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 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.

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Q: 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.

Q: 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.

Q: 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.

Q: 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.

May

2024

What Is Stock Volatility and How Do You Measure It?

By Michael Flannelly | Growing Wealth, invest, Investing | Comments Off

Key Points

• Stock volatility refers to the variation in a stock’s price from its mean, and it can provide opportunities for investors.

• Standard deviation, beta, VIX, and maximum drawdown are common measures used to gauge stock volatility.

• Standard deviation measures how far a stock’s performance deviates from its average, while beta compares a stock’s volatility to the overall market.

• Factors such as company performance, investor behavior, global events, seasonality, and market cycles can contribute to stock market volatility.

• Balancing risk and reward, diversifying your portfolio, sticking to long-term investing strategies, avoiding timing the market, and considering dollar-cost averaging are effective ways to manage volatility when investing.

What Is Stock Volatility?

Stock volatility is often defined as big swings in price, but technically the volatility of a stock refers to how much its price tends to vary from the mean. The same is true of stock market volatility; when an index tends to perform a certain percentage above or below the mean, it’s a signal of volatility.

Generally, the higher the volatility of a stock, the more risk an investor incurs when they purchase or hold it. But volatility can also provide opportunities for some investors.

How to Measure Stock Volatility

There are a handful of ways to measure stock volatility. Each metric gives investors different information, and a different view of stock market fluctuations.

Standard Deviation

Standard deviation is a common stock volatility measure; it refers to how far a stock’s performance varies from its average. Investors often measure an investment’s volatility by the standard deviation of returns compared with a broader market index or past returns. Standard deviation measures the extent to which a data point deviates from an expected value, i.e. the mean return.

Beta

Beta is another way to measure volatility; it captures systematic risk, which refers to the volatility of a security (or of a portfolio) versus the market as a whole.

For example, beta can measure the volatility of a stock versus its benchmark (e.g. the S&P 500 or another relevant index). If a stock or mutual fund has a beta of 1.0, its inherent volatility is no different than the market at large. If the beta of a stock is higher or lower than its benchmark, that indicates higher or lower volatility.

Recommended: How to Find Portfolio Beta

VIX

The Cboe Global Markets Volatility Index, known as the VIX for short, is a tool used to measure implied volatility in the market. In simple terms, the VIX index tells investors how professional investors feel about the market at any given time.

The VIX Index is a real-time calculation that measures expected volatility in the stock market. One of the most recognized barometers of fluctuations in financial markets, the VIX measures how much volatility investing experts expect to see in the market over the next 30 days. This measurement reflects real-time quotes of S&P 500 Index (SPX) call option and put option prices.

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 (though not the risks of the stock market overall). 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. 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

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

Using Standard Deviation to Calculate Volatility

You can use the standard deviation and variance of returns to create a basic measure of stock volatility. This measure captures variance in price changes over a certain period of time, so you can gauge how far from the mean the stock price tends to go (i.e. how volatile it is).

Formula: σ √T = volatility, where:

σ = standard deviation of returns

T = number of time periods

1. To arrive at the variance, imagine a stock that starts in January with a monthly closing price of $10, and adds $1 per month. Month 1 = $10. Month 2 = $11. Month 3 = $12 … and so on, for all 12 months (or whatever time period you choose).

2. Add the stock price for each month, to arrive at a total of $186.

3. Divide $186 by the number of time periods (12 months in this case) to get an average stock price of $15.50 for the year.

4. Subtract the mean ($15.50) from each monthly value; include results that are negative numbers.

5. Square all the deviations (which will also remove negative numbers), and add them together to get the sum ($50.50); divide the sum by the number of time periods (in this case 12) to get a variance of $4.21.

6. Take the square root of $4.21 to get $2.05 = which is the standard deviation for this particular stock. Knowing this provides an important point of comparison for investors, because it indicates whether a stock’s price fluctuations could be within ‘normal’ ranges or too volatile.

Recommended: What Is a Stock?

Types of Stock Volatility

types of stock volatility

There are two common types of stock volatility that investors use to measure the riskiness of an investment: implied volatility and historical volatility. These two types of volatility are often used by options traders, who make trades based on the potential volatility of the options contract’s underlying asset.

Historical Volatility

Historical volatility (HV), also known as statistical volatility, is a measurement of the price dispersion of a financial security or index over a period of time. Investors calculate this by determining the average deviation from an average price. Historical volatility typically looks at daily returns, but some investors use it to look at intraday price changes.

As the name implies, historical volatility used past performance to assess present volatility. When a stock sees large daily price swings compared to its history, it will typically have a historical volatility reading. Historical volatility does not measure direction; it simply indicates the deviation from an average.

Implied Volatility

Implied volatility (IV) is a metric that captures the market’s expectation of future movements in the price of a security. Implied volatility employs a set of predictive factors to forecast the future changes of a security’s price.

