Apr
18
2023

How to Know When to Sell a Stock

By | Growing Wealth, invest, Investing | Comments Off on How to Know When to Sell a Stock

Knowing the right time to sell a stock can be a complicated decision. There’s the desire to sell at a profit, or to sell in order to prevent a loss — and sometimes there’s a logic to selling at a loss for tax purposes.

There can also be times when selling a stock isn’t necessarily a good idea — like when the market is volatile, and an investor lets the market jitters interfere with their wider investing strategy. In any circumstance, it helps to know your rationale for when to sell a stock.

When Is a Good Time to Sell Stocks?

There are a few ways to approach the question of when to sell stocks. Perhaps the most relevant answer is “when you need to.” That will depend on the individual investor, of course. But some investors, looking to generate a profit from their stock holdings, may also want to plan to sell stocks on certain dates, or during certain times of the day.

For example, earnings reports are usually released quarterly, and are often associated with movements in share price. This is often called “earnings season.” While there’s no way to know for sure how an earnings release will affect a stock’s price, more often than not, share prices gain or lose value in the wake of an earnings report.

As for specific times of the day — if you’re a more experienced trader, you may consider selling your shares around the open (9:30 am EST) or close (4 pm EST) of the stock market. Stock prices are most volatile around these times, so you may be able to capitalize on a sudden jump in price.

The point is not that there is a specific time period that’s ideal, or not ideal, when it comes to selling stocks. It’s best to familiarize yourself with the cadence of different economic reports (the jobs report, consumer confidence survey, interest rate changes, etc.), and learn what the impact of those data releases can be.

Once you have a sense of the literal ‘when’ of selling stocks, it’s up to you to judge the right time to make a move based on your rationale for why you want to do so.

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7 Reasons You Might Sell a Stock

There are several reasons that could prompt you to think about selling your stock.

1. When You No Longer Believe in the Company

When you bought shares of a certain company, you presumably did so because you believed that the company was promising and you wanted to invest in its stock, and/or that the share price was reasonable. But if you start to believe that the underlying fundamentals of the business are in decline, it might be time to sell the stock and reinvest those funds in a company with a better outlook.

There are many reasons you may lose faith in a stock’s underlying fundamentals. For example, the company may have declining profit margins or decreasing revenue, increased competition, new leadership taking the company in a different direction, or legal problems.

Part of the task here is differentiating what might be a short-term blip in the stock price due to a bad quarter or even a bad year, and what feels like it could be the start of a more sustained change within the business.

2. Due to Opportunity Cost

Every decision you make comes at the cost of some other decision you can’t make. When you spend your money on one thing, the tradeoff is that you cannot spend that money on something else.

The same goes for investing — for each stock you buy, you are doing so at the cost of not buying some other asset.

No matter the performance of the stock you’re currently holding, it might be worth evaluating to see if there could be a more profitable way to deploy those same dollars. Exchange-traded funds (ETFs) that provide easy access to other asset classes — like bonds or commodities — as well as newer markets like crypto, have also created competition to simply holding plain-vanilla company stocks.

This is easier said than done, however, because we are often emotionally invested in the stocks that we’ve already purchased. It may be a good idea to try and be as objective as possible during the evaluation and re-evaluation processes.

3. Because the Valuation Is High

Often, stocks are evaluated in terms of their price-to-earnings (P/E) ratios. The market price per share is on the top of the equation, and on the bottom of the equation is the earnings per share. This ratio allows investors to make an apples-to-apples comparison of the relative earnings at different companies.

The higher the number, the higher the price as compared to the earnings of that company. A P/E ratio alone might not tell you whether a stock is going to do well or poorly in the future. But when paired with other data, such as historical ratios for that same stock, or the earnings multiples of their competitors or a benchmark market, like the S&P 500 Index, it may be an indicator that the stock is currently overpriced and that it may be time to sell the stock.

A P/E ratio could increase due to one of two reasons: Because the price has increased without a corresponding increase in the expected earnings for that company, or because the earnings expectations have been lowered without a corresponding decrease in the price of the stock. Either of these scenarios tells us that there could be trouble for the stock on the horizon, though nothing’s a sure bet.

4. For Personal Reasons

Though not an analytical reason to sell, it is possible that you may need to sell a stock for personal reasons, such as needing a cash infusion in preparation for the home-buying process or some other purchase. If this is the case, you may want to consider a number of factors in choosing which stock to sell.

You may make the decision based purely on which stocks you feel have the worst forward-looking prospect for growth while keeping those that you feel have a better outlook.

5. Because of Taxes

Employing a tax-efficient investing strategy shouldn’t outweigh making decisions based on investment principles. Still, some people may take the rules of taxation into account when making decisions about which stocks to keep and which stocks to sell.

When purchased outside of a retirement account, gains on the sale of an investment like stock are subject to capital gains tax.

It may be possible to offset some capital gains with capital losses, which are triggered by selling stocks at a loss. If you’re considering this strategy, you may want to consult a tax professional. One strategy that some people use is tax-loss harvesting, where you purposely sell some investments at a loss in order to offset the tax consequences of gains in your portfolio.

6. To Rebalance a Portfolio

If you’re looking to make some tweaks to your investment strategy for one reason or another, you may want to sell some stocks as a part of a strategy to rebalance your portfolio. Investors are often encouraged to rebalance their portfolios often — but not too often — as market and economic conditions can and do change.

This typically involves taking a look at your desired asset allocation, thinking about your risk tolerance (and how it may have changed), and deciding how you may want to change the different asset classes that comprise your portfolio, if at all. Selling stocks would be involved in most rebalancing efforts.

7. Because You Made a Mistake

Finally, you may want to sell stocks if you simply made a mistake. You may have purchased shares of the wrong company, or bought a stock that is simply too risky, and are doing your due diligence and risk management in regards to your portfolio. If that’s the case, you can sell your stocks and reinvest the money elsewhere.

4 Reasons You Might Not Want to Sell a Stock

In addition to weighing possible reasons for selling a stock, there are counter arguments for holding onto your shares: e.g. having a knee-jerk reaction to the recent performance of that stock. There is, of course, a lot to think about when considering risk and investing, but you’ll need to know before buying any stocks that the markets are going to move — a lot.

1. Because a Stock Went Up

As mentioned, stock prices will go up at some point, and you may want to hold onto your stock in the hope that it will continue to grow. But that isn’t necessarily a good reason to try to time the market.

Even the experts cannot always buy at the bottom and sell at the top. There are no crystal balls, as they say. So even if a stock’s price is rising, you may want to have a few other reasons for not selling the stock.

