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Essential Stock Market Terms Every Trader Should Know

If you are new to trading stocks, the sheer volume of stock market terms can be off-putting. But learning some basic stock trading terminology is a great place to begin before investing any money. For any new investor just getting into trading, getting a grasp on some basic stock market terms can be extremely helpful.

The Significance of Knowing Stock Market Terminology

It’s important to have at least a grasp of some basic stock market terms if you plan on trading or investing. If you don’t do a bit of homework beforehand, you may find yourself feeling in over your head, and grasping for help from family members, friends, or a financial professional.

While there are a multitude of different stock market terms out there, it isn’t terribly difficult to develop an understanding of the basics. Yes, it’ll take some time and practice, but like learning anything else, once you get the hang of it, it should become easier as you move along in your investment journey.


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

Fundamental Terms

To get a fundamental understanding of the stock market, it can be helpful to start with some relatively basic terms, including the following.

Asset Allocation

Asset allocation involves investing across asset classes in a portfolio in order to balance the different potential risks and returns, and there are three main asset classes, which are typically stocks, bonds, and cash. Asset allocation is closely tied with portfolio diversification.

Asset Classes

There are several asset classes, or types of assets, that investors can invest in. This can include, but is not limited to, stocks, bonds, money market accounts, cash, real estate, commodities, and more. You can also think of certain assets as equities, debt securities, and more.

Bid

Bid, in the context of bid-ask spread, refers to the “bid price” that an investor is willing to pay for a security or investment.

Ask

Ask, in the context of bid-ask spread, is the opposite of bid, and is the lowest price that investors are willing to sell a security for.

Bid-Ask Spread

The bid-ask spread is the difference between the bid and ask price, and can be a measure of liquidity. When the bid and ask prices match, a sale takes place, on a first-come basis if there is more than one buyer. The bid-ask spread is the difference between the highest price a buyer is willing to bid, and the lowest price a seller is willing to ask.

Market Phrases

There are a number of market phrases, or types of jargon that may be used in and around the stock market, too. Here are some examples.

Bull Market

A bull market describes market conditions when a market index rises by at least 20% over two months or more, and is often used to describe high levels of confidence and optimism among investors.

Bear Market

A bear market describes a 20% fall in a market index, and is the opposite of a bull market. It can signal overall pessimism among investors.

Market Volatility

Market volatility refers to how much a market index’s value increases or decreases within a specific period of time. Volatility can occur for a number of reasons.

Investment Vehicles

There are many specific investment vehicles that investors should know about, too, including different types of stocks, bonds, and more.

Bonds

Bonds are a type of debt security, which effectively means that investors are loaning money to the issuer. There are many types of bonds, and they’re often considered to be a less-risky investment alternative to, say, stocks.

Common Stock

Common stock, also known as shares or equity, is like owning a piece of a company. You purchase stock in a company, and receive a proportional part of that corporation’s assets and earnings. The price of stock is different for each company and fluctuates over time.

Preferred Stock

Preferred stock is similar to common stock, but usually grants shareholders some sort of preferential treatment, such as advanced dividend payments, and more.

ETFs

ETFs, or “exchange-traded funds,” are types of funds that trade on exchanges like stocks. Investors can purchase shares of ETFs, which incorporate numerous different types of securities (like a “basket” of different investments), and may offer built-in diversification as an advantage for investors.

Mutual Funds

Mutual funds are companies or entities that pool money from numerous different investors and then invest it on their behalf. A manager oversees a mutual fund, and actively manages it. Investors can purchase shares of mutual funds, which are similar to ETFs in many ways.

Stock Analysis Terms

Analyzing the stock market incorporates its own set of terminology, and it can be helpful for investors to know a bit of the vernacular.

Earnings Per Share (EPS)

Earnings per share, often shortened as “EPS,” is a ratio that helps determine a company’s ability to drive profits for shareholders. It’s a common and oft-cited business metric for investors.

Dividends

A dividend is a payment made from a company to its shareholders, often drawn from earnings. Usually, these are made in cash, but sometimes they are paid out as additional stock shares. They are typically paid on an annual or quarterly basis, and typically only come from more established companies, not startups.

Dividend Yield

Dividend yield refers to how much a company pays out to shareholders on an annual basis relative to its share price. It’s a ratio that’s calculated by dividing the company’s dividend by its share price.

The Price-to-earnings (P/E) Ratio

The price-to-earnings ratio (often written as the P/E ratio, PER, or P/E) is a ratio of a company’s current share price relative to the company’s earnings per share. It can be used to compare performances of different companies.


💡 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.

Price Movements and Pattern Terms

There are also a number of movement and pattern terms that investors may want to familiarize themselves with.

Trading Volume

Trading volume refers to how much trading is happening on an exchange. For a stock trading on a stock exchange, the stock volume is typically reported as the number of shares that changed hands during any given day. It’s important to note that even with an increasing price, if it’s paired with a decreasing volume, that can mean a lack of interest in a stock. A price increase or drop on a larger volume day (i.e., a bigger trading day) is a potential signal that the stock has changed dramatically.

