Investing Archives | Page 114 of 191

Sep

2023

Understanding Diluted EPS

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

Diluted earnings per share (EPS) is a measure of earnings per share that includes a company’s convertible securities. Convertible, or dilutive, securities are stocks or bonds that could potentially become common shares. Basic earnings per share only considers existing common shares.

Diluted EPS, then, includes in its calculation the factor of convertible bondholders, convertible preferred stockholders, and options holders potentially deciding to turn their securities into common shares. If this were to happen, the number of shares outstanding would increase, with earnings staying the same, resulting in lower earnings per share. Diluted EPS will therefore tend to be lower than basic EPS.

Basic vs. Diluted EPS

What is diluted earnings per share, and how does it differ from basic EPS? Simply put, basic EPS tends to be a higher number than diluted EPS. Basic EPS doesn’t factor in the existence of convertible securities of the impact if they were to be converted into common shares.

Instead, the most basic calculation of earnings per share only takes a company’s net income minus any preferred stock dividends and divides that number by the number of shares outstanding. Convertible securities aren’t factored into the equation.

Because of this, sometimes it’s beneficial to look at a calculation of earnings per share that assumes all possible common shares have been brought into being through existing convertible securities. Doing so gives investors a more realistic view of earnings while assuring no future surprises.

Imagine an investor doing all their homework on the fundamental analysis of a company using only basic earnings per share. EPS, which measures the value that a company delivers to individual shareholders, might look high and the stock pays a good dividend, so the investor might decide the stock is a good one to buy.

But then she learns that the company has been issuing convertible bonds to raise capital and giving new employees stock options to make working there more attractive.

All of a sudden, for some reason, bondholders decide to convert their bonds to common shares, and employees decide to exercise their stock options.

Now this investor’s shares have been diluted, since a bunch of new shares have popped into existence practically overnight. As a result, earnings per share have decreased, and dividends likely have done the same (because the same dividends now have to be paid out to additional shareholders).

If our imaginary investor had used diluted EPS in her calculations, she could have prepared for this kind of scenario at some point. But because this make-believe company created the potential for its stock to be diluted by issuing convertible securities, basic EPS did not provide the full picture.

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How to Calculate Diluted EPS

The formula for diluted EPS is a company’s net income minus any preferred stock dividends, divided by the company’s average outstanding shares minus its dilutive shares. Or:

Diluted EPS = (Net Income – Preferred Stock Dividends)/(Average Outstanding Shares – Dilutive Shares)

The diluted EPS formula is calculating the amount of earnings per share there would be if dilutive shares were to become common shares. The formula is exactly the same as that of calculating basic EPS, but with one important extra step – adding the number of dilutive shares to the number of average outstanding shares (in the bottom half of the equation).

The sum of both existing common shares and the possible dilutive shares creates a larger number on the bottom half of the equation, while the top half remains the same.

Therefore, diluted EPS tends to be lower than basic EPS, as the company’s net income (minus preferred stock dividends) is being divided by a larger number of shares.

For example, let’s say a company makes $1,000,000 in net income and pays no dividend. There are 800,000 common shares outstanding, 100,000 call options, and 100,000 convertible preferred shares.

The diluted EPS formula would yield a result of $1.00 per share in this example, as we would be dividing 1,000,000 dollars in net income by 1,000,000 total potential shares.

Basic EPS, on the other hand, would be calculated as $1,000,000 divided by the 800,000 current shares, yielding a result of $1.25 per share.

While it’s not difficult to calculate EPS and diluted EPS, many companies share the figures with investors in their earnings reports.

Why Is Diluted EPS Important?

Diluted EPS reveals what a company’s earnings per share could look like if holders of convertible securities were to decide to exercise their right to hold common shares, and it’s an important consideration during an investor’s analysis of a stock.

Since companies often issue convertible securities like stock options, convertible bonds, convertible preferred shares, a company’s earnings per share could appear higher than reality when not factoring in the potential for dilution.

Convertible securities might be held by people inside or outside of the company, and they may not be turned into shares anytime soon. But what happens when everyone decides to turn in their convertible securities for shares?

For example, if a company’s stock were to rise in price suddenly, and the company had paid several of its employees bonuses in the form of stock options, those employees might choose to exercise those options.

Now there are more common shares than before, but earnings have not increased. Therefore, in a theoretical example like this, earnings per share will have decreased.

A company issuing employee stock options isn’t always a negative thing, however. If the options keep high-quality employees, the result could be positive for the company over the long run. Using options also reduces expenses that come from paying employee salaries, which could free up capital to help the company grow.

Diluted EPS provides a more conservative earnings per share number since it shows what EPS would be in the event of more new shares coming into existence. Basic EPS could appear to be deceivingly high because it doesn’t calculate for this possibility, so it could be a less reliable indicator of when to buy, sell, or hold a stock.

Of course, there might also be times when diluted EPS is unnecessary. Young companies that are still small and growing might not have had the chance to issue any convertible securities yet, so earnings per share might look the same either way.

The Takeaway

Diluted EPS is a measurement of earnings per share that factors in the potential stock dilution that occurs when convertible securities are converted to common shares. Understanding diluted EPS is important so that investors don’t get caught off guard in the event of new common shares being created through the conversion of securities such as stock options, stock warrants, convertible bonds and convertible preferred shares.

When this happens, earnings per share decline, and those who had only been looking at basic EPS in an attempt to determine the profitability of a company will find they made a miscalculation. In some cases, the difference between basic and diluted EPS might not be that different. If a company hasn’t issued convertible securities, or has issued very few convertible securities, then not much dilution would be possible.

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Sep

2023

What Investors Should Know About Spread

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

A spread represents the difference between any two financial metrics. The type of spread depends on the type of security that’s being traded. For example, when trading bonds, the spread can refer to a difference in yields between bonds of varying maturity lengths or quality.

Further, while there are many differences between bonds and stocks — spread is just one of them. With stocks, though, spreadgenerally refers to differences in price. Specifically, it measures the gap between the bid price and the ask price. Understanding what is spread and how it works can help you more effectively shape your investment strategy.

What Is Spread in Finance?

As noted, spread is the difference between two financial measurements. When talking specifically about a stock spread, it is the difference between the bid and ask price.

The bid price is the highest price a buyer will pay to purchase one or more shares of a specific stock. The ask price is the lowest price at which a seller will agree to sell shares of that stock. The spread represents the difference between the bid price and the ask price.

A good way to visualize spread may be to think of buying a home. As a home buyer, you may have a set price that you’re willing to pay for a property, based on what you can afford and what you’ve been pre-approved for by your mortgage lender.

You search for homes and eventually find one that has everything on your wishlist. When you check the listing price, you see that the seller has it priced $10,000 above your budget. In terms of spread, the maximum amount you’re willing to offer for the home represents the bid price, while the seller’s listing price represents the ask.

What Does Spread Mean?

Aside from stock spread, spread can have a variety of applications and meanings in the financial world.

As mentioned earlier, bond spread typically refers to differences in yield. But if you’re trading futures, the spread can measure the gap between buy and sell positions for a particular commodity. With options trading, it can refer to differences in strike prices when placing call or put options.

Spread can also be used in foreign currency markets or forex (foreign exchange market) trades to represent the difference between the costs for traders and the profits realized by dealers.

With lending, spread is tied to a difference in interest rates. Specifically, it means the difference between a benchmark rate, such as the prime rate, and the rate that’s actually charged to a borrower. So for example, if you’re getting a mortgage there might be a 2% spread, meaning your rate is 2% higher than the benchmark rate.

Bid-Ask Price and Stocks Spread

If you trade stocks online, it’s important to understand how the bid-ask price spread works and how it can affect your investment outcomes. Since spread can help gauge supply and demand for a particular stock, investors can use that information to make informed decisions about trades and increase the odds of getting the best possible price.

Normally, a stock’s ask price is higher than the bid price. How far apart the ask price and bid price are can give you a sense of how the market views a particular security’s worth.

If the bid price and ask price are fairly close together, that suggests that buyers and sellers are more or less in agreement on what a stock is worth. On the other hand, if there’s a wider spread between the bid and ask price, that might signal that buyers and sellers don’t necessarily agree on a stock’s value.

What Influences Stock Spreads?

There are different factors that can affect a stock’s spread, including:

• Supply and demand. Spread can be impacted by the total number of outstanding shares of a particular stock and the amount of interest investors show in that stock.

• Liquidity. Generally, liquidity is a measure of how easily a stock or any other security can be bought and sold or converted to cash. The more liquid an investment is, the closer the bid and ask price may be, since it can be easier to gauge an asset’s worth.

