows between the two countries involved. In addition, speculative positions in one currency or the other, onshore interest rate markets, and any differential between onshore and offshore currency forward rates can also affect pricing. NDF prices may also bypass consideration of interest rate factors and simply be based on the projected spot exchange rate for the contract settlement date.
How are Shooting Star patterns interpreted by analysts and traders?A:
The shooting star candlestick formation is commonly interpreted by traders and market analysts as a bearish signal of market reversal. This formation appears at the end of an uptrend, either long-term or intraday. The shooting star is one of the more visually arresting candlestick patterns since its mere appearance looks very starkly like a downward signal. It forms with an open that gaps higher than the close of the preceding candlestick. Initially, price continues to rise substantially higher, but then turns back downward so the final appearance of the candlestick is one with a very short body, a very long upper shadow, at least twice as long as the body, and virtually no lower shadow. The closing price is the same as, or very near, the opening price.
The shooting star candlestick is identical in appearance to a hammer candlestick formation and is sometimes referred to as a "hammer down." It is only distinguished by where it occurs in an overall chart pattern. The hammer pattern occurs at the end of a downtrend, while the shooting star occurs at the top of an uptrend.
Traders and analysts consider the shooting star a distinctly bearish signal because its formation, from open to close, portrays a sharp shift in momentum. The gap open above the previous candle indicates strong buying momentum, as does the initial continued substantial rise in price. The close of the candle displays a virtual evaporation of all buying momentum, accompanied by a strong push down on the part of sellers.
Factors that strengthen the bearish market reversal indication are:
- If the preceding candle is an up candle with a long body that closed relatively near its high, this is considered a stronger confirmation of the pattern, because the shooting star candlestick that follows is such a radical change.
- The higher the gap open from the preceding candle, the more strongly bearish the interpretation.
- A longer upper shadow also strengthens the interpretation, as this shows a larger range where the market rejected higher prices.
- If the preceding candle is an up candle with a long body that closed relatively near its high, this is considered a stronger confirmation of the pattern, because the shooting star candlestick that follows is such a radical change.
How are StochRSI patterns interpreted by analysts and traders?A:
While both the relative strength index (RSI) and the stochastic oscillator measure momentum, they do so by analyzing different aspects of price change over time. The StochRSI oscillator was developed to take advantage of both momentum metrics and to create a more sensitive indicator that is attuned to a specific security's historical performance rather than a generalized analysis of price change.
The StochRSI is simply the stochastic oscillator calculation applied to a security's historical RSI data rather than price action. The most recent RSI reading is compared to the range of readings over a specified time frame. The result is an oscillator that reflects the current trend momentum compared to its past performance.
For example, assume there is a stock experiencing a strong bullish trend for several weeks, registering RSI readings between 45 and 90 for the past 14 sessions. The current reading is 52. The StochRSI calculation for this session would be (52 - 45) / (90 - 45), or 0.16. The StochRSI is a range-bound metric that fluctuates between 0 and 1, with readings above 0.8 indicating overbought conditions and readings under 0.2 indicating oversold conditions. A reading of 0.16, therefore, means that the current RSI is very close to the lowest RSI of the period. When looking at RSI alone, a reading of 52 signals almost stagnant momentum and would not warrant any trade entry until price began to move with more ambition one way or the other. The StochRSI reading makes it apparent that for this security an RSI of 52 is actually quite low, treading well into oversold territory, and an upswing may be imminent in keeping with the larger trend.
Due to the increased sensitivity of the StochRSI, this indicator is extremely volatile. While it does provide more overbought/oversold signals than other momentum oscillators, that means more actionable signals as well as more false signals. A prudent investor uses multiple indicators to pinpoint optimal trade entries rather than relying on the StochRSI alone.
How are stock warrants different from stock options?A:
A stock option is a contract between two people that gives the holder the right, but not the obligation, to buy or sell outstanding stocks at a specific price and at a specific date. Options are purchased when it is believed the price of a stock will go up or down (depending on the option type). For example, if a stock currently trades at $40 and you believe the price will rise to $50 next month, you would buy a call option today so that next month you can buy the stock for $40, then sell it for $50, and make a profit of $10. Stock options trade on a securities exchange, just like stocks.
A stock warrant is just like a stock option because it gives you the right to purchase a company's stock at a specific price and at a specific date. However, a stock warrant differs from an option in two key ways:
- A stock warrant is issued by the company itself
- New shares are issued by the company for the transaction.
Unlike a stock option, a stock warrant is issued directly by the company. When a stock option is exercised, the shares usually are received or given by one investor to another. When a stock warrant is exercised, the shares that fulfill the obligation are not received from another investor, but directly from the company.
Companies issue stock warrants to raise money. When stock options are bought and sold, the company that owns the stocks does not receive any money from the transactions. However, a stock warrant is a way for a company to raise money through equity. A stock warrant is a smart way to own shares of a company because a warrant usually is offered at a price lower than that of a stock option. The longest term for an option is two to three years, while a stock warrant can last for up to 15 years. So, in many cases, a stock warrant can prove to be a better investment than a stock option if mid- to long-term investments are what you seek.