2. Because a Stock Went Down

Conversely, stock prices will, at some point, go down. Again, it may be tempting to try and cut your losses before you accrue even bigger losses — assuming you think that the stock’s value will continue to plummet. But, again, it may be helpful to think longer-term rather than what’s happening today. Prices will, likely, rebound, and you may only lock your losses in by selling.

3. Because of an Economic Forecast

Economic forecasts come and go, and they change — a lot, and often. This is especially the case in the short term. Therefore, price changes may have as much to do with investor sentiment or outside forces (such as political or economic events or announcements) as they do with the health of the underlying company.

4. Because of Short-Term Reasons

There can be a million potential reasons that could spur you to sell your stocks in the short term. But many financial professionals will probably tell you that focusing on the longer term is a better idea, and not selling — i.e. using a classic buy-and-hold strategy — could lead to bigger returns over time.

So, barring some other reason, short-term issues or market fluctuations may not be a good reason to sell.

When to Sell Depends on You

Ultimately, whether you sell your stocks or not will boil down to your goals as an investor. That includes factors such as your investment style — are you looking at day trading, or employing a buy-and-hold strategy, for instance? — how much risk you’re willing to assume, and your overall time scale.

Many investors who are simply investing for retirement may very rarely sell stocks. Others, who are looking to turn a profit on a weekly or monthly basis, may sell much more frequently. It all depends on the individual. It’s more a matter of looking at what you’re hoping to generate from your investments, and how fast you’re hoping to generate it.

Risk, style, and how much time you have to do it are all critical variables.

Selling a Stock 101

These are the basic steps required to cash out and sell stocks:

1.    Whether by phone or via an online brokerage account platform, let your broker know which of your stock holdings you’d like to sell.

2.    Specify which order type (more on that below). This can determine at what price level your stock is sold.

3.    Fill out any other information your broker requires in order to initiate the sale. For instance, some accounts may have a “time in force” option, or when the order expires. Keep in mind, the trade date is different from the settlement date. It usually takes a couple of days for a trade to settle.

4.    Click “Sell” or “Submit Order.”

Different Sell Order Types

There are several different stock order types that can be useful in different situations.

Market Sell Order

This order type involves selling a stock immediately. The order will be executed without the investor specifying any price level to sell at. It’s important for investors to know however that because share prices are constantly shifting, they might not get the exact price they see on their stock-data feed. There may also be a difference due to delayed versus real-time stock quotes to consider as well.

Generally speaking, the advantage of using a market order is that your trade is likely to be executed quickly. That’s especially true for bigger or more popular stocks, which tend to be more liquid. But again: the biggest potential drawback is that you might not get the exact price you thought you were due to market volatility.

Limit Sell Order

Limit orders involve selling a stock at a specific price. For example, if you’re buying stocks, you can specify a price that you’re willing to pay — the trade will then be executed at that price, or lower.

If you’re selling stocks, the inverse is true — your stock will be sold at the specified price, or higher.

The upside to using limit orders is that they give investors some semblance of control by allowing them to name their price. The investor can then walk away, and let their brokerage handle the execution for them.

The downsides, though, include the fact that the trade may never execute if the specified price isn’t reached, and that using limit orders may take some practice and experience to properly execute.

Stop-Loss Sell Order

A stop-loss order is a level at which an automatic sell order kicks in. In other words, an investor specifies a price at which the broker should start selling, should the stock hit that level. This can also be referred to as a “sell-stop order.” But note that there are other types of stop-loss orders, such as buy-stop orders, and trailing stop-loss orders.

Stop-loss orders can be useful in that they can prevent investors from losing more than they’re comfortable with, or that they can afford to lose. They, as the name implies, are a very useful tool to prevent losses. But depending on overall market conditions, they can also work against an investor. If there’s a short-term drop in share prices, for instance, it’s possible that an investor could miss out on gains if share prices rebound in the medium or long term.

Stop-Limit Sell Order

A stop-limit sell order is an order that’s executed if your stock’s price drops to a certain price, but only if the shares can be sold at or above the limit price specified. They are, in effect, a sort of bridge between stop and limit orders. These types of orders can help investors dodge the risk that a stop order executed at an unexpected price, giving them more control over the price at which a sell order will execute.

Different Ways to Sell Stocks

There are desktop platforms and mobile phone apps that offer brokerage services. These are likely the most common platforms individual or retail investors use to currently buy or sell stocks. However, another option is through a financial advisor.

Financial advisors are professionals who have been entrusted to handle certain financial responsibilities and you can send them a stock sale order to execute. They can do a number of other things for you, too, including proffer advice and help you formulate an investing strategy. But there are costs to using financial advisors, so it may not be worth it, depending on how involved in the markets you are.

The Takeaway

Knowing when to sell stocks is not an intuitive thing — there are a lot of times when it may be a good idea to sell your stocks, and others when it’s not. For example, if you’ve lost faith in a company, need a cash infusion, or are doing some portfolio rebalancing, then it may be a good time to sell stock.

On the other hand, if you’re unnerved that your stock’s price fell after a bad earnings report, you may want to hold on and let things play out. It’s difficult, and is a true test of your risk tolerance. But over time, it should become easier and more natural as you gain experience as an investor.

With SoFi Invest®’s Automated Investing, a robo-advisor service, you can get an investment portfolio of ETFs suggested for you using your goals, risk tolerance, and investing time horizon as a guide. An alternative is SoFi’s Active Investing platform, which allows you to actively buy, sell, and trade stocks, ETFs and fractional shares.

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

FAQ

How can you tell when to sell a stock?

There’s no exact science, and determining whether it’s a good time to sell a stock will come down to the individual investor’s preference, risk tolerance, and time horizon. However, you can also keep an eye on a stock’s valuation, consider your opportunity costs, and weigh other factors in order to make a decision.

Should you ever sell stocks when they’re down?

You can sell stocks when they lose value for any number of reasons, but it’s likely best practice to make sure you’re doing so as a part of an overall investing strategy, e.g. tax-loss harvesting, and not simply because you’re making an emotional or irrational decision based on current market conditions.

How much profit do I need before I sell a stock?

There’s no exact science or answer to determine how much of a return you’d need to see before you sell a stock. That’s up to the specific investor, and there may be times when you actually generate a negative return when selling a stock.

SoFi Invest®
The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
Investment decisions should be based on an individual’s specific financial needs, goals, and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
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For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.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. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A.
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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.
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.
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Mar
29
2023
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2023 Tax Season: Capital Gains Tax Guide

By | Growing Wealth, invest, Investing | No Comments

What Is Capital Gains Tax?

Capital gains taxes are the taxes you pay on any profits you make from selling investments, like stocks, bonds, properties, cars, or businesses. The tax isn’t applied for owning these assets — it only hits when you profit from selling them.

