What Is a Market Maker?

Market makers are trading firms that continuously provide prices at which they will buy or sell assets.

Market makers are typically banks, brokerage firms or proprietary trading firms. Unlike traditional investors, they’re not in the business of betting whether the price of an asset will go up or down. They also don’t tend to hang on to securities for very long. Instead, market makers profit off the tiny price spreads that come from buying and selling securities rapidly.

Because they stand ready to do both sides of a trade, market makers are considered to be liquidity providers. Liquidity is the ease with which an asset can be bought or sold without affecting its price.

How Market Makers Work

In both stock and equity options trading, there are at least a dozen different exchanges. In order to provide prices across multiple exchanges, market makers rely on algorithms and ultra-fast computer systems to make sure their price quotes reflect the supply and demand for a security in the market.

Because of their use of such technology, market makers are sometimes called high-frequency traders. Here’s a closer look at the role market makers play in financial markets today.


💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

How Market Makers Earn Money

Market makers seek to profit off the difference in the bid-ask spread, or the difference between the price at which an asset can be bought and the price at which it can be sold.

Overview of Bid-Ask Spreads

Here’s a hypothetical example of how market making works. Let’s say a firm provides a quote for $10-$10.05, 100×200. That means they’re willing to buy 100 shares for $10, while simultaneously offering to sell 200 shares at the price of $10.05. The first part of the offer is known as the bid, while the latter is known as the ask. The prices that market makers set are determined by supply and demand in the market.

This means an investor or broker executing on behalf of a client can buy shares from the market maker at $10.05. And another investor looking to sell shares, can do so at $10 to this market maker. The difference of 5 cents is how the market maker locks in a profit. While making pennies on each trade sounds miniscule, it can be massively profitable at huge volumes.

Bid-ask stock spreads tend to narrow when markets are more liquid and widen when markets are less liquid. This is because during periods of volatility, sellers are more inclined to sell while buyers are more likely to stay put, anticipating lower prices in the near future. Because bid-ask spreads tend to widen during periods of stock volatility, it also means market makers are able to capture bigger profits when markets are turbulent.

Because of the risk of holding onto securities while making markets on them, market makers often hedge their bets by getting exposure to other assets or shorting securities in separate trades.

Overview of Payment for Order Flow

Another way some market makers earn revenue is through a practice known as payment for order flow. This is when retail brokerage firms send retail client orders to market makers who then execute the orders.

So let’s say for example, a mom-and-pop investor at home puts in a buy or sell trade via their brokerage account. The broker then bundles that order with other client orders and sends them to an electronic market making firm, which then fulfills the orders.

Recommended: Brokerage Accounts Explained

Market makers pay fees to brokerage firms for sending those orders, and this is how brokerage firms have been able to offer zero-commission trading to retail clients in recent years.

Payment for order is common and legal, but it’s come under controversy over the years with some critics saying the practice incentivizes brokers to boost revenue, rather than find the best prices for their customers. Market makers are required by regulatory rules to execute client orders with “best execution, “ but execution quality can be defined by price, speed or liquidity.

Defenders of PFOF argue that retail investors get “price improvement,” when customers get a better price than they would on a public stock exchange. A Bloomberg Intelligence report estimated that retail investors in 2020 benefited from price improvement by $3.7 billion. Separately, brokers are required by Securities and Exchange Commission regulation to make available statistics on execution quality, in what’s known as 605 and 606 disclosures.

What Are Designated Market Makers (DMMs)?

Designated market makers are trading firms on the New York Stock Exchange who are in charge of ensuring orderly trading of stocks listed on the New York Stock Exchange. Each company that chooses to list on the Big Board picks a DMM for its shares.

DMMs are supposed to add a human touch to stock exchange trading in today’s electronic markets. In contrast, the Nasdaq Stock Exchange, the second-biggest venue for U.S. equities, doesn’t have DMMs for its listed companies and trading is instead completely electronic.