For more, see Warrants: A High-Return Investment Tool.
- A stock warrant is issued by the company itself
How are the interest charges calculated on my margin account?A:
One way that investors borrow funds from brokerages is through margin accounts; it is these interest charges that allow them to charge such low commission rates.How do we calculate the interest charges? Well, each brokerage has a different method of calculation, so you should speak to your broker directly. However, you should use this formula as a general rule:
(Interest Rate/365 Days)*(Amount Being Borrowed)*(Number of Days Borrowing Funds)
The easiest way to find out how much you have borrowed is to take the equity in your account and subtract it by the market value. If you have a negative amount, this will be the amount you owe. If it is equal to zero, then you owe nothing, and if it is positive, you will have cash that you should invest somewhere else or take out of the margin account as it generally doesn't pay much interest.
Once again, this is a general approach and does not necessarily reflect the policy of all brokerages. If you want to find out the exact calculations, you're going to have to give them a call.
For further reading on this subject, see our tutorial on Margin Trading.
How are Three Black Crows patterns interpreted by analysts and traders?A:
The three black crows candlestick pattern is considered a relatively reliable bearish reversal pattern. Consisting of three consecutive bearish candles at the end of a bullish trend, the three black crows signals a shift of control from the bulls to the bears. Each candle closes lower than the one before, marking an aggressive move by the bears to drive price back, reversing previous gains by the bulls. Though the pattern may open with a gap down, the second and third candles open within the body of the candles preceding them. In addition, each candle has a very short lower shadow, ideally no shadow at all, indicating bears are able to keep price near the low of the session. All three candles should have large bodies of roughly the same size. This confirms the strength of the bearish push as they force price through a wide range without relinquishing any ground to the bulls.
The bearish three black crows most often occurs at the end of a bullish trend. However, like its bullish counterpart, the three white soldiers, it can also occur after a period of price consolidation. While it is still considered a signal of impending bearish action, it is not as strong a signal as a pattern that emerges after a strong uptrend.
It is possible for this pattern to be too aggressive. Candles that are excessively large may indicate the bears have overstretched themselves, pushing the security into oversold territory. In this situation, the bears should be wary the reversal does not become a retracement as the bulls take advantage of their depleted momentum.
How are Three White Soldiers patterns interpreted by analysts and traders?A:
The three white soldiers pattern and its bearish counterpart, the three black crows, are considered fairly robust reversal signals by both analysts and traders. Typically occurring at the end of a downtrend, the three white soldiers consists of three large bullish candles, each closing higher than the last. However, there should be no gaps between candles; each candle opens within the body of the one preceding it. In addition, the upper wicks are short or non-existent, indicating that bulls managed to keep price near the height of its range for the period. The wide trading range reflected in the large bodies of all three candles and the lack of any substantial upper shadow indicates the strength of bullish momentum. As with any reversal pattern, an expansion on volume accompanying the three white soldiers lends additional strength to the signal.
While the three white soldiers typically appears at the end of a bearish trend, it can also appear after a period of consolidation, though this is not considered a strong bullish signal. In addition, it is possible for this pattern to be almost too robust. A series of three bullish candles that are extremely large can indicate that the bullish opposition has overextended itself by pushing too hard too quickly. Because of this potential ambiguity, it is important to look for additional chart confirmation of the bullish reversal. Additional bullish price action is always the best confirmation, but solid volume in subsequent sessions and proximity to a support level also strengthens the signal.
How can derivatives be used for risk management?A:
Derivatives could be used in risk management by hedging a position to protect against the risk of an adverse move in an asset. Hedging is the act of taking an offsetting position in a related security, which helps to mitigate against adverse price movements.
A derivative is a financial instrument in which the price depends on the underlying asset. A derivative is a contractual agreement between two parties that indicates which party is obligated to buy or sell the underlying security and which party has the right to buy or sell the underlying security.
For example, assume an investor bought 1,000 shares of Tesla Motors Inc. on May 9, 2013 for $65 a share. The investor held onto his investment for over two years and is now afraid that Tesla will be unable to meet its earnings per share (EPS) and revenue expectations.
Tesla's stock price opened at a price of $243.93 on May 15, 2015. The investor wants to lock in at least $165 of profits per share on his investment. To hedge his position against the risk of any adverse price fluctuations the company may have, the investor buys 10 put option contracts on Tesla with a strike price of $230 and an expiration date on August 7, 2015.
The put option contracts give the investor the right to sell his shares of Tesla for $230 a share. Since one stock option contract leverages 100 shares of the underlying stock, the investor could sell 1,000 (100 * 10) shares with 10 put options.