Implied volatility doesn’t anticipate which way prices might move, up or down, only how likely the volatility will be.

What Causes Market Volatility?

what causes stock market volatility

The stock market is known for having boom-and-bust cycles, which is another way of describing stock market volatility. And there are numerous factors that can influence market volatility. Here are just a few:

• Company Performance: Regarding individual stocks, events tied to the company’s performance can drive volatility in its shares. This can include countless factors including: earnings reports, a product announcement, a merger, a change in management, and much more.

• Investor Behavior: Long periods of rising share prices tend to drive investors to take on more risk. They enter into more speculative positions and buy assets like high-risk stocks.

In doing so, investors may disregard their own risk tolerance, and make themselves more vulnerable to market shocks. This pattern can lead to market busts when investors need to sell their holdings en masse when the market is shaky.

• Global Events: For instance, the early stages of the COVID 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.

But even as these efforts took effect, other global factors — the war in Ukraine impacting energy prices — also took a toll. And 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.

• Seasonality: You’ve heard the old saying, “Sell in May and go away.” That’s a reflection of a phenomenon called market seasonality, which means that year in and year out there are certain patterns that tend to occur around the same times.

While seasonality certainly doesn’t guarantee any investment outcomes, some sectors do see more demand and greater production during specific times of year. Summer months tend to impact the travel sector; the fall might see an uptick in school-related consumer goods, and so on.

Depending on the year, this rise and fall of demand can impact volatility for some stocks.

• Market Cycles: In a similar way, markets also have their cycles; these cycles emerge thanks to trends generated by what’s going on in different business sectors. For example, the rapid evolution of AI in 2023 and early 2024 may have sparked a bit of a market cycle in the tech sector, as the demand for certain products and technologies jumped.

That said, it’s difficult to spot a market cycle until it’s over. Sometimes what appears to be a cycle is simply a normal set of fluctuations. But the anticipation or perception of a cycle can drive volatility.

• Liquidity: 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.

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, while others may fall. 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?

Just as nearly anything and everything can drive stock prices up, there are countless factors 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.

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

How to Manage Volatility When Investing

Let’s imagine that it’s 2007, and an individual has money invested in the U.S. stock market. Unfortunately, this investor is about to face one of the largest stock market crashes in history: The S&P 500 fell by 48% during the crash of 2008-2009.

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.

Balance Risk and Reward

Generally speaking, higher rewards sometimes come with higher risks. For example, younger investors in their 20s might want to target higher growth options 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.

Portfolio diversification involves investing your money across a range of different asset classes — such as stocks, bonds, and real estate — rather than concentrating all of it in one area. Studies have shown that by diversifying the assets in your portfolio, you may offset a certain amount of investment risk and thereby improve returns.

For example: 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 useful to know if you’re managing your own portfolio, or if you want to try automated investing, where a sophisticated algorithm provides different asset allocation options in pre-set portfolios.

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

Assess Risk Tolerance

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.

Stick to Long-Term Investing Strategies

One way to manage 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 can somewhat ignore the day-to-day ups and downs of stock prices, and in doing so you may be able to better weather market volatility.

Avoid Timing the Market

Timing the market, as it relates to trading and investing, means waiting for ideal market conditions, and then making a move to try and capitalize on the best market outcome. But nobody can predict the future, and this is a high-risk strategy.

When seeing stock market charts and business news headlines, it can be tempting to imagine you can strike it rich by timing your investments perfectly. In reality, figuring out when to buy or sell securities is extremely difficult. Both professional and at-home investors make serious mistakes when trying to time the market.

Consider Dollar-Cost Averaging

Dollar cost averaging is essentially a way to manage volatility as you continue to save and build wealth. It’s a basic investment strategy where you buy a fixed dollar amount of an investment on a regular cadence (e.g. weekly or monthly). The goal is not to invest when prices are high or low, but rather to keep your investment steady, and thereby avoid the temptation to time the market.

That’s because with dollar cost averaging (DCA) you invest the same dollar amount each time. When prices are lower, you buy more; when prices are higher, you buy less. Otherwise, you might be tempted to follow your emotions and buy less when prices drop, and more when prices are increasing (a common tendency among investors).

How Much Stock Volatility Is Normal?

The average stock market return in the U.S. is roughly 10% annualized over time, or about 6% or 7% taking inflation into account.

When looking at nearly 100 years of data, as of the end of July 26 2023, the yearly average stock market return was between 8% and 12% only eight times. In reality, stock market returns are typically much higher or much lower.

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 might be considered normal. Since the end of World War II, the S&P 500 has posted 14 drops of more than 20%, including the most recent in 2022 — a dip precipitated by the rapid rise in interest rates.

