Mar
29
2024
Price-to-Earnings (P/E) Ratio, Explained
What is a good price to earnings ratio? An exploration into the popular stock analysis tool.
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Mar
22
2024
Understanding Market Sentiment
Market sentiment concerns a complicated blend of thoughts, feelings, and actions, all of which have an effect on stock prices and markets. Flip on the cable news and the vibe might have you believe that political statements, economic data points, natural disasters, or global unrest have some sort of predictable or unilateral effect on investing behavior.
And they might! But in a slightly more roundabout way. These events may well change how investors feel about owning certain investments, which leads them to buy or sell those investments. And it is the forces of supply and demand that push asset prices higher or lower. Said another way, investor sentiment, also known as market sentiment, can cause price volatility.
Market Sentiment Defined
The collection of all investor feelings — and actions — amounts to what is called market sentiment. It is a powerful force in the markets and is the subject of much study (and cable news discourse).
Market sentiment is affected by millions of factors daily. That’s because there are at least as many participants in popular marketplaces, like the stock market.
While one investor may be selling stocks because of poor corporate earnings, others might simply sell because they woke up on the wrong side of the bed. It is overly simplified to assume only one cause of changes to asset prices.
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Collective Mood Swings
Market sentiment is the phrase used to describe the overall spirit of investors in a market. (The stock market was used in the example above, but market sentiment exists in all investment markets.) Think of market sentiment as a giant mood ring for a particular market at a particular time.
The collective psychology of the market has the power to move stock prices. (How much “we” demand something gives it its value.)
When prices go up, the overall tone of the market is said to be positive, or bullish. When prices move downward, it generally means that investor sentiment is negative, or bearish. Investor attitudes about investments are realized in the price of those investments.
And anyone who watches the market knows that investors can be quite emotional at times. It’s human nature. It’s best that investors accept this reality.
In fact, investors should find it freeing that humans aren’t always rational and that sometimes asset prices can have major swings along with global moods. It is not up to the investor to control the swings of the stock market, but instead to weather them calmly.
While company earnings are the engine that drives stock market returns over time, it is the act of buying and selling that, in the shorter term, can cause the stock market to wiggle.
The stock market is of particular interest when looking at market sentiment. It’s a popular, global market, for one. Second, volatility can be dramatic, unlike markets for bonds. Third, it is easy to witness changes happening in real time.
The stock marketplace is like few marketplaces in the world, where prices are updated constantly in direct relation to the buying and selling of items in question. (Imagine how wild that would be if it happened at a grocery store.)
Market sentiment is considered an important tool for market analysis. It is used to make decisions about the very market the sentiment applies to.
Market Sentiment as an Indicator
When analyzing markets in an effort to predict them, indicators are used. An indicator is a sign or trigger that may hold some sort of valuable information. Market sentiment is one such indicator.
Compare market sentiment as an indicator with fundamental analysis, which largely relates to business performance, projected business performance, and the prevailing conditions for business performance.
Imagine a new tax law that’s expected to have a strong impact on the profitability of businesses in a certain industry. This would be considered a fundamental indicator.
Sometimes sentiment indicators and fundamental indicators can be at odds with each other. Fundamental indicators appear to point in one direction, but investor emotion may say otherwise.
For example, a business could have poor business fundamentals, and investors may still feel exuberant about that company and pile into its stock, which pushes the price of that stock higher.
Examples of Market Sentiment as an Indicator
There are many ways in which market sentiment is used as a market indicator. Then there are even more interpretations for what that data could mean.
It’s important to realize that no market indicators should be taken alone as fact. Why? Market indicators are in the business of predicting the future, which, in the stock market and otherwise, is a difficult thing to do.
In forecasting the general trajectory of the stock market, investor sentiment is sometimes used as a contrary indicator.
As the old adage goes, “Be fearful when others are greedy and greedy when others are fearful.” In a broad sense, when market sentiment is poor, it could indicate that it’s a good time to invest. When market sentiment is hot, it could be a bad time to invest.