Tesla is expected to report its earnings on August 5, 2015. If Tesla misses its earnings expectations and its stock price falls below $230, the investor could sell 1,000 shares while locking in a profit of $165 ($230 - $65) per share.
How can I be paying more than what a stock is trading for?A:
It might seem logical that the last traded price of a security is the price at which it would currently be trading, but this rarely occurs.
The market for a security (or its trading price) is based on its bid and ask prices, not the last traded price. Investors can use the last traded price to gauge where the market is and what people have done recently, but once this price is posted, it is not the actual price you will pay if you decide to buy the security.
When you place a market order, you are asking for the market price, which means you must buy at the lowest ask price or sell at the highest bid that is available for the stock. You can ask your broker for these prices – they are normally given to you when you request a quote.
Alternatively, if you really want to buy or sell a stock at a specific price, it may be more advisable to use a limit order to do so. This way, you can be sure all your buy orders will be filled at a price that is equal to or lower than your specified price level. Conversely, a sell limit order will ensure your sell order is executed at a price that is equal to or higher than the price level that you want.
[Note: Deciding what order type to use can make a big difference in your trading profitability – especially when it comes to day trading. Investopedia's Become a Day Trader course provides a detailed introduction to order types, fills and other essential concepts that aspiring day traders need to know to be successful.]
To read more, see "The Basics of the Bid-Ask Spread."
How can I build a trading strategy based on the Aroon indicator?A:
One of the primary goals of technical market analytics is to identify performance trends in individual securities or indexes. The goal is that buying and selling opportunities can be identified before they are realized, allowing the savvy investor to time the market effectively. The Aroon indicator, a lesser-known technical tool developed by Tushar Chande in 1995, is used to locate trends early and show the likelihood that the trend will reverse.
At first glance, the Aroon indicator resembles the directional movement index. It plots multiple lines on a chart with moving values between zero and 100, all below the actual price movements of a security that are normally presented in candlestick style. The two lines on the Aroon indicator are called the "Aroon Up" and "Aroon Down," and the relationship between these two establishes the foundation for any trading strategy built on the Aroon indicator.
The Aroon Up represents the market's upward momentum. Larger values indicate a stronger movement, while low values express very little upward movement. The Aroon Down is interpreted the same way, only it demonstrates the strength of a downward movement. By their very nature, Aroon Up and Aroon Down tend to have an inverse correlation.
Part of the strength of the Aroon indicator is its simplicity: When Aroon Down is trending higher than Aroon Up, the price of the stock is expected to lose value. The opposite is true when Aroon Up is trending higher than Aroon Down. You would look to establish bullish or bearish outlooks on stocks based on the patterned relationship between the two lines. You can apply long and short strategies whenever trends do present themselves, trading long when the Aroon Up has strong values (50+) and trading short when Aroon Down has strong values.
You can also turn the Aroon indicators into a technical oscillator. To do so, make the bullish indicator range from 100 to zero and the bearish indicator from zero to -100, and then solve for the difference between the two values. This allows you to distinguish between trending markets and range-bound markets, which present less opportunity than trending markets.
Once you learn to read the oscillator, establish some cut-off ranges. For example, any values between -30 and 30 are not likely to indicate strong trends (with a value of zero showing no trend whatsoever), and you should most likely avoid making moves on weak trending markets. Instead, aim for trends that are either bullish (greater than +50) or bearish (less than -50).
The Aroon indicator improves the efficiency of your trading decisions. Theoretically, you should be able to identify the opportunity cost of jumping into a trend too early or too late. The Aroon indicator can also help you understand when to look for alternative opportunities during sideways markets.
How can I calculate the delta adjusted notional value?A:
The delta adjusted notional value is used to show the value of an option. This is different from most other derivatives, which use gross notional value or, in the case of interest rate derivatives, 10-year bond equivalent value. Investors can calculate the delta adjusted notional value of a portfolio by adding the options' weighted deltas together.
The delta adjusted notional value quantifies changes to a portfolio's value if it was comprised of underlying equity positions, instead of options contracts. For example, a stock is trading at $70 and the delta of the related call option is 0.8. In this case, the value of the weighted delta for the option is $56 ($70 x 0.80).
In derivatives trading terminology, "delta" refers to the sensitivity of the derivative price to changes in the price of the underlying asset. For example, an investor purchases 20 call option contracts on a stock. If the stock goes up by 100% but the value of the contracts only increases by 75%, the delta for the options will be 0.75. Call option deltas are positive while put option deltas are negative.
Delta measures the change in option premium generated by a change in the underlying security. Delta's value ranges from -100 to 0 for puts and 0 to 100 for calls (multiplied by 100 to move the decimal). Puts generate negative delta because they have a negative relationship to the underlying security i.e. put prices fall when the underlying rises and vice versa.
On the other hand, call options generate a positive relationship to the underlying security's price. So, if the underlying goes higher so does the call premium, as long as other variables that include implied volatility and time remaining until expiration remain constant Conversely, if the underlying price falls, the call premium will also fall, as long as other variables remain constant.