It’s important for beginner investors to understand that a number of factors can affect their capital gains tax rate: how long they hold onto an investment, which asset they’re selling, the amount of their annual income, as well as their marital status.

Here’s a guide on how to calculate stock profits, and below are some basic facts about capital gains taxes.

Capital Gains Tax Rates Today

Whether you hold onto an investment for at least a year can make a big difference in how much you pay in taxes.

When you profit from an asset after owning it for a year or less, it’s considered a short-term capital gain. If you profit from it after owning it for at least a year, it’s a long-term capital gain.

💡 Recommended: Short-Term vs Long-Term Investments

Short-Term Capital Gains Tax Rates (for Tax Year 2022)

The short-term capital gains tax is taxed as regular income or at the “marginal rate,” so the rates are based on what tax bracket you’re in.

The Internal Revenue Service (IRS) changes these numbers every year to adjust for inflation. You may learn your tax bracket by going to the IRS website, or asking your accountant.

Here’s a table that breaks down the short-term capital gains tax rates for the 2022 tax year , or for tax returns that are filed in 2023.

Marginal Rate

 Income — Single

 Married, filing jointly
0% Up to $10,250 Up to $20,550
12% $10,275 to $41,775 $20,550 to $83,550
22% $41,776 to $89,075 $83,556 to $172,750
24% $89,076 to $170,050 $178,151 to $340,100
32% $170,051 to $215,950 $340,101 to $431,900
35% $215,951 to $539,900 $431,901 to $647,850
37% More than $539,900 More than $647,850

Long-Term Capital Gains Tax Rate By Income for Tax Year 2022 (or Tax Season 2023)

Long-term capital gains taxes for an individual are simpler and lower than for married couples. These rates fall into three brackets: 0%, 15%, and 20%.

The following table breaks down the long-term capital-gains tax rates for the 2022 tax year by income and status.

Capital Gains Tax Rate

 Income — Single

 Married, Filing Separately

 Head of Household

 Married, Filing Jointly
0% Up to $41,675 Up to $41,675 Up to $55,800 Up to $83,350
15% $41,676 to $459,750/td>

$41,676 to $258,600 $55,801 to $488,500 $83,351 to $517,200
20% More than $459,750 More than $258,600 More than $488,500 More than $517,200

A higher 28% is applied to long-term capital gains from transactions involving art, antiques, stamps, wine, and precious metals.

Additionally, individuals with modified adjusted gross incomes (MAGIs) over $200,000 and couples filing jointly with MAGIs over $250,00 — who have net investment income, may have to pay the Net Investment Income Tax (NIIT), which is 3.8% of certain net investment income.

Tips For Lowering Capital Gains Taxes

Hanging onto an investment for more than a year can lower your capital gains taxes significantly.

Capital gains taxes also don’t apply to so-called “tax-advantaged accounts” like 401(k) plans, IRAs, or 529 college savings accounts. So selling investments within these accounts won’t generate capital gains taxes. Instead, 401(k)s and IRAs are taxed when you take distributions, while qualified distributions for Roth IRAs and 529 plans are tax-free.

💡 Recommended: Benefits of Using a 529 College Savings Plan

Single homeowners also get a break on the first $250,000 they make from the sale of their primary residence, which they need to have lived in for at least two of the past five years. The limit is twice that for a married couple.

For newbie investors, it might be helpful to know that you may deduct as much as $3,000 in losses from an investment to help offset the amount of taxes on your income.

How US Capital Gains Taxes Compare

Generally, capital gains tax rates affect the richest taxpayers, who make a bigger chunk of their income from profitable investments.

Here’s a closer look at how capital gains taxes compare with other taxes, including those in other countries.

Compared to Other Taxes

The maximum long-term capital gains taxes rate of 20% is lower than the highest marginal rate of 37%.

Proponents of the lower long-term capital gains tax rate say the discrepancy exists to encourage investments as well as risk-taking. It may also prompt investors to sell their profitable investments more frequently, rather than hanging on to them.

Comparison to Capital Gains Taxes In Other Countries

In 2022, the Tax Foundation listed the capital gains taxes of the 27 different European Organization for Economic Cooperation and Development (OECD) countries. The U.S.’ maximum rate of 20% is roughly midway on the spectrum of comparable capital gains taxes.

In comparison, Denmark had the highest top capital gains tax at a rate of 42%. Norway was second-highest at 35.2%. Finland and France were third on the list, both at 34%. In addition, the following European countries all levied higher capital gains taxes than the U.S. (listed in order from highest to lowest): the Netherlands, Sweden, Portugal, Austria, Germany, Italy, Spain, and Iceland.

Compared With Historical Capital Gains Tax Rates

Because short-term capital gains tax rates are the same as those for wages and salaries, they adjust when ordinary income tax rates change. For instance, in 2018, tax rates went down because of the Trump Administration’s tax cuts. Therefore, so did short-term capital gains rates.

As for long-term capital gains tax, Americans today are paying rates that are relatively low historically. Today’s maximum long-term capital gains tax rate of 20% started in 2013.

For comparison, the high point for long-term capital gains tax was in the 1970s, when the maximum rate was at 35%.

Going back in time, in the 1920s the maximum rate was around 12%. From the early 1940s to the late 1960s, the rate was around 25%. Maximum rates were also pretty high, at around 28%, in the late 1980s and 1990s. Then, between 2004 and 2012, they dropped to 15%.

Tax Loss Harvesting

Tax loss harvesting is the strategy of purposely selling some investments at a loss to offset the taxable profits from another investment. It’s a way to delay paying taxes, not to eliminate paying them at all.

Using short-term losses to offset short-term gains is a good way to take advantage of tax loss harvesting — because, as we discussed above, short-term gains are taxed at higher rates. IRS rules also dictate that short-term or long-term losses must be used to offset gains of the same type, unless the losses exceed the gains from the same type.

Investors can also apply losses from investments of as much as $3,000 to offset income. And because tax losses don’t expire, if only a portion of losses was used to offset income in one year, the investor can “save” those losses to offset taxes in another year.

💡 Recommended: Is Automated Tax Loss Harvesting a Good Idea?

The Takeaway

Capital gains taxes are the levies you pay from making money on investments. The IRS updates the tax rates every year to adjust for inflation.

It’s important for investors to know that capital gains tax rates can differ significantly based on whether they’ve held an investment for at least a year. An investor’s income level also determines how much they pay in capital gains taxes.

An accountant or financial advisor can suggest ways to lower your capital gains taxes. When you open a SoFi Invest® brokerage account, you’ll gain access to a team of financial advisors who can help you set financial goals and determine your tolerance for risk. With as little as $1, investors can also sign up for a robo-advisor service that automatically builds and rebalances portfolios for members.

Learn more about SoFi Invest.

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.
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®
The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
Investment decisions should be based on an individual’s specific financial needs, goals, and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.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. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A.

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Mar
28
2023

Guide to Stock Volatility

By | Growing Wealth, invest, Investing | Comments Off on Guide to Stock Volatility

What Is Stock Volatility?

Stock volatility refers to how much a stock’s price or value increases and decreases within a specific period of time. Generally, the more volatile a stock is, the more risk an investor incurs when they purchase or hold it.

Stock volatility occurs when there are big swings in share prices in the stock market. Share prices can change quickly for a multitude of reasons. And while stock volatility usually describes significant declines in share prices, volatility can also happen on the upside.

But when thinking about what stock volatility is, it’s important to remember that stock volatility is often synonymous with risk for investors. That’s because investors generally prefer a steady source of returns rather than an erratic one. But volatility can present opportunities to generate returns, too.

Stocks are considered an important part of an investment portfolio and can be a tremendous source of wealth-building for investors. And while there are some lower-volatility equities versus higher-volatility ones, it’s undeniable that they are a turbulent asset class. That’s why understanding volatility, and how to measure stock volatility, is key to being a good stock investor. In fact, there are some stocks that are more attractive when they’re volatile.

However, volatility in the equity market can also represent significant opportunities for investors. For instance, investors might take advantage of volatility to buy the dip, purchasing shares when prices are momentarily lower.

How to Measure Stock Volatility

There are a handful of ways of how to measure stock volatility:

Standard Deviation

Standard deviation is a common stock volatility measure. Investors often measure an investment’s volatility by its standard deviation of returns compared to a broader market index or past returns. Standard deviation is a calculation determining the extent to which a data point deviates from an expected value, also known as the mean. In other words, it calculates how far off from “normal” a particular value is.

You can think of it this way: You might assume a stock has a value of $5, give or take $1.

A low standard deviation indicates that the data points tend to be close to this expected value. Therefore, an investment with a low standard deviation is considered to have low volatility. A high standard deviation indicates that the data points are spread out over a larger range. For investments, a high standard deviation generally translates to higher volatility.

This isn’t meant to be a math lesson, and calculating standard deviation can be a fairly involved process. You’re probably best off using an online calculator, but here’s what the formula looks like, if you’re curious:

σ = √∑(xi−μ)2 / N

Maximum Drawdown

Maximum drawdown, or MDD, is another stock volatility measure, and can give investors a sense of how much downside risk exists for a given stock. It basically measures the maximum fall in value that a stock has seen in the past, and is reflected in the difference between that maximum trough, and the highest peak in value before its value fell.

You may recognize the terms peak and trough when discussing the business cycle and bull markets, too. Accordingly, MDD is a peak-to-trough calculation, in other words. It’s a simpler calculation than standard deviation, too:

MDD= Trough Value−Peak Value / Peak Value​

VIX

Another popular measure of tracking volatility is the Cboe Volatility Index, otherwise known as the VIX. The VIX measures the short-term volatility of the U.S. stock market via a formula that uses options trading or the price of call and put contracts based on the S&P 500 Index.

Beta

Finally, investors can also monitor the risk in their stock holdings by finding their portfolio beta — or, a stock’s sensitivity to price swings in the broader market. Beta is the financial risk that stems from the entire market and can’t be diversified away.

What Causes Market Volatility?

The stock market is known for having boom-and-bust cycles, which is another way of describing volatility. Long periods of booming share prices tend to drive investors to take on more risk. They enter into more speculative positions and buy assets like high-risk stocks.

They may often adjust their own risk tolerance, and make themselves more vulnerable to shocks in the financial system, leading to market busts when investors need to sell their holdings en masse when the market is shaky.

💡 Recommended: What Is Flight to Quality? – A look at herd-like investor behavior.

Regarding individual stocks, events tied to the company’s performance, such as earnings or a product announcement, can drive volatility in its shares. But when it comes to broader market volatility, various factors can trigger more significant swings in share prices, like changes in economic policy or uncertainty over geopolitical events.

For instance, the early stages of the coronavirus pandemic in February and March 2020 created shockwaves in the markets. As economies across the globe shut down, investors began to sell off risky assets, bringing about high levels of volatility in the financial markets.

Governments enacted extraordinary fiscal and monetary stimulus programs to calm this volatility and bring stability to the markets.

Similarly, federal reserve interest rate increases during 2022 — instituted at the fastest rate in history in an effort to tamper inflation — likewise roiled the markets, causing stock volatility.

What Else Drives Volatility?

Other factors that can drive volatility include liquidity and the derivatives market. Stock liquidity is the ease with which an asset can be bought and sold without affecting prices. If an asset is tough to unload and gets sold at a significantly lower price, that could inject fear into the market and cause other investors to sell, ramping up volatility.

Separately, there’s sometimes a debate as to whether equity derivatives — contracts that are based on an underlying asset (e.g. futures and options) — can cause volatility. For instance, in 2020, investors debated whether large volumes of stock options trading caused sellers of the options, typically banks, to hedge themselves by buying stocks, exposing the market to sudden ups and downs when the banks had to purchase or sell shares quickly.

💡 Recommended: What Is a Derivative? A Beginner’s Guide

What Causes Stock Prices to Go Up?

As noted, any number of things can cause a stock’s price to go up — be it good or bad news. For instance, geopolitical events can cause certain stocks to appreciate in price. When there’s political instability, some investors seek safer investments and may pile into consumer staple stocks, or investments that track the price of precious metals.

When the economy is faring well, earnings season can be another time during which stock prices go up as companies report positive news to investors, who may, in turn, feel better about the economy overall, which can affect their investing decisions.

What Causes Stock Prices to Go Down?

What goes up may come down — right? Just as nearly anything and everything can drive stock prices up, there are numerous things that can likewise drive values down. That can include bad earnings reports from companies, or earnings data that doesn’t live up to expectations. Political or regulatory changes can also spook investors, who may sell certain stocks and drive prices down.

Again: Stock prices can go down for any and every reason, or no reason at all. This is as good a time as any to remind you that there really is no such thing as a completely safe investment.

How to Manage Volatility When Investing

Let’s pretend that it’s 2007, and an investor has money invested in the U.S. stock market. Unfortunately, this investor is facing one of the largest stock market crashes in history: The S&P 500 fell by 57% during the crash of 2007-2008.

This sort of dramatic drop in the stock market isn’t typical, and it can be traumatic even for the savviest and most experienced investor. So, the first step to handling stock market volatility is understanding that there will always be some price fluctuation.

The second step is to know one’s risk tolerance and financial goals, then invest, readjust, and rebalance your portfolio accordingly.

