Terminology Archives | Page 23 of 76

Sep

2023

Advance/Decline Line: Definition, Formula, Examples

By Paulina Likos | Growing Wealth, invest, Investing, Terminology | Comments Off

The Advance/Decline line, or A/D line, is a technical stock market indicator used by traders to measure the overall health of the stock market. This measurement tells market participants whether there are more stocks rising or falling on a trading day, and whether a majority of stocks are pushing the market in either direction.

For traders who are looking for greater insight into market trend analysis, the A/D line may be a suitable indicator to help determine where the market is trending, how strong that trend is, and the direction the market could be going in the short-term.

What Is the Advance/Decline Line (A/D)?

The advance/decline line (A/D) is a market indicator that traders use during stock technical analysis to estimate the breadth, or the overall strength or weakness of the stock market. The A/D line monitors how many stocks are currently trading above or below the previous day’s close. Traders may follow these changes over time to try to forecast the direction of the market.

In a particular index, like the S&P 500, Nasdaq, or Dow Jones Industrial Average, stocks go up and down. But just because some stocks move in one direction, it doesn’t mean that all stocks move in that same direction. Sometimes it can be difficult for investors to discern whether the direction of the market is being influenced by larger stocks that hold more weight in an index, or by a majority of stocks that are pushing the markets in a particular direction.

The purpose of the A/D line is to see how it correlates with the price movement of the index it’s being compared to. Traders and investors can use the A/D line to see how many stocks are rising or declining to form an estimate on market direction.

Where Is the Advance/Decline Line on a Chart?

Market participants can find the advance/decline line above or below a stock index chart. Investors can reference the A/D line and compare it to the chart stock market indexes to better understand the strength of the market and to help gauge the direction of where the market might be headed.

Advance/Decline Line vs the Arms Index

The Arms Index — also known as the story-term trading index (TRIN) — is another technical analysis indicator used to estimate market sentiment and measure volatility. It’s a ratio between advancing and declining stocks versus the volume of stocks whose price increases or decreases. In other words, the TRIN compares advancing and declining stocks to their volume and shows whether the volume is flowing toward advancing or declining stocks.

If more volume is trending toward declining stocks, the TRIN for that day will be greater than one. If more A/D volume correlates with advancing stocks, then the TRIN will be below one for that day. A high TRIN reading could signal to traders that stock selling may be on the horizon. A TRIN reading below one could indicate a buying opportunity.

Traders may use the TRIN ratio as a short-term market gauge to measure overbought or oversold market levels, while the A/D line can be used to gauge longer term market sentiment by measuring the rise and fall of stock over a period of time.

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

Advance/Decline Line Formula

The A/D Line is calculated by taking the difference between the number of stocks that advance and the number of stocks that decline, compared to the prior close. This value is added to the previous day’s A/D Line value. If there are more declining stocks versus advancing stocks on a particular day, then traders will see the A/D line start to move downward. If there are more stocks that are advancing, the A/D number is going to be increasing. Here is the formula:

Advance/Decline Line = Number of advancing stocks – Number of declining stocks + Previous A/D Line value

Calculating the Advance/Decline Line (A/D)

The A/D line is a cumulative, daily calculation that is plotted each day so market participants can see the direction of where stocks are moving. When reading the A/D line, it’s important for traders to look at the direction of the line and not its value.

Traders may use the A/D line to help decide which trades to place next. For example, if the market shows more declining stocks than advancing stocks, this means a majority of stocks closed at a lesser value than their previous day close. As a result, traders may anticipate that the market will fall in the near term, and may choose to sell because the market trend is moving in a bearish direction.

Some indexes, like the S&P 500, are market-cap weighted, which means the larger companies hosted in the index influence the direction of the index. The A/D line allows investors to look at stocks on a level playing field. When a market rises, for example, the A/D line shows investors whether this rise was driven by a majority of stocks increasing or if the rise was caused by a select few of stocks that hold a larger weight in the index.

What Does the Advance/Decline Line Show?

The advance/decline line shows traders the degree of participation of stocks in a market that is either rising or falling and whether the majority of stocks are moving in a similar direction of the market.

The line is a representation of stocks that are ticking up or down cumulatively, adding stock movements each day to see the trend of advancing stocks vs. declining stocks. If there were more declining stocks than advancing stocks on a particular day, the A/D line would start to slope downward. If there were more advancing stocks than declining stocks on the day, then the A/D line would slope upwards.

Sometimes there might be a difference in direction between the index and the A/D line. This is called a divergence, and it can happen in one of two ways.

Bearish Divergence: Declining Line

If the index is on an upward trend but the A/D line has a negative slope, this is known as a bearish divergence. The increase in the index may be driven by some stocks, but this scenario signals to traders the market may reverse and trend downward in the short term.