These prolonged downturns of 20% or more are considered bear markets. While bear markets have a bad name, they don’t always lead to recession, and on average bear markets are shorter than bull markets.

Investing in Stocks With SoFi

Stock volatility is the pace at which the price of a company’s shares move up or down during a certain period of time. Volatility is a complex topic, and it 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.

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

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

FAQ

Is volatility the same as risk?

In a sense, yes. Volatility is an indicator of risk. So a stock that is highly volatile, with big price changes, is considered riskier than a stock that is less volatile and maintains a more stable price.

Who should buy stocks when volatility strikes?

Certain types of investors, e.g. day traders and options traders, may have strategies that enable them to profit from volatile securities (although there are no guarantees). In some cases, ordinary investors with a very high risk tolerance may want to invest in a volatile stock — but they have to be willing to face the possibility of steep losses.

What is the best stock volatility indicator?

Perhaps the most common or popular one is the VIX. Depending on which way the VIX is trending, it may throw off buy or sell signals to investors. The VIX can be helpful for assessing risk in order to capitalize on anticipated market movements.

What is good volatility for a stock?

Deciding whether the volatility of a certain stock is “good” is a matter of your personal investing style and goals. Some investors may seek out volatile equities if they believe they have a strategy that can capitalize on price fluctuations. Other investors with a long-term view may not mind volatility if they believe the outcome over time will be favorable — while others may opt for as little volatility in their portfolios as possible.

What causes volatility in a stock?

Just about anything can cause stock volatility. Some of the more common causes of volatility are earnings reports or other company news; geopolitical news and developments; or broader economic changes, such as interest rate hikes or inflation.

Photo credit: iStock/FluxFactory

SoFi Invest®

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Feb

2024

2024 Tax Season: Capital Gains Tax Guide

By Carla Tardi | 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.

Read on to learn how capital gains work, the capital gains tax rates, and tips for lowering 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.

💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.

Short-Term Capital Gains Tax Rates (for Tax Year 2023)

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 2023 tax year, or for tax returns that are filed in 2024.

Marginal Rate	Income — Single	Married, filing jointly
10%	Up to $11,000	Up to $22,000
12%	$11,000 to $44,725	$22,000 to $89,450
22%	$44,725 to $95,375	$89,450 to $190,750
24%	$95,375 to $182,100	$190,750 to $364,200
32%	$182,100 to $231,250	$364,200 to $462,500
35%	$231,250 to $578,125	$462,500 to $693,750
37%	$578,125 or more	More than $693,750

Long-Term Capital Gains Tax Rate By Income for Tax Year 2023 (or Tax Season 2024)

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 2023 tax year by income and status.

Capital Gains Tax Rate	Income — Single	Married, Filing Separately	Head of Household	Married, Filing Jointly
0%	Up to $44,625	Up to $44,625	Up to $59,750	Up to $89,250
15%	$44,626 to $492,300	$44,626 to $276,900	$59,751 to $523,050	$89,251 to $553,850
20%	$492,301 or more	$276,901 or more	$523,051 or more	$553,851 or more

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 $250,000 — who have net investment income, may have to pay the Net Investment Income Tax (NIIT), which is 3.8% on the lesser of the net investment income or the excess over the MAGI limits.

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, traditional 401(k)s and IRAs are taxed when you take distributions, while qualified distributions for Roth IRAs and 529 plans are tax-free.

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 $500,000 for a married couple filing jointly.

For new 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 wealthiest taxpayers, who typically 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. 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 2023, 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 37.84%. 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): Ireland, 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%.

💡 Quick Tip: Did you know that investment losses aren’t necessarily bad news? Some losses can be used to offset gains, potentially reducing how much tax you owe. Learn more about investment taxes.

Tax Loss Harvesting

Tax loss harvesting is the strategy of selling some investments at a loss to offset the taxable profits from another investment.

Using short-term losses to offset short-term gains is a way to take advantage of tax loss harvesting — because, as 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.

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 as well as help you set financial goals.

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

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®

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

Dec

2023

Investing vs. Speculation: Understanding the Core Differences

By SoFi Editors | Growing Wealth, invest, Investing | Comments Off

All investments carry some risk, but the difference between speculating and investing is the amount of risk involved. Speculative investments are typically short-term, and far riskier than traditional investing products and strategies, and may involve the risk of total loss.

Investing typically indicates a more long-term approach to making a profit, with an eye toward managing risk.

Defining Investing and Speculation

Speculating often describes scenarios when there’s a high chance the investment will deliver losses, but also when the investment could result in a high profit. High-risk, high-reward investments include commodities, crypto, derivatives, futures, and more.

In contrast, investing generally refers to transactions where an individual has researched an asset, and puts money into it with the hope that prices will rise over time. There are no guarantees, of course, and all types of investing include some form of risk.