An at-the-money option generates a delta of approximately 50, meaning the option premium will rise or fall by one-half point in reaction to a one-point move up or down in the underlying security. For example, an at-the-money wheat call option has a delta of 0.5 and wheat rallies 10-cents, The premium will increase by approximately 5 cents (0.5 x 10 = 5), or $250 (each cent in premium is worth $50).
Explaining Notional Value
Notional value is the total amount of an option contract's underlying asset at its spot price.. This term differentiates between the amount of money invested and the amount associated with the whole transaction. Notional value is calculated by multiplying the units in one contract by the spot price.This is easy to demonstrate with an indexed futures contract. For example, an investor or trader wants to buy one gold futures contract. The contract will cost the buyer 100 troy ounces of gold. If the gold futures contract is trading at $1,300, it then has a notional value of $130,000 (1,300 x 100).
Options have a delta-dependent sensitivity so their notional value is not as straightforward as an indexed futures contract. Instead, the option's notional value needs to be adjusted based on the sum of exposures within the portfolio. The easiest way to calculate this delta adjusted notional value is to calculate the delta for each individual option and add them together.
Notional value is useful in determining exposure levels in interest rate swaps, total return swaps, equity options, foreign currency exchange derivatives and exchange-traded funds (ETFs).
How can I determine a stock's next resistance level or target price?A:
Determining where the price of an asset will stop once it has hit a new high is one of the most difficult tasks for any trader. There is no magic way to determine what price an asset is likely to reach, but technical traders have developed a number of methods that can at least give you a fairly good estimate.
This tool is used by technical traders to forecast potential areas of support or resistance. First plot the high and the low. In Figure 1 below, $45 is the high and $36 is the low. This $9 range is now the 100% to 0% range. Extensions consist of all Fibonacci retracement levels that exceed the standard 100% level. Fibonacci extensions predict that a move will advance until it reaches the 161.8% or 261.8% Fibonacci resistance levels and then reverse its direction.
As you can see in Figure 1, once the price breaks above $45 (100%), a trader will set his or her initial target at $50 (161.8% of our $9 range) above the starting point of $36, and the secondary target at $59 (261.8%).
One of the most common methods of setting a target price is achieved by first identifying a technical chart pattern. After the pattern is identified, price targets can be set by measuring the height of the pattern and then adding it to (or subtracting it from) the breakout price. For example, as you can see in Figure 2, the height of the ascending triangle is added to the breakout price to determine a potential area of future resistance.
As you know, nothing is guaranteed in the financial markets and there is no magic way to determine future resistance. The tools mentioned above may give you a better idea of where to set price targets, but don't solely rely on these – they may not always work.
To learn more, see "Fibonacci and the Golden Ratio" and "Trade on Support for the Best Exit Strategy."
How can I hedge against rising diesel prices?A:
In early 2007, the New York Mercantile Exchange announced that traders would be able to buy or sell futures contracts on New York Harbor ultra low sulfur diesel and U.S Gulf Coast ultra low sulfur diesel. These contracts can be used by traders to hedge against rising or falling diesel prices. The contracts started trading on the New York Mercantile Exchange on May 13, 2007. (For background reading, see A Beginner's Guide To Hedging.)
Another interesting point about learning to hedge against rising diesel prices is to understand the process by which this product is made and how it is priced in the commercial market.
One common method used to answering this question lies in learning about a petroleum product known as heating oil. This product is also known as No.2 fuel and is used primarily to heat homes and buildings by fueling furnaces/boilers. When hedging diesel prices, heating oil is important because the two fuels are produced together and are chemically similar. Diesel fuel is often priced at a stable premium to the price of heating oil, which is an underlying commodity of futures contracts listed on the New York Mercantile Exchange.
If you plan to purchase a significant amount of diesel at a later date and you also believe that the price of diesel is going to increase, you may want to take a long position in heating oil futures. This long position will enable you to profit if the price of heating oil does continue to rise prior to the date you wish to purchase the diesel.
(To learn more about futures, see our Futures Fundamentals tutorial.)
How can I identify stocks that also trade as options?A:
The trading of options has become increasingly popular among retail investors as they become aware of the different ways that options can be used to generate profits. The interesting thing about option strategies is that investors can use them in all types of market conditions; the primary question becomes which securities should be used when implementing a certain strategy.
Many beginning option traders quickly discover that not all securities have an option chain associated with them. This means there may be no options available to buy or sell on a certain security, leaving the investor no choice but to buy or sell the underlying instrument to get exposure. (To learn more about this subject, see What requirements must a company meet before exchanges will allow options on the company to be traded?)