Bullish Divergence: Rising Line

If the index is on a downward trend but the A/D line has a positive slope, this is called a bullish divergence. The index seems to be bearish, but the A/D line tells market participants there are more advancing than declining stocks during the period that the index is declining. This may signal a trend reversal in market prices and indicate the market has more strength than meets the eye.

Example of Using the A/D Line

Traders use the A/D line to compare it to the price movement of the index.

For example, when an index you’re monitoring is moving to new highs, you want to see the A/D line moving new highs to confirm the index’s direction.

If the index and the A/D line are both hitting new highs, the market is hitting a bullish trend. If the stock market reaches a new peak but the A/D line reaches a lower peak than the previous rally, that means fewer stocks are participating in a higher move and the rally could be coming to an end. This could suggest that the strength of the market is driven by a few names with larger market caps.

Is the A/D Line a Good Indicator?

The A/D line is considered a reputable and popular measurement for traders to gather reliable insight into the strength of a market trend. Note that there are many market indicators out there, and each will have good and bad use cases. But generally, the A/D line may be a good choice for many investors to utilize.

When the price of an asset changes, traders will want to know whether it’s best to buy or sell. With the A/D line, traders can estimate price trends of assets and potential reversals by reviewing the direction of the A/D line, which is considered to be a reasonably reliable indicator in predicting trends since it shows market participants how the market is behaving.

Pros of the A/D Line

Traders can find the A/D Line indicator either above or below a stock chart on a trading platform and may use it as a tool to try to time the market and potentially catch a particular stock price.

By gauging the direction of where markets are headed, the A/D Line can help traders forecast stock price movements on the upside or downside. This may help market participants position their trades favorably.

Cons of the A/D Line

It’s important for market participants to be careful to not rely on the A/D Line as their only market indicator. While the A/D Line offers insight into overall market direction, it may not be able to capture minor market changes.

The A/D Line does not capture price changes between trading gaps, or when a stock’s price moves higher or lower throughout the trading day even though there’s not much trading going on.

Another limitation is that even though the line shows the general direction of where the market is trending, either a positive or negative slope, the A/D line doesn’t show the precise percentage the stock moved.

How Investors Can Use the Advance/Decline Line

The A/D line is positioned against an index to help spot market trends and reversals. Traders who trade on the major indexes can use the A/D line to gauge overall market sentiment. Market participants can look at a historical A/D line to see how the market performed in different periods of time.

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The Takeaway

The Advance/Decline Line is a tool used by traders and investors to forecast the direction of where the overall stock market is headed. The A/D Line is a well-known market indicator used to predict and confirm trends and forecast market reversals.

The A/D Line offers a great visual guide that may help traders make decisions on market strategies and positions in the short term. But while there are benefits of using this metric, it’s important for market participants to know the A/D line’s drawbacks as well.

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

FAQ

What is considered a good Advance/Decline ratio?

An advance/decline ratio of one or more is generally considered to be good, as it’s a signal that a stock is in a stable or on an upward trend. Conversely, a ratio of less than one is a sign that it could be declining.

What is the 10-day Advance/Decline line?

The 10-day advance/decline line is a technical indicator that allows investors to get a measure of the average number of daily advancers minus decliners within an index or specific sector over the previous ten trading days.

What does a period of decline in investment mean?

A period of decline in investment is a broad description of a period of deflation in the investment market. It could take the form of an overall drop in the value of investments.

Photo credit: iStock/utah778

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Sep

2023

What Is Asset Turnover Ratio?

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

Asset turnover ratio is a calculation used to measure the value of a company’s assets relative to its sales or revenue. It’s used to evaluate how well a company is doing at using its assets to generate revenue.

Similar to cash flow, the asset turnover ratio compares the company’s total assets over the course of a year to its sales. In simpler terms, it shows the dollar amount the company is earning in sales compared to the dollar amount of its assets. It can be calculated annually or over a shorter or longer period of time.

Why Is Asset Turnover Ratio Important?

Although having cash on hand is important for growing and maintaining a business, other types of business assets are also important, as is how a company chooses to use them. Liquid assets can include cash, stock, and anything else the company owns that could be easily liquidated into cash. Fixed assets are things the company owns that are not as easily turned into cash. This could include real estate, copyrights, equipment, etc.

For business owners, asset turnover ratio can be important when applying for loans and learning about their company’s cash flow. A higher asset turnover ratio indicates that a company is efficiently generating sales from its assets, while a low ratio indicates that it isn’t. A higher asset turnover ratio also shows that a company’s assets don’t need to be replaced or discarded, that they are still in good condition.

A higher ratio is preferable for investors, as well. Investors can look at the asset turnover ratio when evaluating the risk of investing in a company, or when comparing similar companies to one another. Each industry has different norms for asset turnover ratios, so it’s best to only compare companies within the same sector. For instance, a utility company or construction company is more likely to have a higher number of assets than a retail company.

Know, too, that asset turnover ratio is only one of many calculations that comprise the list of financial ratios that investors can employ.