Volume-weighted Average Price (VWAP)

Volume-weighted average price, or VWAP, is a short-term price trend indicator used when analyzing intraday, or same-day, stock charts. It’s a type of technical analysis indicator.

Trading Order Types and Execution

Investors need to know the types of orders that they’re likely to use throughout their investing journey. Those include market orders, limit orders, and stop-loss orders.

Market Order

A market order is the most common type of order, and it means that an investor wants to buy or sell a security as soon as possible at the current market price.

Limit Order

Limit orders are another common type of order, and involve an investor placing an order to buy or sell a security at a specific price or within a specific time frame. There are two types: Buy limit orders, and sell limit orders.

Stop-loss Orders

Stop-loss orders, or sometimes called stop orders, are orders that specify a security to be sold at a certain price.

Day Trading Terms

For the prospective day-trader, there are a slate of terms to know as well.

Day Trading

Day trading involves an investor making short-term trades on a daily or weekly basis in an effort to generate returns off of price fluctuations in the market. There are numerous day trading strategies that investors can utilize.

Pattern Day Trader

A pattern day trader is a designation created by FINRA, and refers to traders who trade securities four or more times within five days. There are rules and stipulations that pattern day traders, and their chosen trading platforms, must follow.

Trading Halt

A trading halt can refer to a specific stock or the entire market, and involves a halt to all trading activity for an indefinite period of time.

Long-term Investment Terms

The opposite of day trading, long-term investing also ropes in its own jargon.

Averaging Down

Averaging down involves a scenario in which an investor already owns some stock but then purchases additional stock after the price has dropped. It results in a decrease in the overall average price for which you purchased the company stock. Investors can profit if the company’s price subsequently recovers.

Diversification

Diversification refers to investing in a wide range of assets and asset classes, as opposed to concentrating investments in a specific area or class.

Dollar-cost Averaging

Dollar-cost averaging is a strategy to manage volatility in a portfolio, and involves regularly investing in the same security at different times, but with the identical amount. Effectively, the cost of those investments will average out over time.

Derivatives and Market Predictors

Getting into the weeds now — derivatives and market predictors are more high-level market elements, but it can be helpful to know some of the terminology.

Futures

Futures, or futures contracts, are a form of derivatives that are a contract between two traders, agreeing to buy or sell an asset at a specific price at a future date.

Options Trading

Options trading involves buying and selling options contracts, of which there are many types.

Arbitrage

Arbitrage refers to price differences in the same asset on different markets. Traders may be able to take advantage of those differences to generate returns.

Financial Health Indicators

We’re not done yet — these terms involve financial health indicators.

Debt-to-equity (D/E)

Debt-to-equity is a financial metric that helps investors determine risks with a specific stock, and is calculated by dividing a company’s equity by its debts.

Liquidity

Market liquidity is essentially how easily shares of stock can be converted to cash. The market for a stock is “liquid” if its shares can be sold quickly, and the act of selling only minimally impacts the stock price.

Profit Margin

Profit margin refers to how much profit is generated from a trade when expenses are considered. Lowering related expenses can increase profit margin, all else being equal.

Economic Terms

Knowing some key economic terms can be helpful when trying to size up larger economic and market trends.

Volatility

Volatility refers to the range of a stock price’s change over time. If the price stays stable, then the stock has low volatility. If the price jumps from high to low and then back to high often, it would be considered more of a high-volatility stock.

Economic Bubbles

Economic bubbles or market bubbles are often created by widespread speculative trading, and involve a runup or buildup of prices for a given asset, which can be detached from its actual value. Eventually, the bubble tends to burst and investors may incur a loss.

Recession

A recession is a period of economic contraction, and is usually accompanied by higher unemployment rates, business failures, and lower gross domestic product figures. Recessions are officially declared by the Business Cycle Dating Committee at the National Bureau of Economic Research.

Adaptation and Risk Management

For particularly savvy investors, knowing some terms relating to adaptation and risk management can also be helpful when navigating the markets.

Sector Rotation

Sector rotation involves investing in different sectors of the economy at different times, and rotating holdings between those sectors in an effort to generate the biggest returns.

Hedging

Hedging is an investment strategy that involves limiting risk exposure within different parts of a portfolio, and there are many methods or strategies for doing so.

The Takeaway

Learning some basic stock market terms can go a long way toward helping an investor navigate the markets, and there are a lot of terms and jargon to get familiar with. But doing a bit of homework early on can be enormously helpful so that you’re not trying to figure things out on the fly as an investor.

While you’re not going to learn everything right off the bat, if you start to spend a lot of time investing and trading, you’re likely to quickly catch on to certain terms, while others will come with time. As always, if you have questions, you can reach out to a financial professional for help — or do a bit more research on your own.

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.


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.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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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What is private equity?

Private Equity: Examples, Ways to Invest

Private equity is financing from investors to invest in or buy companies that aren’t listed on a public market and then make improvements to those companies. Their goal is to sell the companies for more than they bought them for. Many people aren’t as familiar with this style of investment as they are with the public trading done through the stock market.