• Trading volume. Trading volume means how many shares of a stock or security are traded on a given day. As with liquidity, the more trading volume a security has, the closer together the bid and ask price are likely to be.

• Volatility. Measuring volatility is a way of gauging price changes and how rapidly a stock’s price moves up or down. When there are wider swings in a stock’s price, i.e. more volatility, the bid-ask price spread can also be wider.

Why Pay Attention to a Stock’s Spread?

Learning to pay attention to a stock’s spread can be helpful for investors in that they may be able to use what they glean from the spread to make better decisions related to their portfolios.

In other words, when you understand how spread works for stocks, you can use that to invest strategically and manage the potential for risk. This means different things whether you are planning to buy, sell, or hold a stock. If you’re selling stocks, that means getting the best bid price; when you’re buying, it means paying the best ask price.

Essentially, the goal is the same as with any other investing strategy: to buy low and sell high.

Difference Between a Tight Spread and a Wide Spread

As discussed, a tight spread could be a signal to investors that buyers and sellers are more or less in agreement that a stock is valued correctly. A wide spread, on the other hand, may signal that there isn’t necessarily a consensus on what the stock’s value should be.

There’s no guarantee, of course, that that inclination is correct, but when looking at tight or wide spreads, it can be yet another useful piece of information to help inform decisions.

Executing Stock Trades Using Spread

If you’re using the bid-ask spread to trade stocks, there are different types of stock orders you might place. Those include:

• Market orders. This is an order to buy or sell a security that’s executed immediately.

• Limit orders. This is an order to buy or sell a security at a certain price or better.

• Stop orders. A stop order, also called a stop-loss order, is an order to buy or sell a security once it hits a certain price. This is called the stop price and once that price is reached, the order is executed.

• Buy stop orders. Buy stop orders are used to execute buy orders only when the market reaches a certain stop price.

• Sell stop orders. A sell stop order is the opposite of a buy stop order. Sell stop orders are executed when the stop price falls below the current market price of a security.

Stop orders can help with limiting losses in your investment portfolio if you’re trading based on bid-ask price spreads. Knowing how to coordinate various types of orders together with stock spreads can help with getting the best possible price as you make trades.

Other Types of Spreads

While we’ve mostly discussed spread as it relates to stocks, there are other types of spreads, too.

Options spreads, for instance, involve buying multiple options contracts with the same underlying asset, but different strike prices or expiration dates.

Under the options spread umbrella are several spreads as well. Box spreads are one example, and they are a type of arbitrage options trading strategy in which traders use some tricks of the trade to reduce their risk as much as possible.

There’s also the debit spread, which is an options trading strategy in which a trader buys and sells an option at the same time — it’s a high-level strategy, and one that may not be suited to investors who are mostly investing in stocks or bonds.

Note, too, that there is something called a credit spread (similar to a debit spread, but its inverse) and that there are some differences traders will need to learn about before deciding to utilize a credit spread vs. debit spread as a part of their strategy. Again, options trading requires a whole new level of market knowledge and know-how, and may not be for all investors.

Investing With SoFi

The more investing terms an investor is familiar with, the better able they’ll be to invest with confidence. Spread is a term that means different things in different situations, but when it comes to stocks, spread is the difference between the bid price and ask price of a given stock. Being able to assess what a spread might mean can help inform individual trading decisions.

As you learn more about stocks, including what is spread and how it works, you can use that knowledge to create a portfolio that reflects your financial needs and goals.

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

How do you read a stock spread?

A stock spread is the difference between the bid and ask price, so calculating it is a matter of subtracting the bid from the ask price. It’s typically expressed as a percentage.

What is the average spread of a stock?

The average spread of a stock ranges between 13% and 18%, but can vary wildly depending on what types of stocks or market segments are being looked at.

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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.

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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.

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 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.

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Sep

2023

What Is a Credit Default Swap (CDS)?

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

Credit default swaps (CDS) are widely used financial derivatives, or contracts, that give investors the ability to “swap” their credit risk with another investor. They’re a popular type of investment, especially for institutional investors.

Investors use CDS for many types of credit investments, including mortgage-backed securities, junk bonds, collateralized debt obligations, corporate bonds, emerging market bonds, and municipal bonds.