The easiest way to find out which securities have options is to visit the websites of the exchanges where the majority of equity options are traded. The exchange listing has grown tremendously in recent years, with current primary operations at BOX Options Exchange LLC, Cboe Exchange Inc, Cboe BZX Options Exchange, Cboe C2 Exchange, Inc, Cboe EDGX Options Exchange, MIAX Options Exchange, MIAX PEARL, LLC, Nasdaq BX Options, Nasdaq GEMX, Nasdaq ISE,Nasdaq MRX, Nasdaq Options Market, Nasdaq PHLX LLC, NYSE American Options and NYSE Arca Options.
Each website has a directory of options that are available for trading on that given exchange. For example, you can click here to go to the symbol directory for options listed on the CBOE Exchange Inc..
How can I prevent my limit order from not getting filled if the stock's price gaps above the entry price?A:
The scenario you describe is very common and can be frustrating for any type of investor. Many traders will identify a potentially profitable setup and place a limit order after hours so their order will be filled at their desired price or better when the stock market opens. The problem is that many buyers do the same thing, and the increased demand can cause the price of the stock to gap higher.
A limit order is ineffective when the price of the underlying jumps above the entry price because the limit price is the maximum amount the investor is willing to pay, and in this case, it is currently below the market price. You can minimize the chances of this situation happening again if you understand two types of orders: the buy-stop order and the buy-stop-limit order. (For an overview of different order types, see "The Basics of Order Entry.")
A buy-stop order is a type of order that is transformed into a market order once the stated stop price has been reached. To explain how this would work, let's consider a hypothetical example. Let's say the current price of XYZ Company is $12.86 and it looks like it is positioned to go higher. You may wish to place a buy-stop order with the stop price set at $13.01. This order would turn to a market order once the market price rose above $13.01. By using this type of order, you would eliminate the problem of not getting filled when the price rises above your desired entry price.
Unfortunately, by using this order you run the risk of getting filled at an unwanted level if the price surges drastically higher. For example, if the price of XYZ Company opens the next day at $17, the buy-stop order will be triggered and you will buy the shares near $17 instead of around $13, as you wanted.
Using an order known as a buy stop limit is a way for you to eliminate the chance of getting a bad fill and to limit the price that is paid for the asset. This order is similar to the buy-stop order, except that a limit price is also set as the maximum amount the investor is willing to pay. For example, assume a buy-stop-limit order is set on XYZ Company with a stop price at $13.01 and a limit price set at $15. If the price jumps to $17, this order will not get filled because you specified that you don't want to pay more than $15.
[Order types are an extremely important concept to learn and understand, especially for short-term traders that rely on fast and accurate order execution. Investopedia's Become a Day Trader course will teach you how to decide what order types to use in addition to other need-to-know information for successful trading. Learn more today! ]
Once you are comfortable with these order types, you will increase the likelihood of your orders getting filled when and how you want them to be filled.
How can I tell if I'm an emotional investor?A:
Successful investors possess the important trait of emotional stability, which means that they base their investment decisions on practical and calculated information. Emotional investors, on the other hand, are guided by their emotions. (To learn more about how emotions can influence your decision-making process, read When Fear and Greed Take Over.)
You know you are an emotional investor if:
- You sell your stock if it falls a few cents. The decision to sell a stock should be the result of careful consideration. If you sell a stock because it pains you to lose a penny, you're an emotional investor.
- You are fixated on stock news. Part of being an investor means keeping abreast of market news. However, if you are not a broker or an employee of the financial services sector, monitoring the stock market 24 hours a day is not healthy and indicates that you could be an emotional investor.
- You celebrate unrealized profit. Unrealized profit is profit gained from an item if you were to sell it at a particular moment. For example, if you buy a stock at $20 and it rises to $40, you have an unrealized profit of $20 per share. Jumping for joy over unrealized profit means you're probably an emotional investor.
- You fear stock updates. If you avoid checking stock prices because you fear price decreases, you're an emotional investor.
- You panic about bad news. The rational way to handle bad news about the stock market or a company you're invested in is to calculate the effects and make a decision accordingly. If you panic at the slightest hint of unfavorable news, you're an emotional investor.
- You make frequent calls to your broker. The stock market undergoes frequent fluctuations during any given day, so unrealized gains, followed by some losses, are to be expected. If you call your broker every five minutes to check the value of your investment, you're an emotional investor.
- You mourn unrealized loss. Unrealized loss is the opposite of unrealized gain. It is the loss you would experience if you were to sell a particular item at a particular moment. Using the stock from the example above, you would experience an unrealized loss of $5 if the stock were to go down to $15. If you grieve these kinds of losses, you're an emotional investor.
Good investors are not emotional; they remain calm, rational and level-headed, despite the innate climate of volatility in the stock market. Being an emotional investor does not mean you cannot be successful in the stock market. However, it does increase the chance that you will miss out on gains and potentially lose money if you are not able to cap your emotions and curtail the impulse to make decisions based on the natural ups and downs of the market. Different temperaments require different investment strategies; therefore, it is important that you take the time to find investment strategies that work for you.
To learn more about investment strategies, read our related articles Active vs. Passive Investing and Investing with a Purpose.
