InvestHL Archives | Page 21 of 67

Sep

2023

Pairs Trading Strategy 101: A Guide for Novice Investors

By Colin Dodds | Financial Independence, Growing Wealth, invest, Investing, Terminology | Comments Off

Pairs trading is a market-neutral trading tactic that allows investors to use the historical performance of stocks to place long and short bets to make big profits.

Pairs trading was first used in the mid-1980s as a way of using technical and statistical analysis as a way to find potential profits. It remained the province of Wall Street professionals until the internet opened online trading and real-time financial information to the public. Before long, there were seasoned amateur investors using pairs trades to make money, while managing their risk exposure.

What Is Pairs Trading?

Pairs trading is a day trading strategy in which an investor takes a long position and a short position in two securities that have shown a high historical correlation, but which have fallen momentarily out of sync.

The correlation between the two securities refers to the degree that two securities move in relation to one other. More specifically, correlation is a statistical measurement that measures the relationship between the historical performance of two securities.

It’s usually expressed as something called a “correlation coefficient.” This measure falls between -1.0 and +1.0, with negative 1 indicating that two securities move in exactly opposite ways. A correlation coefficient of positive one indicates that the two securities move up and down at exactly the same times under the same conditions.

What Types of Assets Are Traded in Pairs?

Numerous types of financial assets can be traded in pairs, and the list includes stocks, commodities, options, funds, and even currencies. In one sense, the asset or security at the heart of the trade is somewhat irrelevant, as traders are looking to take advantage of the difference in value (and thus, a different investment position) between the two. Again, the whole goal is to try and beat the average stock market return.

Often, though, pairs trading is discussed in relation to stocks, as that may be the asset class that most trading discussions revolve around.

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Pros and Cons of Pairs Trading

Pairs trading is something that most investors can take part in, assuming they know the risks of playing the market. That’s to say that there are pros and cons to pairs trading, and investors should review them before engaging in it.

Pros of Pairs Trading

The biggest pro to pairs trading is that there is the potential for profit, or at least bigger returns than investors may have otherwise generated by executing a different investing strategy. There’s also the potential to generate positive returns no matter what the overall market conditions are. Further, pairs trading may actually be a way to mitigate risk when investing in stocks, as there are only two trades involved, and in some ways, the mechanics of the trade setup can benefit the trader — but note that this is not to say that it’s a safe or risk-free strategy.

Cons of Pairs Trading

Cons of pairs trading include the possibility of the trading model failing due to faulty assumptions on the part of a trader — that is, historical correlation between two stocks may not mean that the correlation has continued. Traders should also know that pairs trading involves fast movements, and that there’s a chance trades may not execute at the desired time — this could stymie the strategy’s effectiveness. For traders, it may be worth looking at different stock exchanges and different investment platforms to get a sense of where the strategy may be the most effective.

It may also be helpful to understand the concept of stock volume in order to have a better chance of success with the strategy.

Pairs Trading Example

In a pairs trade, an investor will look for two separate securities that have a historically high correlation, but have fallen out of sync. If “stock Alpha” and “stock Beta” have historically risen and fallen in step, they’d have a very high correlation, maybe as high as positive of 0.95. But, for whatever reason, the two stocks have diverged, with Alpha racking up big gains, while Beta languished. That has knocked the short-term correlation coefficient between the two down to paltry 0.50.

This is the most common scenario for a pairs trade. In it, an investor will take a long position on stock Alpha, which has underperformed. At the same time, they’ll short stock Beta, which has outperformed. What they’re doing in a pairs trade is betting that the relationship between the two stocks will return to their historical norm, either by one security falling, the other one rising, or some combination of the two.

Pairs Trading Strategy: Market Neutral

Pairs trading is considered a “market-neutral” strategy. There are many of these strategies, which share a common aim to profit from both rising and falling security prices, while sidestepping the risks of the broader market.

Many hedge funds will employ market-neutral strategies, because they are paid based on their absolute returns. A common market-neutral trade may involve taking a 50% long and a 50% short position in one industry, sector or market. They usually do so to take advantage of pricing discrepancies within those areas. In addition to earning a return, their main goal is often to hedge out as much systematic risk as possible.

There are also market-neutral mutual funds, which can vary wildly in what they return investors, largely because there are so many market-neutral strategies, and ways to execute them. Interested investors may want to learn the fund’s particular approach to the strategy before jumping in.