When do people feel the worst about investing? At market bottoms, when prices are low. When do investors feel best? After the market has done well, which could indicate that prices are too high.
This is a characteristic of market bubbles, where investor mania causes prices to soar beyond their fundamental value. (Exhibit A was the dot com bubble, which saw investors piling into internet stocks, some of which never had so much as a quarter of positive earnings.)
Another instance in which sentiment might be used to assess an investment is through a strategy called value investing. With this method, investors attempt to uncover underpriced stocks — stocks whose price is lower than the believed value.
This could mean looking for a stock that has a strong fundamental foundation but that has yet to catch fire with investors, or a stock that is being punished (perhaps unnecessarily) by investors. Finding the proverbial diamond in the rough requires both an understanding of a company’s fundamentals and the market sentiment surrounding it.
Day trading, which is the practice of making bets on the price movement of a security during the trading day, relies on what are called technical indicators. And because of the power of investor attitudes to move prices, factors of sentiment can play an important role in short-term market changes.
For example, technical traders may look at a security’s historical price movement, called moving averages, in an attempt to surmise what will happen going forward. It is common to look at both 50-day and 200-day simple moving averages in an attempt to predict what happens next.
Other examples of sentiment indices are the High-Low Index, the CBOE Volatility Index, also known as the “fear” index, and the Bullish Percent Index.
The BPI measures the number of stocks with bullish and bearish patterns according to point and figure charts, ultimately producing a read on the sentiment of the overall market. An output of 50% is neutral, while reads above 80% are bullish and below 20%, bearish.
Some investors might argue that the above technical indicators have a serious limitation: They are using data from the past to project into the future and that the future is more or less unknown.
💡 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.
Building an Investment Strategy
Market sentiment concerns the overall thoughts, feelings, and actions of market participants, and has an effect on what happens in the stock market. Negative sentiment can drive stock values down, while positive sentiment can lead to market euphoria and higher values.
It can be difficult to keep up with market sentiment, or to even read it accurately. But knowing what sentiment is, and how it can affect the markets, can be important when making investment decisions.
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SoFi Invest® INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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Read moreMar
08
2024
Stock Buyback: What It Means & Why It Happens
One of the most popular ways a company can use its cash is through a stock buyback. Over the past five years, according to S&P Dow Jones Indices, big companies have spent more than $3.9 trillion repurchasing their own shares to boost shareholder value. Because of this significant activity, investors need to know the basics of stock buybacks and how they work to feel confident in making investment decisions.
Table of Contents
What Is A Stock Buyback?
A stock buyback, also known as a share repurchase, is when a company buys a portion of its previously issued stock, reducing the total number of outstanding shares on the market. Because there are fewer total shares on the market after the buyback, each share owned by investors represents a greater portion of company ownership.
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How Do Companies Buy Back Stock?
Companies can repurchase stock from investors through the open market or a tender offer.
Open market
A company may buy back shares on the open market at the current market price, just like a regular investor would. These stock purchases are conducted with the company’s brokers.
Tender offers
A company may also buy back shares through a tender offer. One type of tender offer, the fixed-price offer, occurs when a company proposes buying back shares from investors at a fixed price on a specific date. This process usually values the shares at a higher price than the current price per share on the open market, providing an extra benefit to shareholders who agree to sell back the shares.
Another type of tender offer, the dutch auction offer, will specify to investors the number of shares the company hopes to repurchase and a price range. Shareholders can then counter with their own proposals, which would include the number of shares they’re willing to give up and the price they’re asking. When the company has all of the shareholders’ offers, it decides the right mix to buy to keep its costs as low as possible.
Why Do Companies Buy Back Stock?
Stock buybacks are one of several things a company can do with the cash it has in its coffers, including paying the money out to shareholders as a dividend, reinvesting in business operations, acquiring another company, and paying off debt. There are several reasons why a company chooses to buy back its stock rather than some of these other options.
1. Increases Stock Value
One of the most common reasons a company might conduct a share buyback is to increase the value of the stock, especially if the company considers its shares undervalued. By reducing the supply of shares on the market, the stock price will theoretically go up as long as the demand for the stock remains the same. The rising stock price benefits existing shareholders.