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Formula for Calculating Asset Turnover Ratio

It’s fairly simple to calculate asset turnover ratio, which is one reason it’s such a useful tool for investors. Asset turnover ratio can be calculated using the following formula, which divides total (net) sales or revenue by average total assets:

Asset turnover = Net Sales / Average Total Assets

Which can also be shown as:

Asset turnover = Net Sales / ((Beginning Assets + Ending Assets) / 2 )

Where:

Net Sales = Gross annual sales minus returns, allowances, and discounts. Total sales can be found on a company’s income statement (typically part of an earnings report).

Beginning Assets = Assets at the beginning of the year

Ending Assets = Assets at the end of the year

Total Assets = Generally a company will include calculated average total assets on their balance sheet. However, sometimes additional calculations will need to be made.

Calculating Total Assets

The value of a company’s total assets includes the value of its fixed assets, current assets, accounts receivable, and liquid assets (cash).

• Accounts receivable are accounts that hold expected revenues that come from when customers use credit to buy goods and services.

• Fixed assets are generally physical items such as equipment or real estate.

• Current assets are things that the company predicts will be converted into cash within the next year, such as inventory or accounts receivable that will be liquidated.

The formula for calculating total assets is:

Total Assets = Cash + Accounts Receivable + Fixed Assets + Current Assets

Example of Calculating Asset Turnover Ratio

To give an example of the ratio calculation, if a company has $2,000,000 in average assets and $500,000 in sales over the course of a year, the calculation of its asset turnover would be:

500,000 / 2,000,000 = 0.25 = 25% asset turnover ratio

Interpreting Asset Turnover

Sticking with the example above, we’ve calculated a 25% asset turnover ratio. What that means, exactly, is that the company’s assets generated 25% of net sales over the course of the year. In other words, every $1 in assets that the company owns generated $0.25 in net sales revenue. Again, this can be helpful when using various business valuation methods and trying to determine whether an investment fits your overall strategy.

Factors that can Cause Low Asset Turnover

There are several reasons why a company might have a low asset turnover. These include:

• More production capacity than is needed

• Inadequate inventory management

• Poor methods of customer money transaction

• Poor use of fixed assets

The ratio can also change significantly from year to year, so just because it’s low one year doesn’t mean it will remain low over time.

What Is a Good Asset Turnover Ratio?

Investors can use the asset turnover ratio as part of comparing and evaluating stocks. But what is considered a good number for asset turnover?

In general, the higher the number the better — and a number higher than 1 is ideal. This is because a value greater than 1 means the dollar value generated by assets is greater than the dollar amount that the assets cost. A higher number means a company is generating sales efficiently and not wasting assets.

Conversely, a number less than 1 means that assets are generating less than the amount of their dollar value. If a company isn’t effective at generating sales with its assets, it most likely wouldn’t be a great investment — which, again, is important to know if you’re building an investment portfolio.

Since each industry has its own standards for a “good” asset turnover ratio, there isn’t one specific number to look for. For companies in the utilities industry, ratios are generally lower than companies in retail.

Companies can work on improving their asset turnover ratio by increasing sales, decreasing manufacturing costs, and improving their inventory management. Other ways they can improve include adding new products and services that don’t require the use of assets, and selling any unsold inventory still on hand.

What Does a High Ratio Imply About a Company?

If you’re using technical analysis techniques to get some clarity around a company as a possible investment target, you’ll want to get down to brass tacks: What, exactly, is a high ratio telling you?

The answer is that a high ratio implies that a company is in good standing. It’s generating value with its assets, which can signal that it may be a solid investment. But, again, there are no guarantees.

Limitations of Using Asset Turnover Ratio

While asset turnover ratio is a useful tool for evaluating companies, like any calculation, it has its limitations. It is useful for comparing similar companies, but isn’t a sufficient tool for doing a complete stock analysis of any particular company.

Also, a company’s asset turnover ratio could vary widely from year to year, making it an unreliable measure for potential long-term investments. Even if the ratio has been similar in years past, this doesn’t mean it will continue to remain consistent. However, investors can look at the long term trendline of the ratio to get a general indication of whether it’s improving or not.

Since asset turnover is typically calculated once a year, if a company made even a few large purchases this could skew their ratio. This is fairly common, as companies might have certain monthly expenses but occasionally need to invest large sums of money into equipment, office renovations, or other common business needs.

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Drawbacks of Asset Turnover Ratio in Stock Analysis

The limitations outlined above play into some of the potential drawbacks of the asset turnover ratio when analyzing stocks, too. Mostly, it comes down to the fact that as a single ratio, which doesn’t reveal the total health or financial picture for a single company. For that reason, it’s probably a good idea to use the ratio in tandem with other analysis tools and methods.

For instance, other ratios that can be used to gain an understanding of a company’s financials are the debt-to-equity ratio, its P/E ratio, and even looking at its net asset value.