How to Successfully Execute a Pairs Trade

For investors who are ready to incorporate pairs trading into their investment strategy, there are several steps they need to take in order to be successful.

Step One: Decide on Trading Criteria

The first step is to decide what securities to consider for the trade, and can be the most time-consuming in the entire process. This involves researching a vast array of possible investment pairs to find ones that have a historically high correlation coefficient but have since drifted apart. Then investors will want to build and test a model for those securities, using those results to arrive at the best possible buy-and-sell guidelines, as well as how long they intend to stay in a trade.

Step Two: Select Specific Securities

After the investor has settled on a process to select candidates for a pairs trade, it’s time to put that process into action and find securities that currently meet that criteria. Some investors may use manual research, while others prefer mathematical models. Regardless, investors need to think of how they want to use a pairs trade.

For investors who want to get in and out of a trade in a matter of hours or days, they’ll need to run their process to find possible trades on a regular basis. But investors whose trades will last for months won’t need to run their research as often.

Step Three: Execute the Trade

Once an investor has confirmed that a trade fits all their criteria, it’s time to execute the trade. With a pairs trade, there are small but important details to consider. For instance, most experienced pairs traders will execute the short side of the trade before making the long side.

Step Four: Manage the Trade

With the trade in place, the investor now has to wait and watch. This means sizing up the activity of the two securities in the trade to see if they’re approaching the criteria that would trigger one of the predetermined buy-and-sell rules. It also means watching the broader market, as well as any news that might have an impact on either security in the trade. Experienced traders will also constantly adjust the trade’s risk/return profile as markets shift and other news emerges.

Managing the trade is as important as setting it up. If a trader has a pairs trade they expect to last a month, but it reaches 50% of its profit objective in the first day after execution, what should they do? They may choose to close out of the trade that day, because the additional return isn’t worth the risk or the opportunity cost. But they also have other options. They might initiate a trailing stop loss level in the two positions as a way of locking in a portion of the profit. The decision isn’t easy, and may involve a host of other considerations.

Step Five: Close the Trade

The final step is to close the trade. But even this can come with questions and challenges, especially with trades that haven’t worked out, and whose predetermined durations are coming to an end. But it can also be the case with trades that have succeeded and are nearing their time limit. The urge to give a trade more time to turn around — or to do just a little better — has the potential to be the undoing of an otherwise successful trader.

That’s why experienced pairs traders often stress discipline as being as important as research, close monitoring and clear rules when it comes to earning consistent profits with the strategy.

History of Pairs Trading

Pairs trading is a somewhat higher-level trading strategy (though relatively simplistic at the same time), and it was actually first developed by technical analyst researchers at Morgan Stanley during the 1980s. Specifically, Nunzio Tartaglia led the charge, who ran the “quant” group at the firm.

It has since been adopted by traders and investors, big and small.

Investing With SoFi

Pairs trading is a trading strategy that involves the simultaneous purchase and sale of securities in anticipation of a price trend. The idea is that the two securities typically have shown a high historical correlation, but have fallen momentarily out of sync. The investor making the pairs trade is betting that the two stocks will return to their historical norm.

Pairs trading is merely one of many trading strategies, and like all others, it has its pros and cons. Prospective traders may benefit from a discussion with a financial professional before trying it 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.

FAQ

Is pairs trading still profitable?

Yes, pairs trading can be profitable, assuming a trader knows what they’re doing, and the risks involved with using the strategy. As always, there’s no guarantee that it will be profitable, however.

What are the risks of pairs trading?

Risks associated with a pairs trading strategy include the possibility of the trading model failing due to faulty assumptions on the part of a trader — that is, historical correlation between two stocks may not mean that the correlation has continued. Traders should also know that pairs trading involves fast movements, and that there’s a chance trades may not execute at the desired time.

How many pairs should a beginner trade?

It may be wise for a beginner to start with a single pair, until they get the gist or hang of the strategy.

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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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Sep

2023

What Is a Shell Company and Why Do They Exist?

Guide to Shell Companies

By Colin Dodds | Growing Wealth, invest, Investing | Comments Off

A shell company, also called a shell corporation, refers to any legally structured corporation that has no meaningful assets or business operations. In popular culture, they’re often used to conceal illegal businesses, or to conceal the owners of a business from law enforcement, the public, or both. However, shell companies themselves are not illegal, and they do have some legitimate uses.