Recommended: Understanding Capital Appreciation on Investments
2. Puts Money Into Shareholders’ Hands
A company’s stock buyback program can be used as an alternative to dividend payments to return cash to shareholders, specifically those investors who choose to sell back their shares to the company. With dividend payments, companies usually pay them regularly to all shareholders, so investors may not like it if a company reduces or suspends a dividend. Stock buybacks, in contrast, are conducted on a more flexible basis that may benefit the company because investors do not rely on the payments.
3. Takes advantage of tax benefits
Many investors prefer that companies use excess cash to repurchase stock rather than pay out dividends because buybacks have fewer direct tax implications. With dividends, investors must pay taxes on the payout. But with stock buybacks, investors benefit from rising share prices but do not have to pay a tax on this benefit until they sell the stocks. And even when they sell the stock, they usually pay a lower capital gains tax rate.
4. Offsets dilution from stock options
Companies will often offer employee stock options as a part of compensation packages to their employees. When these employees exercise their stock, the number of shares outstanding increases. To maintain an ideal number of outstanding shares after employees exercise their options, a company may buy back shares from the market.
5. Improves financial ratios
Another way stock buybacks attract more investors is by making the company’s financial ratios look much more attractive. Because the repurchases decrease assets on the balance sheet and reduce the number of outstanding shares, it can make financial ratios like earnings per share (EPS), the price-to-earnings ratio (PE Ratio), and return on equity (ROE) look more attractive to investors.
What Happens to Repurchased Stock?
When a company repurchases stock, the shares will either be listed as treasury stock or the shares will be retired.
Treasury stocks are the shares repurchased by the issuing company, reducing the number of outstanding shares on the open market. The treasury stock remains on its balance sheet, though it reduces the total shareholder equity. Shares that are listed as treasury stock are no longer included in EPS calculations, do not receive dividends, and are not part of the shareholder voting process. However, the treasury stock is still considered issued and, therefore, can be reissued by the company through stock dividends, employee compensation, or capital raising.
In contrast, retired shares are canceled and cannot be reissued by the company.
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The Pros and Cons of a Stock Buyback for Investors
When a company announces a stock buyback, investors may wonder what it means for their investment. Stock buybacks have pros and cons worth considering depending on the company’s underlying reasoning for the share repurchase and the investor’s goal.
Pros of a Stock Buyback
Tender offer premium
Investors who accept the company’s tender offer could have an opportunity to sell the stock at a greater value than the market price.
Increased total return
Investors who hold onto the stock after a buyback will likely see a higher share price since fewer outstanding shares are on the market. Plus, each share now represents a more significant portion of company ownership, which may mean an investor will see higher dividend payments over time. A higher stock price and increased dividend boosts an investor’s total return on investment.
Tax benefits
As mentioned above, a stock buyback might also mean a lower overall tax burden for an investor, depending on how long the investor owned the stock. Money earned through a stock market buyback is taxed at the capital gains tax rate. If the company issued a dividend instead of buying back shares, the dividends would be taxed as regular income, typically at a higher rate.
Recommended: Investment Tax Rules Every Investor Should Know
Cons of a Stock Buyback
Cash could be spent elsewhere
As mentioned above, when companies have cash, they can either reinvest in business operations, acquire a company, pay down debt, pay out a dividend, or buy back stock. Engaging in a share repurchase can starve the business of money needed in other areas, such as research and development or investment into new products and facilities. This hurts investors by boosting share price in the short term at the expense of the company’s long-term prospects.
Poorly timed
Companies may sometimes perform a stock buyback when their stocks are overvalued. Like regular investors, companies want to buy the stock when the shares are valued at an attractive price. If the company buys at a high stock price, it could be a bad investment when the company could have spent the money elsewhere.
Benefits executives, not shareholders
Stock buybacks might also be a convenient tactic to benefit company executives, who are often compensated by way of stock options. Also, some executives earn bonuses for increasing key financial ratios like earnings per share, so buying back stock to improve those ratios potentially benefits insiders and not all shareholders.