Credit Default Swaps, Explained

Credit default swaps are the most common type of credit derivative, and they help investors reduce the risk that borrowers on the securities they own will default on their loans. To reduce their risk, the investor purchases a CDS from another investor, who will pay the lender back if the borrower defaults on the loan. There is generally an ongoing payment as part of the contract, which serves as an insurance policy.

The investments used to create credit-default swaps include many types of credit, such as mortgage-backed securities, junk bonds, collateralized debt obligations, corporate bonds, emerging market bonds, and municipal bonds. However, while the contract references a specific security or set of securities, it is not actually connected to it. Most CDS investors are institutional investors, such as hedge funds, due to the securities’ complex and risky nature.

The credit-default swap contract lays out the responsibilities of the seller in the event that the borrower experiences a credit event or defaults on their loan. Credit events can include failure to pay, bankruptcy, moratorium, repudiation, and obligation acceleration. If any of these events occur, the buyer of the CDS may terminate the contract and the seller will need to pay. The specifics of these credit events are outlined in the contract that both parties sign.

The agreement between the borrower and the lender is separate from the lender’s agreement with the CDS seller, in which the lender becomes the CDS buyer.

Here’s a credit default swap example: A company sells a $200 bond with a 20-year maturity term. An investor buys that bond from the company, who agrees to pay back the money to the investor plus interest within 20 years. However, the company can’t guarantee its ability to pay back that money and the interest. This is the risk involved in investing in a bond.

In order to mitigate the risk, the investor who bought the bond purchases a CDS, which guarantees they will get their investment back if the company defaults on the loan. Just as with other types of insurance, the CDS buyer makes regular payments, typically every quarter, on the contract. The CDS seller is usually a bank, insurance company, reporting dealer, or hedge fund.

These sellers protect themselves against risk by diversifying their sales into many different companies, industries, or sectors. If one of their sales falls through, they have income from all the others to carry on their business.

Riskier Credit Default Swaps

The higher the risk of default, the more expensive a CDS will be. Some investors use credit-default to speculate on the credit quality of a company. Essentially, people use the CDS system to place bets on the bond issuer through the CDS system.

Investors can also switch sides on CDS if they come to decide that a borrower might default. The CDS seller can buy its own CDS or sell it to another bank. This makes it extremely difficult to track the market and decide how to invest in it.

💡 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.

The Benefits of Credit Default Swaps

The main reason that people choose to buy CDS is as an insurance policy against the risks of loans in their portfolio. Using a CDS allows the investor to transfer some of the risk to the seller of the CDS or an insurance company.

The credit risk does not disappear with a CDS, the seller simply takes on that risk. However, if the borrower defaults on their loan, the seller of the CDS will default on the contract, and the debt goes back to the buyer.

One benefit of CDS is that they enable bond investors to buy into riskier ventures than they otherwise would, since they know they have some protection. This helps funds go towards innovative and unexplored ideas, which help grow the economy and solve world problems.

Downsides of Credit Default Swaps

Although there are several benefits to credit default swaps, they have some significant downsides as well. CDS are an investment focused on managing risk, and it can be difficult to figure out which ones are safer investments due to the complexities of the market.

Introduced in 1994, the CDS market went largely unregulated until the financial crisis of 2008, and was a key contributor to the problems that led up to it. Since it wasn’t regulated, CDS sellers often did not have the money available to pay the buyer in the case of a default. Many sellers only held a fraction of what would be needed to pay back all their buyers.

As long as nobody defaulted, this system worked, but in 2008, this resulted in a massive financial meltdown. Large scale sellers of CDS, including some of the largest financial institutions in the United States were unable to make good on theirCDS contracts, creating a wave of economic effects around the world and requiring multiple bailouts by the Federal Reserve.

Dodd-Frank Reforms

After the 2008 financial crisis, regulators stepped in to try and prevent the same thing from happening again.

The Dodd-Frank Wall Street Reform Act of 2010 required the regulation of swaps by the Commodity Futures Trading Commission and the Securities and Exchange Commission. It also mandated reporting of all credit-default swaps and imposed capital requirements on CDS sellers.

The Takeaway

Credit-default swaps are complicated securities, but some institutional investors can use them to reduce the risk of other investments or to bet that another company might be close to default.

While credit-default swaps are complex investments, they may have a place in a diversified portfolio. However, due to their complexity, it may be a good idea to consult with a financial professional before diving in.

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

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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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