Balancing Risk and Reward

Generally speaking, higher rewards sometimes come with higher risks. For example, younger investors in their 20s might want to target high growth and be open to more volatile stocks. They may have enough time to weather the gains and losses and, possibly, come out ahead over time.

The reverse is true for someone approaching retirement who wants stable portfolio returns. With a shorter time horizon there’s less time to recover from volatility, so investing in lower risk securities may make more sense.

Some strategies offer ways that more cautious investors might take to mitigate volatility in their portfolios. One way is diversification.

Here is why portfolio diversification matters: Lower volatility stocks, such as utility or consumer staple companies, can add stability to a stock portfolio. Meanwhile, energy, technology, and consumer discretionary shares tend to be more turbulent because their businesses are more cyclical, or tied to the broader economy.

Another way to diversify one’s portfolio is to add bonds, alternative investments, or even cash. When deciding to add bonds or stocks to a portfolio, it’s helpful to know that the former is generally a less volatile asset class.

This is all very useful to know if you decide to start investing online, and managing your own portfolio.

There are a few other things to take into consideration when managing volatility in your portfolio.

Risk Tolerance Assessment

A big part of effectively managing stock volatility as it relates to your portfolio is knowing your limits, or, as discussed, your risk tolerance. How much risk can you actually handle when it comes down to it?

Every investor will need to give that question some thought when deciding how to deploy their money.

While bigger risks often come with bigger rewards, when the market does experience a downturn, there’s the outstanding question of whether you’ll stick to your investing strategy or cut and run. Each investor’s risk tolerance will be different, but it’s important to think about how you can actually handle the risk you take on when investing.

Long-Term Investing

One way to parry market volatility is to stick to a long-term investing strategy, such as a buy-and-hold strategy. If you stick to long-term investments rather than derivatives or other short-term assets or tools, you may be able to better weather market volatility — you don’t plan on making any moves with your portfolio, so you can somewhat ignore the day-to-day ups and downs of stock prices.

Timing Opportunities

You may also want to reframe your thinking around volatility, and remember that price movements also offer an opportunity to make money, rather than just see your share prices erode. This would involve some experience and luck, as timing the market isn’t generally considered a good or wise investing strategy for most investors. But if you know what you’re doing, it’s possible to use volatility to your advantage.

How Much Stock Volatility Is Normal?

The average stock market return in the U.S. is roughly 10% annualized over time. But 10% is an average — returns can be much higher or lower. For example, as measured by the S&P 500, equity prices closed out 2008 down 38%. Then, in 2009, they rallied by 23%. So, the average doesn’t really tell the entire story.

It’s also important to remember that past market performance is not indicative of future returns. But looking at history can help an investor gauge how much volatility and market fluctuation is normal. Since World War II, the S&P 500 has posted 13 drops of more than 20%. These prolonged downturns of 20% or more are considered bear markets.

💡 Recommended: Bear Market Investing Strategies

The table below shows the S&P 500’s returns from the highest point to the lowest point in a downturn. According to this data, bear markets average a decline of 34%, lasting a little more than a year. Bear markets have occurred as close together as two years and as far apart as nearly 12 years.

Peak (Start)

 Trough (End)

 Return

 Length (in days)
May 29, 1946 May 17, 1947 -29% 353
June 15, 1948 June 13, 1949 -21% 363
August 2, 1956 October 22, 1957 -22% 446
December 12, 1961 June 26, 1962 -28% 196
February 9, 1966 October 7, 1966 -22% 240
November 29, 1968 May 26, 1970 -36% 543
January 11, 1973 October 3, 1974 -48% 630
November 28, 1980 August 12, 1982 -27% 622
August 25, 1987 December 4, 1987 -34% 101
March 27, 2000 October 9, 2002 -49% 926
October 9, 2007 March 9, 2009 -57% 517
February 19, 2020 March 23, 2020 -34% 33
January 3, 2022 October 12, 2022 -25% 282
Average -33% 404

Investing in Stocks With SoFi

Stock volatility is the pace at which the market moves up or down during a certain period of time. It’s a complex topic that often sparks debate among investors, traders, and academics about what causes it.

While equities are considered an important part of any investment portfolio, they are also known for being volatile, and some degree of turbulence is something most stock investors have to live with.

However, for long-time investors, periods such as when the dot-com bubble burst in the early 2000s and the financial crisis of 2008 are defining moments when market volatility seemed to get out of hand. While such events are rare, investors may want to diversify their portfolios, monitor the share prices of their stock holdings, and seek downside protection when possible.

If an investor wants to pick stocks and exchange-traded funds (ETFs) for their portfolio, a SoFi online brokerage account might be a good option. The markets may be volatile, but SoFi’s user-friendly interface and helpful supporting materials may help smooth out the ride.

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

FAQ

What is the best stock volatility indicator?

There may not be a “best” stock market volatility indicator, but perhaps the most common or popular one is the VIX. An internet search will lead you to many more, however, that may be useful as well.

What is good volatility for a stock?

Every stock is going to have some level of volatility, so investors should expect it. But the higher the volatility, the riskier (and potentially worse) it is for investors. As such, a “good” level of volatility for a given stock is probably around 15% during a given year.

Is it good if a stock is volatile?

It can be good if a stock is volatile, as price movements open up opportunities for investors to generate returns — assuming they play their cards right. That said, volatility can also be a bad thing, as values can go down, too.

What causes volatility in a stock?

Just about anything and everything can cause stock volatility. Some of the more common causes of volatility, though, are earnings reports, geopolitical news and developments, or broader economic changes, such as recessions — or news of economic changes.

What is the meaning of volatility in the stock market?

Volatility, as it relates to the stock market, refers to the up-and-down nature of stock values. Stock prices go up and down all the time, but usually within a given range. That’s what volatility generally refers to, and investors should anticipate some level of volatility for each investment they buy.

SoFi Invest®
The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
Investment decisions should be based on an individual’s specific financial needs, goals, and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.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. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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 $10 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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Feb
22
2023
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Guide to Building an Investment Portfolio for Beginners

By | Growing Wealth, invest, Investing | No Comments

Investing can seem intimidating, especially for beginners who are just starting out. But building an investment portfolio is one of the best ways to grow your wealth over time.

Before you start pondering what you want to invest in and build an investment portfolio, think this through: Why am I investing? In the end, most of what matters is achieving your financial goals. And what are you saving for? By answering these questions, you can match your goals with your investment strategy — which is important if you want to give yourself a shot at your desired financial outcome.

The Basics: What Is an Investment Portfolio?

An investment portfolio is a collection of investments, such as stocks, bonds, mutual funds, exchange-traded funds (ETFs), real estate, and other assets. An investment portfolio aims to achieve specific investment goals, such as generating income, building wealth, or preserving capital, while managing market risk and volatility.

