Nov
22
2023
What Is Mark to Market and How Does It Work?

Mark to Market Definition and Uses in Account & Investing

By | Growing Wealth, invest, Investing | Comments Off on Mark to Market Definition and Uses in Account & Investing

The term “mark to market” refers to an accounting method used to measure the value of assets based on current market conditions. Mark to market accounting seeks to determine the real value of assets based on what they could be sold for right now.

That can be useful in a business setting when a company is trying to gauge its financial health or get a valuation estimate ahead of a merger or acquisition. Aside from accounting, mark to market also has applications in investing when trading stocks, futures contracts, and mutual funds. For traders and investors, it can be important to understand how this concept works.

Key Points

•   Mark to market is an accounting method used to determine the current value of assets based on market conditions.

•   It is used in business to assess financial health and valuation, as well as in investing for trading stocks, futures contracts, and mutual funds.

•   Mark to market accounting adjusts asset values based on current market conditions to estimate their potential sale value.

•   Pros of mark to market accounting include accurate valuations for asset liquidation, value investing, and establishing collateral value for loans.

•   Cons include potential inaccuracies, volatility skewing valuations, and the risk of devaluing assets in an economic downturn.

What Is Mark to Market?

Mark to market is, in simple terms, an accounting method that’s used to calculate the current or real value of a company’s assets, as noted. Mark to market can tell you what an asset is worth based on its fair market value.

Mark to market accounting is meant to create an accurate estimate of a company’s financial status and value year over year. This accounting method can tell you whether a company’s assets have increased or declined in value. When liabilities are factored in, mark to market can give you an idea of a company’s net worth.


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How Mark to Market Accounting Works

Mark to market accounting works by adjusting the value of assets based on current market conditions. The idea is to determine how much an asset — whether it be a piece of equipment or an investment — could be worth if it were to be sold immediately.

If a company were in a cash crunch, for example, and wanted to sell off some of its assets, mark to market accounting could give an idea of how much capital it might be able to raise. The company would try to determine as accurately as possible what its marketable assets are worth.

In stock trading, mark to market value is determined for securities by looking at volatility and market performance. Specifically, you’re looking at a security’s current trading price then making adjustments to value based on the trading price at the end of the trading day.

There are other ways mark to market can be used beyond valuing company assets or securities. In insurance, for example, the mark to market method is used to calculate the replacement value of personal property. Calculating net worth, an important personal finance ratio, is also a simple form of mark to market accounting.

Mark-to-Market Accounting: Pros and Cons

Mark to market accounting can be useful when evaluating how much a company’s assets are worth or determining value when trading securities. But it’s not an entirely foolproof accounting method.

Mark to Market Pros Mark to Market Cons

•   Can help establish accurate valuations when companies need to liquidate assets

•   Useful for value investors when making investment decisions

•   May make it easier for lenders to establish the value of collateral when extending loans

•   Valuations are not always 100% accurate since they’re based on current market conditions

•   Increased volatility may skew valuations of company assets

•   Companies may devalue their assets in an economic downturn, which can result in losses

Pros of Mark to Market Accounting

There are a few advantages of mark to market accounting:

•   It can help generate an accurate valuation of company assets. This may be important if a company needs to liquidate assets or it’s attempting to secure financing. Lenders can use the mark to market value of assets to determine whether a company has sufficient collateral to secure a loan.

•   It can help mitigate risk. If a value investor is looking for new companies to invest in, for example, having an accurate valuation is critical for avoiding value traps. Investors who rely on a fundamental approach can also use mark to market value when examining key financial ratios, such as price to earnings (P/E) or return on equity (ROE).

•   It may make it easier for lenders to establish the value of collateral when extending loans. Mark to market may provide more accurate guidance in terms of collateral value.

Cons of Mark to Market Accounting

There are also some potential disadvantages of using mark to market accounting:

•   It may not be 100% accurate. Fair market value is determined based on what you expect someone to pay for an asset that you have to sell. That doesn’t necessarily guarantee you would get that amount if you were to sell the asset.

•   It can be problematic during periods of increased economic volatility. It may be more difficult to estimate the value of a company’s assets or net worth when the market is experiencing uncertainty or overall momentum is trending toward an economic downturn.

•   Companies may inadvertently devalue their assets in a downturn. If the market’s perception of a company, industry, or sector turns negative, it could spur a sell-off of assets. Companies may end up devaluing their assets if they’re liquidating in a panic. This can have a boomerang effect and drive further economic decline, as it did in the 1930s when banks marked down assets following the 1929 stock market crash.

Mark to Market in Investing

In investing, mark to market is used to measure the current value of securities, portfolios or trading accounts. This is most often used in instances where investors are trading futures or other securities in margin accounts.

Futures are derivative financial contracts, in which there’s an agreement to buy or sell a particular security at a specific price on a future date. Margin trading involves borrowing money from a brokerage in order to increase purchasing power.

Understanding mark to market is important for meeting margin requirements to continue trading. Investors typically have to deposit cash or have marginable securities of $2,000 or 50% of the securities purchased. The maintenance margin reflects the amount that must be in the margin account at all times to avoid a margin call.

In simple terms, margin calls are requests for more money. FINRA rules require the maintenance margin to be at least 25% of the total value of margin securities. If an investor is subject to a margin call, they’ll have to sell assets or deposit more money to reach their maintenance margin and continue trading.

In futures trading, mark to market is used to price contracts at the end of the trading day. Adjustments are made to reflect the day’s profits or losses, based on the closing price at settlement. These adjustments affect the cash balance showing in a futures account, which in turn may affect an investor’s ability to meet margin maintenance requirements.


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Mark to Market Example

Futures markets follow an official daily settlement price that’s established by the exchange. In a futures contract transaction you have a long trader and a short trader. The amount of value gained or lost in the futures contract at the end of the day is reflected in the values of the accounts belonging to the short and long trader.

So, assume a farmer takes a short position in 10 soybean futures contracts to hedge against the possibility of falling commodities prices. Each contract represents 5,000 bushels of soybeans and is priced at $5 each. The farmer’s account balance is $250,000. This account balance will change daily as the mark to market value is recalculated. Here’s what that might look like over a five-day period.

Day

 Futures Price Change in Value Gain/Loss Cumulative Gain/Loss Account Balance
1 $5 $250,00
2 $5.05 +0.05 -2,500 -2,500 $247,500
3 $5.03 -0.02 +1,000 -1,500 $248,500
4 $4.97 -0.06 +3,000 +1,500 $251,500
5 $4.90 -0.07 +3,500 +5,000 $255,000

Since the farmer took a short position, a decline in the value of the futures contract results in a positive gain for their account value. This daily pattern of mark to market will continue until the futures contract expires.

Conversely, the trader who holds a long position in the same contract will see their account balance move in the opposite direction as each new gain or loss is posted.

Mark to Market in Recent History

Mark to market accounting can become problematic if an asset’s market value and true value are out of sync. For example, during the financial crisis of 2008-09, mortgage-backed securities (MBS) became a trouble spot for banks. As the housing market soared, banks raised valuations for mortgage-backed securities. To increase borrowing and sell more loans, credit standards were relaxed. This meant banks were carrying a substantial amount of subprime loans.

As asset prices began to fall, banks began pulling back on loans to keep their liabilities in balance with assets. The end result was a housing bubble which sparked a housing crisis. During this time, the U.S. economy would enter one of the worst recessions in recent history.

The U.S. Financial Accounting Standards Board (FASB) eased rules regarding the use of mark to market accounting in 2009. This permitted banks to keep the values of mortgage-backed securities on their balance sheets when the value of those securities had dropped significantly. The measure meant banks were not forced to mark the value of those securities down.

Can You Mark Assets to Market?

The FASB oversees mark to market accounting standards. These standards, along with other accounting and financial reporting rules, apply to corporate entities and nonprofit organizations in the U.S. But it’s possible to use mark to market principles when making trades.

If you’re trading futures contracts, for instance, mark to market adjustments are made to your cash balance daily, based on the settlement price of the securities you hold. Your cash balance will increase or decrease based on the gains or losses reported for that day.

If the market moves in your favor, your account’s value would increase. But if the market moves against you and your futures contracts drop in value, your cash balance would adjust accordingly. You’d have to pay attention to maintenance margin requirements in order to avoid a margin call.

Which Assets Are Marked to Market?

Generally, the types of assets that are marked to market are ones that are bought and sold for cash relatively quickly — otherwise known as marketable securities. Assets that can be marked to market include stocks, futures, and mutual funds. These are assets for which it’s possible to determine a fair market value based on current market conditions.

When measuring the value of tangible and intangible assets, companies may not use the mark to market method. In the case of equipment, for example, they may use historical cost accounting which considers the original price paid for an asset and its subsequent depreciation. Meanwhile, different valuation methods may be necessary to determine the worth of intellectual property or a company’s brand reputation, which are intangible assets.

Mark to Market Losses

Mark to market losses occur when the value of an asset falls from one day to the next. A mark to market loss is unrealized since it only reflects the change in valuation of asset, not any capital losses associated with the sale of an asset for less than its purchase price. The loss happens when the value of the asset or security in question is adjusted to reflect its new market value.

Mark to Market Losses During Crises

Mark to market losses can be amplified during a financial crisis when it’s difficult to accurately determine the fair market value of an asset or security. When the stock market crashed, for instance, in 1929, banks were moved to devalue assets based on mark to market accounting rules. This helped turn what could have been a temporary recession into the Great Depression, one of the most significant economic events in stock market history.

Mark to Market Losses in 2008

During the 2008 financial crisis, mark to market accounting practices were a target of criticism as the housing market crashed. The market for mortgage-backed securities vanished, meaning the value of those securities took a nosedive.

Banks couldn’t sell those assets, and under mark to market accounting rules they had to be revalued. As a result banks collectively reported around $2 trillion in total mark to market losses.

The Takeaway

Mark to market is, as discussed, an accounting method that’s used to calculate the current or real value of a company’s assets. Mark to market is a helpful principle to understand, especially if you’re interested in futures trading.

When trading futures or trading on margin, it’s important to understand how mark to market calculations could affect your returns and your potential to be subject to a margin call. As always, if you feel like you’re in the weeds, it can be beneficial to speak with a financial professional for guidance.

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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

Is mark to market accounting legal?

Mark to market account is a legal accounting practice, and is overseen by the FASB. Though it has been used in the past to cover financial losses, it remains a legal and viable method.

Is mark to market accounting still used?

Yes, mark to market accounting is still used both by businesses and individuals for investments and personal finance needs. In some sectors of the economy, it may even remain as one of the primary accounting methods.

What are mark to market losses?

Mark to market losses are losses that are generated as a result of an accounting entry, as opposed to a loss generated by the sale of an asset. The loss is incurred, under mark to market accounting, when the value of an asset declines, not when it is sold for less than it was purchased.

Photo credit: iStock/Drazen_

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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.
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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.

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Nov
22
2023
How Does a Block Trade Deal Work?

Guide to Block Trades

By | Growing Wealth, invest, Investing | Comments Off on Guide to Block Trades

Block trades are big under-the-radar trades, generally carried out in private. Because of their size, block trades have the potential to move the markets. For that reason they’re conducted by special groups known as block houses. And while they’re considered legal, block trades are not regulated by the SEC.

As a retail investor, you likely won’t have anything to do with block trades, but it’s a good idea to know what they are, how they work, and how they can affect the overall market.

Key Points

•   Block trades are large-volume purchases or sales of financial assets, often conducted by institutional investors.

•   Block trades can move the market for a security and are executed through block trade facilities, dark pools, or block houses.

•   Block trades are used to avoid market disruption and can be broken down into smaller trades to conceal their size.

•   Retail investors may find it difficult to detect block trades, but they can provide insights into short-term market movements and sentiment.

•   Block trades are legal and not regulated by the SEC, but they can be perceived as unfair by retail investors.

What Are Block Trades?

A block trade is a single purchase or sale of a large volume of financial assets. A block, as defined by the New York Stock Exchange’s Rule 127.10, is a minimum of 10,000 shares of stock. For bonds, a block trade usually involves at least $200,000 worth of a given fixed-income security.

Though 10,000 shares is the operative figure, the number of shares involved in most block trades is far higher. Individuals typically don’t execute block trades. Rather, they most often come from institutional investors, such as mutual funds, hedge funds, or other large-scale investors.

Why Do Block Trades Exist?

Block trades are often so large that they can move the market for a given security. If a pension fund manager, for example, plans to sell one million shares of a particular stock without sparking a broader market selloff, selling all those shares on a public market will take some time.

During that process, the value of the shares the manager is selling will likely go down — the market sees a drop in demand, and values decrease accordingly. Sometimes, the manager will sell even more slowly. But that creates the risk that other traders will identify the institution or the fund behind the sale. Then, those investors might short the stock to take advantage.

Those same risks exist for a fund manager who is buying large blocks of a given security on a public market. The purchase itself can drive up the price, again, as the market sees an increase in demand. And if the trade attracts attention, other traders may front-run the manager’s purchases.

How Block Trades Are Executed

Many large institutions conduct their block trades through block trade facilities, dark pools, or block houses, in an effort to avoid influencing the market. Most of those institutions typically have expertise in both initiating and executing very large trades, without having a major — and costly — effect on the price of a given security.

Every one of these non-public exchange services operates according to its own rules when it comes to block trades, but what they have in common is relationships with hedge funds and others that can buy and sell large blocks of securities. By connecting these large buyers and sellers, blockhouses and dark pools offer the ability to make often enormous trades without roiling the markets.

Investment banks and large brokerages often have a division known as a block house. These block houses run dark pools, which are called such because the public can’t see the trades they’re making until at least a day after they’ve been executed.

Dark pools have been growing in popularity. In 2020, there were more than 50 dark pools registered with the Securities and Exchange Commission (SEC) in the United States. In April 2022, dark pools executed about 13.5% of all US equity trades, according to an analysis by Rosenblatt Securities.

Smaller Trades Are Used to Hide Block Trades

To help institutional traders conceal their block trades and keep the market from shifting, blockhouses may use a series of maneuvers to conceal the size of the trade being executed. At their most basic, these strategies involve breaking up the block into smaller trades. But they can be quite sophisticated, such as “iceberg orders,” in which the block house will break block orders into a large number of limit orders.

By using an automated program to make the smaller limit orders, they can hide the actual number of orders at any given time. That’s where the “iceberg” in the name comes from — the limit orders that other traders can see are just the tip of the iceberg.

Taken together, these networks of traders who make block trades are often referred to as the Upstairs Market, because their trades occur off the trading floor.

Pros and Cons of Block Trades

As with most things in the investment field and markets, block trades have their pros and cons. Read on to see a rundown of each.

Pros of Block Trades

The most obvious advantage of block trades is that they allow for large trades to commence without warping the market. Again, since large trades can have an effect on market values, block trades, done under the radar, can avoid causing undue volatility.

Block trades can be used to conceal information, too, which can also be a “pro” in the eyes of the involved parties. If Company A stock is moving in a block trade for a specific reason, traders outside of the block trade wouldn’t know about it.

Block trades are also not regulated by the SEC, meaning there are fewer hoops to jump through.

Cons of Block Trades

While masking a large, market-changing trade may be a good thing for those involved with the trade, it isn’t necessarily a positive thing for everyone else in the market. As such, block trades can veil market movements which may be perceived as unfair by retail investors, who are trading none the wiser.

Block trades can be hard to detect, too, as mentioned. Since they’re designed to be obscure to the greater market, it can be difficult to tell when a block trade is actually occuring.

Block trades are also not regulated by the SEC — it’s a pro, and a con. The SEC doesn’t regulate them, but rather the individual stock exchanges. That may not sit well with some investors.

Block Trade Example

An example of a block trade could be as follows: A large investment bank wants to sell one million shares of Company A stock. If they were to do so all at once, Company A’s stock would drop — if they do it somewhat slowly, the rest of the market may see what’s going on, and sell their shares in Company A, too. That would cause the value of Company A stock to fall before the investment bank is able to sell all of its shares.

To avoid that, the investment bank uses a block house, which breaks the large trade up into smaller trades, which are then traded through different brokerages. The single large trade now appears to be many smaller ones, masking its original origin.

Are Block Trades Legal?

Block trades are legal, but within stock market history they exist in something of a gray area. As mentioned, “blocks” are defined by rules from the New York Stock Exchange. But regulators like the SEC have not issued a legal definition of their own.

Further, while they can move markets, block trades are not considered market manipulation. They’re simply a method used by large investors to adjust their asset allocation with the least market disruption and stock volatility possible.

How Block Trades Impact Individual Investors

Institutional investors wouldn’t go to such lengths to conceal their block trades unless the information offered by a block trade was valuable. A block trade can offer clues about the short-term future movement and liquidity of a given security. Or it can indicate that market sentiment is shifting.

For retail (aka individual) investors, it can also be hard to know what a block trade indicates. A large trade that looks like the turning of the tide for a popular stock may just be a giant mutual fund making a minor adjustment.

But it is possible for retail investors to find information about block trades. There are a host of digital tools, some offered by mainstream online brokerages, that function like block trade indicators. This might be useful for trading stocks online.

Many of these tools use Nasdaq Quotation Dissemination Service (NQDS), Level 2 data. This subscription service offers investors access to the NASDAQ order book in real time. Its data feed includes price quotes from the market makers who are registered to trade every NASDAQ and OTC Bulletin Board security, and is popular among investors who trade using market depth and market momentum.

Even access to tools like that doesn’t mean it’ll be easy to find block trades, though. Some blockhouses design their strategies, such as the aforementioned “iceberg orders,” to make them hard to detect on Level 2. But when combined with software filters, investors have a better chance of glimpsing these major trades before they show up later on the consolidated tape, which records all trades through blockhouses and dark pools — though often well after those trades have been fully executed.

These software tools vary widely in both sophistication and cost, but may be worth considering, depending on how serious of a trader you are. At the very least, using software to scan for block trades is a way to keep track of what large institutional investors and fund managers are buying and selling. Active traders may use the information to spot new trends.

The Takeaway

It can be difficult for individual investors to detect block trades — which, again, are giant position shifts by institutional investors — on their own. But these trades have some benefits for individual investors. The mutual funds and exchange-traded funds (ETFs) that most investors have in their brokerage accounts, IRAs, 401(k)s and 529 plans may take advantage of the lower trading costs and volatility-dampening benefits of block trades, and pass along those savings to their shareholders.

An easy way to start building a portfolio of ETFs and other investments like stocks is to set up an Active Invest account on the SoFi Invest® brokerage platform. You can trade stocks, ETFs, IPO shares, and more.

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.

Photo credit: iStock/marchmeena29

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.

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Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.

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Nov
07
2023
What Is the MOASS and When Will It Happen?

What Is the MOASS?

By | Growing Wealth, invest, Investing | Comments Off on What Is the MOASS?

“MOASS,” or, the “Mother of All Short Squeezes,” was largely unknown to investors prior to 2021. But a saga involving so-called “meme stocks,” most notably GameStop stock, changed that, and MOASS entered the investing lexicon. In short, that specific scenario, bringing the Mother of All Short Squeezes, as a strategy, to investors’ attention, involved a rag-tag band of day traders taking on the hedge fund giants, with a short-sale “squeeze” that greatly impacted some of those giants.

The episode shined a much-needed light on investors, short-sales, trading squeeze strategies, and digital trading on a massive scale, all of which fell under the MOASS umbrella.

Short Squeeze Basics

A short squeeze is an orchestrated effort to drive up shares of a stock that’s being heavily shorted. MOASS, meaning the Mother of All Short Squeezes, as noted, is a trading strategy in which a high volume of buyers drive up shares of stocks that were being “shorted” by other investors.

A short squeeze trading strategy needs two components to work – a short seller or, more preferably, several short sellers on one side and a group of disciplined contrarian investors who unroll a short squeeze and buy shares of the stock being shorted.

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How the MOASS Works

In a short squeeze, short sellers aim to drive a stock’s price downward and profit as the stock declines in value. Short sellers are usually organized institutional investors with enough assets to move a stock in a preferred direction, and they sometimes use dark pools to make their bets.

They do so by borrowing and selling shares of a stock that they believe will decline in value. Then, when the stock price falls, a short seller buys the stock at the reduced price, returns the shares, and pockets the profit.

If the short seller makes the right call, meaning the price does fall, they earn the difference between the price when they entered the short position and the lower stock price at which they bought to cover. If the short seller makes the wrong call, and the price goes up, the investor must buy the stock at a price higher than when they entered the short position, thereby losing money – and negating any potential for a profit.

As short sellers wind up leaving their short positions when they execute a buy order on the stock, those short-squeeze buy positions get noticed by other investors, who also jump in to purchase the stock. That, in turn, drives the stock’s price even higher, since there are fewer shares of the stocks available to purchase.

Short-sellers, highly alarmed by the rising share price, also issue buy orders on the stock to exit the short sale strategy and reduce their investment risk, which completes the cycle and puts the short squeeze in full effect. This can result in the short sales losing money and the MOASS trader making a profit on the rising stock price.

Recommended: Understanding Low Float Stocks

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GameStop: The Prime Example of MOASS

A good example of MOASS in action is the GameStop saga in early 2021. At the time, several hedge fund firms had “shorted” GameStop stock, which essentially meant betting the share price of the stock would decline. That didn’t happen with GameStop shares.Some context is important to understand, too, as many retail stocks, like GameStop, had been heavily affected by the pandemic at the time.

But GameStop shares bucked the trend.

A group of day traders hanging out on a Reddit investing forum called “Wallstreetbets” banded together and started buying up shares of GameStop stock. The gambit worked, with GameStop shares skyrocketing from $19 per share to around $350 per share. The retail investors had successfully “squeezed” the short sellers, causing several hedge funds to lose hundreds of millions of dollars on their short positions on GameStop.

If the short squeeze works, the share price will continue to rise and the short investors, many of whom have fixed deadlines built into their short sales positions, will have to sell their shares and cut their losses, thereby driving the stock price even higher. That rewards the short squeeze investor, who profits from the rising share price, especially as other buyers enter the fray and drive the share price up even higher.

Once victory was declared with the GameStop short squeeze, the Reddit traders turned their attention to other so-called meme stocks where short selling activity was particularly high. That group included AMC Entertainment Holdings, Koss Corporation, and Blackberry, which all saw share volumes rise after the MOASS traders entered the fray.

Thus, a series of short squeezes that target more and more short sellers is really what MOASS is all about: squeezing enough short-sellers to achieve critical mass in the trading markets, and making huge profits in the process.

Recommended: Pros and Cons of Momentum Trading

MOASS Trading Tips

Investors who want to participate in the next short squeeze effort should be careful. So-called “meme” stock trading can be fraught with risk, especially if you’re left holding the bag after other short-squeezers sell out of their positions before you do.

Take these risk considerations with you before participating in a mass short squeeze play.

Buy Minimally to Limit Losses

While the adrenaline level can be high when participating in a short squeeze trading event, tamp down emotions by limiting the amount of money you invest in a GameStop-type situation. It may be relatively boring to do so, but your money is likely better in a well-researched fund that has a good management team and a history of solid portfolio performance results.

As the old gambling adage says, never risk money you can’t afford to lose. That goes double when chasing the thrill of a MOASS scenario.

Expect to Lose Money

There’s a significant chance that you’ll lose money at some point with a short squeeze play.

Nothing is guaranteed in the stock market and that’s especially the case as short-sellers have learned their lesson after the GameStop fiasco, and grow more cautious about their investing habits. MOASS trading patterns can be something of a roller coaster ride for investors, and the odds that your ride will dip along the way are high. That can translate into days or even weeks of your short-squeeze buying strategy where your investment returns are written in red ink.

💡 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).

MOASS Tip: Have a Plan to Sell Quickly

Short squeeze investing isn’t exactly an orderly process and you need to put your interest first ahead of other MOASS investors. Why? Because volatility can be high and prices can swing at a moment’s notice when trading MOASS-themed stocks. Additionally, nobody really has any idea how high a price can go with a short squeeze in play, and nobody really knows if a stock will rise higher at all.

That’s why it’s a good idea to have a fixed “sell price” in mind when engaging in a short squeeze situation – a stop loss order to automatically sell the stock at a specific price can be a good idea in this scenario.

If you buy a targeted MOASS stock at $50 and it goes to $70, there’s no way of knowing if the stock will go any higher – it might and it might not. Worse, the price could slide back to $30 when buyers lose interest in the stock.

Having a good investment exit strategy in a short squeeze scenario, can help minimize investment losses and capitalize on a stock increase when and if it happens.

The Takeaway

“MOASS” means the “Mother of All Short Squeezes,” and perhaps the best example of it in action involved GameStop shares in 2021. Short squeeze trading strategies can bring a great deal of portfolio-shaking volatility to the investment table, and there are plenty of heavily shorted stocks that could be the next MOASS, but it’s impossible to know which one could trigger a squeeze.

That means MOASS may not be the best strategy for long-term investors or those with an aversion to risk. A short squeeze takes a significant amount of discipline, patience, and attention on the part of the investors, with continual risk in play until the squeeze is played out.

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).

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.

Photo credit: iStock/PeopleImages

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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Oct
23
2023

Short Squeezes Explained

By | Financial Independence, Growing Wealth, invest, Investing | Comments Off on Short Squeezes Explained

A short squeeze is a market event in which short sellers quickly close out bearish positions in a stock, leading to a dramatic surge in the share price. Short squeezes typically occur after a company stock posts a sudden increase. This causes short sellers to try to exit a bearish position quickly.

In order to exit their short positions, these investors have to actually buy back shares they’ve lent out. This causes further gains in the share price, sometimes to dizzying levels.

What Is a Short Squeeze?

As mentioned, a short squeeze is an event in the market that involves short sellers quickly selling or closing out their positions, which in turn, causes changes in the share price of a security.

There are many investors, both retail and institutional, who use short selling to bet that a given stock will go down over a fixed period of time. But short selling is incredibly risky as stock prices have historically tended to drift upward. And timing a bearish position can also be picky. Even if an investor has good reason to believe that a company’s shares will fall, it could be some time before they actually do.

What Causes Short Squeezes?

To understand how short squeezes occur, we first have to understand how shorting a stock works. To sell a stock short, an investor must first borrow the shares. They then consequently sell in the open market. At an agreed-upon time, the investor will buy back the shares in order to return them to the original lender.

If the stock goes down between the time they borrow the stock and when they return it the investor makes money. That’s because they pocket the difference between what they sold the stock for and what they purchased it for when it came time to return it.

And if those short investors borrow a stock that goes up instead of down, they lose money.

Example of Short Selling

Let’s look at a hypothetical case of a short sale. Let’s say an investor borrows a stock that’s trading at $10 with an agreement to pay back the shares in 90 days.

The investor then sells the stock for $10. Then 90 days later, if the stock is trading at $5, they can buy back the number of shares they borrowed and return them to the lender, capturing the $5 per share profit (often minus interest and fees).

Example of Short Squeeze

Now, let’s use this example to look at a short squeeze. Let’s say the investor borrows the stock again that’s trading at $10 with an agreement to pay back the shares in 90 days.

This time however, the share price shoots up to $15. The investor still has to buy the shares they borrowed and return them to the lender. But other investors are also trying to cover their shorts as well, so there’s a shortage of shares in the market to buy back.

The shortage causes the stock’s price to jump even higher to $20, which in turn triggers other short sellers to close their positions. They have to now also purchase back shares, and hence a buying frenzy and short squeeze occurs.

Theoretically, there’s no limit to how much money short sellers can lose. When an investor is long a stock but wrong, the share prices can only go down as low as $0. But when an investor is short and wrong, the share prices can go infinitely higher, making it possible losses can be limitless for the short-selling investor.

Recommended: How Low Can a Stock Go?

Famous Short Squeezes

One famous example of a short squeeze occurred in 2021, when electronics retailer GameStop saw its shares jump 2,300% in a few weeks as a wide range of investors looked to take advantage of the high number of short sellers in the stock. This was during the “meme stock craze” that overtook the market that year.

Another example occurred in 2008, when automaker Volkswagen briefly became the world’s most valuable stock by market cap when it became known that Porsche was increasing its stake in its fellow German carmaker.

What’s a Long Squeeze?

By contrast, a long squeeze is when short sellers drive down the price of a stock or asset until the bullish investors begin to sell their positions in response, driving the price lower still. It can be helpful to review short positions vs long positions to get a deeper understanding of a long squeeze.


💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.

What Was the MOASS?

The “MOASS” is an acronym for the “Mother of all short squeezes.” And it’s more or less exactly what it sounds like: A monstrous short squeeze event in the market.

The short squeeze involving GameStop shares, as mentioned above, is perhaps the best and most recent example of a MOASS. Many institutional investors had shorted GameStop stock, anticipating that its value would fall, but groups of day traders worked together to drive up demand of the stock, and its value. This “squeezed” the short sellers, and caused many big firms to lose significant amounts of money on their positions.

How to Trade a Short Squeeze

Given the chance for dramatic returns, many investors have taken an interest in getting in on the winning side of a short squeeze.

To invest in a short squeeze, traders start by surveying the markets for stocks that have garnered substantial interest from short sellers. This factor is often called “short interest,” and as a metric, it represents the number of a company’s shares that have been sold short, but not yet returned to the lender. Traders know that the short sellers of all those shares will have to buy back shares – at any price – to return them to the lender.

There are two ways to understand short interest. One is short interest percentage, which shows how many of a company’s overall shares are currently shorted. A higher number means that more short sellers will be bidding up the stock to buy it back. The second metric is short interest ratio, which shows how much short sellers are responsible for a stock’s daily trading volume. A higher ratio means it’s likely that short sellers will help drive up the stock’s price once it starts to rise.

Another key metric has to do with when the short sellers will have to deliver those shares to the lender. It’s known as “days to cover,” and it’s the ratio comparing the total short-selling interest in a stock with the average daily shares that trade. As a metric, it gives traders a sense of how long until short sellers buy back the stocks they borrowed for their short positions.

Stocks with a high short-interest number and a high days-to-cover number are vulnerable to a short squeeze. Once these traders find stocks that seem like short-squeeze candidates, they buy the stocks outright, and watch those key metrics, along with the news, to decide when to sell. Short squeezes can make a stock shoot up, but those returns often evaporate quickly.

Short Squeezes vs Naked Shorts

As discussed, shorting typically involves borrowing shares to create tenable positions. Naked shorts, often involving naked options, are a type of short selling, but it involves not borrowing, or otherwise securing possession of, shares before making a trade or taking a short position. This leaves the trader “naked” in the event that a trade goes south.

Risks of a Short Squeeze

While short squeeze investments can produce eye-popping returns in the short term, they come with real risks for individual investors, and institutions.

Risks for Investors

For investors, perhaps the biggest risk of a short squeeze is that they’ll get caught on the wrong side of one, and lose some money. Obviously, that’s a risk for institutions as well, but individual investors likely don’t have as many resources on hand to try and recover.

Similarly, investors may misread the room – that is, not quite understand what’s happening in the market, and misjudge their position. They’ll also need to be vigilant in watching their positions to make sure they change those positions at the right time.

Risks for Institutions

Most of the risks involved with short squeezes for individual investors hold true for institutions, too.

For instance, the risks involved with stocks themselves include the fact that stocks with a high short-interest number may be undervalued or misunderstood, or they may simply be failing businesses. And if there is no good news, or market interest, they may continue to sink.

At the same time, the price increases caused by short squeezes are short-lived. Once the short-sellers have paid back their lenders, the market runs out of buyers who will pay any price for that stock. And the share prices often fall as quickly as they rose. The danger to traders in a short squeeze is that they’ll get in too late and stay in too long and lose money.

Long-term investors may try their hands at winning a short-squeeze trade here and there. But it requires deep research, constant monitoring and the ability to move in and out of a stock quickly – something that institutions may have access to more so than individuals.

Investing With SoFi

A short squeeze is a market event in which investors inadvertently bid up the price of a heavily shorted stock, while trying to get out of their bearish positions. In order to buy the stocks that investors borrow to sell short, those investors must buy the stock at ever-increasing values.

Short squeezes involving short positions and financial derivatives are relatively high-level concepts and may involve a skilled hand in navigating. For that reason, it may be worth discussing them, and their risks, with a financial professional.

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).


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

Are short squeezes legal?

Short squeezes are a natural occurrence in the stock market, but market manipulation is illegal. As the SEC says, “abusive short sale practices are illegal,” and that may play into short squeezes. As such, it’s a gray area.

What is the biggest short squeeze of all time?

While the Volkswagen short squeeze in 2008 was one of the largest of all time, the GameStop short squeeze was, perhaps, the largest of all time, and the most notable recent example of a short squeeze.

How high can a short squeeze go?

Theoretically, there is no limit on how high a stock can go, and accordingly, how high a short squeeze can go.

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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Oct
20
2023
How Does High Frequency Trading (HFT) Impact Markets

How Does High-Frequency Trading (HFT) Impact Markets?

By | Growing Wealth, invest, Investing | Comments Off on How Does High-Frequency Trading (HFT) Impact Markets?

High-frequency trading (HFT) firms use ultrafast computer algorithms to conduct big trades of stocks, options, and futures in fractions of a second. HFT firms also rely on sophisticated data networks to get price information and detect trends in markets.

A key characteristic of HFT trading — in addition to high speed, high-volume transactions — is the ultra-short time time horizon.

How high-frequency trading impacts markets is a controversial topic. Proponents of HFT say that these firms add liquidity to markets, helping bring down trading costs for everyone. HFT critics argue such firms are an example of how bigger, better-funded players have an advantage over smaller retail investors, and that HFT technology can be used for illegal purposes like front-running and spoofing.

What is High Frequency Trading?

Ultrafast speeds are paramount for high-frequency trading firms. Executing these automated trades at nanoseconds faster can mean the difference between profits and losses for HFT firms.

There are broadly two types of HFT strategies. The first is looking for trading opportunities that depend on market conditions. For instance, HFT firms may try to arbitrage price differences between exchange-traded funds (ETFs) and futures that track the same underlying index.

Futures contracts based on the S&P 500 Index may experience a price change nanoseconds faster than an ETF that tracks the same index. An HFT firm may capitalize on this price difference by using the futures price data to anticipate a price move in the ETF.

Another type of HFT is market making. Not all market makers are HFT firms, but market making is one of the businesses some HFT firms engage in.

A big market-making business for HFT firms is payment for order flow (PFOF). This is when retail brokerage firms send their client orders to HFT firms to execute. The HFT firms then make a payment to the retail brokerage firm.


💡 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 HFT Works and Makes Money

High-frequency trading enables traders to profit from miniscule price fluctuations, and permits institutions to gain significant returns on bid-ask spreads. HFT algorithms can scan exchanges and multiple markets simultaneously, allowing traders to arbitrage slight price differences for the same asset.

Bid-Ask Spreads 101

High-frequency trading firms often profit from bid-ask spreads — the difference between the price at which a security is bought and the price at which it’s sold.

For instance, an HFT may provide a price quote for a stock that looks like this: $5-$5.01, 500×600. That means the HFT firm is willing to buy 500 shares at $5 each — the bid — while offering to sell 600 shares at $5.01 — the ask. The 1 cent difference is how the market maker makes a profit. While this seems small, with millions of trades, the profits can be sizable.

How wide bid-ask spreads are is also a marker of market liquidity. Bigger chunkier spreads are a sign of less liquid assets, while smaller, tighter spreads can indicate higher liquidity.

Recommended: What Is Quantitative Trading?

Payment For Order Flow 101

When it comes to payment for order flow, high-frequency traders can make money by seeing millions of retail trades that are bundled together.

This can be valuable data that gives HFT firms a sense of which way the market is headed in the short-term. HFT firms can trade on that information, taking the other side of the order and make money.

Background on High-Frequency Trading

High-frequency trading became popular when different stock exchanges started offering incentives to firms to add liquidity to the market. Liquidity is the ease with which trades can be done without affecting market prices.

Like momentum trading, the HFT industry grew rapidly as technology in the financial space began to take off in the mid-2000s.

Adding liquidity means being willing to take the other sides of trades and not needing to get trades filled immediately. In other words, you’re willing to sit and wait. Meanwhile, taking liquidity is when you’re seeking to get trades done as soon as possible.

During 2009, about 60% of the market was said to be HFT. Since then, that percentage has declined to about 50% as some HFT firms have struggled to make money due to ever-increasing technology costs and a lack of volatility in some markets. These days the HFT industry is dominated by a handful of trading firms.

Pros and Cons of High-Frequency Trading

HFT comes with certain pros and cons.

Pros of HFT

High-frequency trading is automated and efficient, thanks to its use of complex algorithms to identify and leverage opportunities.

HFT may create some liquidity in the markets.

Cons of HFT

Because high-frequency trades are conducted by institutional investors, like investment banks and hedge funds, these firms and their clientele tend to benefit more than retail investors.

Because high-frequency trades are made in seconds, HFT may only add a kind of “ghost liquidity” to the market.

Some HFT firms may also engage in illegal practices such as front-running or spoofing trades. Spoofing is where traders place market orders and then cancel them before the order is ever fulfilled, simply to create price movements.

The Debate Over High Frequency Trading

High-frequency trading is a controversial topic, and HFT firms have been involved in lawsuits alleging that they create an unfair advantage and potentially create volatility.

Criticism of HFT

One complaint about HFT is that it’s giving institutional investors an advantage because they can afford to develop rapid-speed computer algorithms and purchase extensive data networks.

Critics argue that HFT can add volatility to the market, since algorithms can make quick decisions without the judgment of humans to weigh on different situations that come up in markets.

For instance, after the so-called “Flash Crash” on May 6, 2010, when the S&P 500 dropped dramatically in a matter of minutes, critics argued that HFT firms exacerbated the selloff.

HFT critics also argue that such traders only provide a very temporary kind of liquidity that benefits their own trades, but not retail investors. A December 2020 paper published by the European Central Bank also argued that too much competition in the HFT industry can cause firms to engage in more speculative trading, which can harm market liquidity.


💡 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.

Defense of HFT

Defenders of high-frequency trading argue that it has improved liquidity and decreased the cost of trading for small, retail investors. In other words, it made markets more efficient.

This can be particularly important in markets like options trading, where there are thousands of different types of contracts that brokerages may have trouble finding buyers and sellers for. HFT can be helpful liquidity providers in such markets.

When it comes to payment for order flow, defenders of HFT also argue that retail investors have enjoyed price improvement, when they get better prices than they would on a public stock exchange.

The Takeaway

It’s tough to be an investor in many markets today without being affected by high-frequency trading. HFT firms are proprietary trading firms that rely on ultrafast computers and data networks to execute large orders, primarily in the stocks, options, and futures markets.

HFT proponents argue that their participation helps markets be more efficient. Critics argue that they have a big advantage over smaller investors, given how much they pay for information and data networks.

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 high-frequency trading profitable?

High-frequency trading aims to profit from micro changes in price movements through the use of highly sophisticated, ultrafast technology. That said, HFT investors are subject to losses as well as gains.

Is high-frequency trading illegal?

High-frequency trading has been the subject of lawsuits alleging that HFT firms have an unfair advantage over retail investors, but HFT is still allowed. That said, HFT firms have been linked to illegal practices such as front-running.

What is an example of high-frequency trading?

High-frequency trading can be used with a variety of strategies. One of the most common is arbitrage, which is a way of buying and selling securities to take advantage of (often) miniscule price differences between exchanges. A very simple example could be buying 100 shares of a stock at $75 per share on the Nasdaq stock exchange, and selling those shares on the NYSE for $75.20.

Photo credit: iStock/wacomka

SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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

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