InvestGen Archives | Page 5 of 64

Aug

2024

What Is an Exponential Moving Average (EMA) in Stock Trading? How Does It Work?

What Is Exponential Moving Average (EMA)?

By Laurel Tincher | Growing Wealth, invest, Investing | Comments Off

An exponential moving average (EMA) is a commonly used average price calculation done for a specific time period that places more weight and importance on the most recent price data. Since it is weighted this way it reacts faster to recent price changes than a simple moving average (SMA) which is a type of average price calculation, which equally weights all data points within a time period.

Moving averages are technical analysis trading indicators used by traders to help them understand the direction, market trend, and strength of price movement of an asset. They measure the average price of a security by taking averages of the prices of the security over a specific period of time, and can be used to show traders the location of support and resistance levels. Read on to learn more about the meaning of EMA in stocks, the EMA formula, and how to calculate EMA.

Key Points

• An exponential moving average (EMA) gives more weight to recent price data, making it a useful tool for traders to gauge market trends and price movements.

• The formula for calculating EMA incorporates the current price, the previous EMA, and an exponential smoothing constant, allowing for dynamic adjustments based on market behavior.

• Calculating EMA involves determining the simple moving average first, then applying a weighting multiplier, and finally using the EMA formula to derive values.

• While EMAs can effectively indicate support and resistance levels, they have limitations, such as lagging indicators and the potential for false signals in flat markets.

• Traders often use EMA alongside other indicators to enhance their analysis, helping them make informed decisions about entry and exit points in their trading strategies.

What is EMA?

An EMA, exponentially weighted moving average, is a type of moving average (MA) used by traders to evaluate the potential trajectory of a financial security. Using the EMA calculation, the most recent price data has the greatest impact on the moving average, while older data has a lower impact. The previous EMA value is included in the calculation, so the current value includes all the price data.

As noted, it reacts faster to price changes than a simple moving average, which may be helpful to some investors.

EMA Formula

The formula for calculating EMA is:

EMA = (K x (C – P)) + P

Where:

C = Current Price

P = Previous Period’s EMA (for the first period calculated the SMA is used)

K = Exponential Smoothing Constant (this applies appropriate weight to the most recent security price, using the number of periods specified in the moving average. The most common smoothing constant is 2, but the higher it is the more influence recent data points have on the EMA)

💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

How to Calculate EMA

Technical analysts follow three steps to calculating an EMA.

1. Calculate the simple moving average (SMA) to find the initial EMA data point. The SMA is used as the previous period’s EMA for the first calculated data point of the EMA. To calculate the SMA of the last 20 days, a trader would add the amounts of the last 20 closing prices of the security and then divide that sum by 20.

2. Calculate the weighting multiplier for the number of periods that will be used to calculate the EMA. The number of periods used for the EMA has a significant impact on the value of the weighting multiplier.

The formula for finding the weighting multiplier is:

EMA(current) = ((Price(current) – EMA (prev)) x Multiplier) + EMA(prev)

3. Calculate the EMA using the formula described above.

Some traders also use the open, high, low, or median price instead of the closing price for the EMA calculation.

Example of EMA

Taking the above into consideration and following the three steps to calculate EMA, here’s an example of how it might all come together.

Again, here’s the EMA formula: EMA = (K x (C – P)) + P

We’ll assume that the previous period’s EMA is 50, and that the current price is 60. We’ll also assume that our smoothing constant is 2, for simplicity’s sake.

So: EMA= (2 x (60 – 50)) + 50 = 70

What Does EMA Show You?

An EMA follows prices more closely than a SMA since it puts more weight on recent data points. This is helpful for determining when to enter and exit trades. EMA is a lagging indicator that shows market trends and directions and the strength of price movements. It’s best used in trending markets.

By looking at past trends traders can gain an understanding of what might happen with a security’s price in the future, which may help them identify investment opportunities. Although past performance is no guarantee of future performance.

Limitations of Using EMA

Although EMA is a very useful trading tool, it does have some constraints.

• Spotting trends and directions using EMA is difficult in a flat market.

• The EMA shows present market trends but is not a predictor of future trends and prices. It also doesn’t show exact highs and lows or precise entry and exit points.

• The EMA can show false signals and can show more short term price changes that aren’t trading indicators.

• Even though it is weighted toward recent prices, the EMA does rely on past price movements, so it is a lagging indicator. Because of this the optimal time to enter a trade may have already passed by the time the trend direction shows up in an EMA chart.

How Investors Can Use EMA

Usually traders look at the direction the EMA is going in and they trade in the direction of the trend. In addition to spotting market trends and direction, EMA can also identify spot reversals that occur when a security is overbought or oversold.

The EMA is a fairly accurate tool because stock prices typically only stray so far from the average before returning to test the average, creating support or resistance and continuing to rise or fall. Even beginning investors can use EMA to spot trends and gain an understanding of what direction the market is heading.

Like other indicators, It’s best to use EMA in conjunction with other tools such as relative strength index (RSI) and moving average convergence divergence (MACD) to get a more comprehensive and accurate picture of the market. There are a few ways investors can use EMA:

Trend Trading

Traders can use the EMA to discover and trade primary market trends. When the EMA rises this is a bullish indicator, a trader may buy when the stock price dips to hit the EMA line or just below it. When EMA goes down, a trader might sell their position when the stock price goes up to hit the EMA line or just above. If the stock has a closing price that crosses over the average line, the trader closes out their trade.

Support and Resistance

EMA lines can track support and resistance levels, another useful way to track price movements and trends. If EMA goes up, this is a support indicator, while if it goes down this shows resistance to the security’s price movement.