Famous for wearing distinctive blue-colored jackets on the floor of the NYSE, DMMs used to be known as “specialists” back in the day. There used to be dozens of specialist firms in the 1980s, but these days there are just a handful of DMMs active on the NYSE floor.

The Takeaway

Market makers are intermediaries who provide prices all day in two-sided markets, where both bids to buy and offers to sell are quoted. Instead of making long-term bets on whether an asset will rise or fall, they make money from holding on to assets for short periods and profiting off their tiny bid-ask spreads. Market makers rely on high volumes in order to generate significant revenue.

Market makers are also sometimes called high-frequency traders because they use ultra-fast technology and algorithms to connect to multiple exchanges and quote numerous prices continuously. They’re considered important participants in modern financial markets because they speed up the pace at which transactions take place, particularly in stock and equity options trading.

On the SoFi Invest® online brokerage app, users can buy and sell stocks, exchange-traded funds (ETFs) or fractional shares. SoFi Securities LLC (Active Investing) earns a small amount of money from market makers–a process that allows users to trade without commission fees. For users who choose the Automated Investing service, SoFi will build and manage their portfolios for them and charge no management fees.

Check out SoFi Invest today.



SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Stock Bits
Stock Bits is a brand name of the fractional trading program offered by SoFi Securities LLC. When making a fractional trade, you are granting SoFi Securities discretion to determine the time and price of the trade. Fractional trades will be executed in our next trading window, which may be several hours or days after placing an order. The execution price may be higher or lower than it was at the time the order was placed.

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

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Intrinsic Value vs Market Value, Explained

Intrinsic value vs. market value refers to the difference between where a stock is currently trading and where it perhaps ought to be, according to its fundamentals. The term “market value” simply refers to the current market price of a security. Intrinsic value represents the price at which investors believe the security should be trading at. Intrinsic value is also known as “fair market value” or simply “fair value.”

When it comes to value vs. growth stocks, value investors look for companies that are out of favor and below their intrinsic value. The idea is that sooner or later stocks return to their intrinsic value. That’s why it can be important to understand the differences and help it inform your strategy.

What Is Market Value?

In a sense, there is only one measure of market value: what price the market assigns to a stock, based on existing demand.

Market value tends to be influenced by public sentiment and macroeconomic factors. Fear and greed are the primary emotions that drive markets. During a stock market crash, for example, fear may grip investors and the market value of many stocks could fall well below their fair market values.

News headlines can drive stock prices above or below their intrinsic value. After reading a company’s annual report that’s positive, investors may pile into a stock. Even though better-than-expected earnings might increase the intrinsic value of a stock to a certain degree, investors can get greedy in the short-term and create overextended gains in the stock price.

The rationale behind value vs price, and behind value investing as a whole, is that stocks tend to overshoot their fair market value to the upside or the downside.

When this leads to a stock being oversold, the idea is that investors could take advantage of the buying opportunity. It’s assumed that the stock will then eventually rise to its intrinsic value.


💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

What Is Intrinsic Value?

The factors that can be used to determine intrinsic value are related to the fundamental operations of a company. It can be tricky to figure out how to evaluate a stock. Depending on which factors they examine and how they interpret them, analysts can come to different conclusions about the intrinsic value of a stock.

It’s not easy to come to a reasonable estimation of a company’s valuation. Some of the variables involved have no direct physical, measurable counterpart, like intangible assets. Intangible assets include things like copyrights, patents, reputation, consumer loyalty, and so on. Analysts come to their own conclusions when trying to assign a value to these assets.

Tangible assets include things like cash reserves, corporate bonds, equipment, land, manufacturing capacity, etc. These tend to be easier to value because they can be assigned a numerical value in dollar terms. Things like the company’s business plan, financial statements, and balance sheet have a tangible aspect in that they are objective documents.