As business entities, shell companies exist to protect, and sometimes to conceal (or at least misrepresent) the assets of the shell company’s owner. But there’s nothing necessarily illegal about shell corporations themselves. It’s important to not only understand the definition of a shell company, but also to recognize how and why they’re used by businesses and people.

How Are Shell Companies Created?

There is more than one way to create a shell company. Most often, the people or corporations that launch new shell corporations use a registered agent in the country where the company will have its legal headquarters. So, in the United States, shell companies would need to register with the Securities and Exchange Commission.

In most countries, the agent must register his or her name, and the name of an owner or a shareholder director. The cost of creating and legally registering a corporation will vary from country to country, from as little as a few thousand dollars to as much as several hundred thousand dollars.

Being “hollow,” by definition, shell companies can do many things. They can open bank and brokerage accounts. They can transfer funds in and out of their home country. They can buy and sell real estate or other companies. And own copyrights and earn royalties on those copyrights.

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

3 Uses of Shell Companies

People and corporations use shell companies in a wide range of legitimate businesses for legitimate reasons. Those might be used as a vehicle to raise funds, as a legal entity to attempt to take over another business via a reverse merger, or as a legal entity to give form to a company that intends to go public.

1. Tax Benefits of Shell Companies

Many shell corporations operate in a legal gray area, and it’s possible that corporations and wealthy individuals may use them to avoid taxes.

Many companies have found ways to move their profits to offshore shell corporations to take advantage of less expensive, or more permissive tax regimes in other countries (similar to how some states may be more tax-friendly than others). American corporations might set up shell companies in countries with inexpensive labor, where they have already begun to outsource some of their operations.

Corporations aren’t the only ones that use shell companies to avoid paying taxes. Wealthy individuals around the world may also use shell corporations, domiciled all over the world, to hide their earnings and their wealth from the governments of the countries in which they prosper.

2. Less Risk, More Opportunity

Tax avoidance isn’t the only reason a corporation would set up a shell corporation. It might create a shell company to operate in a country, while protecting its other operations from the legal, political, and financial risks related to that country. That way, if something goes wrong in the country where it operates, the parent company can limit its exposure by existing — at least on paper — offshore.

A corporation may also set up a shell corporation in another country to gain a window into new regions. A business might set up a shell company in Panama or Switzerland to gain access to the local business community, in order to generate contacts and information that would lead it to business opportunities in Latin America or Western Europe.

3. SPACs

While shell companies come up in the news in relation to questionable tax-avoidance schemes, in recent years, they’ve also been mentioned alongside special purpose acquisition companies, or SPACs.

At any given time, there may be hundreds of shell companies that qualify as SPACs — which may be a reason that SPACS were so popular for a couple of years in 2020 and 2021. These are companies formed exclusively to raise capital via an initial public offering (IPO), which will then purchase a company already in operation. SPACs are a type of “blank check company.”

These companies issue an IPO, then hold the money in a trust, until the SPAC management team chooses a company and buys it. And if the SPAC doesn’t find a company to buy, or can’t buy the company or companies it likes within a pre-set deadline — often two years — then the managers promise to liquidate the SPAC and give investors their money back.

Recommended: What Is A Backdoor Listing?

Example Shell Companies

An example of a shell company could be as follows.

Say there’s an entrepreneur that’s looking to raise money before they officially launch a startup — maybe the next big emerging growth company. They may create an LLC, which is a business entity, that doesn’t have any assets or employees. It only exists on paper. But the business entity — a shell company — can be used to store the money being raised for the startup prior to its launch.

In effect, the company itself is merely a shell used to hold cash until it’s ready for use. It’s not really a functional business in the traditional sense.

Shell Companies and Shady Dealings

While there are many legitimate uses for shell companies, as outlined, bad actors also might use them to shield their operations and their assets from authorities. And as different jurisdictions compete for business, new loopholes emerge on a regular basis. In Panama, the British Virgin Islands, Nevada and Delaware, to name only a few, there are strong laws that prevent the government from revealing the beneficial owner of a given shell corporation.

And for creative financiers, there are always new ways to add layers of anonymity, such as phony company directors, who agree to sign their names for a few dollars. Among professionals who specialize in such things, there are ways to find would-be board members, and for countries and states with convenient tax and privacy laws.

Are Shell Companies Legal?

Yes, shell companies are legal, and are most often used for perfectly legal purposes. While they can be used for illegal purposes, a shell company is generally used for a more or less boring or run of the mill business purpose — as discussed in the previous example above.