Buy and Sell Signals

Traders can set up fast and slow moving averages and then find buy and sell signals when the two lines cross each other.

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

The Takeaway

EMA is a useful tool for both advanced and beginner traders to understand market trends and directions. It’s a technical indicator that evaluates a stock’s price trend with a greater emphasis on recent price levels.

Whether you’re planning to use in-depth technical analysis or not, a great way to get started building a portfolio is by opening an investment account on the SoFi Invest® stock trading app. It lets you research, track, buy and sell stocks, exchange-traded funds, and other assets right from your phone.

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

FAQ

Which EMA is best?

Day traders often use 8- and 20-day EMA periods, while long-term investors use 50- and 200-day EMA. Indicators such as the moving average convergence divergence (MACD) and percentage price oscillator (PPO) use 12- and 26-day periods. If a security passes over a 200-day EMA this is a technical sign that a trend reversal has occurred.

What’s the difference between EMA and SMA?

Both simple moving average and exponential moving average are used by traders to measure market trends. They both create a graphical line that smoothes out price fluctuations using calculated averages. But they weigh price data differently, and may have different sensitivities to price changes.

What is 5 EMA and 20 EMA?

There are different EMAs referring to different time periods that can identify trends. In that sense, 5 EMA and 20 EMA refers to the 5-day and 20-day EMA, a shorter and longer-term EMA measure.

Photo credit: iStock/South_agency

SoFi Invest®

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

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

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

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

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Aug

2024

Shorting a Stock Defined and How Short Selling Works

By Brian Nibley | Investing | Comments Off

Shorting a stock, also known as short selling, is one way to potentially profit from a stock’s price decline. When investors think a stock’s price will fall, they can sell borrowed shares, hope to buy them back at a lower price, and pocket the difference as profit. This strategy is popular among savvy, risk-tolerant investors with a knack for market research and predicting trends.

Short selling is one of the strategies that make it possible to make money in the market no matter how it moves — up, down, or sideways. For new investors, the idea of making trades that can be profitable even when the price falls may sound strange. After all, the traditional way to profit in financial markets is a buy-and-hold strategy: purchasing a security, holding it, and selling it later for a higher price. However, by understanding how short selling works, investors can utilize new strategies to bolster their financial portfolios.

Key Points

• Shorting a stock involves borrowing shares to sell at a high price, hoping to repurchase them later at a lower price for profit.

• The strategy can be risky, as potential losses are unlimited if the stock price rises instead of falling.

• A short squeeze occurs when a sudden price increase forces short sellers to buy shares back quickly, further driving up the stock price.

• Alternatives to short selling include purchasing put options, which allow investors to profit from stock price declines without borrowing shares.

• Short selling may serve as a hedge against other investments, but it requires careful consideration due to its high risk and potential costs.

What Is Shorting a Stock?

A trader shorts a stock when they think the stock price will fall. Shorting involves borrowing the stock from a brokerage, selling it, and then buying it when the price is lower than when they sold. The trader then returns the shares to the brokerage and pockets the profit.

Shorting a stock is a way for investors to bet that a particular stock’s future share price will be lower than its current price. It’s the opposite of going long a stock, where an investor buys shares with the expectation that the stock price will increase.

Short selling can be risky because if the stock price goes up instead of down, the investor will have to buy the shares at a higher price and may lose money.

💡 Recommended: Short Position vs Long Position, Explained

Example of Shorting a Stock

Suppose an investor found a company that they think is overvalued, so its share price is likely to decline. They borrow 100 shares of stock in company A from their brokerage and sell the shares for $10 per share for a total of $1,000 (plus any applicable brokerage fees).

In scenario A, the investor made a spot-on prediction, and the price fell to $9 per share. The investor can buy back 100 shares for $9 per share for $900, return the borrowed shares, and pocket the leftover $100 as profit ($1,000 – $900 = $100).

In scenario B, the investor misses the mark, and the price rises to $11 per share. Now the investor has to buy back 100 shares for $11 per share for a total of $1,100, for a loss of $100 ($1,000 – $1,100 = -$100).

Why Short a Stock?

There are various reasons why traders might choose to short a stock. In general, traders might short a stock when they believe that the security’s price will fall in the future. This might be due to several factors, such as an overall bearish outlook on the market or specific concerns about a company’s financial health or prospects.

Some traders might also short a stock to hedge their portfolios. For example, if a trader is long a stock that they think will fall in value, they might short a similar stock to offset potential losses.

Whatever the reason, shorting a stock can be a risky proposition. If the stock price does not fall as expected, the trader will be forced to cover their position at a loss. As such, traders must be cautious when considering whether or not to short a stock.

How to Short a Stock

Before you can short a stock, you will need to set up a margin account with your broker. Margin accounts are brokerage accounts that allow investors to borrow money or shares to make trades.

To short a stock, you will place a sell order for the number of shares you want to short. Your brokerage will often lend you the shares — a practice known as share lending — and allow you to complete the sale on the open market to another investor.

Ideally, when the stock price drops, you will buy back the same number of shares you borrowed, pocketing the difference between the sale and purchase costs, and returning the borrowed shares to the brokerage firm.

However, if the share price increases, you will have to buy the same shares for a higher price, potentially resulting in substantial losses,

In rare cases, the lender may request that you return the shares you borrowed, but it’s far more likely that you will close your position because the short is losing money. A short seller can hang onto their short position for as long as they can pay the required interest fees for borrowing stock and maintaining the margin amounts required by the brokerage firm.

Potential Risks and Benefits of Short Selling

Potential Risks

Selling a stock short involves significant risk — far surpassing the risk of “going long” on an investment. When holding a stock, there’s a limit to how low a stock can go, and investors can only lose as much as their initial investment.

If someone buys 10 shares of XYZ company at $10 per share, for example, and the share price goes to zero, they will lose $100. The price can’t go lower than zero, so someone can never lose more than what they had first invested.

However, when someone shorts a stock, they risk infinite losses because there is no upward limit on a stock’s share price. If the price keeps going up, they will keep losing money.

Additionally, there are significant costs associated with shorting a stock. For one, the margin interest in a required margin account can add up over time if an investor keeps the position open for a while. Also, a brokerage firm will charge interest on the borrowed shares, ranging from a few basis points to over 100%, depending on how difficult the shares are to borrow. These costs can make shorting a stock prohibitively expensive.

Potential Benefits

While risky, shorting a stock could be profitable. It’s possible to make a lot of money in a short period of time, as stocks sometimes experience rapid, steep declines.

When investing during a recession, for example, sudden drops in the share prices of many stocks across many different industries can occur. While this might cause many investors’ portfolios to decline, others may be profiting because of their short positions.

Investors might choose to short a stock to hedge against their long positions. The term “hedge” is used to refer to an investment that protects against losses in another asset. So, in this case, an investor may put on a short position to hedge or offset a potential loss in a long position.

What Happens in a Short Squeeze?

A short squeeze refers to the rapid flight of short sellers from a stock in order to limit losses — a situation that leads to a dramatic surge in the stock’s price.

Here’s how they typically occur: a sudden increase in the stock price causes investors to scramble to close their short positions by purchasing shares. This results in further gains in the stock, which in turn causes massive “covering” by other short sellers, bringing about a “squeeze.”

Famous cases include Volkswagen in 2008, after Porsche increased its stake in the German automaker, causing a short squeeze that briefly made Volkswagen the world’s most valuable stock by market cap.

More recently, in January 2021, the gains in GameStop (GME), a brick-and-mortar video-game retailer, were due to a massive short squeeze after retail investors piled into the stock, which hedge funds heavily shorted. Shares of movie-theater operator AMC Entertainment Holdings (AMC) and retailer Bed Bath & Beyond (BBBY) underwent similar experiences.

Is Shorting a Stock Wrong?

The practice of short selling is not without controversy. Shorting may have received a bad rap by being associated with the fear that shady investors will spread malicious rumors about a company to influence its share price.

But this kind of trickery can go both ways. There have also been investors who sought to manipulate the price of a stock upward by spreading bullish rumors that turned out to be false. Such tactics are considered market manipulation, and it is illegal. Anyone caught attempting to manipulate markets might be subject to regulatory punishment by the Securities and Exchange Commission (SEC).

Shorting can be a way of handling investing risks. For instance, shorting to hedge a position can be a type of risk management that helps investors minimize their losses, although doing so will also cap their gains.

Alternatives to Shorting a Stock

Shorting a stock is one of the several ways investors can bet on an asset’s price decline.

Put Options

If a brokerage account allows investors to trade options, buying a put option on a stock may allow the buyer to profit when it declines in price.

A put option is an options contract that gives the buyer the right to sell shares of an underlying asset at its strike price up until the option’s expiration date. The put option buyer pays a premium for the contract.

For example, imagine that an investor wants to short a stock that we’ll call ABC company. Shares of ABC are currently selling for $10. The investor believes the company is overvalued and the stock will soon head to $8 or lower.

So, they buy a put option for ABC with a strike price of $10 and an expiration date of three months in the future. The investor pays a $1 premium for the put. If ABC stock falls under $10 during that time, this option holder could exercise the contract to make money on the put option.

Suppose the stock falls below $8, as the put option buyer forecasted. They could sell it for an increased premium to someone else. If an investor were to exercise the option, they’d profit from being able to sell shares for $10 that are worth $8, pocketing the $2 difference, minus the $1 premium, leaving them with $1. Since each option contract is usually worth 100 shares, the total profit would be $100.

Buying put options is just one of the several options trading strategies investors can utilize if they have a bearish outlook on a stock. Options trading strategies can be profitable, but they are risky. Trading them requires more knowledge than trading stocks or exchange-traded funds (ETFs).

💡 For beginners: Options Trading 101: An Introduction to Stock Options

Inverse ETFs

Inverse ETFs are another way to make a bearish trade. These investment vehicles aim to provide returns that are opposite the performance of an underlying index. Investors can buy inverse ETF shares just like ordinary stock.

Investors must understand that inverse ETFs are designed to be held and traded during a single trading day. Kept for longer, inverse ETFs may not achieve the exact -1x return of the underlying index. That’s because of how returns get compounded.

Let’s look at the S&P 500 Index and a hypothetical inverse ETF that tracks it. The S&P 500 is at 2,000 on a given day, while the inverse ETF is trading at $20 a share. If the S&P 400 Index falls 1%, its new level would be 1,980. Meanwhile, the inverse ETF’s price would rise to $20.20 since it’s supposed to move in the opposite direction of the S&P 500.

If the S&P 500 rose 2% the next day, however, the index would climb to 2,019.60. The index’s total gain over the two days would be 0.98%. Meanwhile, prices of the inverse ETF would fall to about $19.796 — so a loss of -1.02% over two days.

While the difference between 0.98% and -1.02% appears small, such discrepancies can add up over time, causing the inverse ETF to deliver returns that aren’t the mirror opposite of its underlying index. Therefore, investors should not assume that just because a market falls 5% in a week, its corresponding inverse ETF will rise 5% in that same period.

The Takeaway

Shorting a stock is when investors bet that the price of a specific stock or ETF will fall. Sophisticated investors with a bearish view of the market will often use short sales to profit from falling share prices. Short positions also help investors mitigate losses during widespread market downturns or hedge losses from another holding.

While shorting can be a useful investment tool, it’s also very risky. That’s because there’s no limit to how high a stock can go, meaning there’s also no limit to the losses a short seller can potentially book. Add to that the risk of a short squeeze — when there’s a massive rush by bearish investors to exit their short positions — and it’s fair to say that shorting can lead to painful losses.

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FAQ

What is naked short selling, and why is it illegal?

Naked short selling is a type of short selling where the seller does not have the borrowed securities in their possession at the time of the sale. This practice is illegal because it creates a potential for manipulation and fraud.

Why do short sellers have to borrow shares?

When a trader wants to sell a stock short, they must first borrow it from somebody else. They have to borrow shares because when you sell something, you have to have it to sell. The trader then hopes to repurchase the stock at a lower price so they can return the shares to the person they borrowed them from and pocket the difference.

Can I sell short in my brokerage account?

Many brokerages allow short selling in a regular account, but some require the investor to have a margin account. Your broker can tell you what kind of account you have and the requirements for short selling.

How is short selling different from regular investing?

Short selling is selling a borrowed security and hoping to repurchase it at a lower price to realize a profit. With regular investing, the investor buys the security and hopes to sell it at a higher price.

What is the opposite of shorting a stock?

The opposite of shorting a stock would be going long on a stock, meaning that the investor would purchase shares of the stock with the hope that the stock price would increase so that they could then sell the shares at a higher price and profit from the difference.

SoFi Invest®

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

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

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

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

SOIN0922058

Aug

2024

What You Need to Know About Margin Balance

By Rebecca Lake | Growing Wealth, invest, Investing | Comments Off

Margin trading simply means borrowing money from a brokerage to purchase securities, and margin balance is the amount of money an investor owes to the brokerage. Trading stocks and other securities on margin allows investors to expand their purchasing power, though the availability of margin is predicated on the holdings an investor has in the first place.

Accordingly, when an investor uses the brokerage’s funds to buy securities, this results in a margin debit balance. Similar to a credit card or traditional loan, a margin balance is a line of credit that the borrower must repay with interest. Having a margin balance outstanding is common in margin trading, but investors should understand the implications of owing money to a brokerage — and what can happen if you’re subject to a margin call.

Key Points

• Margin balance refers to the amount an investor owes to a brokerage after borrowing funds to purchase securities, enabling increased purchasing power in trading.

• Investors must meet minimum margin requirements, including an initial deposit and ongoing maintenance margin guidelines, to avoid margin calls from the brokerage.

• A negative margin balance indicates the amount owed to the brokerage, while a positive balance signifies excess funds available in the margin account.

• Interest on margin balances varies by brokerage and account size, impacting the net return on investments and necessitating careful management of margin accounts.

• To mitigate risks, investors should maintain adequate funds in their margin accounts and consider setting limits on borrowing to avoid overextending themselves financially.

What Is Margin Balance?

Again, margin balance is the amount of money an investor owes to its brokerage at any given time in a margin trading account. When an investor opens a margin account, they must make an initial deposit, called the “minimum margin.” The Financial Industry Regulatory Authority (FINRA) requires a minimum margin of at least $2,000, though some brokerages may require a higher minimum.

After making that deposit to their brokerage account, investors can then trade using an initial margin. Federal Reserve Board Regulation T allows investors to borrow up to 50% of the purchase price of securities when trading on margin. So, for example, a margin trader could purchase $10,000 worth of stocks using their own funds and another $10,000 using the brokerage’s funds. The $10,000 borrowed from the brokerage represents the investor’s margin balance.

You can trade a variety of securities in a margin account, including stocks, and derivatives such as options or futures.

The rules for margin balance forex are slightly different. In forex trading, margin represents collateral or security that an investor must deposit with the brokerage to start trading. The brokerage typically sets this as a percentage of the trading order.

💡 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 Margin Balance Works

Margin balance allows investors to borrow money, then repay it to the brokerage with interest. A negative margin balance or margin debit balance represents the amount subject to interest charges. This amount is always either a negative number or $0, depending on how much an investor has outstanding.

Unlike other types of loans, margin balance loans do not have a set repayment schedule. Investors can make payments toward the principal and interest through their brokerage account at a pace convenient for them. They can also deposit cash into their margin accounts or sell off margin securities to reduce their margin balance.

Margin Calls

While there is some flexibility associated with paying off a negative margin balance, investors should understand their interest charges as well as the possibility of being subject to a margin call. Margin calls essentially act as a stopgap risk management tool for the brokerage.

In addition to the minimum margin and the initial margin requirements, investors must observe maintenance margin guidelines. This represents a minimum amount of equity the investor must keep in their account. Under FINRA rules, the maintenance requirement is at least 25% equity, based on the value of the margin account. Some brokerages may raise this to 30%, 40% or more.

Using the previous example, assume that an investor deposits $10,000 of their own money and borrowers $10,000 from their brokerage to invest in marginable securities. Now, say that the investment doesn’t go as planned and the stock’s value drops. That initial $20,000 investment is now worth $10,000. When the margin debit balance of $10,000 is subtracted, that results in a net balance of $0, meaning the trader has zero equity and does not meet the maintenance margin requirements.

At this point, the brokerage may initiate a margin call which would require the investor to deposit more cash into their account in order to continue trading. If an investor can not add more cash to cover the maintenance margin requirement, the brokerage may sell off securities from the account to recoup the negative margin balance.

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Negative Margin Balance

A negative margin balance in a margin account represents what’s owed to the brokerage. Depending on the brokerage, the margin debit balance may be listed inside parentheses or have a negative symbol in front of it.

Margin Balance Example

For example, an investor who has a negative margin balance of $12,225 may see one of the following when logging into their account:

• Margin balance: -$12,225

• Margin balance: ($12,225)

They both mean the same thing: that investor owes the brokerage $12,225 for trading on margin.

If a trader’s margin balance shows as a positive amount, that means they have a margin credit balance rather than a margin debit balance. A credit balance can occur if an investor sells off shares to clear their negative margin balance but the settlement amount is more than what they owe to the brokerage.

How Margin Balance Is Calculated

Brokerages can lend investors money on margin but in exchange for this convenience, they can charge those investors interest, or margin rates. The level of those rates depends on the brokerage and the type of securities that you’re trading. Many brokerages use a benchmark rate, known as a broker call rate or call money rate, then tier that rate across different margin account balances.

Brokerages can use this as a baseline rate, then add or deduct percentage points. Generally, the larger the margin account balance, the deeper the margin rate discount. Meanwhile, traders who maintain lower margin balances tend to pay higher interest rates. So, an investor with less than $25,000 in their account might pay 7%-8% for margin rates while an investor with over $1 million in their account might pay 4%-5% instead.

Brokerages typically calculate margin interest on a daily basis and charge it to an investor’s account monthly. The interest charges on a margin account can directly affect the net return realized from an investment. Higher margin rates can increase the rate of return needed to break-even on an investment or realize a profit on a stock.

Managing Your Margin Balance

Managing a margin account and margin balances begins with understanding the risks involved, including the possibility of a margin call. The value of your securities can impact your margin balance, and increased volatility could cause the value of margin securities to drop, which could put you below the maintenance margin requirements. You’d then need to deposit more money to your account to continue trading.

Maintaining a cushion of funds inside your margin account could help avoid margin calls. Alternatively, you may keep a reserve of funds elsewhere that you could transfer to your margin account if increased volatility threatens to diminish the value of margin securities in your portfolio.

It’s also important to consider how much money you’re comfortable owing to your brokerage at any given time. Setting a cap on the maximum margin can help you avoid overextending yourself. You can also keep margin balances under control by scheduling regular cash deposits or routinely selling securities to reduce what’s owed. One strategy is to pay enough to cover the interest each month to keep your balance from ballooning.

💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

The Takeaway

A margin balance refers to the balance in an investor’s margin account, which involves borrowing money from a brokerage with which to make trades. That can help investors or traders increase their potential returns, if used wisely.

When you open a brokerage account, you can choose either a cash account or a margin account that allows you to engage in margin trading. Margin trading is a more advanced investment strategy that requires some know-how of the markets and a willingness to accept higher levels of risk.

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

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Aug

2024

Guide to Self-Directed IRAs (SDIRA)

By Austin Kilham | Growing Wealth, invest, Investing | Comments Off

Individual retirement accounts, or IRAs, typically allow for a lot of flexibility in the kinds of investments you can make, from stocks and bonds to mutual funds and exchange-traded funds (ETFs).

However, most IRAs don’t allow certain alternative investments like precious metals and real estate. If you want to hold assets like these in your retirement account, you’ll need a self directed IRA (SDIRA), a specific type of Roth or traditional IRA.

Key Points

• A self-directed IRA (SDIRA) allows individuals to invest in a broader array of assets, including real estate, cryptocurrency, and precious metals, compared to traditional IRAs.

• Account holders of SDIRAs manage their investments independently, which involves conducting research and due diligence on potential assets, thus increasing their responsibility.

• While SDIRAs can offer high potential returns, they also carry higher fees and risks, particularly due to the illiquidity of many alternative investments.

• Contribution limits for SDIRAs mirror those of traditional IRAs, allowing up to $7,000 annually, or $8,000 for individuals aged 50 and older.

• Opening an SDIRA requires finding an approved custodian, selecting investments, completing transactions through a reputable dealer, and planning for less liquid withdrawals.

What Is a Self-Directed IRA (SDIRA)?

Self directed IRAs and self directed Roth IRAs allow account holders to buy and sell a wider variety of investments than regular traditional IRAs and Roth IRAs. Experienced investors, familiar with sophisticated or risky investments, often use these.

While a custodian or a trustee administers the SDIRA, the account holder typically manages the allocation themselves, taking on responsibility for researching investments and due diligence. These accounts may also come with higher fees than regular IRAs, which can cut into the size of your retirement nest egg over time.

What Assets Can You Put in a Self-Directed IRA or a Self-Directed Roth IRA?

Individuals can hold a number of unique alternative investments in their SDIRA, including but not limited to:

• Real estate and land

• Cryptocurrency

• Precious metals

• Mineral, oil, and gas rights

• Water rights

• LLC membership interest

• Tax liens

• Foreign currency

• Startups through crowdfunding platforms

Recommended: Types of Alternative Investments

Types of SDIRAs

There are specific kinds of SDIRAs customized to investors looking for certain types of investments. The different types include:

Self-directed SEP IRAs

Simplified Employee Pension IRAs (SEP IRAs) are for small business owners or those who are self-employed so that they can make contributions that are tax deductible for themselves and any eligible employees they might have. This type of retirement account gives them the flexibility to invest in alternative investments.

Self-directed SIMPLE IRAs

A Savings Incentive Match Plan IRA (SIMPLE IRA) is a tax-deferred retirement plan for employers and employees of small businesses. Both the employer and the employees can make contributions to this plan. It allows for some alternative kinds of investments.

Recommended: SIMPLE IRA vs Traditional

Self-directed Precious Metal IRAs

Similarly, there are self-directed IRAs for those who would like to invest in precious metals like gold. However, be aware that some precious metal IRAs may charge higher fees than the market price for precious metals.

How Do Self-Directed IRAs Work?

Now that you know the answer to the question, what is a self directed IRA?, it’s important to understand how these accounts work and the self directed IRA rules. You’ll also want to familiarize yourself with the guidelines regarding opening an IRA if you have a 401(k).

Aside from their ability to hold otherwise off-limits alternative investments, SDIRAs work much like their traditional counterparts. SDIRAs are tax-advantaged retirement accounts, and they can come in two flavors: traditional SDIRAs and Roth SDIRAs.

Traditional IRA Contributions and Withdrawal Rules

IRA contributions to traditional accounts goes in before taxes, which reduces investors’ taxable income, lowering their income tax bill in the year they make the contribution. For 2024, individuals can contribute up to $7,000 in total across accounts. Those age 50 and up can make an extra $1,000 catch-up contribution for a total of $8,000. Investments inside the account grow tax-deferred.

It’s important to pay close attention to self directed IRA rules, particularly rules for IRA withdrawals. Once individuals begin to make withdrawals at age 59 ½, they are taxed at normal income tax rates. Account holders who make withdrawals before that age may owe taxes and a possible 10% early withdrawal penalty. Traditional SDIRA account holders must begin making required minimum distributions (RMDs) after age 73.

Roth IRA Contributions and Withdrawal Rules

Roth SDIRAs have the same contribution limits as traditional SDIRAs. However, retirement savers contribute to Roths with after-tax dollars. Investments inside the account grow tax-free, and withdrawals after age 59 ½ aren’t subject to income tax.

Roths are also not subject to RMD rules. As long as an individual has had the account for at least five years (as defined by the IRS), they can withdraw Roth contributions at any time without penalty, though earnings may be subject to tax if withdrawn before age 59 ½.

There are also rules restricting who can contribute to a Roth IRA, based on their income. In 2024, Roth eligibility begins phasing out at $146,000 for single people, and $230,000 for people who are married and file their taxes jointly.

Individuals can maintain both traditional and Roth IRA accounts, however, contribution limits are cumulative across accounts, and cannot exceed $7,000, or $8,000 for those 50 and over.

Traditional vs Roth SDIRA

There are some differences between a self-directed traditional IRA and a self-directed Roth IRA.

With a traditional SDIRA, you save pre-tax money for your retirement, just like you do with a traditional IRA plan. You pay taxes on the money when you withdraw it, which you can do without penalty starting at age 59 ½. However, a self-directed traditional IRA gives you the flexibility to invest in alternative assets, like real estate or precious metals.

With a self-directed Roth IRA, just like a regular Roth IRA, you make after-tax contributions to the plan. The withdrawals you make starting at age 59 ½ are tax-free, as long as you have had the account for at least five years, according to the five-year rule. With this type of self-directed IRA, you can invest in alternative investments, such as private equity, real estate, and precious metals.

💡 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.

Pros and Cons of Self-Directed IRAs

Self-directed IRAs offer unique perks for the right investor. However, those interested must weigh those benefits against potential drawbacks.

Benefits of Self-Directed IRAs

An SDIRA allows investors to branch out into different types of investments to which they might otherwise not have access. This allows investors to seek out potentially higher returns and diversify their portfolios beyond the offerings in traditional IRAs.

Alternative investments have the potential to offer higher returns than investors might achieve with stock market investments. However, investors beware: These opportunities for higher rewards come at the price of higher risk.

Also, investors’ ability to hold a broader spectrum of investments that can help them diversify their portfolio and potentially manage risks, such as inflation risk or longevity risk, the chance an investor will run out of money before they die. For example, some SDIRAs allow investors to hold gold, a traditional hedge against inflation.

Drawbacks of Self-Directed IRAs

While there are some very real advantages to using SDIRAs, these must be weighed against their disadvantages.

For starters, investments like stocks and shares of ETFs are highly liquid. Investors who need their money quickly can sell them in a relatively short period of time, usually a matter of days.

However, some of the investments available in SDIRAs are not liquid. For example, real estate and physical commodities like precious metals may take quite a bit of time to sell if you need to access your money. Individuals who need to sell these assets quickly may find themselves in a situation in which they must accept less than they believe the asset is worth.

SDIRAs may also carry higher fees. Individuals who hold regular IRA accounts may not have to pay management or investment fees. However, SDIRA holders may have to pay fees associated with holding the account and with the purchase and maintenance of certain assets.

Finally, SDIRAs place a lot of responsibility in the hands of their account holders. Investors must research investments themselves and perform due diligence to make sure that whatever they’re buying is legitimate and matches their risk tolerance.

What’s more, investors must make sure the assets they hold meet IRS rules. Running afoul of these rules can be costly, in some cases causing investors to pay taxes and penalties.
Here’s a look at the pros and cons of SDIRAs at a glance:

Pros	Cons
Tax-advantaged growth. Contributions to traditional accounts are tax deductible. Investments grow tax-deferred in traditional accounts and tax-free in Roth accounts.	Not liquid. Selling alternative investments may be slow and difficult.
Same contribution limits as regular IRAs. In 2024, individuals can contribute up to $7,000 a year, or $8,000 for those aged 50 and up.	Higher fees. Individuals may be on the hook for account fees and fees associated with alternative investments.
Higher returns. Alternative investments may offer higher returns than those available in the stock market.	Increased responsibility. Investors must research investments carefully themselves and ensure they stay within rules for approved IRA investments.
Diversification. SDIRAs offer investors the ability to invest in assets beyond the stock and bond markets.	Higher risk. Alternative investments tend to be riskier than more traditional investments.