If you’ve ever wondered, what is private equity?, read on to learn more about what it is, how it works, and how to invest in private equity.

What Is Private Equity?

Private equity (PE) is a type of investment where qualified investors can purchase shares of companies that are not publicly traded on a stock exchange or regulated by the Securities and Exchange Commission (SEC). They typically do this through investment partnerships or funds managed by private equity firms.

With publicly traded companies, investors purchase shares of the company on a public market such as the New York Stock Exchange. With private equity, qualified investors can combine their assets to invest in private companies that aren’t typically available to the average investor.

Alternative investments,
now for the rest of us.

Start trading funds that include commodities, private credit, real estate, venture capital, and more.


How Do Private Equity Firms Work?

Private equity firms have funds that allow various investors to pool their assets in order to invest in or buy private companies and manage them.

These investors are referred to as limited partners. They are often high-net-worth individuals or institutions such as insurance companies. Equity firms usually require a sizable financial commitment from limited partners to qualify for this investment opportunity.

The equity firm uses the assets from investors to help the companies they invest in achieve specific objectives — like raising capital for growth or leveraging operations.

To help further these objectives, equity firms offer a range of services to the companies they invest in, from strategy guidance to operations management. The amount of involvement and support the firm gives depends on the firm’s percentage of equity. The more equity they have, the larger the role they play.

In helping these private companies reach their business objectives, private equity firms are working toward their own goal: to end the relationship with a large return on their investment. Equity firms may aim to receive their profits a few years after the original investment. However, the time horizon for each fund depends on the specifics of the investment objectives.

The more value a firm can add to a company during the time horizon, the greater the profit. Equity firms can add value by repaying debt, increasing revenue streams, lowering production or operation costs, or increasing the company’s previously acquired price tag.

Many private equity firms leave the investment when the company is acquired or undergoes an initial public offering (IPO).

Types of Private Equity Funds

Typically, private equity funds funnel into two categories: Venture Capital (VC) and Leveraged Buyout (LBO) or Buyout.

Venture Capital Funds

Venture capital (VC) funds focus their investment strategy on young businesses that are typically smaller and relatively new with high growth potential, but have limited access to capital. This dynamic creates a reciprocal relationship between VC fund investors and emerging businesses. The start-up depends on VC funds to raise capital, and VC investors can possibly generate large returns.

Leveraged Buyout

In comparison to VC funds, a leveraged buyout (LBO) is typically less risky for investors. LBO or buyouts target mature businesses, which tend to turn out larger rates of return. On top of that, an LBO fund typically holds ownership over a majority of the corporation’s voting stock, otherwise known as controlling interest.

Can Anyone Invest in Private Equity?

When it comes to how to invest in private equity, only qualified or accredited investors are allowed to become limited partners in a private equity fund. Because private equity funds are not registered with the SEC, they don’t require SEC security disclosures. Thus, investors must understand the highest risk of such investments and be willing to lose their entire investment if the fund doesn’t meet performance expectations.

Since the initial investment is typically pretty high, and may be well into the millions of dollars, an individual must meet strict criteria to qualify as an individual accredited investor. A person must make over $200,000 per year (for two consecutive years) as an individual investor or $300,000 per year as a married couple. Alternatively, an investor can qualify as accredited if they have a net worth of at least $1 million individually or as a married couple to qualify (excluding the value of their primary residence), or if they hold a Series 7, 65, or 82 license. Other examples of accredited investors include insurance companies, pension funds, and banks.

How to Invest in Private Equity

Many private equity funds require very large investments that are out of reach for many individuals. And directly investing in private equity funds is not possible for investors who are not accredited. However, there are an increasing number of options for average investors seeking to gain exposure to private equity, including:

Exchange-traded funds (ETFs): Investors can invest in ETFs that have shares of private equity firms.

Publicly traded stock: Some private equity firms have publicly traded stock that investors can buy shares of. This includes PE firms like the Carlyle Group, the Blackstone Group, and Apollo Global Management.

Funds of funds: Mutual funds are restricted by the SEC from buying private equity, but they can invest indirectly in publicly traded private equity firms. This is known as funds of funds.

Interval funds: These closed-end funds, which are not traded on the secondary market and are largely illiquid, may give some investors access to private equity. Interval funds may invest directly or indirectly through a third-party managed fund in private companies. Investors may be able to sell a portion of their shares back to the fund at certain intervals at net asset value (NAV). Interval funds typically have high minimum investments.

💡 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.

Advantages and Disadvantages of Private Equity

While private equity funds provide the opportunity for potentially larger profits, there are some key considerations, costs, and high risks investors should know about.

Advantages

Here are some possible benefits of private equity investments.

Potentially Higher Returns

With private equity, returns may be greater than those from the public stock market. That’s because PE firms tend to invest in companies with significant growth potential. However, the risk is higher as well.

More Control Over the Investment

Private equity investors are typically involved in the management of the companies they are invested in.