Shell Companies vs Holding Companies

Though there may be some superficial similarities, shell companies and holding companies are not the same thing. As discussed, shell companies may be formed to serve as empty entities that may be used to take advantage of different taxation regulations, for example. A holding company, on the other hand, is a parent company — holding companies holds or owns other companies within it, like an umbrella. It allows its owners to control numerous businesses without necessarily actively managing any of them.

The Takeaway

Shell companies are legal business entities that are often used for perfectly legal reasons, and often to reduce tax liabilities or store funds. Shell companies can be used for illegal purposes, too, which is what they’re often associated with.

Most investors wouldn’t use shell companies in their day-to-day trading, but they might consider allocating part of their portfolios to a SPAC. It’s important to remember that these are speculative, risky investments, so they don’t make sense for every portfolio.

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*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.

FAQ

Is a shell company legal?

Yes, shell companies are legal, and are generally used for perfectly legal purposes. A shell company is simply a business entity that has no assets or employers, or engages in much or any meaningful business operations.

What is an example of a shell company?

An example of a shell company could be an LLC formed by an entrepreneur planning to launch a startup. The entrepreneur files the paperwork to create the LLC, and then uses it simply to store funds until the startup launches, rather than have the LLC engage in any business itself.

What is the difference between a holding company and a shell company?

Holding companies are parent companies, or umbrella organizations, that often have multiple businesses running underneath or within them. Shell companies do not have assets or employees, or any meaningful business operations.

Photo credit: iStock/akinbostanci

Sep

2023

What Is Scalp Trading?

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

Scalp trading, or scalping, is a style of short-term trading used with stocks, cryptocurrencies, and other assets. The goal of this trading style is to make profits off of small changes in asset prices. Generally this means buying a stock, waiting for it to increase in value by a small amount, then selling it.

The theory behind it is that many small gains can add up to a significant profit over time. Scalp trading is one of the most popular day trading strategies. Scalping requires a lot of focus, quick decision-making, the right trading tools, and a strategy — and even then, it’s no sure thing. Since traders make many small gains, one big loss could wipe out all their profits.

How Scalping Works in Trading

The goal of scalping is to make many small profits during a trading session. This is the opposite of a buy-and-hold or long term trading strategy, where one hopes to see their portfolio grow over time. Scalpers might make anywhere from 10 to more than 100 trades in a single day, taking a small profit on as many of them as possible. And they might only stay in each position for a few minutes.

With each trade they assess the risk-to-reward ratio with a goal of profiting on more than 50% of their trades. Each win may be small, but the profits can add up over time if they outnumber the losses. Often, scalpers make use of stop losses and leverage when making trades.

Scalp trading reduces risk exposure, since traders only have their money in the market for a short amount of time. It can also be an easier day trading strategy than some others because the goal is to capitalize on small price movements. Small moves happen constantly in the market, and it’s easier to make a profit of a few cents or dollars than a larger amount.

However, any type of day trading involves a significant amount of risk. Scalping is challenging and can result in large losses. This is just one reason why some traders use scalping along with other trading methods.

💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

Scalp Trading Strategies

There are many different scalp trading strategies, some of which can be used together.

Systematic Planning

Technical analysis helps scalp traders spot trading opportunities and plan exits ahead of time. Traders use one-minute charts, Level II quotes, moving averages, exchange order books, and other tools while scalping. Since positions may be entered and exited within seconds or minutes, five- or 10-minute charts aren’t very useful.

On the Fly

Although fundamental analysis doesn’t play a large role in scalping, it can help to identify stocks that are currently in the news or of interest based on a current event, which may lead to more price movement and trading opportunities. Higher volatility is generally a good sign for scalpers.

Shorting Stocks

Some scalpers also short stocks and sell when they decrease in value. This can be done with the same asset repeatedly, or with different assets throughout a trading session.

Bid/Ask Profiting

Some scalpers prefer to earn profits off of the bid/ask spread rather than actual stock price movements. This takes a significant amount of experience and is a particular trading skill that takes time to learn. It entails looking for trades with a wide spread, meaning a large difference between the broker’s ask price and the price at which a trader buys the asset.

Range Trading

With this strategy, the trader waits for an asset to enter a specific price range before they start trading. Generally, the range is between a support and a resistance level.

Market Making

Market making is when traders post a bid and an offer on a stock at the same time. This only works with stocks that trade a large volume but have low volatility, and the profits are small.