💡 Quick Tip: Newbie investors may be tempted to buy into the market based on recent news headlines or other types of hype. That’s rarely a good idea. Making good choices shouldn’t stem from strong emotions, but a solid investment strategy.

Calculating Intrinsic Value vs Market Value

There can be multiple different ways to determine the intrinsic value of an asset. These methods are broadly referred to as valuation methods, or using fundamental analysis on stocks or other securities. The methods vary according to the type of asset and how an investor chooses to look at that asset.

Calculating Intrinsic Value

For dividend-yielding stocks, for example, the dividend discount model provides a mathematical formula that aims to find the intrinsic value of a stock based on its dividend growth over a certain period of time. Dividends are periodic income given to shareholders by a company.

Upon calculating the dividend discount model, an investor could then compare the answer to the current market value of a stock. If market value were to be lower, then the stock could be seen as undervalued and a good buy. If market value were to be higher, then the stock could be seen as overvalued and not worth buying or possibly an opportunity to sell short.

Another method for estimating intrinsic value is discounted cash flow analysis. This method attempts to determine the value of an investment in terms of its projected future cash flows.

While the dividend discount model and discounted cash flow analysis can be seen as objective ways to determine a stock’s value, they also have a large subjective component. Analysts must choose a timeframe to use in their model. Using different timeframes can lead to different conclusions.

Longer timeframes are often thought of as being more accurate because they include more data points. But they could also dilute the significance of more recent trends.

Example Using Dividend Discount Model

For example, if a company had years of steady dividend growth, but recently slashed its dividend by 50%, a dividend discount model analysis based on a long timeframe would show this reduction in dividend payments to be less severe than an analysis based on a shorter time frame.

The longer timeframe would include previous years of dividend growth, which would theoretically outweigh the recent reduction.

The reduction may have come from a large decrease in earnings. If that trend were to continue, the company could be doomed to the point of having to suspend its dividends. So in this hypothetical example, a shorter time frame could actually lead to a more realistic conclusion than a longer one.

Calculating Market Value

The determination of market value is rather simple by comparison. Someone can either simply look at what price a stock is trading at or calculate its current market capitalization. The formula for market capitalization or market cap is:

Total number of outstanding shares multiplied by the current stock price.

Dividing market cap by number of shares also leads to the current stock price.

Sometimes companies engage in “corporate stock buybacks,” whereby they purchase their own shares, which reduces the total number of shares available on the market.

This increases the price of a stock without any fundamental, tangible change taking place. Value investors might say that stocks pumped up by share buybacks are overvalued. This process can lead to extreme valuations in stocks, as can extended periods of market euphoria.

The Takeaway

Intrinsic value and market value describe the values of a security as they’re currently trading versus where their underlying fundamentals suggest they should be trading. Using the intrinsic value vs market value method is likely best suited to a long-term buy-and-hold strategy.

Stock prices can remain elevated or depressed for long periods of time depending on market conditions. Even if an investor’s analysis is spot on, there’s no way to know for sure exactly when any stock will return to its intrinsic value. That’s critical to understand if you hope to utilize intrinsic value vs market value in your own investing strategy.

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


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


SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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

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

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What Are Leveraged ETFs?

Leveraged exchange-traded funds (ETFs) are tradable funds that allow investors to make magnified bets on an underlying index. Leveraged ETFs have been popular among investors looking to amplify their exposure to a market with a single trade. But they have their risks, like all investments.

Because of how they augment price swings, leveraged ETFs can cause massive losses. And for reasons related to their inner mechanics, they’re not good at delivering sizable returns when held for an extended time. That means investors may not see the returns they expect.

How Do Leveraged ETFs Work?

Exchange-traded funds, or ETFs, are securities, but themselves are a form of index investing. They’re typically baskets of stocks, bonds or other assets that aim to mirror the moves of an index, though ETFs can have many different aims or goals. Leveraged ETFs use derivatives so that investors can double (2x), triple (3x) or short (-1) the daily gains or losses of the index. Financial derivatives are contracts whose prices are reliant on an underlying asset.