Diversification

Private equity investments allow investors to invest in industries they may not be able to invest in through the public stock market. This may help them diversify their holdings.

Disadvantages

The drawbacks of investing in private equity include:

Higher Risk

Private companies are not required to disclose as much information about their finances and operations, so PE investments can be riskier than publicly traded stocks.

Lack of Liquidity

Private equity funds tend to lack liquidity due to the extensive time horizon required for the investment. Since investors’ funds are tied up for years, equity firms may not allow limited partners to take out any of their money before the term of the investment expires. This might mean that individual investors are unable to seek other investment opportunities while their capital is held up with the funds.

Contradicting Interests

Because equity firms can invest, advise, and manage multiple private equity funds and portfolios, there may be conflicts. To uphold the fiduciary standard, private equity firms must disclose any conflicts of interest between the funds they manage and the firm itself.

High Fees

Private equity firms typically charge management fees and carry fees. Upon investing in a private equity fund, limited partners receive offer documentation that outlines the investment agreement. All documents should state the term of the investment and all fees or expenses involved in the agreement.

Private Equity Comparisons

Private equity is one type of alternative investment, but there are others. Here’s how a few of them compare.

Private Equity vs IPO Investing

From an investor’s standpoint, private equity investing means you’re putting money into a company, and hopefully making money in the form of distributions as the company becomes profitable.

Investing in an IPO, on the other hand, means you’re buying stocks in a new company that has just gone public. In order to make money, the company’s stock price needs to rise, and then you need to sell your stocks in that company for more than you initially paid.

Private Equity vs Venture Capital

Venture capital funding is a form of private equity. Specifically, venture capital funds typically invest in very young companies, whereas other private equity funds typically focus on more stable companies.

Private Equity vs Investment Banking

The difference between these two forms of investing is of the chicken-and-egg variety: Private equity starts by building high-net-worth funds, then looks for companies to invest in. Investment banking starts with specific businesses, then finds ways to raise money for them.

The Takeaway

Private equity firms manage funds that invest in private companies that might otherwise not be available to investors. Sometimes these companies are small and new with high growth potential; in other cases, the companies are well-established, and may offer a higher rate of return.

Not everyone qualifies to invest in private equity. If you do qualify, it’s important to remember that while private equity funds may offer the opportunity for profitability, they also come with some hefty risks. As with any investment, it’s a good idea to make sure you fully understand the risks of investing in a private equity fund before moving forward.

Ready to expand your portfolio's growth potential? Alternative investments, traditionally available to high-net-worth individuals, are accessible to everyday investors on SoFi's easy-to-use platform. Investments in commodities, real estate, venture capital, and more are now within reach. Alternative investments can be high risk, so it's important to consider your portfolio goals and risk tolerance to determine if they're right for you.


Invest in alts to take your portfolio beyond stocks and bonds.

FAQ

What’s the history of private equity?

Pooling money to buy stakes in a private company can be traced back to 1901, when JP Morgan bought Carnegie Steel for $480 million and merged it with two other companies to create U.S. Steel. That is considered one of the earliest corporate buyouts. In 1989, KKR bought RJR Nabisco for $25 billion, which, adjusting for inflation, is still considered the largest leveraged buyout in history.

How does private equity make money?

Private equity firms make money by buying companies they consider to have value and potential for improvement. PE firms then make improvements, which in turn, can increase profits. These firms also benefit when they can sell the company for more than they bought it for.

How much money do you need to invest in private equity?

Private equity funds typically have very high minimum investments that are often tens of millions of dollars. Some firms may have lower requirements around $250,000. In addition to putting up the minimum investment amount, an individual needs to be an accredited investor with a net worth of at least $1 million or an annual income higher than $200,000 for at least the last two years.



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


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.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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

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


Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
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.


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


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

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

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Ultimate Guide to Understanding Mutual Funds

Mutual funds are a type of investment vehicle that rope together numerous types of securities in one basket. They’re similar to exchange-traded funds, or ETFs, in that way, but there are some key differences. They can provide investors with an easy and turnkey way to build a diversified portfolio, often with a manager watching over the fund.

The ABCs of Mutual Funds

Mutual funds are funds, or a basket of different securities, that are packaged together and sold, in shares or fractional shares, to investors.

Mutual funds were designed for people to get started investing with small amounts of money. You can think of them as suitcases filled with different types of securities, such as stocks and bonds. Buying even one share of the fund immediately invests you in all the individual securities the fund holds.

The primary benefit of mutual funds is instant portfolio diversification. Say you invest in a mutual fund that holds stocks of every company in the S&P 500. If one company in the S&P 500 goes bankrupt, your fund might lose some value, but you most likely won’t lose everything. But if your whole investment was in that one company’s stock, you’d lose all or most of your money.

How Mutual Funds Work

A mutual fund itself is actually a company that pools investors’ resources and invests it on their behalf. They create a fund of many different investment types, and manage it on behalf of the group of investors.

Mutual funds can be managed actively or passively. Passively managed funds attempt to track an index, such as the Russell 2000 (an index of 2,000 small-cap U.S. companies). In other words, if one company leaves the index and another one joins, the fund sells and buys those company’s stocks accordingly. The risk and return of these funds is very similar to the index.