How to Scalp Trade

While there is no one way to engage in scalp trading, these are the general guidelines that scalpers follow to make decisions:

• Create a watchlist each day based on fundamental analysis and news

• Trade stocks with enough liquidity that there will be price movement and more options for exit points

• Quickly sell a stock isn’t increasing in value

• Make a daily profit goal

• Set goals for each stock trade and stick to them

• Buy stocks at breakouts

• Keep trades short for more chance at a profitable exit

• Adjust exit points as stocks move.

Pros and Cons of Scalp Trading

Scalp trading is a particular day trading strategy which works well for some people, there are many risks associated with day trading.

Pros of Scalp Trading

• Small gains can add up to significant returns

• It reduces risk exposure to market due to short trade times

• It may be easier than some other day-trading strategies

• It can be easier to make profitable trades when the goal is to profit off of small movements rather than large price movements

• There are many trading opportunities, no matter what the market conditions are.

💡 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.

Cons of Scalping

• Even one large loss can cancel out any gains made during a trading session

• It requires a lot of focus to watch the charts for several hours and execute trades, and can be tedious

• It requires knowledge and experience with technical analysis

• Transaction and commission fees can add up quickly if making multiple trades per day—and potentially cancel out profits. It’s key to use a broker that doesn’t charge commissions or one that offers discounts to high volume traders.

• If traders experience a few losses it can be distressing, and it’s easy to let emotions get in the way of good trading habits. Scalping may be one of the most stressful trading strategies.

• Scalpers often use margin trading and leverage to increase their positions, which can be very risky.

The Takeaway

Scalp trading, or scalping, is a style of short-term trading used with stocks or other securities. Scalping is best suited for more experienced traders, since it requires an understanding of technical analysis, fast trades, and an understanding of how to set up and execute trades in specific ways.

But scalp trading is just one of many different strategies when it comes to trading stocks and other assets. While trading can seem complex, there are simple ways to get started building a portfolio.

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Sep

2023

Averaging Down Stocks: Meaning, Example, Pros & Cons

By AJ Smith | Growing Wealth, invest, Investing | Comments Off

Averaging down stocks refers to a strategy of buying more shares of a stock you already own after that stock has lost value — effectively buying the same stock, but at a discount. In other words, it’s a way of lowering the average cost of a stock you already own.

It’s similar to dollar-cost averaging, where you invest the same amount of money in the same securities at steady intervals, regardless of whether the prices are rising or falling.

While this strategy has a potential upside — if the stock price then rises again — it does expose investors to greater risk.

Table of Contents

What Is Averaging Down?
Example of Averaging Down
Why Average Down on Stock
Pros and Cons of Averaging Down
Tips for Averaging Down on Stock
The Takeaway

What Is Averaging Down?

By using the strategy of averaging down and purchasing more of the same stock at a lower price, the investor lowers the average price (or cost basis) for all the shares of that stock in their portfolio.

So if you buy 100 shares at one price, and the price drops 10%, for example, and you decide to buy 100 more shares at the lower price, the average cost of all 200 shares is now lower.

💡 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 Averaging Down

Consider this example: Imagine you’ve purchased 100 shares of stock for $70 per share ($7,000 total). Then, the value of the stock falls to $35 per share, a 50% drop.

To average down, you’d purchase 100 shares of the same stock at $35 per share ($3,500). Now, you’d own 200 shares for a total investment of $10,500. This creates an average purchase price of $52.50 per share.

Potential of Gain Averaging Down

If the stock price jumps to $80 per share, your position would be worth $16,000, a $5,500 gain on your initial investment of $10,500. In this case, averaging down helped boost your average return. If you’d simply bought 200 shares at the initial price of $70 ($14,000), you’d only see a gain of $2,000.

Potential Risk of Averaging Down

As with any strategy, there’s risk in averaging down. If, after averaging down, the price of the stock goes up, then your decision to buy more of that stock at a lower price would have been a good one. But the stock continues its downward price trajectory, it would mean you just doubled down on a losing investment.

While averaging down can be successful for long-term investors as part of a buy-and-hold strategy, it can be hard for inexperienced investors to discern the difference between a dip and a warning sign.

Why Average Down on Stock

Some investors may use averaging down stocks as part of other strategies.

1. Value Investing

Value investing is a style of investing that focuses on finding stocks that are trading at a “good value” — in other words, value stocks are typically underpriced. By averaging down, an investor buys more of a stock that they like, at a discount.