4 Steps to Opening a Self-Directed IRA

Investors who want to open an SDIRA will need to take the following steps:

1. Find a custodian or trustee.

This can be a bank, trust company, or another IRS-approved entity. You’ll need to follow their requirements for opening an IRA account. Some SDIRAs specialize in certain asset classes, so look for a custodian that allows you to invest in the asset classes in which you’re interested.

2. Choose investments.

Decide which alternatives you want to hold in your SDIRA. Perform necessary research and due diligence.

3. Complete the transaction.

Find a reputable dealer from which your custodian can purchase the assets, and ask them to complete the sale.

4. Plan withdrawals carefully.

Because alternative assets have less liquidity than other types of investments, you may need to plan sales well in advance of needing retirement income or meeting any required minimum distributions.

Investing in Your Retirement With SoFi

If you’re opening your first IRA account, you’re likely best served with a traditional or Roth IRA. Because of the complications involved in using an SDIRA, only sophisticated investors should consider it.

Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

Easily manage your retirement savings with a SoFi IRA.

FAQ

Are self-directed IRAs a good idea?

There are advantages and disadvantages to self-directed IRAs. Benefits include the fact that you can make alternative types of investments you might not otherwise be able to. That could help you diversify your portfolio and potentially increase your returns.

However, there are drawbacks to SDIRAs, including higher risk because alternative investments tend to be riskier, and potentially higher fees for maintenance of investments in the plan and account fees. In addition, investors need to research the investments themselves and follow the IRS rules carefully to make sure they comply. Finally, many alternative investments are not liquid, which means they could take longer and be more difficult to sell.

Can you set up a self-directed IRA yourself?

To set up a self-directed IRA, find a custodian or trustee such as a bank or trust company to open an account, research and choose your investments, find a reputable dealer for the investments you’d like to make, and have your custodian complete the transactions.

How much money can you put in a self-directed IRA?

In 2024, you can contribute up to $7,000 to a traditional or Roth self-directed IRA, plus an additional $1,000 if you’re 50 or older.

Photo credit: iStock/Andres Victorero

An investor should consider the investment objectives, risks, charges, and expenses of the Fund carefully before investing. This and other important information are contained in the Fund’s prospectus. For a current prospectus, please click the Prospectus link on the Fund’s respective page. The prospectus should be read carefully prior to investing.
Alternative investments, including funds that invest in alternative investments, are risky and may not be suitable for all investors. Alternative investments often employ leveraging and other speculative practices that increase an investor's risk of loss to include complete loss of investment, often charge high fees, and can be highly illiquid and volatile. Alternative investments may lack diversification, involve complex tax structures and have delays in reporting important tax information. Registered and unregistered alternative investments are not subject to the same regulatory requirements as mutual funds.
Please note that Interval Funds are illiquid instruments, hence the ability to trade on your timeline may be restricted. Investors should review the fee schedule for Interval Funds via the prospectus.
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.

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

Aug

2024

In the Money (ITM) vs Out of the Money (OTM) Options

In the Money vs Out of the Money Options: Main Differences

By Brian Nibley | Growing Wealth, invest, Investing | Comments Off

In options trading, knowing the difference between being “in the money” (ITM) and “out of the money” (OTM) allows the holder of a contract to know whether they’ll enjoy a profit from their option. The terms refer to the relationship between the options strike price and the market value of the underlying asset.

“In the money” refers to options that have profit potential if exercised today, while “out of the money” refers to those that do not. In the rare case that the market price of an underlying security reaches the strike price of an option exactly at the time of expiry, this would be called an “at the money option.”

Key Points

• Understanding the difference between “in the money” and “out of the money” options is crucial for options traders to gauge potential profitability.

• Options classified as “in the money” have intrinsic value and can yield profits when exercised, while “out of the money” options lack intrinsic value and may expire worthless.

• The potential for profit from options depends on the relationship between the strike price and the current market price of the underlying asset.

• Higher volatility often leads to options being written “out of the money,” appealing to speculators due to lower premiums and potential for larger price swings.

• Decisions to buy “in the money” or “out of the money” options should align with an investor’s goals, risk tolerance, and confidence in the underlying asset’s future performance.

What Does “In the Money” Mean?

In the money (ITM) describes a contract that would be profitable if its owner were to choose to exercise the option today. If this is the case, the option is said to have intrinsic value.

A call option would be in the money if the strike price is lower than the current market price of the underlying security. An investor holding such a contract could exercise the option to buy the security at a discount and sell it for a profit right away.

Put options, which are a way to short a stock, would be in the money if the strike price is higher than the current market price of the underlying security. A contract of this nature allows the holder to sell the security at a higher price than it currently trades for and pocket the difference.

In either case, an in the money contract has intrinsic value, so the options trader can exercise the option and make money doing so.

💡 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.

Example of In the Money

For example, say an investor owns a call option with a strike price of $15 on a stock currently trading at $16 per share. This option would be in the money because its owner could exercise the option to realize a profit. The contract gives the holder the right to buy 100 shares of the stock at $15, even though the market price is currently $16.

The contract holder could take shares acquired through the contract for a total of $1,500 and sell them for $1,600, realizing a profit of $100 minus the premium paid for the contract and any associated trading fees or commissions.