Actively managed mutual funds attempt to beat the performance of an index. The idea is that with careful investment selection, they will get higher returns than the index.

Different Types of Mutual Funds

There are numerous types of mutual funds that investors can choose to invest in.

Breaking Down Various Mutual Fund Types

Mutual funds can invest in stocks, bonds, real estate, commodities, and more. There are tens of thousands of mutual funds that cover every investing strategy you can imagine. Those can include asset class funds, sector funds, or target date funds, among many others.

Asset Class Funds

Asset classes are groups of similar assets that share similar risks, such as stocks, bonds, cash, or real estate. Some funds specialize in a particular type of investment or asset class — for example, large cap growth stocks or high yield bonds. These mutual funds assume that you or your adviser will choose the strategic mix of funds that’s right for you.

Sector or Industry Funds

Some funds will attempt to represent all or most of the stocks in a particular sector or industry. What’s the difference? Sectors are broader than industries — for example, oil is an industry, but energy is a sector that also includes coal, gas, wind, and solar companies. The stocks in each industry or sector share similar characteristics and risks.

Target Date Funds

A target date fund will provide you with a mix of asset classes (for example, 20% bonds and 80% stocks). They assume you will terminate the fund some year in the future, usually when you retire, and they shift to less risky investments as the target year approaches.

Target-date funds are intended to be a generic, low-cost solution to retirement saving and. They can be a good choice for a 401(k) investment if you don’t have the time or expertise to pick funds.


💡 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.

The Financial Mechanics of Mutual Funds

As mentioned, mutual funds pool money from a group of investors and invest it for them in various securities. That seems simple enough — but figuring out how to price shares is a bit more involved.

The Pricing Puzzle: Net Asset Value Explained

Mutual funds are companies, and investors purchase shares of the company. Share prices of mutual funds are also called net asset value, or NAV, and NAV corresponds to the net value of all the fund’s assets, with liabilities subtracted. Then, the number is divided by the number of shares outstanding.

In effect, investors can calculate share prices using the NAV formula if they wish.

Fee Structures: Costs Associated with Mutual Fund Investing

There are also costs associated with mutual funds. All mutual funds have some expenses, but they can vary a lot from one fund to another. It’s important to understand them, because fund expenses can have a big impact on your returns over time.

Another problem with actively managed funds is that they typically cost you more because funds are paying people who make investment decisions, and they are making more trades, which have transaction costs. As such, you may want to look out for operating expenses or transaction fees.

You won’t get a bill, but your returns on the fund will be reduced by the fund’s expenses. Some brokerage firms also charge commission for buying mutual funds.

The Pros and Cons of Investing in Mutual Funds

Like all investments, mutual funds have their pros and cons that investors should consider.

Benefits of Diversification and Professional Management

The two biggest pros or advantages of mutual funds are likely the built-in diversification that they offer investors, and professional management. The diversification element allows many investors to take a “set it and forget it” approach to their portfolio management, and many may find confidence knowing that professional fund managers are steering the ship.

Considering the Risks: No Guarantees and Potential for High Costs

Cons include the fact that there’s no guarantee in terms of returns (there never are when investing!), and the costs associated with mutual funds. As noted, mutual funds may incur additional costs compared to other investment types, depending on the individual fund. That may turn some investors off.

Taxes and Cash Drag: The Other Side of Mutual Funds

Taxes are another potential con for mutual funds, as investors will need to pay capital gains taxes on mutual fund payouts throughout the year — and they won’t have much control over that, either. And cash drag (or performance drag), which refers to the difference between returns between two investments when one incorporates trading costs, can be another thing for investors to think about.

Mutual Fund Investments and You

How can you determine if mutual funds are right for your strategy or portfolio? It may require some consideration of your goals, time horizon, and risk tolerance.

Are Mutual Funds Right for Your Portfolio?

There’s no way to say definitively that a certain investment or investment type, like mutual funds, are “right” for any given investor. But in a general sense, mutual funds may be a good choice if you’re a new or young investor, and looking to add some out-of-the-box investments to your portfolio. Again, mutual funds are typically already diversified, to a degree, and are managed by professionals.

Can You Cash Out Anytime? Understanding Liquidity

Mutual funds are not as liquid as stocks or other investments, but they are fairly liquid. That’s to say that if you want to cash out or sell your mutual fund holdings, a prospective trade will only execute once per day — after the stock markets close at 4pm ET. Conversely, stocks can trade any time during market hours.

Mutual Funds Compared to ETFs

Mutual funds are, in many ways, similar to other types of investments, like ETFs.

Mutual Funds vs ETFs: A Comparative Analysis

Mutual funds have been around since the 18th century, but exchange-traded funds, or ETFs, are relatively new, having debuted in the early 1990s. Traditional (old-school) mutual funds are issued by the fund sponsor when you buy them and redeemed when you sell them.