But in some cases, a stock may appear undervalued when it’s not. This can lead investors who may not understand how to value stocks into something called a value trap. A value trap is when a company has been trading at low valuation metrics (e.g. the P/E ratio or price-to-book value) for some time.

While it may seem like a bargain, if it’s not a true value proposition the price is likely to decline further.

2. Dollar-Cost Averaging

For some investors, averaging down can be a way to get more money into the market. This is a similar philosophy to the strategy known as dollar-cost averaging, as noted above, where the idea is to invest steadily regardless of whether the market is down or up, to reap the long-term average gains.

3. Loss Mitigation

Some investors turn to this strategy to help dig out of the very hole that the lower price has put them into. That’s because a stock that has lost value has to grow proportionally more than it fell in order to get back to where it started. Again, an example will help:

Let’s say you purchase 100 shares at $75 per share, and the stock drops to $50, that’s a 33% loss. In order to regain that lost value, however, the stock needs to increase by 50% (from $50 to $75) before you can see a profit.

Averaging down can change the math here. If the stock drops to $50 and you buy another 100 shares, the price only needs to increase by 25% to $62.50 for the position to be profitable.

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*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.

Pros and Cons of Averaging Down

As you can see, averaging down stocks is not a black-and-white strategy; it requires some skill and the ability to weigh the advantages and disadvantages of each situation.

Pros of Averaging Down

The primary benefit to averaging down is that an investor can buy more of a stock that they want to own anyway, at a better price than they paid previously — with the potential for gains.

Whether to average down should as much be a decision about the desire to own a stock over the long-term as it is about the recent price movement. After all, recent price changes are only one part of a stock’s analysis.

If the investor feels committed to the company’s growth and believes that its stock will continue to do well over longer periods, that could justify the purchase. And, if the stock in question ultimately turns positive and enjoys solid growth over time, then the strategy will have been a success.

Cons of Averaging Down

The averaging down strategy requires an investor to buy a stock that is, at the moment, losing value. And it is always possible that this fall is not temporary — and is actually the beginning of a larger decline in the company and/or its stock price. In this scenario, an investor who averages down may have just increased their holding in a losing investment.

Price change alone should not be an investor’s only indication to buy more of any stock. An investor with plans to average down should research the cause of the decline before buying — and even with careful research, projecting the trajectory of a stock can be difficult.

Another potential downside is that the averaging down strategy adds to one particular position, and therefore can affect your asset allocation. It’s always wise to consider the implications of any shift in your portfolio’s allocation, as being overweight in a certain asset class could expose you to greater risk of loss.

💡 Quick Tip: It’s smart to invest in a range of assets so that you’re not overly reliant on any one company or market to do well. For example, by investing in different sectors you can add diversification to your portfolio, which may help mitigate some risk factors over time.

Tips for Averaging Down on Stock

If you are going to average down on a stock you own, be sure to take a few preparatory steps.

• Have an exit strategy. While it may be to your benefit to buy the dip, you want to set a limit should the price continue to fall.

• Do your research. In order to understand whether a stock’s price drop is really an opportunity, you may need to understand more about the company’s fundamentals.

• Keep an eye on the market. Market conditions can impact stock price as well, so it’s wise to know what factors are at play here.

The Takeaway

To recap: What is averaging down in stocks? Simply put, averaging down is a strategy where an investor buys more of a stock they already own after the stock has lost value.

The idea is that by buying a stock you own (and like) at a discount, you lower the average purchase price of your position as a whole, and set yourself up for gains if the price should increase. Of course, the fly in the ointment here is that it can be quite tricky to predict whether a stock price has simply taken a dip or is on a downward trajectory — so there are risks to the averaging down strategy for this reason.

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Sep

2023

Exit Strategy for Investors: Definition and Examples

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

An exit strategy is a plan to leave an investment, ideally by selling it for more than the price at which it was purchased.

Individual investors, venture capitalists, stock traders, and business owners all use exit strategies that set specific criteria to dictate when they’ll get out of an investment. Every exit strategy plan is unique to its situation, in terms of timing and under which conditions an exit may occur.

What Is an Exit Strategy?

Broadly speaking, the exit strategy definition is a plan for leaving a specific situation. For instance, an employee who’s interested in changing jobs may form an exit strategy for leaving their current employer and moving on to their next one.

What is an exit strategy in a financial setting? In this case, the exit strategy definition is a plan crafted by business owners or investors that cover when they choose to liquidate their position in an investment. To liquidate means to convert securities or other assets to cash. Once this liquidation occurs, the individual or entity that executed the exit strategy no longer has a stake in the investment.