In finance, leverage is the practice of using borrowed money to increase the potential return on an investment. Leveraged ETFs use derivatives to increase the potential return on an investment.

Let’s look at a hypothetical example. Say an investor buys a regular, non-leveraged ETF. Here’s how such an ETF would work. If it tracks the S&P 500 Index and the benchmark gauge rises 1% on a given day, the non-leveraged ETF would also climb about 1%.

If, however, the investor buys a triple leveraged ETF or 3x ETF, their return for that given trading day could be a 3% gain. The reverse scenario could also happen, though. If the S&P 500 fell 1% on a given day, the owner of the triple leveraged ETF can suffer a 3% loss.


💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

What Is ‘Decay’ in Leveraged ETFs?

There are pros and cons to ETFs themselves. But leveraged ETFs can be particularly problematic for investors due to their design. They are constructed to deliver multiples of an underlying asset’s daily returns, not weekly, monthly or annual returns. Leveraged ETFs don’t deliver the exact magnitude of 2x or 3x if held for longer than a day.

So, if the S&P 500 were to rise 5% in a week, a triple leveraged S&P 500 would not climb 15% in that week. The same would be true for a double leveraged ETF. There’s no guarantee it would return 2x or 10% to its owner.

That’s because of how leveraged ETFs are constructed. In order to maintain their 2x or 3x exposure, leveraged ETFs use derivatives that need to be rebalanced at the end of each day. This process can erode the returns of the ETFs — a process known as “decay” in the market.

Types of Leveraged ETFs

1.    Double Leveraged (2x) ETFs give investors double exposure to the daily return of an index of stocks, bonds, or commodities. So if an asset or market moves 1.5% in a single day, the fund aims to deliver a return of 3% that day.

2.    Triple Leveraged (3x) ETFs try to provide investors with 3x amplification. So if the underlying asset or index rises or falls 2% on a trading day, the ETF seeks to rise or fall 6%.

3.    Inverse (-1) ETFs are also considered to be leveraged ETFs. They move in the opposite direction of the underlying asset they’re designed to follow. So if an index moves -1%, the ETF would aim to climb 1%, and vice versa. Inverse ETFs are essentially a form of shorting a stock. Investors are able to short the underlying market by buying shares of an inverse ETF.

Pros of Leveraged ETFs

Easy Leveraged Trades

Leveraged ETFs have made it easier for investors to make leveraged wagers on the market, which can be a day-trading strategy but not a practice that’s readily available to all investors, particularly retail investors at home who may be trading in smaller increments.

Useful For Quick Leveraged Market Wagers

Leveraged ETFs can be useful for a one-day wager that an investor wants to make on an underlying market, such as technology stocks, high-yield bonds, or emerging markets.

Allow For Easy Shorting

Inverse ETFs can give investors the ability to short, or bet against, an asset. Short sales aren’t easily available to non-professional investors, particularly retail investors at home. Shorting can be a way for investors to hedge or offset the risk in their holdings.

Cons of Leveraged ETFs

Potential For Outsized Losses

With leveraged ETFs, investors could potentially see outsized losses due to how the products compound returns. For instance, if an index were to tumble 3% in a single day, a holder of leveraged ETFs would experience a plunge of 9% in the shares of their fund.

Rebalancing Needs

Because of how they’re constructed, leveraged ETFs need to be rebalanced daily. This process can cause what’s known as “decay” in the fund, when the performance veers from the underlying asset’s returns. This means investors may not see the 2x or 3x returns if the leveraged ETF is held for longer than a single trading session.

Increased Investment Risk

Inverse ETFs allow investors to short assets, but because of how there’s no limit to how high an asset can go, that means investors could see their holdings in the inverse ETF go to zero.