They are priced once a day, after the market closes, at the value of all the underlying securities in the fund divided by the number of fund shares — again, their net asset value (NAV).

Exchange Traded Funds (ETFs) trade on stock exchanges throughout the day. You buy them from and sell them to another investor — just like a stock.

Since the assets in the fund are constantly changing value throughout the day, and the fund price is set by market supply and demand, it might trade a little higher or lower than its NAV at different points in the day, but ETFs generally track their NAV very closely. Both traditional funds and ETFs can be actively or passively managed.

ETFs have two advantages — liquidity and cost. Even though you may pay a commission for buying or selling them—just like a stock, they generally have lower expenses that more than make up for it.

Since they can be bought or sold whenever the market is open, you don’t have to wait until the end of the day to buy or sell. This liquidity can be a big advantage on days when the market is way up or way down.

Understanding Fund Classes and What They Mean for Your Investment

There are some mutual funds that offer classes of shares, or different types of shares (similar to some stocks). The different classes of shares tend to correlate to the types of fees or expenses associated with them. Investors may find Class A, Class B, and Class C shares on the market for certain funds.

Class A shares tend to charge fees up front and have lower ongoing expenses, which may be attractive to long-term investors. Class B shares may have high exit fees and expense ratios. Class C shares tend to have mid-level expense ratios and small exit fees, and are often popular with the typical investor.

Getting Started with Mutual Funds

If you think mutual fund investing is a good option for your strategy, getting started can be relatively simple.

Steps to Your First Mutual Fund Investment

The first thing to do if you’re looking to invest in mutual funds is to sit down and do some homework. As discussed, there are myriad mutual funds out there, and they’re all different. You’ll want to pay close attention to what each fund offers, the costs associated with it, and the risks, too.

If you’ve found a mutual fund that you think is a good fit for your portfolio, you’ll want to choose a brokerage or platform that will allow you to buy shares of a given fund, or otherwise have an account that you can trade with, such as a retirement account.

From there, it’s more or less about placing an order and executing the trade. And, after that, managing and rebalancing your portfolio every so often.

Working With Financial Advisors: Finding Guidance in Mutual Fund Investing

As with all investments, if you feel that mutual fund investing has thrown you for a loop or is over your head, you can and maybe should reach out to a financial professional for guidance. Advisors of various types should be able to help you figure out which funds may be a good fit, describe their fees and risks, and help you make a wise selection that will help put you on track to reaching your financial goals.


💡 Quick Tip: How do you decide if a certain trading platform or app is right for you? Ideally, the investment platform you choose offers the features that you need for your investment goals or strategy, e.g., an easy-to-use interface, data analysis, educational tools.

The Takeaway

Mutual funds are companies that pool investors’ money, and then invest it in numerous types of securities on their behalf. Investors can purchase or invest in shares of mutual funds and add them to their portfolios. Mutual funds can be useful to new or beginner investors, as they offer built-in diversification, and active management.

They do have higher costs than other investments, though, which is something investors should consider. Further, there are thousands of mutual funds on the market, which may be overwhelming to some. If you’re interested in investing in mutual funds, it may be a good idea to speak with a financial professional for guidance.

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.


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.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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 $50 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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What is a Roth 401(k)?

A Roth 401(k) is a type of retirement plan that may be offered by your employer. You contribute money from your paychecks directly to a Roth 401(k) to help save for retirement.

A Roth 401(k) is somewhat similar to a traditional 401(k), but the potential tax benefits are different.

Here’s what you need to know about a Roth 401(k) to help answer the question of what is a Roth 401(k)?, and to decide if it may be the right type of retirement account for you.

Roth 401(k) Definition

What is a Roth 401(k)? The plan combines some of the features of a traditional 401(k) and a Roth IRA.

Like a traditional 401(k), a Roth 401(k) is an employer-sponsored retirement account. Your employer may offer to match some of your Roth 401(k) contributions.

Like a Roth IRA, contributions to a Roth 401(k) are made using after-tax dollars, which means income tax is paid upfront on the money you contribute.

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

Get a 1% IRA match on rollovers and contributions.

Double down on your retirement goals with a 1% match on every dollar you roll over and contribute to a SoFi IRA.1


1Terms and conditions apply. Roll over a minimum of $20K to receive the 1% match offer. Matches on contributions are made up to the annual limits.

How a Roth 401(k) Works

Contributions to a Roth 401(k) are typically made directly and automatically from your paycheck. Your employer may match your Roth 401(k) contributions up to a certain amount or percentage, depending on the employer and the plan.

Your contributions to a Roth 401(k) are taxed at the time you contribute them, and you pay income taxes on them. In general, your money grows in the account tax-free and withdrawals in retirement are also tax-free, as long as the account has been open at least five years.

Differences Between a Roth 401(k) and a Traditional 401(k)

While a Roth 401(k) shares some similarities to a traditional 401(k), there are some differences between the two plans that you should be aware of. Here is how a Roth 401(k) differs from a traditional 401(k):

•   Contributions to a Roth 401(k) are made with after-tax dollars and you pay taxes on them upfront. With a traditional 401(k), your contributions are made with pre-tax dollars, and you pay taxes on them later.