Examples of Investments and Speculative Investments

Assets that are thought of as more traditional types of investments include publicly traded stocks, mutual funds, exchange-traded funds (ETFs), bonds (e.g. U.S. Treasury bonds, municipal bonds, high-grade corporate bonds), and real estate.

Even some so-called alternative investments would be considered more long-term and less speculative: e.g., jewelry, art, collectibles.

Assets that are almost always considered speculative are junk bonds, options, futures, cryptocurrency, forex and foreign currencies, and investments in startup companies.

Sometimes it isn’t as simple as saying that all investments in the stock market or in exchange-traded funds or in mutual funds hold the same amount of risk, or are “definitely” classified as investments. Even within certain asset classes, there can be large variations across the speculation spectrum.

💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

The Traditional Approach to Investing

When it comes to the more traditional approach to investing, individuals typically buy and hold assets in their investment portfolios or retirement accounts, with the aim of seeing reasonable, long-term gains.

Traditional forms of investing focus on the performance of the underlying business or organization, not on the day-to-day or hour-by-hour price movements of an asset.

For this reason, more traditional investors tend to rely on various forms of analysis (e.g. fundamental analysis of stocks) and analytical tools and metrics to gauge the health of a company, asset, or market sector.

Speculation: A High-Risk, High-Reward Game

The difference between speculating and investing can be nuanced and a matter of opinion. (After all, some investors view the stock market as a form of gambling.) But when traders are speculating, they are typically seeking super-high gains in a relatively short period of time: e.g., hours, days, or weeks.

In the case of commodities or futures trading, the time horizon might be longer, but the aim of making a big profit fairly quickly is at the heart of most speculation.

Speculators may also use leverage, a.k.a. margin trading, to boost their buying power and amplify gains where possible (although using leverage can also lead to steep losses).

The Psychology of Investing vs. Speculating

The psychology of a typical investor is quite different from that of a speculative investor, and again revolves around the higher tolerance for risk in pursuit of a potentially bigger reward in a very short time frame.

Long-Term Investing	Speculating
Taking calculated or minimal risks	Willing to take on high-risk endeavors
Pursuit of reasonable gains	Pursuit of abnormally high returns
Willing to invest for the long term	Willing to invest only for the short term
Uses a mix of traditional investments and strategies (e.g. stocks, bonds, funds)	Uses single strategies and alternative investments
Infrequent use of leverage/margin	Frequent use of leverage/margin

Historical Perspectives on Investing and Speculation

The history of investing and speculating has long been entwined. In the earliest days of trading thousands of years ago, most markets were focused on the exchange of tangible commodities like livestock, grain, etc. Wealthy investors might put their money into global voyages or even wars. Thus many early investors could be described as speculators.

But investing in forms of debt as a way to make money was also common, eventually leading to the bond market as we know it today.

The concept of investing in companies and focusing on longer-term gains took hold gradually. As markets became more sophisticated over the centuries, and a wider range of technologies, strategies, and financial products came into use, the division between investing and speculating became more distinct.

Recommended: What Causes a Stock Market Bubble?

Speculation History: Notable Market Bubbles and Crashes

The history of investing is rife with market bubbles, manias, and crashes. While the speculative market around tulip bulbs in 17th-century Holland is well known, as is the Great Financial Crisis here in the U.S. in 2008-09, there have been many similar financial events throughout the world — most of them driven by speculation.

What marks a bubble is a well-established series of stages driven by investor emotions like exuberance (i.e., greed) followed by panic and loss. That’s because many investors tend to be irrational, especially when in pursuit of a quick profit that seems like “a sure thing.”

Some classic examples of financial bubbles that changed the course of history:

• The South Sea Bubble (U.K., 1711 to 1720) — The South Sea company was created in 1711 to help reduce national war debt. The company stock peaked in 1720 and then crashed, taking with it the fortunes of many.

• The Roaring Twenties (U.S., 1924 to 1929) — The 1920s saw a rapid expansion of the U.S. economy, thanks to both corporations’ and consumers’ growing use of credit. Stock market speculation reached a peak in 1929, followed by the infamous crash, and the Great Depression.

• Japanese Bubble Economy (1984 to 1989) — The Japanese economy experienced a historic two-decade period of growth beginning in the 1960s, that was further fueled by financial deregulation and widespread speculation that artificially inflated the worth of many corporations and land values. By late 1989, as the government raised interest rates, the economy fell into a prolonged slowdown that took years to recover from.

• Dot-Com Bubble (1995 to 2002) — Sparked by rapid internet adoption, the dot-com boom saw the rapid growth of tech companies in the late 1990s, when the Nasdaq rose 800%. But by October 2002 it had fallen 78% from that high mark.