The Difference Between Asset Turnover and Fixed Asset Turnover

Fixed asset turnover and asset turnover are two different ratios that can tell you about a company, and for investors, it’s important to understand the difference between the two.

In short, and to recap, asset turnover ratio looks at average total assets of a company — “total,” in this case, being the important qualifier. On the other hand, fixed asset turnover ratio looks at a company’s fixed assets to measure performance.

Investing With SoFi

Knowing how to calculate asset turnover ratio can be useful for investors who are evaluating companies as they start building an investment portfolio. While the formula is simple — Asset turnover = Net Sales / Average Total Assets — it’s important to remember that the calculations work best when comparing companies within one industry, rather than across various industries.

Additionally, there are other metrics by which to evaluate a company or value its stock. The asset turnover ratio can be helpful, but it has its limitations. As always, speak with a financial professional if you feel like you’d benefit from more guidance.

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

FAQ

How can you improve asset turnover ratio?

Some ways that a company can improve its asset turnover ratio include increasing its revenues, selling some of its assets, renting or leasing assets rather than purchasing them, and optimizing its inventory and ordering systems.

Is an asset turnover of 1.5 good?

Yes, an asset turnover ratio of 1.5 is a sign that a company is on solid financial footing. It indicates that a company’s total assets are generating enough revenue from its current assets.

Can asset turnover ratio be negative?

Yes, and a negative asset turnover ratio would be a signal that a company lost money during the year, rather than earned it. A negative number represents that its liabilities or expenditures exceeded its assets.

Sep

2023

IPO Oversubscription: Definition & Examples

By Kenny Zhu | Growing Wealth, invest, Investing, Terminology | Comments Off

When an IPO is “oversubscribed” that means certain investors have committed to buy more than the available number of shares that were originally set for the initial public offering.

That’s because when new stocks or bonds are issued via initial public offerings (IPOs), they’re issued in limited amounts, based around the new company’s financing needs and desired debt-to-equity structure.

Depending on investor appetite for the new stocks, IPOs can either be under or oversubscribed; this reflects the level of demand investors have for the shares.

In most cases, though, only institutional investors and accredited investors can subscribe to an IPO stock before it actually goes public. Retail investors may hear about an IPO being over- or undersubscribed, but they typically can’t take advantage of it — although knowing the information may aid an individual’s assessment of the opportunity.

Key Points

• Oversubscription for an IPO means that investor demand is higher than the available number of shares.

• Oversubscription can benefit the issuing company by providing additional funding and the underwriting team by generating fees.

• Early investors may benefit from the initial pop in pricing caused by excitement.

• Retail investors should be cautious when investing in IPO shares due to potential overinflation and the possibility of a price tumble.

What Is Oversubscription in an IPO?

Investors interested in IPO investing may be interested in an IPO’s subscription status. If an IPO is oversubscribed, that means there aren’t enough shares of the new stock issued to meet initial investor demand at the listed IPO price.

To compensate for this mismatch in supply and demand, the underwriters selling the IPO can choose to either raise the IPO price to reduce demand, or increase the supply of shares to meet demand.

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

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How Does Oversubscription Work?

Oversubscribed IPOs generate a shortage in shares that usually results in a higher price or additional shares being issued, which can lead to more capital being raised for the now-public company. These funds are also called the IPO proceeds.

This contrasts with “undersubscription” for IPOs. Undersubscribed IPOs are caused by the converse scenario happening, where there’s insufficient investor demand to buy all available shares at the listed IPO price.

What Is Undersubscription?

When an IPO is undersubscribed, it generally signals a lack of enthusiasm for a newly public company and may be the result of either poor marketing, overpricing, or poor company fundamentals.

When an IPO is undersubscribed, underwriters may work to reduce the size of the issue, cut the share price, or pull the IPO offering altogether.

In some cases, as a result of contract terms with the issuing company, underwriters may be forced to “eat” the cost of the IPO and purchase remaining shares at a pre-agreed price themselves. This is generally an undesirable outcome for underwriters as it may force them to hold shares on their books rather than flip them to investors.

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Pros of Oversubscription

Oversubscription can be beneficial to both the issuer and underwriters of new securities, as well as to investors who manage to obtain an allocation of shares around the IPO price.

The issuing company can benefit, as the high demand for IPO shares allows the underwriting team to either reprice the IPO shares higher or offer up additional shares from company reserves to alleviate demand.

In either case, this results in additional funding for the issuing company at more favorable terms while the underwriter generates additional fees.

Early investors to an oversubscribed IPO may benefit from the initial pop in pricing that excitement can generate. This sometimes leads to positive momentum that may continue to push the price upward in the short run.

Cons of Oversubscription

For most average investors, oversubscription ends up being a net negative. First, it’s rare for individual investors to be able to subscribe to an IPO. Typically that’s reserved for large institutional or high-net-worth investors. Then, by the time the average investor can buy the stock, higher pricing may make the IPO opportunity less attractive — with the risk of being overinflated.