A well-diversified investment portfolio can help investors achieve their financial objectives over the long term.

Recommended: Investing for Beginners: Considerations and Ways to Get Started

Why Building a Balanced Portfolio Matters

Building a balanced investment portfolio matters for several reasons. As noted above, a balanced, diversified portfolio can help manage the risk and volatility of the financial markets. Many people avoid building an investment portfolio because they fear the swings of the market and the potential to lose money. But by diversifying investments across different asset classes and sectors, the impact of any one investment on the overall portfolio is reduced. This beginner investment strategy can help protect the portfolio from significant losses due to the poor performance of any one investment.

Additionally, a balanced portfolio can help investors achieve their long-term investment objectives. By including a mix of different types of investments, investors can benefit from the potential returns of different asset classes while minimizing risk. For example, building a portfolio made up of relatively risky, high-growth stocks and stable government bonds may allow you to benefit from long-term price growth from the stocks while also generating stable returns from the bonds.

What Is Your Risk Tolerance?

When it comes to braving risk, everyone is different. And in life, there are no guarantees. So where does that leave you? Take your risk temperature and see which type of investing you can live (and grow) with. Below are two general strategies many investors follow depending on their risk tolerance.

Aggressive Investing

An aggressive investment strategy is for investors who want to take risks to grow their money as much as possible. High risk sometimes means big losses (but not always). The idea here is to “go for it.” Find investments that feel like they have a lot of potential to generate significant gains.

Your stock picks can ride the rollercoaster, and if you opt for an aggressive investing strategy when you’re young and just starting out, you can watch them take the ride without you doing much hand-wringing.

If it doesn’t work out, you can own the loss and move on. Downturns happen. So do bull markets. And when you’re young, you can likely afford to take risks.

Conservative Investing

Conservative investing is for investors who are leery of losing a lot of their money. It may be better suited for older investors because the closer you get to your ultimate goal, the less room you will have for big drawdowns in your portfolio should the market sell off.

You can prioritize lower-risk investments as you inch closer to retirement. Research investments with more stable and conservative returns. Lower-risk investments can include fixed-income (bonds) and money-market accounts.

These investments may not have the same return-generating potential as high-risk stocks, but often the most important goal is to not lose money.

Choosing a Goal for Your Portfolio

Long- and short-term goals depend on where you are in life. Your relationship with money and investing may change as you get older and your circumstances evolve. As this happens, it’s best to understand your goals and figure out how to meet them ahead of time.

If you’re still a beginner investing in your 20s, you’re in luck. Time is on your side, and when building an investment portfolio, you have that time to make mistakes (and correct them).

You can also potentially afford to take more risks because you’ll have more time to work on reversing losses or at least shrugging them off and moving on.

If you’re older and closer to retirement age, you can reconfigure your investments so that your risks are lower and your investments become more conservative, predictable, and less prone to significant drops in value.

As you go through life, consider creating short and long-term goal timelines. If you keep them flexible, you can always change them as needed. But of course, you’d want to check on them regularly and the big financial picture they’re helping you create.

Short Term: Starting an Emergency Fund

Before you do any serious investing, making sure you have enough money stashed away for emergencies is a good idea. Loss of income, unplanned moves, health situations, auto repairs, and all of those other surprises can tap you on the shoulder at the worst possible time — and that’s when your emergency fund comes in.

It may make sense to keep your emergency money in liquid assets for short-term expenses. Liquidity helps ensure you can get your money if and when you need it. Try to take only a few risks with emergency money because you may not have time to recover if the market experiences a severe downturn.

Long Term: Starting a Retirement Fund

Think about what age you would want to retire and how much money you would need to live on yearly. You can use a retirement calculator to get a better idea.

One of the most frequently recommended strategies for long-term retirement savings is opening a 401(k), an IRA, or both. The benefit of this type of investment account is that they have tax advantages.

Another benefit of 401(k)s and IRAs is that they help you build an investment portfolio over decades: the long term.

Prioritizing Diversification

As mentioned above, portfolio diversification means keeping your money in more than one place: think stocks, bonds, and real estate. And once you diversify into those asset classes, you’ll need to drill down and diversify again within each sector.

Understanding Systematic Risk

Big things happen, like economic uncertainty, geopolitical conflicts, and pandemics. These incidents will affect almost all businesses, industries, and economies. There are not many places to hide during these events, so they’ll likely affect your investments too.

One smart way to fight this: diversify. Spread out. High-quality bonds, like U.S. Treasuries, tend to do well in these environments and have offset some of the negative performances that stocks usually suffer during these times.

It might also be helpful to calculate your portfolio’s beta, the systemic risk that can’t be diversified away. This can be done by measuring your portfolio’s sensitivity to broader market swings.

Understanding Idiosyncratic Risk

Smaller things happen. For instance, a scandal could rock a business, or a tech disruption could make a particular business suddenly obsolete. This risk is more micro than macro; it may occur in a specific company or industry.

As a result, a stock’s value could fall, along with the strength of your investment portfolio. The best way to fight this: diversify. Spread out. If you only invest in three companies and one goes under, that’s a big risk. If you invest in 20 companies and one goes under, not so much.

Owning many different assets that act differently in various environments can help smooth your investment journey, reduce your risk, and hopefully allow you to stick with your strategy and reach your goals.

4 Steps Towards Building an Investment Portfolio

Here are four steps toward building an investment portfolio:

1. Set Your Goals

The first step to building an investment portfolio is determining your investment goals. Are you investing to build wealth for retirement, to save for a down payment on a home, or another reason? Your investment goals will determine your investment strategy.

2. What Sort of Account Do You Want?

Investors can choose several kinds of investment accounts to build wealth. The type of investment accounts that investors should open depends on their investment goals and the investments they plan to make. Here are some common investment accounts that investors may consider:

•   Individual brokerage account: This is a standard brokerage account that allows investors to buy and sell stocks, bonds, mutual funds, ETFs, and other securities. This account is ideal for investors who want to manage their own investments and have the flexibility to buy and sell securities as they wish.

•   Retirement accounts: These different retirement plans, such as 401(k)s, IRAs, and Roth IRAs, offer tax advantages and are specifically designed for retirement savings. They have contribution limits and may restrict when and how withdrawals can be made.

•   Automated investing accounts: These accounts, also known as robo advisors, use algorithms to manage investments based on an investor’s goals and risk tolerance.

Recommended: What Is Automated Investing?

3. Choosing Investments Based on Risk Tolerance

Once you have set your investment goals, the next step is to determine your investments based on your risk tolerance. As discussed above, risk tolerance refers to the amount of risk you are willing to take with your investments. If you are comfortable with higher levels of risk, you may be able to invest in more aggressive assets, such as stocks or commodities. If you are risk-averse, you may prefer more conservative investments, such as bonds or certificates of deposit (CDs).

Recommended: How to Invest in Stocks: A Beginner’s Guide

4. Allocating Your Assets

The next step in building an investment portfolio is to choose your asset allocation. This involves deciding what percentage of your portfolio you want to allocate to different investments, such as stocks, bonds, and real estate.

Once you have built your investment portfolio, it is important to monitor it regularly and make necessary adjustments. This may include rebalancing your portfolio to ensure it remains diversified and aligned with your investment goals and risk tolerance.

Paying Off Debt First

Student loans and credit card debt may stand in the way of pumping money into your investment portfolio. Do what you can to pay off most or all of your debt, especially high-interest debt.

Get an aggressive repayment plan going. Also, remember it can be wise to pay yourself first (by that, we mean to keep a steady flow of cash flowing into your short and long-term investments before you pay anything else).

Investing in the Stock Market

Building an investment portfolio is a process that depends on where a person is in their life as well as their financial goals. Every individual should consider long-term and short-term investments and the importance of portfolio diversification when building an investment portfolio and investing in the stock market.

These are big decisions to make. And sometimes you may need help. That’s where SoFi comes in. With a SoFi Invest® online brokerage account, you can trade stocks, ETFs, fractional shares, and more with no commissions for as little as $5. And you can get access to educational resources to help learn more about the investing process.

Take a step toward reaching your financial goals with SoFi Invest.

FAQ

How much money do you need to start building an investment portfolio?

The amount of money needed to start building an investment portfolio can vary depending on the type of investments chosen, but it is possible to start with a small amount, such as a few hundred or thousand dollars. Some online brokers and investment platforms have no minimum requirement, making it possible for investors to start with very little money.

Can beginners create their own stock portfolios?

Beginners can create their own stock portfolios. Access to online brokers and trading platforms makes it easier for beginners to buy and sell stocks and build their own portfolios.

What should be included in investment portfolios?

Experts recommended that investment portfolios should be diversified with a mix of different types of investments, such as stocks, bonds, mutual funds, ETFs, and cash, depending on the investor’s goals, risk tolerance, and time horizon. Regular monitoring and rebalancing are important to keep the portfolio aligned with the investor’s objectives.

SoFi Invest®
The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
Investment decisions should be based on an individual’s specific financial needs, goals, and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.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. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A.
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Jan
04
2023
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What Is a Pattern Day Trader?

By | Financial Independence, invest, Investing | Comments Off on What Is a Pattern Day Trader?

A pattern day trader is actually a designation created by the Financial Industry Regulatory Authority (FINRA), and it refers to traders who day trade a security four or more times within a five-day period.

Because of their status, there are certain rules and stipulations that apply only to pattern day traders, which brokerages and investing firms must adhere to.

Read on to learn more about pattern day traders, what rules apply to them, and how they’re different from regular day traders.

Pattern Day Trader, Definition

The FINRA definition of a pattern day trader is clear: A brokerage or investing platform must classify investors as pattern day traders if they day trade a security four or more times in five business days, and the number of day trades accounts for more than 6% of their total trading activity for that same five-day period in a margin account.

When investors are identified as pattern day traders, they must have at least $25,000 in their trading account. Otherwise, the account could get restricted per FINRA’s day-trading margin requirement rules.

How Does Pattern Day Trading Work?

Pattern day trading works as the rules stipulate: An investor or trader trades a single security at least four times within a five business day window, and those moves amount to more than 6% of their overall trading activity.

Effectively, this may not look like much more than engaging in typical day trading strategies for the investor. The important elements at play are that the investor is engaging in a flurry of activity, often trading a single security, and using a margin account to do so.

Remember: A margin account allows the trader to borrow money to buy investments, so the brokerage that’s lending the trader money has an interest in making sure they can repay what they owe.

Example of Pattern Day Trading

Here is how pattern day trading might look in practice:

On Monday, you purchase 10 shares of Stock A using a margin account. Later that day, you sell the 10 shares of Stock A and make a small profit, as Stock A’s price increased over the course of the day.

On Tuesday, you buy 100 shares of Stock A, and sell 50 shares after two hours at a loss, so you sell 50 more after another two hours. You’ve made another small profit, but have also completed three day trades within a couple of days, all involving the same security.

On Thursday, you once again buy 100 shares of Stock A, and make two sales a couple of hours apart, just as you did on Tuesday, and come out even. You’ve now executed more than five trades with a single security within five business days, and run the risk of being labeled a pattern day trader.

Do Pattern Day Traders Make Money?

Yes, pattern day traders can and do make money — if they didn’t, nobody would engage in it, after all. But pattern day trading incurs much of the same risks of day trading. Day traders run the risk of getting in over their heads when using margin accounts, and finding themselves in debt.

This is why it’s important for aspiring day traders to make sure they have a clear and deep understanding of both margin and the use of leverage before they give serious thought to trading at a high level.

It’s the risks associated with it, too, that led to the development and implementation of the Pattern Day Trader Rule, which can have implications for investors.

What is the Pattern Day Trader Rule?

The Pattern Day Trader Rule established by FINRA requires that an investor have at least $25,000 cash and other eligible securities in their margin account in order to conduct four or more day trades within five days. If the account dips below $25,000, the investor will need to bring the balance back up in order to day trade again.

Essentially, this is to help make sure that the trader actually has the funds to cover their trading activity if they were to experience losses.

Note that, according to FINRA, a day trade occurs when a security is bought and then sold within a single day. However, simply purchasing shares of a security would not be considered a day trade, as long as that security is not sold later on that same day, per FINRA rules. This also applies to shorting a stock and options trading.

The PDT Rule established by FINRA requires that an investor have at least $25,000 in their margin account in order to conduct four or more day trades within five days.

But merely day trading isn’t enough to trigger the PDT Rule.

All brokerage and investing platforms are required by FINRA, a nongovernmental regulatory organization, to follow this rule. Most firms provide warnings to their clients if they are close to breaking the PDT rule or have already violated it. Breaking the rule may result in a trading platform placing a 90-day trading freeze on the client’s account. Brokers can allow for the $25,000 to be made up with cash, as well as eligible securities.

Some brokerages may have a broader definition for who is considered a “pattern day trader.” This means they could be stricter about which investors are classified as such, and they could place trading restrictions on those investors.

A broker can designate an investor a pattern day trader as long as the firm has a “reasonable basis” to do so, according to FINRA guidelines.

Why Did FINRA Create the Pattern Day Trader Rule?