The Takeaway
Like almost everything else to do with the stock market, the benefits and drawbacks of stock buybacks aren’t exactly straightforward. Investors need to ask themselves a few questions when analyzing the share repurchases of a company, like “why is the company conducting the buyback?” and “does the company have a history of delivering good returns?” Answering these questions can help investors decide whether a stock buyback is the best thing for a company.
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FAQ
Is a stock buyback positive or negative?
Stock buybacks have advantages and disadvantages for investors and companies. For instance, buybacks may increase the stock value and increase dividend payments to shareholders over time. However, stock buybacks may not be the best way for a company to spend its money in the long-term, and they may potentially benefit company executives more than shareholders.
When should a company do a stock buyback?
A company may do a stock buyback when it has the cash available and wants to increase the value of the stock, improve financial ratios, consolidate ownership, or drive demand for the stock.
Do I lose my shares in a buyback?
You won’t lose your shares in a buyback unless you want to sell them. The way a buyback works is that a company buys back stock from any investors who want to sell it. But you are under no obligation to sell your stock back to the company — it’s up to you whether to keep your stock or sell it back.
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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.
SoFi Invest®
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.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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Read moreFeb
27
2024
What Is a Quiet Period?
Table of Contents
When a company is in the process of going public — getting ready for an initial public offering, or IPO — it is required to enter a so-called “quiet period.” During the quiet period, company executives, board members, management, and employees cannot publicly promote the company or its stock. Investment bankers and underwriters also cannot put out buy or sell recommendations.
In effect, the company and its personnel are required to stay quiet for a period of time surrounding the IPO filing.
Key Points
• A quiet period is a period of time when a company going public cannot publicly promote itself or its stock.
• The purpose of a quiet period is to allow the SEC to review the company’s registration without bias or interruption.
• During the quiet period, companies can discuss information already in the prospectus but should avoid generating public interest.
• Quiet periods are not only limited to IPOs but also observed by companies around the end of a quarter.
• Violating the quiet period can result in consequences such as delayed IPO, liability for violating the Securities Act, or disclosure of the violation in the prospectus.
What Is the Point of a Quiet Period?
While companies always have to comply with the federal securities laws — impending IPO or not — the time around an initial public offering is a special time for any company and comes with special rules and restrictions.
It starts when the company files the registration statement (called an S-1) with the Securities and Exchange Commission (SEC), including a recommended offering price for the security, and lasts for 30 days. The S-1 contains:
• a description of the company’s properties and business
• a description of the security being offered
• information about company management
• financial statements certified by independent accountants
During this time, the SEC looks over all the documentation and approves the registration. The quiet period allows the SEC to complete the review process without bias or interruption, and ensures that the company doesn’t attempt to hype, manipulate, or pre-sell their stock.
Companies are allowed to discuss information already in the prospectus during the quiet period, and oftentimes they will go on a “road show” to present this information to big, institutional investors and get a sense for the potential market. Activities generally avoided during the quiet period are advertising campaigns, conferences, and press interviews — basically, anything that might generate public interest in a company or its securities.
Quiet Periods Not Connected to an IPO
While the IPO quiet period by far gets the most attention, it is not the only time that the SEC reins in the communications of companies and their executives. Typically around the end of a quarter, when a company knows the results it will likely release in its quarterly earnings report to investors, the company observes a quiet period to avoid tipping anyone off or trying to get ahead of them in any way.
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How Do Companies Violate the Quiet Period?
While the general investing public is supposed to rely on the information contained in S-1s and other official company communications when deciding whether or not to buy the stock, the irony is that public attention to the company is typically very high right before an IPO. All this attention comes at a time when the company itself is supposed to be in its quiet period.
In the past, some companies have run into issues with their senior executives talking to the media during the quiet period. In some cases, the interviews were conducted earlier but published during that time — but either way, it can appear to be a violation of the terms.
What Happens When Quiet Periods Are Violated?