Key Differences Between Investing and Speculating

What can be confusing for some investors is that there is an overlap between investing in the traditional sense, and speculative investing in higher risk instruments.

And some types of investing fall into the gray area between the two. For example, options trading, commodities trading, or buying IPO stock are considered high-risk endeavors that should be reserved for more experienced investors. What makes these types of investments more speculative, again, is the shorter time frame and the overall risk level.

Time Horizon: Long-term Goals vs. Quick Gains

As noted above, investors typically take a longer view and invest for a longer time frame; speculators seek quick-turn profits within a shorter period.

That’s because more traditional investors are inclined to seek profits over time, based on the quality of their investments. This strategy at its core is a way of managing risk in order to maximize potential gains.

Speculators are more aggressive: They’re geared toward quick profits, using a single strategy or asset to deliver an outsized gain — with a willingness to accept a much higher risk factor, and the potential for steep losses.

Fundamental Analysis vs. Market Timing

As a result of these two different mindsets, investors and speculators utilize different means of achieving their ends.

Investors focused on more traditional strategies might use tools like fundamental analysis to gauge the worthiness of an investment.

Speculators don’t necessarily base their choices on the quality of a certain asset. They’re more interested in the technical analysis of securities that will help them predict and, ideally, profit from short-term price movements.
While buy-and-hold investors focus on time in the market, speculators are looking to time the market.

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

Real-World Implications of Investment vs. Speculation

To better understand the respective value and impact of investing vs. speculating, it helps to consider the real-world implications of each strategy.

The Impact of Speculation on Markets

It’s important to remember that speculation occurs in many if not all market sectors. So speculation isn’t bad, nor does it always add to volatility — although in certain circumstances it can.

For example, some point to IPO shares as an example of how speculative investors, who are looking for quick profits, may help fuel the volatility of IPO stock.

Speculation does add liquidity to the markets, though, which facilitates trading. And speculative investors often inject cash into companies that need it, which provides a vital function in the economy.

Strategic Approaches to Investment

Whether an investor chooses a more traditional route or a more speculative one, or a combination of these strategies, comes down to that person’s skill, goals, and ability to tolerate risk.

Diversification and Asset Allocation

For more traditional, longer-term investors, there are two main tools in their toolkit that help manage risk over time.

• Diversification is the practice of investing in more than one asset class, and also diversifying within that asset class. Studies have shown that by diversifying the assets in your portfolio, you may offset a certain amount of investment risk and thereby improve returns.

• Asset allocation is the practice of balancing a portfolio between more aggressive and more conservative holdings, also with the aim of growth while managing risk.

When Does Speculation Make Sense?

Speculation makes sense for a certain type of investor, with a certain level of experience and risk profile. It’s not so much that speculative investing always makes sense in Cases A, B, or C. It’s more about an investor mastering certain speculative strategies to the degree that they feel comfortable with the level of risk they’re taking on.

The Takeaway

One way to differentiate between investment and speculation is through the lens of probability. If an asset is purchased that carries a reasonable probability of profit over time, it’s an investment. If an asset carries a higher likelihood of significant fluctuation and volatility, it is speculation.

A long-term commitment to a broad stock market investment, like an equity-based index fund, is generally considered an investment. Historical data shows us that the likelihood of seeing gains over long periods, like 20 years or more, is high.

Compare that with a trader who purchases a single stock with the expectation that the price will surge that very day (or even that year!) — which is far more difficult to predict and has a much lower probability of success.

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

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

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

Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments. Limitations apply to trading certain crypto assets and may not be available to residents of all states.

*Borrow at 12%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Aug

2023

Exploring Different Types of Investments

By Pam O’Brien | Growing Wealth, Investing | No Comments

You probably have things you want to do with your money down the road: buy a house, save for retirement, fund college for your kids, maybe even go on a big trip or do a major remodel. And you may be wondering if investing can help you achieve those goals.

It’s never too early or too late to start investing. There are a number of different ways you can put your money to work, including choosing different investment types.

9 Types of Investments

Before deciding on your investments, ask yourself what your financial goals are. Then try to build a portfolio that achieves those goals, balancing risk with return and maintaining a diverse mix of assets.

Having different types of investments, as well as short term vs long term investments can help you achieve portfolio diversification.

1. Stocks

When you think of investing and investment types, you probably think of the stock market. They are, essentially, investment fund basics. A stock gives an investor fractional ownership of a public company in units known as shares.

Only public companies trade on the stock market; private companies are privately owned. They can sometimes still be invested in, though the process isn’t always as easy and open to as many investors.

A stock makes money in two ways: It could pay dividends if the company decides to pay out part of its profits to its shareholders, or an investor could sell the stock for more than they bought it.

Some investors are looking for steady streams of income and therefore pick stocks because of their dividend payments. Others may look at value or growth stocks, companies that are trading below their true worth or those that are experiencing revenue or earnings gains at a faster pace.