•   With a Roth 401(k), your take-home pay is a little less because you’re paying taxes on your contributions now. That typically lowers your tax bill for the year. With a traditional 401(k), your contributions are taken before taxes.

•   Your money generally grows tax-free in a Roth 401(k). And in retirement, you withdraw it tax-free, as long as the account is at least five years old and you are at least 59 ½. With a traditional 401(k), you pay taxes on your withdrawals in retirement at your ordinary income tax rate.

•   You can start withdrawing your Roth 401(k) money at age 59 ½ without penalty or taxes. However, you must have had the account for at least five years. With a traditional 401(k), you can withdraw your money at age 59 ½. There is no 5-year rule for a traditional 401(k).

Roth 401(k) Contribution Limits

A Roth 401(k) and a traditional 401(k) share the same contribution limits. Both plans allow for the same catch-up contributions for those 50 and older.

Here are the contribution limits for each type of plan.

Roth 401(k) Traditional 401(k)
2023 Contribution Limit $22,500 $22,500
2023 Contribution Limit for individuals 50 and older $30,000 $30,000
2024 Contribution Limit $23,000 $23,000
2024 Contribution Limit for individuals 50 and older $30,500 $30,500
2023 Contribution Limit on employer and employee contributions combined $66,000
($73,500 for individuals 50 and older)
$66,000
($73,500 for individuals 50 and older)
2024 Contribution Limit on employer and employee contributions combined $69,000
($76,500 for individuals 50 and older)
$69,000
($76,500 for individuals 50 and older)

Roth 401(k) Withdrawal Rules

When it comes to withdrawal rules, a Roth 401(k) is subject to the 5-year rule. Under this rule, an individual can start taking tax-free and penalty-free withdrawals from a Roth 401(k) at age 59 ½ only once they’ve had the account for at least five years.

This means that if you open a Roth 401(k) at age 56, you can’t take tax- or penalty-free withdrawals of your earnings at age 59 ½ the way you can with a traditional 401(k). Instead, you’d have to wait until age 61, when your Roth 401(k) is five years old.

Early Withdrawal Rules

It’s possible to take early withdrawals — meaning withdrawals taken before age 59 ½ or from an account that’s less than five years old — from a Roth 401(k), but it’s complicated. Early withdrawals are subject to taxes and a 10% penalty.

However, you may not owe taxes and penalties on the entire amount. Here’s how it typically works: You can withdraw as much as you’ve contributed to a Roth 401(k) without paying taxes or penalties because your contributions were made with after-tax dollars. In other words, you’ve already paid taxes on them. Any earnings you withdraw, though, are subject to taxes and penalties, and you’ll owe tax proportional to your earnings.

For example, if you have $150,000 in a Roth 401(k) and $130,000 of that amount is contributions and $20,000 is earnings, those $20,0000 in earnings are taxable gains, and they represent 13.3% of the account. Therefore, if you took an early withdrawal of $30,000, you would owe taxes on 13.3% of the amount to account for the gains, which is $3,990.


💡 Quick Tip: How much does it cost to set up an IRA? Often there are no fees to open an IRA, but you typically pay investment costs for the securities in your portfolio.

Roth 401(k) RMDs

Previously, individuals with a Roth 401(k) had to take required minimum distributions (RMDs) starting at age 73. However, in 2024, as a stipulation of the SECURE 2.0 Act, RMDs will be eliminated for Roth accounts in employer retirement plans.

By comparison, traditional 401(k)s still require you to take RMDs starting at age 73.

Pros and Cons of a Roth 401(k)

A Roth 401(k) has advantages, but there are drawbacks to the plan as well. Here are some pros and cons to consider:

Pros

You can make tax-free withdrawals in retirement with a Roth 401(k).
This can be an advantage if you expect to be in a higher tax bracket when you retire, since you’ll pay taxes on your Roth 401(k) contributions upfront when you’re in a lower tax bracket. Your money grows tax-free in the account.

Your current taxable income is reduced when you have a Roth 401(k).
Because Roth 401(k) contributions are made after taxes, your paycheck will typically be reduced. That lowers your tax bill for the year.

There are no longer RMDs for a Roth 401(k).
Because of the SECURE 2.0 Act, required minimum distributions will no longer be required for Roth 401(k)s as of 2024. With a traditional 401(k), you must take RMDs starting at age 73.

Early withdrawals of contributions in a Roth 401(k) are not taxed.
Because you’ve already paid taxes on your contributions, you can withdraw those contributions early without paying a penalty or taxes. However, if you withdraw earnings before age 59 ½, you will be subject to taxes on them.

Cons

Your Roth 401(k) account must be open for at least five years for penalty-free withdrawals.
Otherwise you may be subject to taxes and a 10% penalty on any earnings you withdraw if the account is less than five years old. This is something to consider if you are an older investor.

A Roth 401(k) will reduce your paycheck now.
Your take home pay will be smaller because you pay taxes on your contributions to a Roth 401(k) upfront. This could be problematic if you have many financial obligations or you’re struggling to pay your bills.