If you’re unable to obtain an allocation at the original IPO price, it’s likely that secondary market prices for these securities may be substantially higher due to the high demand for these shares.

While this may not be a concern for long-term investors, this can pose a challenge if initial momentum causes the price of a new security to skyrocket beyond its reasonable fundamental value. This can cause the value of shares to tumble back to lower levels in subsequent months.

This is one of many reasons that retail investors should be cautious about IPO shares. They are a high-risk proposition at best.

Strategies to Maximize the Oversubscription Opportunity

Even if you were one of the lucky few to obtain early IPO shares, there isn’t much you can do to capitalize on an oversubscription opportunity.

If you receive shares from an oversubscribed IPO, you will want to consider both the long-term prospects of the company as well as the short-term prospects for its share price.

Depending on the company and your investment strategy, this will influence whether you intend to hold the security for the long-run or flip the shares for a quick profit.

If you’re unable to obtain an allocation during an IPO, it’s likely that the oversubscribed IPO would see its shares bid up in the secondary market. In this case, it’s not a bad strategy to wait a few weeks, or even months, after the initial IPO to see whether prices come back down — and gauge the company’s prospects from there.

In some instances, shares often decline a few months later after the expiration of the initial lockup period, once insiders are free to sell their shares. However this isn’t always the case, and can vary widely from company to company.

Seek Advice From a Professional

If you’re allocated shares from an IPO and are unsure of what to do with your new holdings, it might be worth consulting with a financial advisor or investment advisor to determine your next steps.

Financial professionals can help inform your decision making on how to proceed with an oversubscribed IPO. However, the final decision will ultimately be up to you and should be made within the context of your overall investment portfolio.

Do Your Research

Regardless of whether you’re able to gain access to the IPO, you should base your investment decisions on your own due diligence and fundamental analysis, i.e. a thorough review of a company’s disclosures, financial statements, and future prospects.

Reviewing the track record of company executives and the board of directors can offer insight into how competent the company’s management may be when it comes to executing on long-term strategies.

Thoroughly reading the prospectus of the new IPO shares can help you understand the core drivers of a firm’s business, its core customer base, key markets, and major risks it might face.

Additionally, there’s a multitude of research out there that follows your stock’s performance on both fundamental and technical grounds; these can go a long-way towards informing your investment actions for new IPOs.

The Takeaway

Oversubscriptions for hot IPOs can sometimes offer opportunities for investors who are able to secure allocation of shares; however, they can also turn into feeding frenzies for retail investors who wish to buy these securities on the secondary market.

The resulting media blitz, and (typically) wide swings in valuations, can easily end with inexperienced investors getting burned on the share price. In short: IPOs can be volatile. To protect yourself, it’s important to understand the drivers of IPO pricing and how it impacts demand.

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

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

FAQ

What is the meaning of oversubscription?

Oversubscription, as it pertains to IPOs, refers to a supply and demand mismatch of the newly issued IPO shares. Either the price must adjust upward, the supply of shares issued must be increased, or a combination of the two must occur to meet investor demand.

In the event that the supply of IPO shares is unable to meet all investor orders, shares will typically be issued out to investors on a partial pro rata basis, or in proportion to each investor’s requested order size, subject to minimum block sizings.

In some instances, a lottery system may be implemented to maintain impartiality. Any unfilled orders will be rejected and cash returned to investors.

How can you calculate oversubscription?

At the basic level, IPO oversubscriptions are calculated as a ratio of the aggregate order size for IPO shares relative to the total number of IPO shares available to be distributed.

For example, if there are 1,000,000 shares of new stock available for an IPO pricing, but the underwriters receive an orderbook totaling 3,000,000 shares from investors, this IPO would be considered “3X oversubscribed.”

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

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

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

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Sep

2023

Pairs Trading Strategy 101: A Guide for Novice Investors

By Colin Dodds | Financial Independence, Growing Wealth, invest, Investing, Terminology | Comments Off

Pairs trading is a market-neutral trading tactic that allows investors to use the historical performance of stocks to place long and short bets to make big profits.

Pairs trading was first used in the mid-1980s as a way of using technical and statistical analysis as a way to find potential profits. It remained the province of Wall Street professionals until the internet opened online trading and real-time financial information to the public. Before long, there were seasoned amateur investors using pairs trades to make money, while managing their risk exposure.

What Is Pairs Trading?

Pairs trading is a day trading strategy in which an investor takes a long position and a short position in two securities that have shown a high historical correlation, but which have fallen momentarily out of sync.

The correlation between the two securities refers to the degree that two securities move in relation to one other. More specifically, correlation is a statistical measurement that measures the relationship between the historical performance of two securities.

It’s usually expressed as something called a “correlation coefficient.” This measure falls between -1.0 and +1.0, with negative 1 indicating that two securities move in exactly opposite ways. A correlation coefficient of positive one indicates that the two securities move up and down at exactly the same times under the same conditions.

What Types of Assets Are Traded in Pairs?

Numerous types of financial assets can be traded in pairs, and the list includes stocks, commodities, options, funds, and even currencies. In one sense, the asset or security at the heart of the trade is somewhat irrelevant, as traders are looking to take advantage of the difference in value (and thus, a different investment position) between the two. Again, the whole goal is to try and beat the average stock market return.

Often, though, pairs trading is discussed in relation to stocks, as that may be the asset class that most trading discussions revolve around.

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Pros and Cons of Pairs Trading

Pairs trading is something that most investors can take part in, assuming they know the risks of playing the market. That’s to say that there are pros and cons to pairs trading, and investors should review them before engaging in it.

Pros of Pairs Trading

The biggest pro to pairs trading is that there is the potential for profit, or at least bigger returns than investors may have otherwise generated by executing a different investing strategy. There’s also the potential to generate positive returns no matter what the overall market conditions are. Further, pairs trading may actually be a way to mitigate risk when investing in stocks, as there are only two trades involved, and in some ways, the mechanics of the trade setup can benefit the trader — but note that this is not to say that it’s a safe or risk-free strategy.

Cons of Pairs Trading

Cons of pairs trading include the possibility of the trading model failing due to faulty assumptions on the part of a trader — that is, historical correlation between two stocks may not mean that the correlation has continued. Traders should also know that pairs trading involves fast movements, and that there’s a chance trades may not execute at the desired time — this could stymie the strategy’s effectiveness. For traders, it may be worth looking at different stock exchanges and different investment platforms to get a sense of where the strategy may be the most effective.

It may also be helpful to understand the concept of stock volume in order to have a better chance of success with the strategy.

Pairs Trading Example

In a pairs trade, an investor will look for two separate securities that have a historically high correlation, but have fallen out of sync. If “stock Alpha” and “stock Beta” have historically risen and fallen in step, they’d have a very high correlation, maybe as high as positive of 0.95. But, for whatever reason, the two stocks have diverged, with Alpha racking up big gains, while Beta languished. That has knocked the short-term correlation coefficient between the two down to paltry 0.50.

This is the most common scenario for a pairs trade. In it, an investor will take a long position on stock Alpha, which has underperformed. At the same time, they’ll short stock Beta, which has outperformed. What they’re doing in a pairs trade is betting that the relationship between the two stocks will return to their historical norm, either by one security falling, the other one rising, or some combination of the two.

Pairs Trading Strategy: Market Neutral

Pairs trading is considered a “market-neutral” strategy. There are many of these strategies, which share a common aim to profit from both rising and falling security prices, while sidestepping the risks of the broader market.

Many hedge funds will employ market-neutral strategies, because they are paid based on their absolute returns. A common market-neutral trade may involve taking a 50% long and a 50% short position in one industry, sector or market. They usually do so to take advantage of pricing discrepancies within those areas. In addition to earning a return, their main goal is often to hedge out as much systematic risk as possible.

There are also market-neutral mutual funds, which can vary wildly in what they return investors, largely because there are so many market-neutral strategies, and ways to execute them. Interested investors may want to learn the fund’s particular approach to the strategy before jumping in.

How to Successfully Execute a Pairs Trade

For investors who are ready to incorporate pairs trading into their investment strategy, there are several steps they need to take in order to be successful.

Step One: Decide on Trading Criteria

The first step is to decide what securities to consider for the trade, and can be the most time-consuming in the entire process. This involves researching a vast array of possible investment pairs to find ones that have a historically high correlation coefficient but have since drifted apart. Then investors will want to build and test a model for those securities, using those results to arrive at the best possible buy-and-sell guidelines, as well as how long they intend to stay in a trade.

Step Two: Select Specific Securities

After the investor has settled on a process to select candidates for a pairs trade, it’s time to put that process into action and find securities that currently meet that criteria. Some investors may use manual research, while others prefer mathematical models. Regardless, investors need to think of how they want to use a pairs trade.

For investors who want to get in and out of a trade in a matter of hours or days, they’ll need to run their process to find possible trades on a regular basis. But investors whose trades will last for months won’t need to run their research as often.

Step Three: Execute the Trade

Once an investor has confirmed that a trade fits all their criteria, it’s time to execute the trade. With a pairs trade, there are small but important details to consider. For instance, most experienced pairs traders will execute the short side of the trade before making the long side.

Step Four: Manage the Trade

With the trade in place, the investor now has to wait and watch. This means sizing up the activity of the two securities in the trade to see if they’re approaching the criteria that would trigger one of the predetermined buy-and-sell rules. It also means watching the broader market, as well as any news that might have an impact on either security in the trade. Experienced traders will also constantly adjust the trade’s risk/return profile as markets shift and other news emerges.

Managing the trade is as important as setting it up. If a trader has a pairs trade they expect to last a month, but it reaches 50% of its profit objective in the first day after execution, what should they do? They may choose to close out of the trade that day, because the additional return isn’t worth the risk or the opportunity cost. But they also have other options. They might initiate a trailing stop loss level in the two positions as a way of locking in a portion of the profit. The decision isn’t easy, and may involve a host of other considerations.

Step Five: Close the Trade

The final step is to close the trade. But even this can come with questions and challenges, especially with trades that haven’t worked out, and whose predetermined durations are coming to an end. But it can also be the case with trades that have succeeded and are nearing their time limit. The urge to give a trade more time to turn around — or to do just a little better — has the potential to be the undoing of an otherwise successful trader.

That’s why experienced pairs traders often stress discipline as being as important as research, close monitoring and clear rules when it comes to earning consistent profits with the strategy.

History of Pairs Trading

Pairs trading is a somewhat higher-level trading strategy (though relatively simplistic at the same time), and it was actually first developed by technical analyst researchers at Morgan Stanley during the 1980s. Specifically, Nunzio Tartaglia led the charge, who ran the “quant” group at the firm.

It has since been adopted by traders and investors, big and small.

Investing With SoFi

Pairs trading is a trading strategy that involves the simultaneous purchase and sale of securities in anticipation of a price trend. The idea is that the two securities typically have shown a high historical correlation, but have fallen momentarily out of sync. The investor making the pairs trade is betting that the two stocks will return to their historical norm.

Pairs trading is merely one of many trading strategies, and like all others, it has its pros and cons. Prospective traders may benefit from a discussion with a financial professional before trying it out.

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FAQ

Is pairs trading still profitable?

Yes, pairs trading can be profitable, assuming a trader knows what they’re doing, and the risks involved with using the strategy. As always, there’s no guarantee that it will be profitable, however.

What are the risks of pairs trading?

Risks associated with a pairs trading strategy include the possibility of the trading model failing due to faulty assumptions on the part of a trader — that is, historical correlation between two stocks may not mean that the correlation has continued. Traders should also know that pairs trading involves fast movements, and that there’s a chance trades may not execute at the desired time.

How many pairs should a beginner trade?

It may be wise for a beginner to start with a single pair, until they get the gist or hang of the strategy.

Sep

2023

How to Use the Risk-Reward Ratio in Investing

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

In the investment world, a reward-to-risk ratio indicates how much money an investor stands to gain, against how much they’ll have to risk. For example, a reward-to-risk ratio of 6:1 means that for every dollar an investor stands to lose, they have the potential to gain $6.

The risk-reward ratio is a valuable analytical tool available to investors. Since no investment is genuinely risk-free, the risk-reward ratio helps calculate the potential outcomes of any investment transaction — good or bad.

What Is the Risk-Reward Ratio?

As noted, the reward-to-risk ratio indicates how much money an investor stands to gain levied against how much they’re risking in order to generate that potential gain. This can be particularly important for those with small portfolios, and it may be helpful to review tips on risk for new investors.

Typically, the more money one invests — such as in high-risk stocks — the more ample the reward if the investment turns out to be a winner. On that note, it may be beneficial to review a guide to high risk stocks, too. Conversely, the less risk you take with an investment, the less reward will likely be earned on the investment.

In addition, the investment itself directly impacts the risk-reward ratio. For example, if an individual parks his money in a savings account at a bank, the risk of losing that money is significantly low, as bank deposits are insured and there’s little chance the bank saver will lose any money on the deal.

In other words, using a savings account to accrue interest is a fairly safe investment.

Likewise, the potential reward for parking cash in a bank savings account is also low. Bank savings accounts offer routinely low interest rates earned on insured bank deposits, meaning the individual will likely earn little in interest on the deposit. If savings accounts were somewhere on an investment risk pyramid, they’d be among other relatively safe investments — low risk, but low potential returns.

Compare that scenario to a stock market investor, who has no guarantees that the money she steers into a stock transaction will be intact in the future. It’s even possible the stock market investor will lose all of her investment principal if the stock turns sour and loses significant value.

Correspondingly, this investor is presumably looking at a greater reward for the risk taken when buying a stock. If the stock climbs in value, the investor is rewarded for the risk she took with the investment, as she’ll likely earn significantly more money on the stock deal than the bank saver will make on the interest earned on his bank deposit.

💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

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How To Calculate Risk-Reward Ratio

The reward-to-risk ratio formula is a fairly straightforward calculation, and involves following a formula.

Risk-Reward Ratio Formula

To calculate risk-reward ratio, divide net profits (which represent the reward) by the cost of the investment’s maximum risk.

For instance, for a risk-reward ratio of 1:3, the investor risks $1 to hopefully gain $3 in profit. For a 1:4 risk-reward ratio, an investor is risking $1 to potentially make $4.

Example of a Risk-Reward Ratio Calculation

Let’s say an investor is weighing the purchase of a stock selling at $100 per share and the consensus analyst outlook has the stock price topping out at $115 per share with an expected downside bottom of $95 per share.