Derivative Risks

Leveraged ETFs use derivatives to achieve their amplified returns. Therefore, investors should be aware of the counterparty risk — or the risk from the other parties involved in the derivatives.

Higher Costs

Leveraged ETFs tend to be more expensive than traditional ETFs. Investors who want to understand how fund fees work should look at the ETF’s expense ratio. For instance, some popular leveraged ETFs can have an expense ratio of 0.95%. That compares with more traditional ETFs, which can have an expense ratio of around 0.20%.

Closure Risks

There’s a high risk of closure. Investors who don’t sell out of their leveraged ETF shares before the delisting date could be left with positions that are difficult or costly to liquidate.


💡 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.

Regulation of Leveraged ETFs

Regulators’ rules on leveraged ETFs have varied in recent years. And they continue to change. In early 2023, the Securities and Exchange Commission (SEC) issued a bulletin about leveraged ETFs, warning investors about the particular risks associated with them.

In October 2020, the SEC made a rule change that would make it easier to launch leveraged ETFs, while capping the amount of leverage at 200%. The move was a break away from prior announcements that sought to slow down the creation of new leveraged ETFs. The SEC had previously allowed existing leveraged ETFs to be continued to be traded, while putting restrictions on the approval of new such funds. The SEC issued an alert about leveraged funds to retail investors in 2009.

In May 2017, the SEC approved the first quadruple (4x) leveraged ETF, only to halt its decision soon after.

Some investment firms and ETF providers have pushed for the term “ETF” to not be applied to leveraged and inverse funds. They argue that the term “ETF” is used for a range of products that can lead to significantly different outcomes for investors.

The Takeaway

Leveraged ETFs use derivatives in their construction to try to deliver amplified returns for an investor. Relative to index funds, ETFs can allow entire markets to be more easily traded, similar to how shares of a stock are traded. Leveraged ETFs are not safe for all investors, particularly inexperienced ones.

These ETFs can cause massive losses because of how they magnify returns. In addition, market observers and regulators have said that leveraged ETFs may be better suited for professional or experienced investors to be used within a single trading session. The use of derivatives in such funds causes their performance to veer from the underlying market if the ETFs are bought and held. As always, it’s important to do your research about any ETF or investment before investing.

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


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


SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at [email protected]. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.


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

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How Does Magic Formula Investing Work?

Magic formula investing is a rules-based investing strategy developed by hedge fund manager and professor Joel Greenblatt. First outlined in his book, “The Little Book That Beats the Market,” the magic formula investing strategy takes a simplified approach to choosing investments that virtually any investor can apply.

It draws on principles of value investing to create portfolios with the potential to outperform the market. For interested investors, knowing the ins and outs of the strategy before applying it is important.

What Is Magic Formula Investing?

At its core, Greenblatt’s magic investing formula focuses on finding good companies to invest in that are trading at attractive prices. Specifically, this strategy focuses on two things: Stock price, and the cost of capital.

The magic formula helps investors find or pinpoint companies that they deem undervalued by the market, and that are likely to offer a high return on their invested capital. It shares some similarities with value investing, which emphasizes finding the “hidden gems” that trade below their intrinsic value.

Value investors often follow a buy-and-hold strategy, in which securities are purchased with the intent to hold them long-term. The idea is that even though the market may have undervalued a company, it could grow in value over time and result in higher returns once an investor decides to sell.

This strategy utilizes fundamental analysis, which involves looking at things like revenue and earnings, and calculating return on equity to measure a company’s financial health.

The difference between a buy and hold strategy and magic formula investing is that fundamental analysis doesn’t come into play. Instead, the formula relies on Greenblatt’s stock-screening method to identify the most promising stocks to invest in.


💡 Quick Tip: How do you decide if a certain trading platform or app is right for you? Ideally, the investment platform you choose offers the features that you need for your investment goals or strategy, e.g., an easy-to-use interface, data analysis, educational tools.

What Is the Magic Investing Formula?