There are no set penalties for violating a quiet period, which is also called “gun-jumping.” If the SEC deems a statement made by a company is in violation of the quiet period, consequences can include:
• A delayed IPO
• Liability for violating the Securities Act
• Requirement to disclose the violation in the company’s prospectus
Delaying the IPO process allows all potential investors to get back on the same page with equal access to information disclosed by the company.
The SEC is also empowered to exact more severe punishments, like civil or even criminal penalties, but typically only pursue these in extreme cases.
What Investors Can Do During a Quiet Period
Quiet periods can be a good time to assess whether you’re interested in investing in a company’s IPO. IPOs have the potential to be lucrative investments, but can also turn out to be extremely volatile and may lose value. There is no guarantee.
Seasoned investors may try to profit at the end of the quiet period, called the quiet period expiration. At this time the stock price and trading volume may see drastic movement up or down, as a flood of information gets released from analysts.
Unbiased prospectus information about recent filings can be viewed on the SEC website. Reading the prospectus can help an investor judge for themself whether a company’s mission, team, and financials look like a sound investment to them.
The Takeaway
The quiet period before an IPO is a time for founders, executives, and employees of a company to stay off the radar, as their official registration forms and other existing info about the company speaks for itself. This allows potential investors to make decisions based on the same information, with no pre-IPO investing hype or manipulation.
Companies may violate quiet periods intentionally or unintentionally, but there are no set penalties for doing so. The SEC may ask that certain measures are taken, however.
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).
SoFi Invest® INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. IPOs offered through SoFi Securities are not a recommendation and investors should carefully read the offering prospectus to determine whether an offering is consistent with their investment objectives, risk tolerance, and financial situation.
New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For SoFi’s allocation procedures please refer to IPO Allocation Procedures.
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Feb
27
2024
What Is Leverage in Finance?
Table of Contents
Leverage in finance involves using a relatively small amount of capital to make larger trades or investments, increasing the potential of larger returns. In the world of finance, it’s critical to understand leverage if you plan to day trade or make other types of short-term investments, and the additional risks involved.
In general, leverage means doing a lot with a little. Think about how you may use an actual, physical lever to turn a switch, for instance. The switch itself may be small, and require a turn that’s a quarter of an inch to flip from off to on. But by using a lever — which is much bigger, physically, than the switch itself — the work becomes easier.
Key Points
• Leverage in finance involves using a small amount of capital to make larger trades or investments, potentially increasing returns.
• Leverage can be achieved through borrowing money or trading on margin, allowing investors to make increased dollar investments.
• While leverage can amplify gains, it also magnifies losses and comes with additional risks and costs.
• Different types of leverage exist, including financial leverage used by businesses to raise capital and operating leverage used to analyze fixed and variable costs.
• Leverage can be used in personal finance, such as taking out a mortgage, and is also utilized by professional traders to potentially increase profits.
What Is Leverage?
In finance, leverage refers to using a small amount of capital to do a relatively big amount of work — making big investments with a small amount of money. The rest of the money used to make the investment is borrowed, or investors are trading on margin.
In short: Leverage is about borrowing capital to make bigger bets in an effort to increase returns.
How Leverage Works
In leveraged investing, the leverage is debt that investors use as a part of their investing strategy. While it’s easy to think that all debt is bad, in fact it can actually be useful when folded into a specific investing tactic, although it also introduces additional risks and costs.
Leverage typically works like this: A person or company wants to make an outsized investment, but doesn’t have enough capital to do it. So, they use the capital they do have in conjunction with margin (borrowed money) to make a leveraged investment. If they’re successful, the return on their investment is far greater than it would’ve been had they only invested their own capital.
The risk, of course, is that those returns do not materialize, putting the investor in debt. Investors will also need to consider how their overall costs could increase, as they’ll likely pay interest on the money they borrow, too.
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Example of Leverage
Here is an example of how leverage could be used:
Let’s say that you found a startup. To get the company off the ground, you take in $10 million from investors, but you want to expand operations fast — hire employees, ramp up research and development efforts, and build out a distribution network.