While call options give the holder the right to buy a security, put options give holders the right to sell. For example, say an investor owns a put option with a strike price of $10 on a stock that is trading at $9 per share. This would be an in the money option. The holder could sell 100 shares of stock at a price of $10 for a total of $1,000, even though it only costs $900 to buy those same shares. The contract holder would realize that difference of $100 as profit, minus the premium and any fees.

What Does “Out of the Money” Mean?

Out of the money (OTM) is the opposite of being in the money. OTM contracts do not have intrinsic value. If an option is out of the money at the time of expiration, the contract will expire worthless. Options are out of the money when the relation of their strike prices to the current market price of their securities are opposite that of in the money options.

For calls, an option with a strike price higher than the current price of the underlying security would be out of the money. Exercising such an option would result in an investor buying a security for a price higher than its current market value.

For puts, an option with a strike price lower than the current price of its security would be out of the money. Exercising such an option would cause an investor to sell a security at a price lower than its current market value.

In either case, contracts are out of the money because they don’t have intrinsic value – anyone exercising those contracts would lose money.

Example of Out of the Money

Say an investor buys a call option with a strike price of $15 on a stock currently trading at $13. This option would be out of the money. An investor might buy an option like this in the hopes that the stock will rise above the strike price before expiration, in which case a profit could be realized.

Another example would be an investor buying a put option with a strike price of $7 on a stock currently trading at $10. This would also be an out of the money option. An investor might buy this kind of option with the belief that the stock will fall below the strike price before expiration.

💡 Quick Tip: In order to profit from purchasing a stock, the price has to rise. But an options account offers more flexibility, and an options trader might gain if the price rises or falls. This is a high-risk strategy, and investors can lose money if the trade moves in the wrong direction.

What’s the Difference Between In the Money and Out of the Money?

The premium of an options contract involves two different factors: intrinsic value and extrinsic value. Options that have intrinsic value at the time they are written to have a strike price that is profitable relative to the current market price. In other words, such options are already in the money when written.

But not all options are written ITM. Those without intrinsic value rely instead on their extrinsic value. This value comes from speculative bets that investors make over a period of time. For this reason, assets with higher volatility often have their options contracts written out of the money, as investors expect there to be bigger price swings. Conversely, assets considered to be less volatile often have their options written in the money.

Options written out of the money are ideal for speculators because such contracts come with less expensive premiums and are often created for more volatile assets.

Should I Buy ITM or OTM Options?

The answer to this question depends on an investor’s goals and risk tolerance. Options that are further out of the money can be more rewarding, but come with greater risk, uncertainty, and volatility. Whether an option is in or out of the money (and how far they’re out of the money), and the amount of time before the expiry of the option impacts the premium for that option, with riskier options typically costing more.

Whether to buy ITM or OTM options also depends on how confident an investor feels about the future of the underlying security. If a trader feels fairly certain that a particular stock will trade at a much higher price three months from now, then they might not hesitate to buy a call option with a very high strike price, making it out of the money.

Conversely, if an investor thinks a stock will fall in price, they can buy a put option with a very low strike price, which would also make the option out of the money.

Beginners and those with lower risk tolerance may prefer buying options that are only somewhat out of the money or those that are in the money. These options usually have lower premiums, meaning they cost less to buy. There are also generally greater odds that the contract will wind up in the money before expiration, as it will take a less dramatic move to make that happen.

Investors can also choose to combine multiple options legs into a spread strategy that attempts to take advantage of both possibilities.

Recommended: 10 Important Options Trading Strategies

The Takeaway

In options trading, “in the money” refers to options that have profit potential if exercised immediately, while “out of the money” refers to those that don’t. Options contracts don’t have to be exercised to realize a profit. Sometimes investors buy contracts with the intent of selling them on the open market soon after they become in the money for quick gains.

In either case, it’s important to consider if an option is in the money or out of the money when buying or writing options contracts, as well as when deciding when to execute them. Options trading is an advanced investing strategy, and investors should know what they’re doing before engaging with it – or should speak with a financial professional for guidance.

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

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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.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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SOIN0723065

What Is Exponential Moving Average (EMA)?

What is EMA?

EMA Formula

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Trend Trading

Support and Resistance

Buy and Sell Signals

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FAQ

Which EMA is best?

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What is 5 EMA and 20 EMA?

Shorting a Stock Defined and How Short Selling Works

What Is Shorting a Stock?

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Potential Risks

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What Is Margin Balance?

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Negative Margin Balance

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Guide to Self-Directed IRAs (SDIRA)

What Is a Self-Directed IRA (SDIRA)?

What Assets Can You Put in a Self-Directed IRA or a Self-Directed Roth IRA?

Types of SDIRAs

Self-directed SEP IRAs

Self-directed SIMPLE IRAs

Self-directed Precious Metal IRAs

How Do Self-Directed IRAs Work?

Traditional IRA Contributions and Withdrawal Rules

Roth IRA Contributions and Withdrawal Rules

Traditional vs Roth SDIRA

Pros and Cons of Self-Directed IRAs

Benefits of Self-Directed IRAs

Drawbacks of Self-Directed IRAs

4 Steps to Opening a Self-Directed IRA

1. Find a custodian or trustee.

2. Choose investments.

3. Complete the transaction.

4. Plan withdrawals carefully.

Investing in Your Retirement With SoFi

FAQ

Are self-directed IRAs a good idea?

Can you set up a self-directed IRA yourself?

How much money can you put in a self-directed IRA?

In the Money vs Out of the Money Options: Main Differences

What Does “In the Money” Mean?

Example of In the Money

What Does “Out of the Money” Mean?

Example of Out of the Money

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