Is a Roth 401(k) Right for You?

If you expect to be in a higher tax bracket when you retire, a Roth 401(k) may be right for you. It might make sense to pay taxes on the account now, while you are making less money and in a lower tax bracket.

However, if you expect to be in a lower tax bracket in retirement, a traditional 401(k) might be a better choice since you’ll pay the taxes on withdrawals in retirement.

Your age can play a role as well. A Roth 401(k) might make sense for a younger investor, since they are likely to be earning less now than they may be later in their careers. That’s something to keep in mind as you choose a retirement plan to help reach your future financial goals.

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

FAQ

How is a Roth 401(k) taken out of a paycheck?

Contributions to a Roth 401(k) are automatically deducted from your paycheck. Because contributions are made with after-tax dollars, meaning you pay taxes on them upfront, your paycheck will be lower.

What is the 5-year rule for a Roth 401(k)?

According to the 5-year rule for a Roth 401(k), the account must have been open for at least five years in order for an investor to take withdrawals of their Roth 401(k) earnings at age 59 ½ without being subject to taxes and a 10% penalty.

What happens to a Roth 401(k) when you quit?

When you quit a job, you can either keep your Roth 401(k) with your former employer, transfer it to a new Roth 401(k) with your new employer, or roll it over into a Roth IRA.

There are some factors to consider when choosing which option to take. For instance, if you leave the plan with your former employer, you can no longer contribute to it. If you are able to transfer your Roth 401(k) to a plan offered by your new employer, your money will be folded into the new plan and you will choose from the investment options offered by that plan. If you roll over your Roth 401(k) into a Roth IRA, you will be in charge of choosing and making investments with your money.

Do I need to report a Roth 401(k) on my taxes?

Because your contributions to a Roth 401(k) are made with after tax dollars and aren’t considered tax deductible, you generally don’t need to report them on your taxes. And when you take qualified distributions from a Roth 401(k) they are not considered taxable income and do not need to be reported on your taxes. However, it’s best to consult with a tax professional about your particular situation.



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

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


Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.

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Understanding Stop-Loss Orders: A Comprehensive Guide

When an investor places a stop-loss order, sometimes referred to as a stop order, they order their broker to buy or sell a stock once shares reach a certain price. This price is called a “stop price.” Placing a stop-loss order can potentially help keep people from losing money.

There are several types of stop-loss orders, too, that investors can use to increase their chances of retaining any applicable returns. Knowing what they are, and how to use them, can be beneficial to many investors.

What Is a Stop-Loss Order?

A stop-loss order is a market order type that automatically executes a transaction once certain parameters are met — those parameters being set by the investor. In effect, a stop-loss order limits an investor’s potential losses, by “locking in” their profit or gain in relation to a given position.

It may be helpful to think of stop-loss orders as a set of instructions given to your brokerage or investment platform that will automatically execute a trade once a security reaches a given price.


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

How Stop-Loss Orders Work

Stop-loss orders work by executing a predetermined order or set of instructions set by an investor or trader. Effectively, an investor can decide that if the value of one of their stocks falls below a certain threshold, they’ll want to sell it, thereby preserving the gain or profit they’ve made on the stock’s appreciation over time.

So, if the stock’s value starts to fall, and hits the threshold decided upon by the investor, an automatic sell order will execute, and the investor’s position will be vacated – or, their stocks will be sold automatically. This way, if the stock continues to lose value, the investor’s already cashed out, and they won’t lose any more value if they had held onto their stocks.

Different Types of Stop-Loss Orders

There are a few key types of stop-loss orders investors should know about:

Sell-stop Order

A sell-stop order is an order to sell a stock when shares hit a certain price. Let’s look at two examples. The first shows how sell-stop orders can help investors limit their losses.

Daniel buys 10 shares of Stock X at $150 each. He knows he could lose money, but he wouldn’t be comfortable losing more than 10% of what he initially invests.

To ensure he doesn’t lose more than 10%, Daniel sets up a sell-stop order for $135, which is 10% less than he originally paid for his shares of Stock X. If Stock X shares drop to $135, his broker will immediately sell them, so he only loses 10%.

By setting up a sell-stop order, Daniel has limited his losses. (Remember, 10% is just an example, not a suggestion. Everyone has different preferences when investing.)

Now let’s look at an example of how a sell-stop order can lock in profits. This time, Daniel buys 10 shares of Stock Y for $100 each. Six months later, shares have increased to $150 each.

Daniel doesn’t want to lose any of his unrealized gains. “Unrealized gains” are the gains investors make when share prices increase, but they haven’t sold their shares, so they haven’t collected any of the money yet.

Daniel’s Stock Y shares have increased by $50, or $500 total. If the share price drops below the original $100, he could lose all those unrecognized gains.

But Daniel isn’t ready to sell his Stock Y shares yet, either. If the share price continues to increase, he wants to keep earning money. So, he sets up a sell-stop order.

Now that the Stock Y share price is $150, