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Market overhang is a market phenomenon whereby investors hold off on trading a stock that’s seen a drop in price because they expect that the price will drop even further. A market or stock overhang can be precipitated by the awareness that a large block of shares — say, from an institutional investor — is about to hit the market, potentially driving a stock’s price down.

But it can result from other factors as well. Although the event has not happened, investors may hesitate to sell or buy shares in anticipation of a price drop — and this can further depress the stock price. While there is also a business use of the term “overhang,” for investors it may be useful to focus on how market overhang works in finance specifically.

Market Overhang Definition

In its broadest use, an overhang describes a somewhat artificial market condition brought on by an anticipated shift in supply and demand (i.e., the price of a stock). Market overhang has a couple of uses in the business and finance worlds, and in an IPO market as well.

What Is an Overhang in Business?

An overhang in a business context can refer to the practice whereby a company, typically an industry leader, delays the release of a new product in order to stoke greater consumer demand for that product.

A familiar example might be the release of a new technology product or video game. The anticipation of the new release may cause consumers to avoid buying other products as they wait for the arrival of the new one. The overhang may result in fewer purchases of existing products and more purchases of the newly released product. While this practice may be considered manipulative, it’s not uncommon.

What Is an Overhang in Finance?

An overhang in finance is used to describe a dynamic that’s specific to how investors’ expectations about supply and demand can impact a company’s share price.

A market overhang occurs when a stock’s price declines because investors expect a further price drop on the horizon. Thus, some shareholders may hesitate to sell their shares because that could further drive down the share price. Other investors may also hesitate to buy shares because of the anticipated price drop.

The business use of the term and the finance use describe different situations, but the common element is how investors’ anticipation of a future event can impact a company’s revenues or share price.

Needless to say, a market overhang can cast a shadow over a company’s performance, influencing share price, liquidity, and more, especially if the situation is prolonged. In many cases, though, market overhang is relatively short-lived and temporary. The difficulty for investors is knowing when the overhang, like bad weather, will finally pass. To that end, it helps to know some conditions that can cause a market overhang.

How Market Overhang Is Created

There are a few conditions that can lead to a market overhang. Often, these conditions can overlap.

A Stock Decline

The first is where a stock is already declining, perhaps owing to a change in key economic indicators or market conditions, and there is a buildup of selling pressure as investors hesitate to let go of their shares in a down market. This type of market overhang may be resolved once there are signs of price stability (even if it’s at a lower level).

The Role of Institutional Investors

Another type of stock overhang can be created by institutional investors, which are companies that manage investments on behalf of clients or members of a firm. Institutional investors tend to have larger stakes in particular stocks compared with individual investors. This means that when an institutional investor plans to sell a large portion of their shares, a market overhang could kick in when other investors become aware of this possible sale.

The anticipation of a large block of shares entering the market could drive prices down. Thus, investors might hold off on trading this particular stock, affecting its price, even before the institutional investor has made a move.

The stock overhang might be worse if it occurs during a price decline. In that case, investors may see the decline in share price, become aware that a large investor may sell a block of shares (which could further depress the price), and be even more wary of buying or selling the company’s shares.

IPOs and Market Overhang

A third way that market overhang may occur is after an initial public offering (IPO). An IPO market can be a hot market, after all, and a company may get significant press coverage as its IPO approaches, which can drive up the stock price.

But if the IPO isn’t a big hit, and the share price isn’t what investors hoped (in IPO terms), there might be a bit of an overhang as investors wait for the lock-up period to end. The lock-up period is when company insiders can sell their shares, potentially flooding the market and further lowering the price.

Understanding the Effects of Market Overhang

Market overhang can last for a few weeks or even months — sometimes longer. The chief impact of a market overhang is that it can artificially depress the price of a stock, and if the market overhang is prolonged, that can have a negative impact on company performance.

As noted above, a market overhang typically ends when a stock price stabilizes. Unfortunately, that often occurs at a lower price point than before the shares began to decline.

Example of Market Overhang

While some consider the market overhang phenomenon more anecdotal than technical, it’s something to watch out for. It could present an opportunity. And it doesn’t require a complicated, technical stock analysis to understand.

For example, let’s say a large tech company is trading at $300 a share. But there are reports that the company has been facing some headwinds and may undergo a rebranding and repositioning. In the face of this change and uncertainty, it’s natural that it might impact company performance, and the share price might wobble a bit. But then, if enough investors are concerned about the company’s new direction, there could be a bigger shift in trading behavior that might further depress the share price in advance of the company pivot — creating an overhang.