Pros and Cons of Stock Investments
Pros	Cons
If the stock goes up, you can sell it for a profit.	There are no guaranteed returns. For instance, the market could suddenly go down.
Some stocks pay dividends to investors.	The stock market can be volatile. Returns can vary widely from year to year.
Stocks tend to offer higher potential returns than bonds.	You typically need to hang onto stocks for many years to achieve the highest potential returns.
Stocks are considered liquid assets, so you can typically sell them quickly if necessary.	You can lose a lot of money or get in over your head if you don’t do your research before investing.

2. Bonds

Bonds are essentially loans you make to a company or a government — federal or local — for a fixed period of time. In return for loaning them money, they promise to pay it back to you in the future and pay you interest in the meantime.

When it comes to bonds vs. stocks, the former are typically backed by the full faith and credit of the government or large companies. Because of this, they’re often considered lower risk than stocks.

However, the risk varies, and bonds are rated for their quality and credit-worthiness. Because the U.S. government is less likely to go bankrupt than an individual company, Treasury bonds are considered to be some of the least risky investments. However, they also tend to have lower returns.

Different Types of Bonds

Treasurys: These are bonds issued by the U.S. government. Treasurys can have maturities that range from one-month to 30-years, but the 10-year note is considered a benchmark for the bond market as a whole.

Municipal bonds: Local governments or agencies can also issue their own bonds. For example, a school district or water agency might take out a bond to pay for improvements or construction and then pay it off, with interest, at whatever terms they’ve established.

Corporate bonds: Corporations also issue bonds. These are typically given a credit rating, with AAA being the highest. High-yield bonds, also known as junk bonds, tend to have higher yields but lower credit ratings.

Mortgage and asset-backed bonds: Sometimes financial institutions bundle mortgages or other assets, like student loans and car loans, and then issue bonds backed by those loans and pass on the interest.

Zero-coupon bonds: Zero coupon bonds may be issued by the U.S. Treasury, corporations, and state and local government agencies. These bonds don’t pay interest. Instead, investors buy them at a great discount from their face value, and when a bond matures, the investor receives the face value of the bond.

Pros and Cons of Bond Investments
Pros	Cons
Bonds offer regular interest payments.	The rate of returns with bonds tends to be much lower than it is with stocks.
Bonds tend to be lower risk than stocks.	Bond trading is not as fluid as stock trading. That means bonds may be more difficult to sell.
Treasurys are considered to be safe investments.	Bonds can decrease in value during periods of high interest rates.
High-yield bonds tend to pay higher returns and they have more consistent rates.	High-yield bonds are riskier and have a higher risk of default, and investors could potentially lose all the money they’ve invested in them.

💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.

3. Mutual Funds

A mutual fund is an investment managed by a professional. Funds typically focus on an asset class, industry or region, and investors pay fees to the fund manager to choose investments and buy and sell them at favorable prices.

Pros and Cons of Mutual Fund Investments
Pros	Cons
Mutual funds are easy and convenient to buy.	There is typically a minimum investment you need to make.
They ate more diversified than stocks and bonds so they carry less risk.	Mutual funds typically require an annual fee called an expense ratio and some funds may also have sales charges.
A professional manager chooses the investments for you.	Trades are executed only once per day at the close of the market, which means you can’t buy or sell mutual funds in real time.
You earn money when the assets in the mutual fund rise in value.	The management team could be poor or make bad decisions.
There is dividend reinvestment, meaning dividends can be used to buy additional shares in the fund, which could help your investment grow.	You will generally owe taxes on distributions from the fund.

4. ETF

Exchange traded funds can appear to be similar to a mutual fund, but the main difference is that ETFs can be traded on a stock exchange, giving investors the flexibility to buy and sell throughout the day. They also come in a range of asset mixes.

Pros and Cons of ETF Investments
Pros	Cons
ETFs are easy to buy and sell on the stock market.	The ease of trading ETFs might tempt an investor to sell an investment they should hold onto.
They often have lower annual expense ratios (annual fees) than mutual funds.	A brokerage may charge commission for ETF trades.This could be in addition to fund management fees.
ETFs can help diversify your portfolio.	May provide a lower yield on asset gains (as opposed to investing directly in the asset).
They are more liquid than mutual funds.

5. Annuities

An annuity is an insurance contract that an individual pays upfront and, in turn, receives set payments.

There are fixed annuities, which guarantee a set payment, and variable annuities, which put people’s payments into investment options and pay out down the road at set intervals. There are also immediate annuities that begin making regular payments to investors right away.