- You sell your stock if it falls a few cents. The decision to sell a stock should be the result of careful consideration. If you sell a stock because it pains you to lose a penny, you're an emotional investor.
How can I trade in cross currency pairs if my forex account is denominated in U.S. dollars?A:
The forex market allows individuals to trade on nearly all of the currencies in the world. However, most of the trading is done on a group of currencies called the "majors", which include the U.S. dollar, the euro, the British pound, the Japanese yen and the Canadian dollar.
Currencies are traded against one another and are subsequently quoted in pairs. An example of a currency pair is the EUR/USD, which is one of the most widely traded currency pairs. Because the U.S. dollar is one of the most traded currencies, it is included in the majority of the pairs that are traded. However, other widely traded pairs that do not include the U.S. dollar, such as the GBP/JPY currency pair, are called cross currencies.
Most American forex investors will deposit U.S. dollars into their margin accounts. However, just because they have U.S. dollars doesn't mean that they are limited to trading currency pairs that include the U.S. dollar. American investors are still able to trade on cross currencies, they just have to make two trades instead of one.
For example, assume that an investor with an account denominated in U.S. dollars wants to buy the Japanese yen against the British pound. To do this, he or she would have to trade the GBP/JPY currency pair by purchasing British pounds with U.S. dollars. Once this trade is complete, the investor can then use the British pound to complete the trade on the GBP/JPY currency pair. Because two trades need to be completed, the broker calculates a margin for both trades and adds them together. To avoid having to do this, brokers will often accept margin deposits in foreign currencies such as the British pound. Usually investors who have currency available in foreign bank accounts are able to use this option.
To learn more, see A Primer On The Forex Market, Getting Started in Forex and Wading Into The Currency Market.
How can you cancel your Walmart credit card?A:
Wal-Mart offers two types of credit cards: the Walmart MasterCard and the Walmart credit card. Both are administered through Synchrony Bank. To closer either one of these credit cards, contact Wal-Mart by sending a letter to the address shown on your latest billing statement or by calling the company's customer service number (you can find it on the back of your Walmart credit card or on your statement, or online).
If you need to close your account right away, calling customer service is the fastest way to process your request.
Details About Closing Your Walmart Credit Card
Under most circumstances, you are still liable for the full outstanding credit card balance. To prevent accumulating additional charges by any other authorized users of your Walmart credit card, collect all cards issued and destroy them. If authorized users are in other states than the one in which you reside, notify them about your plans to close your Walmart credit card right away.
Until you settle the account in full, the variable 23.15% annual percentage rate (APR) for the Walmart credit card and the variable 17.15% to 23.65% APR (26.15% for cash advances) for the Walmart MasterCard apply to remaining balances.
Wal-Mart reports your credit card activity to the three credit bureaus (Equifax, Experian and TransUnion). Closing your account may negatively impact your credit history, depending on how long you have had the card. If your Walmart credit card is your oldest credit card, consider paying off the full balance but keeping your account open; otherwise, the average age of all your accounts will go down, which can reduce your credit score.
Wal-mart offers several payment options for its credit cards, including online, over the phone, by mail and in store (both Wal-Mart and Sam's Club sites, if you're a Sam's Club member). For details, see "Can You Pay off a Walmart Credit Card in Store?"
How can you lose more money than you invest shorting a stock?A:
The simple answer to this question is that there is no limit to the amount of money you can lose in a short sale. This means that you can lose more than the original amount you received at the beginning of the short sale. Therefore, it is crucial for any investor who is using short sales to monitor his/her positions and use tools such as stop-loss orders. (To learn more, see "The Stop-Loss Order – Make Sure You Use It.")
First, you need to understand the short sale itself. When you short a stock, you are hoping the stock's price will fall as far as possible. Because stocks never trade in negative numbers, the furthest a stock can possibly fall is to zero. This puts a limit on the maximum profit that can be achieved in a short sale. On the other hand, there is no limit to how high the price of the stock can rise, and because you are required to return the borrowed shares eventually, your losses are potentially limitless. This is why you are able to lose more money than you received from the investment in the short. (For further information, see our Short Selling Tutorial.)
For example, if you were to short 100 shares at $50, the total amount you would receive would be $5,000. You would then owe the lender 100 shares at some point in the future. If the stock's price dropped to $0, you would owe the lender nothing and your profit would be $5,000, or 100%. If, however, the stock price went up to $200 per share, when you closed the position you would return 100 shares at a cost of $20,000. This is equal to a $15,000 loss, or -300% return on the investment ($5,000 - $20,000 or -$15,000 / $5,000). (To learn how to short stocks with minimal risk, check out the Options for Beginners course on the Investopedia Academy.)