FINRA and the Securities and Exchange Commission (SEC) created the PDT margin rule during the height of the dot-com bubble in the late 1990s and early 2000s in order to curb excessive risk-taking among individual traders.

FINRA and the Securities and Exchange Commission (SEC) created the PDT margin rule amidst the heyday of the dot-com bubble in order to curb excessive risk taking among individual traders.

FINRA set the minimum account requirement for pattern day traders at $25,000 after gathering input from a number of brokerage firms. The majority of these firms felt that a $25,000 “cushion” would alleviate the extra risks from day trading. Many firms felt that the $2,000 for regular margin accounts was insufficient as this minimum was set in 1974, before technology allowed for the electronic day trading that is popular today.

Investing platforms offering brokerage accounts are actually free to impose a higher minimum account requirement. Some investing platforms impose the $25,000 minimum balance requirement even on accounts that aren’t margin accounts.

Pattern Day Trader vs Day Trader

As discussed, there is a difference between a pattern day trader and a plain old day trader. The difference has to do with the details of their trading: Pattern day traders are more active and assume more risk than typical day traders, which is what catches the attention of their brokerages.

Essentially, a pattern day trader is someone who makes a habit of day trading. Any investor can engage in day trading — but it’s the repeated engagement of day trading that presents an identifiable pattern. That’s what present more of a risk to a brokerage, especially if the trader is trading on margin, and which may earn the trader the PDT label, and subject them to stricter rules.

Does the Pattern Day Trader Rule Apply to Margin Accounts?

As a refresher: Margin trading is when investors are allowed to make trades with some of their own money and some money that is borrowed from their broker. It’s a way for investors to boost their purchasing power. However, the big risk is that investors end up losing more money than their initial investment.

Investors trading on margin are required to keep a certain cash minimum. That balance is used as collateral by the brokerage firm for the loan that was provided. The initial minimum for a regular margin account is $2,000 (or 50% of the initial margin purchase, whichever is greater). Again, that minimum moves up to $25,000 if the investor is classified as a “pattern day trader.”

FINRA rules allow pattern day traders to get a boost in their buying power to four times the maintenance margin excess – any extra money besides the minimum required in a margin account. However, most brokerages don’t provide 4:1 leverage for positions held overnight, meaning investors may have to close positions before the trading day ends or face borrowing costs.

If an investor exceeds their buying power limitation, they can receive a margin call from their broker. The investor would have five days to meet this margin call, during which their buying power will be restricted to two times their maintenance margin. If the investor doesn’t meet the margin call in five days, their trading account can be restricted for 90 days.

Does the Pattern Day Trader Rule Apply to Cash Accounts?

Whether the Pattern Day Trader Rule applies to other types of investing accounts, like cash accounts, is up to the specific brokerage or investing firm. The primary difference between a cash account vs. a margin account is that with cash accounts, all trades are done with money investors have on hand. Some trading platforms only apply the PDT rule to margin accounts and don’t apply it to cash accounts.

However, some platforms may adhere to FINRA rules that govern margin accounts even if they don’t offer margin trading. This means that a $25,000 minimum balance of cash and other securities must be kept in order for an investor to do more than four day trades in a five-business-day window.

Investors with cash accounts also need to be careful of free riding violations. This is when an investor buys securities and then pays for the purchase by using proceeds from a sale of the same securities. Such a practice would be in violation of the Federal Reserve Board’s Regulation T and result in a 90-day trading freeze.

Pros of Being a Pattern Day Trader

The pros to being a pattern day trader are somewhat obvious: High-risk trading goes along with the potential for bigger rewards and higher profits. Traders also have a short-term time horizon, and aren’t necessarily locking up their resources in longer-term investments, either, which can be a positive for some investors.

Also, the use of leverage and margin allows them to potentially earn bigger returns while using a smaller amount of capital.

Cons of Being a Pattern Day Trader

The biggest and most obvious downside to being a pattern day trader is that you’re contending with a significant amount of risk. Using leverage and margin to trade compounds that risk, too, so day trading does require thick skin and the ability to handle a lot of risk. (Make sure to consider your risk tolerance and investment objectives before engaging in day trading.)

Given the intricacies of day trading, it can also be more time and research intensive.

Tips to Avoid Becoming a Pattern Day Trader

Here are some steps investors can take to avoid getting a PDT designation:

1.    Investors can call their brokerage or trading platform or carefully read the official rules on what kind of trading leads to a “Pattern Day Trader” designation, what restrictions can potentially be placed, and what types of accounts are affected.

2.    Investors can keep a close count of how many day trades they do in a rolling five-day period. It’s important to note that buying and selling during premarket and after-market trading hours can cause a trade to be considered a day trade. In addition, a large order that a broker could only execute by breaking up into many smaller orders may constitute multiple day trades.

3.    Investors can consider holding onto securities overnight. This will help them avoid making a trade count as a day trade, although with margin accounts, they may not have the 4:1 leverage afforded to them overnight.

4.    If an investor wants to make their fourth day trade in a five-day window, they can make sure they have $25,000 in cash and other securities in their brokerage account the night before to prevent the account from being frozen.

5.    Investors can open a brokerage account with another firm if they’ve already hit three day trades over five days with one trading platform. However, it’s good to keep in mind that the PDT rule is meant to protect investors from excessive risk taking. It’s also important to know that taking time to make wise or careful investment decisions could be in the investor’s favor.

The Takeaway

Pattern day traders, as spelled out by FINRA guidelines, are traders who trade a security four or more times within five business days, and their day trades amount to more than 6% of their total trading activity using a margin account.

Being labeled a pattern day trader by a brokerage can trigger the PDT Rule, which means that the trader needs to keep at least $25,000 in their margin account.

While day trading can reap big rewards, it also has big risks — and that’s something that brokerages are keenly aware of, and why they may choose to have stricter requirements for pattern day traders.

You can invest in stocks without becoming a day trader, of course. It’s easy when you open an account with SoFi Invest and set up an Active Invest account. You won’t pay any SoFi trading commissions, and you can learn to buy, sell, and trade stocks as you go.

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

FAQ

What happens if you get flagged as a pattern day trader?

If you’re labeled as a pattern day trader, your brokerage may require you to keep at least $25,000 in cash or other assets in your margin account as a sort of collateral.

Do pattern day traders make money?

Yes, some pattern day traders make money, which is why some people choose to do it professionally. But many, perhaps most, lose money, as there is a significant amount of risk that goes along with day trading.

What is the pattern day trader rule?

The Pattern Day Trader Rule was established by FINRA, and requires traders to have at least $25,000 in their margin account in order to conduct four or more day trades within five days. If the account dips below $25,000 the trader needs to deposit additional funds.

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