Pros and Cons of Annuity Investments
Pros	Cons
Annuities are generally low risk investments.	Annuities typically offer lower returns compared to stocks and bonds.
They offer regular payments.	They typically have high fees.
Some types offer guaranteed rates of return.	Annuities are complex and difficult to understand.
Can be a good supplement investment for retirement.	It can be challenging to get out of an annuities contract.

6. Derivatives

There are several types of derivatives but two popular ones are futures and options. Futures contracts are agreements to buy or sell something (a security or a commodity) at a fixed price in the future.

Meanwhile, in options trading, buyers have the right, but not the obligation, to buy an asset at a set price.

A derivatives trading guide can be helpful to learn more about how these investments work.

Pros and Cons of Derivative Investments
Pros	Cons
Derivatives allow investors to lock in a price on a security or commodity.	Derivatives can be very risky and are best left to traders who have experience with them.
They can be helpful for mitigating risk with certain assets.	Trading derivatives is very complex.
They provide income when an investor sells them.	Because they expire on a certain date, the timing might not work in your favor.

7. Commodities

A commodity is a raw material — such as oil, gold, corn or coffee. Trading commodities has a reputation for being risky and volatile. That’s because they’re heavily driven by supply and demand forces. Say for instance, there’s a bad harvest of coffee beans one year. That might help push up prices. But on the other hand, if a country discovers a major oil field, that could dramatically depress prices of the fuel.

Investors have several ways they can gain exposure to commodities. They can directly hold the physical commodity, although this option is very rare for individual investors (Imagine having to store barrels and barrels of oil).

So many investors wager on commodity markets via derivatives — financial contracts whose prices are tied to the underlying raw material. For instance, instead of buying physical bars of precious metals to invest in them, a trader might use futures contracts to make speculative bets on gold or silver. Another way that retail investors may get exposure to commodities is through exchanged-traded funds (ETFs) that track prices of raw materials.

Pros and Cons of Commodity Investments
Pros	Cons
Commodities can diversify an investor’s portfolio.	Commodities are considered high-risk investments because the commodities market can fluctuate based on factors like the weather. Prices could plummet suddenly.
Commodities tend to be more protected from the volatility of the stock market than stocks and bonds.	Commodities trading is often best left to investors experienced in trading in them.
Prices of commodities are driven by supply and demand instead of the market, which can make them more resilient.	Commodities offer no dividends.
Investing in commodities can help hedge against inflation because commodities prices rise when consumer prices do.	An investor could end up having to take physical possession of a commodity if they don’t close out the position, and/or having to sell it.

8. Real Estate

Owning real estate, either directly or as part of real estate investment trust (REIT) investing or limited partnerships, gives you a tangible asset that may increase in value over time.

If you become invested in real estate outside of your own home, rent payments can be a regular source of income. However, real estate can also be risky and labor-intensive.

Pros and Cons of Real Estate Investments
Pros	Cons
Real estate is a tangible asset that tends to appreciate in value.	Real estate is not liquid. You may have a tough time selling it quickly.
There are typically tax deductions and benefits, depending on what you own.	There are constant ongoing expenses to maintain a property.
Investing in real estate with a REIT can help diversify your portfolio.	Owning rental property is a lot of work. You have to handle managing it, cleaning it, and making repairs.
By law, REITs must pay 90% of their income in dividends.	With a REIT, dividends are taxed at a rate that’s usually higher than the rate for many other investments.
REITs offer more liquidity than owning rental property you need to sell.	REITs are generally very sensitive to changes in interest rates, especially rising rates.
REITs don’t require the work that maintaining a rental property does.	REITs can be a risky short-term investment and investors should plan to hold onto them for the long term.

9. Private Companies

Only public companies sell shares of stock, however private companies do also look for investment at times — it typically comes in the form of private rounds of direct funding. If the company you invest in ends up increasing in value, that can pay off, but it can also be risky.

Pros and Cons of Investing in Private Companies
Pros	Cons
Potential for good returns on your investment.	You could lose your money if the company fails.
Lets investors get in early with promising startups and/or innovative technology or products.	The value of your shares in the company could be reduced if the company issues new shares or chooses to raise additional capital. Your shares may then be worth less (this is known as dilution).
Investing in private companies can help diversify your portfolio.	Investing in a private company is illiquid, and it can be very difficult to sell your assets.
	Dividends are rarely paid by private companies.
	There could be potential for fraud since private company investment tends to be less regulated than other investments.

Investment Account Options

An investor can put money into different types of investment accounts, each with their own benefits. The type of account can impact what kinds of returns an investor sees, as well as when and how they can withdraw their money.

401(k)

A 401(k) plan is a retirement account provided by your employer. You can often put money into a 401(k) account via a simple payroll deduction, and in a traditional 401(k), your contribution isn’t taxed as income. Many employers will also match your contributions to a certain point. The IRS puts caps on how much you can contribute to a 401(k) annually.