The loss created by a short sale gone bad is like any other debt. If you are unable to pay for this debt, you will have to sell other assets to pay for the debt or file for bankruptcy. The good news is that you are unlikely to sustain such massive losses. When you open a margin account, you usually sign an agreement stating that the brokerage firm can institute stops, which essentially purchase the shares on the market for the investor and close the position. This purchase returns the shares to the lender, and the purchase amount is owed by the short investor to the firm. So, while the mechanics of a short sale mean the potential for infinite losses is there, the likelihood of you actually experiencing infinite losses is small.
How do 50-day, 100-day and 200-day moving averages differ?A:
Whether you are using the 50-day, 100-day or 200-day moving average, the method of calculation and the manner in which the moving average is interpreted remain the same.
A moving average is simply an arithmetic mean of a certain number of data points. The only difference between a 50-day moving average and a 200-day moving average is the number of time periods used in the calculation. The 50-day moving average is calculated by summing up the past 50 data points and then dividing the result by 50, while the 200-day moving average is calculated by summing the past 200 days and dividing the result by 200. (To learn more, see our Moving Averages tutorial.)
As the question implies, many technical traders use these averages to aid in choosing where to enter or exit a position, which then causes these levels to act as strong support or resistance.
Simple moving averages (SMA) are often viewed as a low-risk area to place transactions, since they correspond to the average price that all traders have paid over a given time frame. For example, a 50-day moving average is equal to the average price that all investors have paid to obtain the asset over the past 10 trading weeks (or two and a half months), making it a commonly used support level.
Similarly, the 200-day moving average represents the average price over the past 40 weeks, which is used to suggest a relatively cheap price compared to the price range over most of the past year. Once the price falls below this average, it may act as resistance because individuals who have already taken a position may consider closing the position to ensure that they do not suffer a large loss.
[Note: Moving averages are a great way to identify areas of support and resistance, but they work best when combined with other forms of technical analysis. Investopedia's Technical Analysis course will provide you with an in-depth overview of technical analysis with over five hours of video along with real-life case studies to help you apply the concepts in the wild.]
Critics of technical analysis say that moving averages act as support and resistance because so many traders use these indicators to inform their trading decisions. For more on this debate, see "Can Technical Analysis Be Called a Self-Fulfilling Prophecy?"
How do balance transfers affect my credit score?A balance transfer can be a good way to pay down credit card debt. But, depending on several factors, balance transfers can either help your credit score or hurt it.
By initially applying for several different cards with low introductory rates, you can negatively affect your credit. Fifteen percent of your credit score is based on the length of time your credit accounts have been open. The longer you have your accounts, the better your score. By opening several new accounts, you bring down the average age of all your credit accounts, thereby hurting your credit.
Every time you apply for credit, a hard inquiry is made on your credit report. Each hard inquiry has the potential to lower your score by 35 points. If you apply for five different cards, you could lower your credit score by up to 175 points. To keep the negative effect on your credit at minimum through the application process, do your research and only apply for one card.
After transferring a balance to a new card, keep the old account open. Why? Because closing an account can negatively affect your credit score. By keeping existing accounts open, your average account age remains high.
If possible, find a card with a credit limit much higher than the amount you need to transfer. Exhausting your credit limit increases your credit utilization ratio (your debt as a percentage of your available funds), which accounts for 30% of your score. Conversely, if you increase the amount of credit available to you, the money owed becomes a smaller percentage of the whole – you are less "maxed out" – and your credit utilization ratio goes down.
In the long run, balance transfers can improve your credit score if the transfer makes it easier and faster to pay down your outstanding debt. Of course, you will make those payments on time – a crucial part of maintaining a good credit score; doing so will burnish your credit history, too.
How do central banks acquire currency reserves and how much are they required to hold?A:A currency reserve is a currency that is held in large amounts by governments and other institutions as part of their foreign exchange reserves. Reserve currencies usually also become the international pricing currencies for products traded on the global market such as oil, gold and silver. Currently, the U.S. dollar is the primary reserve currency used by other countries.Manipulating reserve levels can enable a country's central bank to intervene against volatile fluctuations in currency by affecting the exchange rate and increasing the demand for and value of the country's currency. Reserves act as a shock absorber against factors that can negatively affect a country's exchange rates and, therefore, the central bank uses reserves to help maintain a steady rate.The most popular currency held in reserves is the U.S. dollar. In the U.S., almost all banks are part of the Federal Reserve system and it is required that a certain percentage of their assets be deposited with the regional Federal Reserve Bank. The reserve requirements are established by the Board of Governors and by varying the requirements, the Fed is able to influence the money supply. Reserves also keep the banks secure by reducing the risk that they will default by ensuring that they maintain a minimum amount of physical funds in their reserves. This increases investor confidence and stabilizes the economy.Basically, the Board of Governors of a central bank meets and decides on the reserve requirements as a part of monetary policy. The amount that a bank is required to hold in reserve fluctuates depending on the state of the economy and what the Board of Governors determines as the optimal level.For further reading, see Formulating Monetary Policy, Get To Know The Major Central Banks and What Are Central Banks?