Creating an exit strategy prior to making an investment can be advantageous for managing and minimizing risk. It can also help with defining specific objectives for making an investment in the first place. In other words, formulating your exit strategy beforehand can give you clarity about what you hope to achieve.

Exit strategies often go overlooked, however, as investors, venture capitalists, and business owners may move ahead with an investment with no clear plan for leaving it.

💡 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.

How Exit Strategies Work

Investors use exit strategies to realize their profit or to mitigate potential losses from an investment or business. When creating an exit strategy, investors will typically define the conditions under which they’ll make their exit.

For instance, an exit strategy plan for investors may be contingent on achieving a certain level of returns when starting to invest in stocks, or reaching a maximum threshold of allowable losses. Once the contingency point is reached, the investor may choose to sell off their shares as dictated by their exit strategy.

A venture capital exit strategy, on the other hand, may have a predetermined time element. Venture capitalists invest money in startups and early stage companies. The exit point for a venture capitalist may be a startup’s IPO or initial public offering.

Again, all exit strategies revolve around a plan. The mechanism by which an individual or entity makes their exit can vary, but the end result is the same: to leave an investment or business.

When Should an Exit Strategy Be Used?

There are different scenarios when an exit strategy may come into play. For example, exit strategies can be useful in these types of situations:

• Creating a succession plan to transfer ownership of a profitable business to someone else.

• Shutting down a business and liquidating its assets.

• Withdrawing from a venture capital investment or angel investment.

• Selling stocks or other securities to minimize losses.

• Giving up control of a company or merging it with another company.

Generally speaking, an exit strategy makes sense for any situation where you need or want to have a plan for getting out.

Exit Strategy Examples

Here are some different exit strategy examples that explain how exit strategies can be useful to investors, business owners, and venture capitalists.

Exit Strategy for Investors

When creating an exit strategy for stocks and investing, including how to buy stocks, there are different metrics you can use to determine when to get out. For example, say you buy 100 shares of XYZ stock. You could plan your exit strategy based on:

• Earning target return from the investment

• Realizing a maximum loss on the investment

• How long you want to stay invested

Say your goal is to earn a 10% return on the 100 shares you purchased. Once you reach that 10% threshold you may decide to exit while the market is up and sell your shares at a profit. Or, you may set your maximum loss threshold at 5%. If the stock dips and hits that 5% mark, you could sell to head off further losses.

You may also use time as your guide for making an exit strategy for stocks. For instance, if you’re 30 years old now and favor a buy-and-hold strategy, you may plan to make your exit years down the line. On the other hand, if you’re interested in short-term gains, you may have a much shorter window in which to complete your exit strategy.

Exit strategies can work for more than just stock investments. For instance, you may have invested in crowdfunding investments, such as real estate crowdfunding or peer-to-peer lending. Both types of investments typically have a set holding period that you can build into your exit plan.

Exit Strategy for Business Owners

An exit strategy for business owners can take different forms, depending on the nature of the business. For instance, if you run a family-owned business then your exit strategy plan might revolve around your eventual retirement. If you have a fixed retirement date in mind your exit plan could specify that you will transfer ownership of the business to your children or sell it to another person or company.

Another possibility for an exit strategy may involve selling off assets and closing the business altogether. This is something a business owner may consider if the business is not turning a profit, and it looks increasingly unlikely that it will. Liquidation can allow a business owner to repay their creditors and walk away from a failed business without having to file bankruptcy.

Exit Strategy for Startups

With startups and larger companies, exit strategies can be more complex. Examples of exit strategy plans may include:

• Launching an IPO to allow one or more founders to make an exit

• A merger or acquisition that allows for a transfer of ownership

• Selling the company

• Liquidating assets and shutting the company down

If a founder is ready to move on to their next project, they can use an IPO to leave the company intact while extricating themselves from it. And angel investors or venture capitalists who invested in the company early on also have an opportunity to sell their shares.

Startup exit strategies can also create possible opportunities for some investors. IPO investing allows investors to buy shares of companies when they go public.

The mechanics of using an IPO as an exit strategy can be complicated, however. There are IPO valuations and regulatory requirements to consider.

It’s important for startup founders to know how to value a business before taking it public to ensure that an IPO is successful. And early-stage investors may have to observe IPO lock-up period restrictions before they can sell their shares.