You can do that with the $10 million, but if you were to borrow another $10 million, you would be able to double your efforts. That would allow you to hire more employees, improve your products faster, and distribute them further and wider, though you’d need to pay interest on the loan, too, factoring into overall costs.
That $10 million you borrowed is allowing you to do more with less. Of course, you run the risk that the company won’t be able to sustain a quick growth pace, in which case you may not be able to pay back the loan, or end up paying additional costs for interest and fees. But if things do work out, you’d be able to grow faster and accrue more value than if you hadn’t taken on any additional debt.
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Pros and Cons of Leverage
On the surface, leverage can sound like a powerful tool for investors — which it can be. But it’s a tool that can cut both ways: Leverage can add to buying power and potentially increase returns, but it can also magnify losses, and put an investor in the hole.
What’s important to remember is that there are both pros and cons to a tool like leverage.
| Pros of Leverage | Cons of Leverage |
|---|---|
| Adds buying power | Increased risks and costs |
| Potential to earn greater returns | Leveraged losses are magnified |
| For investors, it’s generally easy to access | It can be more complex than meets the eye |
Leverage vs Margin
Margin is a type of leverage that is specifically tied to use in the financial markets by investors. It is basically like a line of credit for a brokerage or investment account.
Here’s how margin works: An investor has a cash balance, which acts as collateral, and there are interest rates at play, like any other type of loan. With a margin account, investors can tradesome, but not all stocks or other assets on margin.
Using margin, an investor can effectively supercharge their potential gains or losses. It’s also important to note — and it’s worth repeating over and over — that using margin as an investor can increase overall costs and risks. Not every investor will be comfortable assuming those risks and costs (such as interest charges), so you’ll want to know what you’re doing before using margin.
Margin and leverage are related, and it’s easy to confuse the two. Even if you know what margin trading is and how margin accounts work, it’s important to make sure you know what the differences are. This chart should help.
Leverage vs Margin |
|
|---|---|
| Leverage | Margin |
| A loan from a bank for a specific purpose | A loan from a brokerage for investing in financial instruments |
| May involve a cash injection to be used for a specific purpose | No cash is exchanged; acts as a line of credit |
| Can be used by businesses or individuals; May take the form of a mortgage or to expand inventory | Can be used to create leverage and increase investment buying power |
Types of Leverage
So far, we’ve mostly discussed leverage as it relates to the financial markets for investors. But there are other types of leverage, too.
Financial Leverage
Financial leverage is used by businesses and organizations as a way to raise money or access additional capital without having to issue additional shares or sell equity. For instance, if a company wants to expand operations, it can take on debt to finance that expansion.
The main ways that a company may do so is by either issuing bonds or by taking out loans. Much like in the leverage example above, this capital injection gives the company more spending power to do what it needs to do, with the expectation that the profits reaped will outweigh the costs of borrowing in the long run.
Operating Leverage
Operating leverage is an accounting measure used by businesses to get an idea of their fixed versus variable costs.
When discussing financial leverage, math needs to be done to figure out whether a company’s borrowing is profitable (called the debt-to-equity ratio). When calculating operating leverage, a company looks at its fixed costs as compared to variable costs to get a sense of how the costs of borrowing are affecting its profitability.
Leverage Investing
Leverage trading is the use of borrowed money to try and increase profits or returns. A company can use leverage investing by purchasing a new factory, allowing it to expand its ability to create products, and as such, increase profitability. An individual investor can borrow money to buy more stocks, increasing their potential returns.
It’s important to keep in mind, though, that leverage trading, or the use of borrowed money to invest, increases overall costs for investors, as they will need to pay interest on the money they borrow, and may be subject to other fees, too.
With that in mind, there are a few ways that leverage can be used in investing, either by individuals, or organizations.
Buying on Margin
Margin is a form of leverage, and trading on margin means that an investor is using money borrowed from their brokerage to execute a trade. In other words, an investor is borrowing money from their trading platform or brokerage — paying an applicable interest rate to do so, which can vary and should be considered as a part of overall trading costs — and making trades with it. It’s similar to using a credit card for investing, in some ways.