Screening stocks using the magic formula method is based on a rankings system. As developed by Greenblatt, this system uses three distinct criteria to rank companies: earnings before interest and taxes (EBIT), earnings per share, and return on capital.

Earnings Before Interest and Taxes (EBIT)

This is one way to measure a company’s profitability. This figure represents the net income of a company before income tax expense and interest expenses are deducted. To calculate a company’s EBIT, you’d subtract income tax expense and interest expenses from its revenue.

Earnings Per Share (EPS)

EPS is another measure of profitability, though it’s calculated differently than EBIT. With EPS, you divide a company’s net profit by the total number of common shares of stock it has outstanding. This is also a way to measure a company’s value, since EPS can tell you roughly how much money it makes per share of stock. A higher EPS may suggest higher value and a willingness for investors to pay more for shares of a company’s stock.

Return on Capital

Return on capital measures how well a company is able to allocate its capital to investments that are profitable. To figure out this number, you’d subtract dividends from net income, then divide that by the sum total of the company’s debt and equity.

By applying EBIT, EPS, and return on capital, the magic formula method is intended to determine the best quality companies at the best price.

How Magic Formula Investing Works

For investors interested in using the magic investing formula to build a portfolio, there’s a specific sequence of steps to follow that Greenblatt outlines.

1. Set a Market Capitalization Threshold

Market capitalization (commonly known as market cap) represents the current number of shares of stock a company has outstanding multiplied by the price per share. Companies can be categorized as small-cap, mid-cap or large-cap, based on their market capitalization.

For magic formula investing, an investor will typically start by excluding any companies with a market capitalization below $100 million. But one could set this number higher or lower, depending on personal preferences. Greenblatt advocates setting the threshold at $1 billion (which means large-cap) to minimize volatility.

2. Exclude Certain Securities

In magic formula investing, an investor next needs to eliminate several categories of investments. Those include stocks in the financials and utilities sectors, as well as foreign companies and American Depositary Receipts (ADRs). An ADR offers a way to indirectly own foreign companies that aren’t traded on U.S. stock exchanges.

3. Make the Necessary Calculations

Once an investor has narrowed down their list of companies, they can start running the numbers. Specifically, this means calculating:

•   Earnings before interest and taxes (EBIT)

•   Earnings yield (EBIT divided by enterprise value, which is a company’s total value as measured by its market capitalization plus total debt minus its cash assets)

•   Return on capital (EBIT divided by the sum total of net fixed assets and working capital)

4. Create Your Rankings

After doing the above math, an investor can move on to ranking companies according to the magic formula — from highest earnings yield and highest return on capital to lowest. From this point on, one would focus on the top 20 to 30 companies when choosing how to invest.

5. Start Building Your Portfolio

Greenblatt suggests buying the stocks that rank in that top 20-30 list on a rolling basis. For instance, an investor would buy two to three positions per month for one year, eventually owning 24 to 36 of the top ranking companies. According to Greenblatt’s formula, owning at least 20 different companies will help to maintain diversification.

At the end of the 12-month period, the magic formula dictates that investors would sell off the losing stocks and the winners, being mindful of capital gains taxes rules. Then they’d start the cycle over again, using the magic formula rules to select a new crop of stocks to invest in.

Holding stocks for a year before selling at a gain or loss is intended to help maximize your after-tax returns. When you sell stocks at a profit that you’ve held longer than one year you’d be subject to the more favorable long-term capital gains tax rate.


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

Magic Formula Investing Results

Any time one is considering an investment strategy, it’s important to look at how well it works when it comes to generating returns. Greenblatt’s approach is intended to help investors choose companies whose performance can potentially beat the market. And according to him, it has helped generate a 30% annual rate of return for investors who use the strategy, which is well above the typical return generated by the S&P 500.

There’s no guarantee that investors will see a positive return utilizing the strategy for any given year, however.

Whether investors can replicate those magic formula investing results for themselves can depend on different variables. For example, an individual portfolio may produce a very different return profile if an investor adjusts the market capitalization threshold up or down. Or if a company has an above-average year for revenue and profits, that could affect how the ranking calculations shake out.

Pros and Cons of Magic Formula Investing

The main idea behind the magic formula method is that it’s a simple enough strategy for even beginner investors to use. The idea is that by following the formula, an investor can eliminate some of the noise when making investment decisions.

That includes not giving in to investment biases that could prompt an investor to buy or sell at the wrong time. By focusing on the rankings and sticking with a one-year rolling schedule of buying and then selling, an investor can potentially remove their emotions from the equation. This can help avoid selling off stocks in a panic if the market becomes more volatile.

Downsides of Magic Formula Investing

While this formula can help an investor create a diversified portfolio, it’s still exclusionary in that it doesn’t include investing in foreign companies or companies in the financials and utilities sectors.

Beyond that, there’s no certainty that an investor will see positive magic formula investing results in the form of above-average returns — as noted. Greenblatt himself says that there’s nothing “magical” about the formula and that it shouldn’t be considered a guarantee of investment returns or performance. As with any investing strategy, it isn’t foolproof.

Finally, the magic formula investing strategy is meant to be a long-term one. For investors more interested in seeing quick results versus adopting a buy and hold mindset, day trading might be more appropriate.

The Takeaway

Hedge fund manager and professor Joel Greenblatt devised his magic formula investing strategy as a way to invest in a curated group of good companies with high potential for returns. The system ranks companies according to three criteria: earnings before interest and taxes (EBIT), earnings per share, and return on capital. The system is simple enough that it’s intended for anyone from first-time investors to more seasoned investors.

But as with any investment strategy, there is no guarantee that the magic formula investing results will be positive every time. There is a potential for both gains and losses.

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


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


SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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

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

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What Is a Straddle in Options Trading?

A straddle is an options trade with which investors can profit regardless of which direction an asset moves. Because of this, a straddle is considered a “neutral options strategy.”

Long straddles are used when an investor expects greater volatility in an underlying asset. They involve buying a call option and put option simultaneously. Short straddles are used when an investor expects little movement in an asset. They involve selling a call and a put at the same time. It’s important to keep in mind that straddles are a complex options strategy that aren’t suitable for most investors.

Understanding Puts and Calls

A call option gives investors the right, but not the obligation, to buy an asset. A put option versus a call gives the right to sell. A seller of a call is obligated to deliver the underlying asset if the buyer exercises the contract. Meanwhile, a seller of a put is obligated to buy the underlying asset if the contract is exercised.

Long straddles are popular when investors anticipate an event will significantly move a stock’s price, such as after a company’s earnings or big product announcement. On the flip side, short straddles are common when investors think volatility expectations are too high, meaning that share prices will move sideways or only change slightly.


💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.

How to Put on a Straddle Trade

In options trading, an investor can put on a straddle in two ways: 1) They can buy a call option and put option. Both contracts need to have the same strike price and expiration date. Or 2) They can sell a call and put option that both have the same strike price and expiration date.

In options terminology, the strike price is the level at which the options contract can be exercised. For instance, say a stock is trading at $10 a share and a call option on it has a strike price of $12. If the stock reaches $12, the investor has the right, but not the obligation, to exercise the option.

An option’s expiration date is the date by which the call or put must be exercised. So an investor has until the expiry to exercise the option by buying or selling the underlying asset. After that date, the options become worthless. Another important term for options investors is the premium. This is the value or cost of the option itself.

Examples of Straddles

The two types of straddles discussed here are the long straddle and the short straddle. These are just two of many different options trading strategies.

In a long straddle, the move in the underlying asset needs to exceed the cost of the two premiums — one for the call, one for the put — in order for the investor to break even on the trade. The cost of the two premiums is the maximum amount of money the investor can lose. In a short straddle, the cost of the two premiums is the maximum amount the investor can earn from the trade.

Long Straddle Example

Let’s say an investor believes Company A will either soar or plummet after releasing its quarterly earnings call. Company A’s shares currently trade in the market at $50 each.

In order to put on a long straddle, the investor pays $2 for a call contract and $2 for a put contract for a total cost of $4. Both contracts have a strike price at $50. The total cost for the investor will be $400, since each options contract equals 100 shares of stock.

So in order for the investor to break even on the trade, the stock will have to either rise above $54 a share or fall below $46. That’s because $50 plus $4 is $54, while $50 minus $4 is $46. Here is the formula to calculate the breakeven levels in long straddles:

Upper breakeven level = Strike price + Total cost of options premiums

Lower breakeven level = Strike price – Total cost of options premiums

Short Straddle Example

In a short straddle trade, the investor sells a call and put that have the same strike price and expiration. An investor might do this when they believe the market’s expectations for volatility in a stock are too high.

Say for instance, the implied volatility for Company B has climbed substantially. Implied volatility is the market’s expectations for volatility in an asset. In other words, the market believes Company B will see a big stock move after making a product announcement.

However, one investor thinks these expectations are inflated. If the stock’s move after the announcement is actually muted, the value of both the calls and puts would drop quickly. Meanwhile, the short-straddle investor has benefited by having collected the premiums from selling the options.

However, the potential investment risks of a short straddle trade are high, because the underlying asset’s potential to climb higher is unlimited and an investor may have to pay the market price to cover the short call.

Pros & Cons of Straddles

Pros of Straddles

1.    Market neutral: Investors can benefit from an options trade even if they’re uncertain which direction the underlying asset will move.

2.    Premiums costs: With long straddles, the cost of premiums could be relatively low. Say for instance an investor finds a stock that they believe will see high volatility. Meanwhile, the cost of the calls and puts are not yet too expensive. The investor can potentially make a profit from this long straddle trade.

3.    Volatility bet: With long straddles, investors can make money when an asset’s stock volatility is high.

Cons of Straddles

1.    Pricey premiums: It can be tricky to get market timing right. When implied or expected volatility for an asset is high, the price of options premiums can also rise. This means investors looking to put on a long straddle trade can encounter costlier premiums. Plus, with long straddles, investors have to pay the cost of two premiums.

2.    Time decay: Options lose value as they get closer to their expiration date — a concept known as theta or time decay in the derivatives market. Time decay may become a concern if market volatility is low for a while and an investor is trying to exercise a long straddle position.

3.    Potential losses: In a short straddle, the potential loss is unlimited while the potential upside is limited.



💡 Quick Tip: If you’re an experienced investor and bullish about a stock, buying call options (rather than the stock itself) can allow you to take the same position, with less cash outlay. It is possible to lose money trading options, if the price moves against you.

Straddles vs Strangles

In contrast to a straddle, a long strangle involves buying both calls and puts but with different strike prices.

Strangles are more common when investors believe a stock is more likely to move in one direction, but still want to hold some protection in case the opposite scenario occurs.

The advantage of a strangle is that the costs of putting them on are typically lower than straddles.

The Takeaway

An options straddle is essentially a two-trade bundle that’s designed to allow investors to wager whether there will be a major move in an asset’s price or not.

In a long straddle, investors have the potential to capture a significant profit while having paid only a relatively low cost for the options premiums. However, If the stock trades sideways or doesn’t post a big move, the investor will lose the money they invested in the premiums. In a short straddle, the opposite is true. If the underlying asset doesn’t post a big move, the investor can make money.

Qualified investors who are ready to try their hand at options trading, despite the risks involved, might consider checking out SoFi’s options trading platform. The platform’s user-friendly design allows investors to trade through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.

Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors.


With SoFi, user-friendly options trading is finally here.


SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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