While this isn’t ideal for current shareholders, a market overhang like this could be a “buy” opportunity for other investors. It depends on a number of factors, and it’s always important to understand market trends as well as company fundamentals. But it’s possible that some investors may view the company as a good prospect, despite a currently undervalued share price, and buy shares based on their assessment of the company’s valuation and long-term prospects.

Why Market Overhang Matters

Market overhang is a valuable phenomenon for investors to be aware of, largely because it reflects many of the basic tenets of behavioral finance, which is the study of how emotions can impact financial choices. A market overhang could be viewed as the result of loss aversion and herd mentality — two well-documented behavioral patterns among investors.

Loss aversion is, as it sounds, the wish to avoid incurring losses. Herd mentality is, not surprisingly, the tendency for investors to behave as a group: buying or selling in waves. You can see how these two very human impulses — to protect oneself from losses, and to follow the herd — might create a market overhang.

The good news, though, is that investors are fickle and markets can be volatile, which means the market overhang will usually pass, and the stock will regain its normal momentum, whatever that may be. As an investor watching the market change, it’s up to you to decide whether a stock overhang might present a buy opportunity or a sell opportunity, such as if you need to harvest some losses for tax purposes.

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What Market Overhang Means for Shareholders

Market overhang affects different shareholders differently. Since institutional investors tend to be the ones who create market overhang, they also tend to have the upper hand on what it means for their investments.

Regular investors might worry that some of their shares are losing value. But with the ebbs and flows of the stock market, a price can rise and fall at various times throughout the year, even throughout a given day. Fluctuation is normal, and this is part of the risk in investing in the stock market. Consider waiting out the storm to make an informed decision. There’s a chance the stock could rise to new highs, and your investment will be worth even more.

The Takeaway

A market overhang is a trend that’s considered more behavioral in nature, but it can be worthwhile for investors to keep it in mind when a stock isn’t performing as expected. In some cases, when investors anticipate an event that could drive down a stock’s price, they may hold off on trading that stock, further depressing the price and creating a market overhang. In that sense, a market overhang can become a self-fulfilling prophecy.

Institutional investors can create a market overhang, for example, when they contemplate selling a large portion of their holdings. This might spook other investors, who likewise decide not to trade their shares, creating a sort of temporary downward spiral in the share price. But because two common investor dynamics are at play here (the fear of losses, and the desire to comply with what other investors are doing) the emotions are usually temporary, and the market overhang passes.

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FAQ

Is market overhang always negative for investors?

Not necessarily. While market overhang can hurt current shareholders by depressing prices, it may create buying opportunities for others. If the price drop is driven by anticipation rather than fundamentals, some investors may view the stock as undervalued and buy in before conditions normalize.

How does market overhang affect stock prices?

Market overhang can temporarily push a stock’s price down because investors hold off trading, which reduces demand and increases perceived selling pressure. Even before any actual sale occurs, the expectation of more shares entering the market can weaken price momentum. Depending on liquidity, this effect can last weeks or months.

How do institutional investors affect markets?

Institutional investors can move markets because they trade in large volumes, and their decisions often signal confidence or concern. Heavy buying can push prices up, while plans to sell large blocks may cause others to hold back, creating downward pressure even before the sale. Their actions influence liquidity, volatility, and overall market sentiment, which is why individual investors watch them closely.

Photo credit: iStock/kupicoo

SOIN-Q126-056

A central counterparty clearing house (CCP), or central counterparty, is a financial institution that facilitates trading activities in European equity and derivative markets. Regional banks typically operate CCPs, which are an important part of the international financial system.

CCPs maintain stability and efficiency across financial markets and reduce risks, including counterparty, default, and market risks. In the United States, CCPs are called Derivatives Clearing Organizations (DCOs) and are regulated by the Commodity Futures Trading Commission (CFTC).

Defining Central Counterparty Clearing Houses

The Bank for International Settlements (BIS) defines a CCP as “a clearing house that interposes itself between counterparties to contracts traded in one or more financial markets, becoming the buyer to every seller and the seller to every buyer and thereby ensuring the future performance of open contracts.” The Eurex is a well-known CCP.

Central counterparty clearing houses act as intermediaries between buyers and sellers in financial transactions. They handle clearing and settlements in various types of securities and derivatives transactions to reduce credit risk in the markets.

Clearinghouses have existed for more than a century, and act as a way to reduce the risk of over-the-counter (OTC) derivative transactions.

How Central Counterparty Clearing Houses Work

Central counterparty clearing houses guarantee trade terms for buyers and sellers, using strict risk controls. They help reduce risk for investors by taking on credit risk involved in transactions, so even if a buyer or seller defaults on a transaction, the other party doesn’t have as much loss as they might have without the CCP.

Margin, Novation, and Trade Settlement

When buyers and sellers enter into transactions, they each deposit money with the CCP to cover the amount of the transaction. All CCP users must have a margin account.

In a process called “novation,” the CCP enters into two different contracts, one with the buyer and one with the seller. This provides a guarantee to the other party that if one side doesn’t follow through with the agreement, the other side will still receive payment. CCPs typically use margin calls to settle trades if one party doesn’t have the funds in their account.

If the trade falls through, the CCP completes the trade at the current market price.

Business Models, Market Structure, and Risk Controls

CCPs are for-profit businesses that generate revenue from their members and their transactions. They also work with stock exchanges that require them to remain financially sound and well-capitalized. Just like other types of businesses, CCPs each operate differently and have different business strategies to attract customers and earn revenue.

For instance, there are different types of derivative products that a CCP might choose to offer. One common business model for CCPs is to cross-margin products in a single netting pool. Parent exchanges place obligations on CCPs, so they need to earn enough revenue to meet those.

The specific financial products offered by a CCP, as well as its risk level, fee structure, and other features, lead to different types of members, organizational structure, regulations, and rules for margin balances.

Evolution and Regulation of CCPs

CCPs continue to evolve, offer new products, and become more sophisticated over time. Regulations are also evolving for CCPs, which may change how they operate in the future.

Uses of a Central Counterparty Clearing House

CCPs maintain the anonymity of investors’ identities from other participants to protect their privacy. They also maintain the privacy of trading firms from buyers and sellers by using electronic order books and protect brokerage firms from the risk of buyers and sellers defaulting on their end of options, such as calls or puts.

Another use of CCPs is to lower the number of transactions settled in order to move funds efficiently between investors.

CCP Members

Financial institutions that want to clear trades through a central counterparty can become members of a particular CCP. Membership allows them to reduce credit risk for their customers and themselves. There are CCPs for different types of financial transactions, so financial institutions can choose the appropriate CCP to apply to for their needs.

CCPs want members that have a significant transaction volume, are creditworthy, and have a trading operation that works efficiently with the system run by the CCP. CCPs also want members to contribute funds to their default fund and secure collateral for their transactions. Each CCP has somewhat different criteria and requirements for membership, and membership information isn’t always publicly available.

Pros and Cons of CCPs

There are benefits and drawbacks to CCPs. Here are a few important ones to understand:

Pros

CCPs benefit investors in the following ways:

•   Reduce counterparty risk

•   Maintain stability in financial markets

•   Increase efficiency of transactions

•   Maintain the privacy of customers

Cons

There are also some drawbacks to CCPs for investors, including the following:

•   Most charge participation fees

•   May not be able to process nonstandard transactions

•   May not have adequate scale

•   May create systemic concentration risk

CCPs and Blockchain

CCPs are now being used with blockchain technology, made popular in cryptocurrency markets, to further reduce risk and costs. An international group of financial, legal, and academic firms, including clearing houses, launched the Post Trade Distributed Ledger (PTDL) Group in 2015. The group studies ways to use blockchain technology for transactions.

According to the Global Blockchain Business Council, since the formation of the PTDL Group, it has expanded to include about 80 global financial institutions collaborating to bring CCPs together with blockchain. The goal of using blockchain technology with CCPs is to reduce margin requirements and risk, reduce operational costs, improve regulatory oversight, and increase the efficiency of trade settlements. Ideally, blockchain can help support better settlements, clearing processes, and reporting.

Decentralized exchanges already operate similarly to CCPs as a third party that handles transactions.

The Takeaway

Central counterparty clearing houses help reduce the risk of trading derivatives and securities. They became more popular after the financial crisis as a way for investors to minimize counterparty risk.

While CCPs may help maintain stability in financial markets and increase efficiency, they may involve participation fees and may not be able to process nonstandard transactions. Understanding the ins and outs of CCPs can be helpful to investors as they learn to navigate the markets.

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FAQ

What is the difference between a clearing house and a central counterparty?

While a central counterparty clearing house (CCP) acts as a clearing house for transactions, it has an additional step involved before doing so. The two parties involved in a transaction agree upon transaction terms, and then the CCP must agree to the terms before they clear the transaction.

What is the CCP margin?

Central counterparty clearing houses (CCPs) require customers to make collateral deposits, known as margin deposits, before entering into transactions. This provides them with funds they can use to guarantee trades in the event that one party defaults on an agreement. The initial margin required depends on the customer, the type of financial product, and the particular trade agreement.

Does central clearing reduce counterparty risk?

Central clearing reduces counterparty risk by guaranteeing trades for buyers and sellers under strict risk controls. Central counterparty clearing houses take on the credit risk involved in transactions by becoming the buyer to every seller and the seller to every buyer.

Photo credit: iStock/vm

SOIN-Q126-053

As its name indicates, a profit and loss (P&L) statement shows a company’s profits and losses (i.e., revenue vs. expenses and other costs) over a certain period of time, like a quarter or year.

A profit and loss statement, also called an “income statement,” is one of a business’s most important accounting tools, as it provides important insights into operations and the company’s ability to generate income and manage losses, with an eye toward profitability.

Investors can also use the P&L to assess certain aspects of a company’s performance and compare it to other companies in the same industry.

What Is a Profit and Loss Statement?

A profit and loss report shows how much revenue a company earned over a specific period and then subtracts how much money it spent. The result is a net profit (or loss), which is the final line in the calculation, commonly known as the bottom line.

While a profit and loss statement provides contextual insight into a company’s financials, these figures only tell us what has happened in the past, and not what will happen in the future. This information alone is not able to determine whether a company is a “good” investment, but it’s one of the many pieces of information needed to value a stock.

Other Key Documents

In addition to filing a P&L report, companies will also file a balance sheet, cash flow statement, and statement of shareholders’ equity. Filings are made quarterly (called 10-Q filings) and annually (10-K filings) with the Securities and Exchange Commission (SEC), and are publicly available. Investors can find this information by searching for the company within the SEC’s EDGAR database.

Although having a basic overview of how to read a profit and loss statement can be helpful, it’s important to bear in mind that different companies and industries may include different line items in their P&L report.

Generally speaking, it’s useful to think of each of the financial statements as individual pieces in an overall puzzle. For example, you might compare a company’s P&L to its balance sheet, which is a snapshot of a company’s assets and liabilities as of a specific date.

The balance sheet alone won’t indicate whether the company is operating at a profit, and a P&L statement may not provide an accurate picture of a company’s indebtedness. But together, both statements provide important context for further analysis.

What Is a P&L Statement Used For?

Profit and loss statements are a particularly useful tool for looking into the operations of a company and identifying important trends in that business, often providing insights into where (and maybe why) it is making or losing money. For example:

•   Where is most of the revenue being spent?

•   Are there expenses that could be trimmed?

•   Are gross sales covering the cost of production?

The P&L statement is also useful when used to compare two or more time periods, or when comparing companies within the same industry.

An Aid to Analysis

As with almost any accounting report, the P&L can spark important questions. What changed from last year (or last quarter)? What has improved? What has not? In particular, has the company been able to decrease expenses or increase revenue in order to secure more profit?

Most importantly, the P&L statement may provide additional clues about the financial inner workings of the company. It can help identify problem areas as well as growth opportunities.

For example, perhaps a company is profitable in one period, but not the next, because of an increase in research and development (R&D) costs. This is valuable information, as it may indicate a crucial investment for a new product. Knowing this information can aid in an evaluation of this investment and a more sophisticated analysis.

Is this a wise use of capital, and will it pay off in terms of a new product’s success? Could the money be better spent elsewhere, or is there a more efficient way to develop the new product line?

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How to Read a P&L

When learning how to read a profit and loss statement, investors should know that they generally follow a similar format.

Each begins, at the top of the page, with total revenue. This is how much money a company earned through sales. Next, costs and expenses are subtracted. Finally, at the bottom of the page, is the company’s bottom line: profit or loss.

Although a company’s “top line” revenue is a compelling figure, a company’s bottom line is typically a better indicator of whether it will be an enduring, successful business.

To illustrate the point, consider a simple example of two companies. The first company posted revenue of $10,000,000 last year, but incurred the same amount in expenses (– $10,000,000). They had high revenue, but earned no profit.

The second business earned $1,000,000, but incurred $700,000 in expenses — resulting in a $300,000 profit. The second company brought in less revenue but was more profitable than the first.

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Understanding Each Section of the P&L

To really make sense of a P&L, you need to understand what each line item stands for and its relevance to the company’s overall operations.

Revenue (Or Sales)

To recap, one would find the total revenue at the top. This number is also called gross sales, and it’s usually broken down by source. (A gross figure is one calculated before expenses are taken out.)

Net Revenue

On certain sales, a company may ultimately receive a modified amount. For example, items that are returned or are discounted must be accounted for. Therefore, the next line in the statement may include a figure representing what a company actually expects to collect on overall sales (i.e., net revenue). Net refers to a figure after the necessary deductions are made. This is a more accurate picture of what incoming cash flow looks like.

Cost of Goods Sold (COGS)

Moving down the statement, direct costs or cost of goods sold usually comes next. This is what the company spent directly on the production of goods or services that it sold during that period. For example, if a company produces shoes, it would include money spent on supplies, labor, packaging, and shipping (but not rent, for example, as that’s not a direct cost).

Gross Profit

After subtracting COGS from revenue, there may be a line titled gross profit or gross margin. This indicates the profit made on the goods sold before operating expenses.

Operating Expenses

Operating expenses include everything the company spent money on to stay in business: from IT and sales and marketing expenses to facilities costs and so on. These categories are often broken down into subcategories for specific expenses within each (for example, employee expenses might include payroll and benefits).

Total operating expenses are deducted from gross profit to get net operating income.

Net Operating Income

Net operating income, also known as EBITDA (earnings before interest, taxes, depreciation, and amortization), is a crucial part of the income statement. It reveals how much the company has after all the expenses are covered. If the number is positive, the company is able to cover the cost of doing business; if it’s negative, it means the company is operating at a loss. While that’s not uncommon, spending more than you earn is typically a red flag calling for some adjustments.

Interest Income and Expense

Interest income is money earned in interest-bearing bank accounts or other investment vehicles. Interest expense is the cost of borrowing money and paying interest on that debt. These numbers may or may not be combined into one figure.

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Depreciation and Amortization

Depreciation is defined as the reduction in the value of an asset with the passage of time, due in particular to wear and tear (e.g., the depreciating value of computer systems or vehicles). Businesses are able to treat this depreciation as an expense.

Amortization is the distribution of a business expense over time (i.e., the ongoing cost of a certain software program over a few years).

Tax

Finally, any tax the company paid is also deducted. Typically, this is the last deduction before the final line of the statement: the net profit, or bottom line.

The bottom line represents the net profit or the net loss, and answers the question: During this accounting period, was this company able to turn a profit, or did it operate at a loss?

Note that profit is just one way to evaluate a company and its stock — and it’s not the same as cash on hand. To understand how much actual cash a company has in the bank, you have to read the cash-flow statement.

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Earnings Per Share

A profit and loss statement may also include an earnings per share (EPS) calculation. This is a representation of how much money each shareholder would receive if all net profit was paid out. EPS is calculated by dividing the total net profit by the number of shares a company has outstanding.

The EPS is a hypothetical calculation used by investors to assess the amount of profit created by a company. Do companies actually distribute total earnings? Not generally. Companies will typically keep some or all profits, and may make some payments to shareholders in the form of dividend payments. (The profit and loss statement may also include information on dividend payments.)

A large or growing EPS is generally preferable, but yet again, this metric alone is not sufficient to decide whether a stock is a good investment. EPS should also be compared to the price of that stock. A company could boast a robust EPS, but if the cost of the stock is relatively expensive, it might not be a good value.

For a deeper look into the correlation between earnings and price, investors can consider the price-to-earnings (P/E) ratio, which divides the price of a stock by the EPS.

The Takeaway

A profit and loss statement can give an investor a look at a company’s bottom line in terms of earnings, and also allows them to compare statements from companies in the same industry, as well as statements from the same company over different time periods. Learning how to read a profit and loss statement can be an important part of researching a company that one might want to invest in.

Invest in what matters most to you with SoFi Active Invest. In a self-directed account provided by SoFi Securities, you can trade stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, options, and more — all while paying $0 commission on every trade. Other fees may apply. Whether you want to trade after-hours or manage your portfolio using real-time stock insights and analyst ratings, you can invest your way in SoFi's easy-to-use mobile app.

FAQ

How do I analyze the information in a profit and loss statement?

Analyzing a P&L statement involves reviewing revenue, costs, and expenses over a specific period to determine profitability. This information reveals whether the business made money or operated at a loss and can give you a picture of how the company performed financially during that time.

How do investors use a P&L statement?

Investors use a P&L to understand how a company is running its business, where it’s earning or losing money, and how its performance changes over time. It helps highlight trends, problem areas, and strengths. Investors also compare P&Ls across different periods or against other companies in the same industry.

What are some other important ways to evaluate a company I might want to invest in?

A P&L statement should be analyzed in conjunction with a cash-flow statement and a balance sheet. Important metrics for analyzing stock performance include earnings per share and the price-to-earnings ratio.