The investor makes the trade, hoping the stock will rise to 115, but hedges his investment by putting in a “stop-loss” order at $95, ensuring his investment will do no worse by automatically selling out at $95. The investor can also lock in a profit by instructing the broker to automatically sell the stock once it reaches its perceived apex of $115 per share.

As an aside: A stop loss order is a type of market order in which the order that is placed with a stockbroker to buy or sell a specific stock once that security reaches a predetermined price level. The mechanism is specifically designed to place a limit on an investor’s stock position.

In this scenario, the “risk” figure in the equation is $5 — the total amount of money that can be lost if the stock declines and is automatically sold out at $95 (i.e., $100 minus $95 = $5).

The “reward” figure is $15. That’s the amount of per-share money the investor will earn once the share price rises from buying the stock at $100 per share and selling it if and when the stock rises to $115 per share.

Thus, with an expected risk of 5 and an expected reward of 15, the actual risk reward ratio is 1:3 — the potential to lose $5 in order to gain $15.

Pros and Cons of the Risk-Reward Ratio

There are pros and cons to using the risk-reward ratio when investing.

As for the upsides, it’s a relatively simple formula and calculation that can help investors get a sense of whether their strategy makes sense. In that sense, it can be very useful with some basic risk management when tinkering with a portfolio.

On the other hand, it’s a relatively simple formula and calculation that may not be terribly accurate, and doesn’t necessarily deliver a whole lot of additional insight into a strategy. That’s something investors should take to heart, and why they may not want to only rely on risk-reward ratio to guide their overall strategy.

Recommended: Guide to Risk Neutral Probability

Three Risk-and-Reward Investor Types

Investors have their own comfort levels when assessing risk and reward ratios with their portfolios, with some proceeding cautiously, some taking a moderate dose of investment risk, and still others taking on more risk by investing aggressively on a regular basis.

The investment portfolios you build, either by yourself or with the help of a money management professional, reflect your personal risk tolerance.

Typically, there are three different types of investor when it comes to risk:

• Conservative investors. These investors focus on low-risk, low-reward investments like cash, bonds, bond funds, and large-company stocks or stock funds.

• Moderate investors. These investors look for a blend of risk and reward when constructing their investment portfolios, putting money into lower-risk investment vehicles like bonds, bond funds, and large-company stocks and funds with more broadly based categories like value and/or growth stocks and funds, international stocks, and funds, along with a small slice of alternative funds and investments like real estate, commodities, and stock options and futures.

• Aggressive investors. This type of investor may completely bypass conservative investments and elect to fill his investment portfolio with higher-risk stocks and funds (like overseas stocks or small company stocks), along with higher-risk assets like gold and oil (commodities), stock options and futures, and more.

Each of the above investors recognizes the realities of risk and the potential of reward and balances them in different ways. Even conservative investors will accept a little risk to gain some reward.

For example, a conservative investor may invest in a corporate bond or municipal bond, knowing that in return for a guaranteed profit (in the form of paid interest) and upside asset protection (the bond’s principal being repaid), she takes on the small risk that the bond will default, and the principal and interest on the bond disappears.

An aggressive investor understands that by placing money in a high-risk stock, he is potentially risking some or all of his investment if the stock goes under, or significantly underperforms. In return for that risk, the more aggressive investor may reap the financial rewards of a booming stock price and a resulting major return on his investment.

In either scenario, the investor gauges the risk reward ratio and acts accordingly, betting that the outcome will work out in their favor, and that the risk outweighs the reward.

By not acting at all, and taking both risk and reward out of the equation, the investor won’t see their investment portfolio appreciate in value, and risk losing ground as economic realities like inflation, taxes, and stagnation eat into their wealth.

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

Investing With SoFi

The risk-reward ratio is helpful in allowing investors to get an idea of how much they stand to gain versus how much they stand to lose in a given investment situation. Any risk-reward engagement depends on the quality of the research undertaken by the investor and/or a professional money management specialist.

That research should set the proper expected parameters of the risk (i.e., the money the investor can lose) and the reward (i.e., the expected portfolio gain the investment can make.) Once the risk and reward boundaries are set, the investor can weigh the potential outcomes of the investment scenario and make the decision to go forward (or not) with the investment.

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

FAQ

What is a good risk-reward ratio?

Generally speaking, a good risk-reward ratio is one that skews toward reward, rather than risk. If the ratio is calculated, a ratio below 1 is better, as it indicates that an investment has a bigger potential reward compared to risk.

What is a poor risk-reward ratio?

A poor risk-reward ratio would be one that is higher or greater than 1, as that would indicate that an investment involves more risk relative to the potential reward.

What are some things that the risk-reward ratio doesn’t take into account?

The risk-reward ratio doesn’t take several factors into account, and some of those include external and current events, market volatility, and liquidity in the markets.