Pros and Cons of 401(k)s
Pros	Cons
Contributions you make to a 401(k) can reduce your taxable income. The money is not taxed until you withdraw it when you retire.	There is a cap on how much you can contribute each year.
Contributions can be automatically deducted from your paycheck.	Most withdrawals before age 59 ½ will incur a 10% penalty
Your employer may provide matching funds up to a certain limit.	You must take required minimum distributions from the plan (RMDs) when you reach a certain age.
You can roll over a 401(k) if you leave your job.	You may have limited investment options.

IRA

IRA stands for “individual retirement account” — so it isn’t tied to an employer. There are IRS guidelines for IRAs, but, essentially, they’re retirement accounts for individuals. IRAs allow people to set aside money pre-tax for retirement without needing an employer-backed 401(k).

Pros and Cons of 401(k)s
Pros	Cons
Contributions are tax deferred. You don’t pay taxes until you withdraw the funds.	Low contribution limits ($6,500 in 2023).
You can choose how the money is invested, giving you more control.	There is a 10% penalty for most early withdrawals before age 59 ½.
Those aged 50 and over can contribute an extra $1,000 in catch-up contributions.

Brokerage Accounts

A brokerage account is a taxed account through which you can buy most of the investments discussed here: stocks, bonds, ETFs. Some brokerage firms charge fees on the trades you make, while others offer free trading but send your orders to third parties to execute — a practice known as payment for order flow. Investors can be taxed on any realized gains.

You might also consider enlisting the help of a wealth manager or financial advisor who can provide financial planning and advice, and then manage your portfolio and wealth. Typically, these advisors are paid a fee based on the assets they manage.

There are even a number of investment options out there not listed here — like buying into a venture capital firm if you’re a high-net-worth individual or putting funding into your own business.

Pros and Cons of 401(k)s
Pros	Cons
Offer flexibility to invest in a wide range of assets.	You must pay taxes on your investment income and capital gains in the year they are received.
Brokerage accounts provide the potential for growth, depending on your investments. However, all investments come with risks that include the potential for loss.	Investments in brokerage accounts are not tax deductible.
You can contribute as much as you like to a brokerage account.	There is a risk that you could lose the money you invested.

Investing With SoFi

It might still seem overwhelming to figure out what kinds of investments will help you achieve your goals. There are different investment strategies and finding the right one can depend on where you are in your career, what your financial goals are and how far away retirement is.

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

FAQ

What is the most common investment type?

Stocks are one of the most common and well-known types of investments. A stock gives an investor fractional ownership of a public company in units known as shares.

How do I decide when to invest?

Some prime times to start investing include when you have a retirement fund at work that you can contribute to and that your employer may contribute matching funds to (up to a certain amount); you have an emergency fund of three to six months’ worth of money already set aside and you have additional money to invest for your future; there are financial goals you’re ready to save up for, such as buying a house, saving for your kids’ college funds, or investing for retirement. Please remember you need to consider your investment objectives and risk tolerance when deciding the “right” time to start investing.

Should I use multiple investment types?

Yes. It’s wise to diversify your portfolio. That way, you’ll have different types of assets which will increase the chances that some of them will do well even when others don’t. This will also help reduce your risk of losing money on one single type of investment. In short, having a diverse mix of assets helps you balance risk with return. However, diversification does not eliminate all risk.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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®

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

Aug

2023

What Is a Pattern Day Trader?

By Inyoung Hwang | Financial Independence, invest, Investing | Comments Off

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. This is a day trade.

On Tuesday, you purchase 15 shares of stock A in the morning and then sell the 15 shares soon after lunch. Subsequently, you purchase 5 shares of stock A, which you hold only briefly before selling prior to the market close. You have completed two day trades during the day, bringing your running total — including Monday’s trades — to three.

On Thursday, you purchase 10 shares of stock A and 5 shares of stock B in the morning. That same afternoon, you sell the 10 shares of stock A and the 5 shares of stock B. This also constitutes two day trades, bringing your total day trades to five during the running four-day period. Because you have executed four or more day trades in a rolling five business day period, you may now be flagged as a pattern day trader.

Note: Depending on whether your firm uses an alternative method of calculating day trades, multiple trades where there is no change in direction might only count as one day trade. For example:

• Buy 20 shares of stock A

• Sell 15 shares of stock A

• Sell 5 shares of stock A

If done within a single day, this could still only count as one day trade.

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.

If you’re an experienced trader and have the risk tolerance to try out trading on margin, consider enabling a SoFi margin account. With a SoFi margin account, experienced investors can take advantage of more investment opportunities, and potentially increase returns. That said, margin trading is a high-risk endeavor, and using margin loans can amplify losses as well as gains.

Get one of the most competitive margin loan rates with SoFi, 12%*

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.

*Borrow at 12%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
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