💡 Quick Tip: IPO stocks can get a lot of media hype. But savvy investors know that where there’s buzz there can also be higher-than-warranted valuations. IPO shares might spike or plunge (or both), so investing in IPOs may not be suitable for investors with short time horizons.

5 Types of Exit Strategies

There are different types of exit strategies depending on whether you’re an investor, a business owner, or a venture capitalist. Some common exit strategies include:

1. Selling Shares of Stock

Investors can use an exit strategy to set a specific goal with their investment (say, 12%), reach a certain level of profit, or determine a point at which they’ll minimize their loss if the investment loses value. Once they reach the target they’ve set, the investor can execute the exit strategy and sell their shares.

2. Mergers and Acquisitions

With this business exit strategy, another business, often a rival, buys out a business and the founder can exit and shareholders may profit. However, there are many regulatory factors to consider, such as antitrust laws.

3. Selling Assets and Closing a Business

If a business is failing, the owner may choose to liquidate all the assets, pay off debts as well as any shareholders, if possible, and then close down the business. A failing business might also declare bankruptcy, but that’s typically a last resort.

4. Transferring Ownership of a Business

This exit strategy may be used with a family-run business. The owner may formulate an exit plan that allows him to transfer the business to a relative or sell it at a particular time so that he or she can retire or do something else.

5. Launching an IPO

By going public with an IPO, the founder of a startup or other company can leave the company if they choose to, while leaving the business intact. As noted, using an IPO as an exit strategy can be quite complicated for business founders and investors because of regulatory requirements, IPO valuations, and lock-up period restrictions.

Why Exit Strategies Are Important

Exit strategies matter because they offer a measure of predictability in a business or investment setting. If you own a business, for example, having an exit strategy in place that allows you to retire on schedule means you’re not having to work longer than you planned or want to.

An exit strategy for investors can help with staying focused on an end goal, rather than following the crowd, succumbing to emotions, or attempting to time the market. For example, if you go into an investment knowing that your exit plan is designed to limit your losses to 5%, you’ll know ahead of time when you should sell.

Using an exit strategy can prevent doubling or tripling losses that could occur when staying in an investment in the hopes that it will eventually turn around. Exit strategies can also keep you from staying invested too long in an investment that’s doing well. The market moves in cycles and what goes up eventually comes down.

If you’re on a winning streak with a particular stock, you may be tempted to stay invested indefinitely. But having an exit strategy and a set end date for cashing out could help you avoid losses if volatility sends the stock’s price spiraling.

How To Develop an Exit Strategy Plan

Developing an exit strategy may look different, depending on whether it involves an investment or business situation. But the fundamentals are the same, in that it’s important to consider:

• What form an exit will take (i.e. liquidation, IPO, selling shares, etc.)

• Whether an exit is results-based or time-based (i.e. realizing a 10% return, reaching your target retirement date, etc.)

• Key risk factors that may influence outcomes

• Reasons and goals for pursuing an exit strategy

If you’re an individual investor, you may need to formulate an exit plan for each investment you own. For instance, how you exit from a stock investment may be different from how you sell off bonds. And if you’re taking on riskier investments, such as cryptocurrency, your exit strategy may need to account for the additional volatility involved.

For business owners and founders, exit strategy planning may be a group discussion that involves partners, members of the board, or other individuals who may have an interest in the sale, transfer, or IPO of a company. In either situation, developing an exit strategy is something that’s best done sooner, rather than later.

SoFi Investing

Investing can help you build wealth for the long-term and an exit strategy is an important part of the plan. It allows you to decide ahead of time how and when you’ll get out of an exit, and could help you lock in returns or minimize losses.

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FAQ

What are different exit strategies?

Examples of some different exit strategies include selling shares of a stock once an investor realizes a certain return or profit, transferring ownership of a family business so an owner can retire, or selling all the assets and closing down a failing business.

What are the most common exit strategies?

The most common exit strategies depend on whether you’re an investor, the owner of an established business, or the founder of a startup. For investors, the most common exit strategy is to sell shares of stock once they reach a certain target or profit level. For owners of an established business, the most common exit strategy is mergers and acquisitions, because doing so is often favorable to shareholders. For founders of startups, a common exit strategy is an initial public offering (IPO).

What is the simplest exit strategy?

For an investor, the simplest exit strategy is to sell shares of stock once they reach a certain profit or target level of return. At that point they can sell their shares for more money than they paid for them.

Photo credit: iStock/Christian Guiton

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