Given that margin concerns interest charges and additional costs, using it to trade or invest involves additional risks, particularly for inexperienced investors.
Leveraged ETFs
ETFs, or exchange-traded funds, can also have leverage baked into them. Leveraged ETFs are tradable funds that allow investors to potentially increase their returns by using borrowed money to invest in an underlying index, rather than a single company or stock. Leveraged ETFs utilize derivatives to increase potential returns for investors.
Using Borrowed Money to Invest
While many investors utilize margin, it’s also possible to borrow money from an outside source (not your broker or brokerage) to invest with. This may be appealing to some investors who don’t have high enough account balances to meet the thresholds some brokerages have in place to trade on margin. For example, a platform may require an investor to have a minimum balance of $25,000 in their account before they’ll offer the investor margin trading.
If an investor doesn’t have that much, looking for an outside loan — a personal loan, a home equity loan, etc.— to meet that threshold may be an appealing option.
But, as mentioned when discussing margin, borrowing money to invest can rope in additional risk, and investors will need to consider the additional costs associated with borrowing funds, such as applicable interest rates. So, before doing so, it may be a good idea to consult a financial professional.
Leverage in Personal Finance
The use of leverage also exists in personal finances — not merely in investing. People often leverage their money to make big purchases like cars or homes with auto loans and mortgages.
A mortgage is a fairly simple example of how an individual may use leverage. They’re using their own money for a down payment to buy a home, and then taking out a loan to pay for the rest. The assumption is that the home will accrue value over time, growing their investment.
Leverage in Professional Trading
Professional traders tend to be more aggressive in trying to boost returns, and as such, many consider leverage an incredibly important and potent tool. While the degree to which professional traders use leverage varies from market to market (the stock market versus the foreign exchange market, for example), in general most pro traders are well-versed in leveraging their trades.
This may allow them to significantly increase returns on a given trade. And professionals are given more leeway with margin than the average investor, so they can potentially borrow significantly more than the typical person to trade. Of course, they also have to stomach the risks of doing so, too — because while it may increase returns on a given trade, there is always the possibility that it will not.
Leveraged Products
There are numerous financial products and instruments that investors can use to gain greater exposure to the market, all without increasing their investments, like leveraged ETFs.
Volatility and Leverage Ratio
A leverage ratio measures a company’s debt situation, and gives a snapshot of how much debt a company currently has versus its cash flows. Companies can use leverage to increase their profitability by expanding operations, etc., but it’s a gamble because that profitability may not materialize as planned.
Knowing the leverage ratio helps company leaders understand just how much debt they’ve taken on, and can even help investors understand whether a company is a potentially risky investment given its debt obligations.
The leverage ratio formula is: total debt / total equity.
Volatility is another element in the mix, and it can be added into the equation to figure out just how volatile an investment may be. That’s important, given how leverage can significantly amplify risk.
💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.
The Takeaway
Leverage can help investors, buyers, corporations and others do more with less cash on hand in their accounts at a given time. But there are some important considerations to keep in mind when it comes to leverage. In terms of leveraged investing, it has the potential to magnify gains — but also to magnify losses, and increase total costs.
Utilizing leverage and margin as a part of an investing or trading strategy has its pros and cons. But investors should give the risks some serious consideration before getting in over their heads. It may be a good idea to speak with a financial professional accordingly.
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).
FAQ
What is leverage in simple terms?
In simple terms, the concept of leverage means to do a lot with a little. As it relates to finance or investing, this can mean using a small amount of capital to make large or outsized trades or investments.
What is an example of leverage?
An example of leverage could be a mortgage, or home loan, in which a borrower makes a relatively small down payment and borrows money to purchase a home. They’re making a big financial move with a fraction of the funds necessary to facilitate the transaction, borrowing the remainder.
Why do people want leverage?
Leverage allows investors or traders to make bigger moves or take larger positions in the market with only a relatively small amount of capital. This could lead to larger returns — or larger losses.
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