How do companies benefit from interest rate and currency swaps?A:
In general, both interest rate and currency swaps have the same benefits for a company. First, let's define interest rate and currency swaps.
An interest rate swap involves the exchange of cash flows between two parties based on interest payments for a particular principal amount. However, in an interest rate swap, the principal amount is not actually exchanged. In an interest rate swap, the principal amount is the same for both sides of the currency and a fixed payment is frequently exchanged for a floating payment that is linked to an interest rate, which is usually LIBOR.
A currency swap involves the exchange of both the principal and the interest rate in one currency for the same in another currency. The exchange of principal is done at market rates and is usually the same for both the inception and maturity of the contract.
In the case of companies, these derivatives help to limit or manage exposure to fluctuations in interest rates or to acquire a lower interest rate than a company would otherwise be able to obtain. Swaps are often used because a domestic firm can usually receive better rates than a foreign firm.
For example, suppose company A is located in the U.S. and company B is located in England. Company A needs to take out a loan denominated in British pounds and company B needs to take out a loan denominated in U.S. dollars. These two companies can engage in a swap in order to take advantage of the fact that each company has better rates in its respective country. These two companies could receive interest rate savings by combining the privileged access they have in their own markets.
Swaps also help companies hedge against interest rate exposure by reducing the uncertainty of future cash flows. Swapping allows companies to revise their debt conditions to take advantage of current or expected future market conditions. Currency and interest rate swaps are used as financial tools to lower the amount needed to service a debt as a result of these advantages.
Currency and interest rate swaps allow companies to more efficiently navigate the global markets by bringing together two parties that have an advantage in different markets. The benefits that a company receives from participating in a swap far outweigh the costs, although there is some risk associated with the possibility that the other party will fail to meet its obligations.
For further reading, see "Corporate Use of Derivatives for Hedging" and "How Does the Foreign-Exchange Market Trade 24 Hours a Day?"
How do currency swaps work?A:
A currency swap, also known as a cross-currency swap, is an off-balance sheet transaction in which two parties exchange principal and interest in different currencies. The parties involved in currency swaps are generally financial institutions that either act on their own or as an agent for a non-financial corporation. The purpose of a currency swap is to hedge exposure to exchange rate risk or reduce the cost of borrowing a foreign currency.
A currency swap is similar to an interest rate swap, except that in a currency swap, there is often an exchange of principal, while in an interest rate swap, the principal does not change hands.
In currency swap, on the trade date, the counter parties exchange notional amounts in the two currencies. For example, one party receives $10 million British pounds (GBP), while the other receives $14 million U.S. dollars (USD). This implies a GBP/USD exchange rate of 1.4. At the end of the agreement, they will swap again using the same exchange rate, closing out the deal.
Since swaps can last for a long time, depending on the individual agreement, the exchange rate in the market place (not on the swap) can change dramatically over time. This is one of the reasons institutions use these currency swaps. They know exactly how much money they will receive and have to pay back in the future.
During the term of the agreement, each party pays interest periodically, in the same currency as the principal received, to the other party. There are number of ways interest can paid. It can paid at a fixed rate, floating rate, or one party may pay a floating while the other pays a fixed, or they could both pay floating or fixed rates.
On the maturity date, the parties exchange the initial principal amounts, reversing the initial exchange at the same exchange rate.
Examples of Currency Swaps
Company A wants to transform $100 million USD floating rate debt into a fixed rate GBP loan. On trade date, Company A exchanges $100 million USD with Company B in return for 74 million pounds. This is an exchange rate of 0.74 USD/GBP (equivalent to 1.35 GBP/USD).
During the life of the transaction, Company A pays a fixed rate in GBP to Company B in return for USD six-month LIBOR.
The USD interest is calculated on $100 million USD, while the GBP interest payments are computed on the 74 million pound amount.
At maturity, the notional dollar amounts are exchanged again. Company A receives their original $100 million USD and Company B receives 74 million pounds.
Company A and B might engage in such a deal for a number of reasons. One possible reason is the company with US cash needs British pounds to fund a new operation in Britain, and the British company needs funds for an operation in the US. The two firms seek each other and come to an agreement where they both get the cash they want without having to go to a bank to get loan, which would increase their debt load. As mentioned, currency swaps don't need to appear on a company's balance sheet, where as taking a loan would.
Having the exchange rate locked in lets both parties know what they will receive and what they will pay back at the end of the agreement. While both parties agree to this, one may end up better off. Assume in the scenario above that shortly after the agreement the the USD starts to fall to a rate of 0.65 USD/GBP. In this case, Company B be would have been able to receive $100 million USD for only $65 million GBP had they waited a bit longer on making an agreement, but instead they locked in at $74 million GBP.
While the notional amounts are locked in are and not subject to exchange rate risk, the parties are still subject to opportunity costs/gains in that ever changing exchange rates (or interest rates, in the case of a floating rate) could mean one party is paying or more less than they need to based on current market rates.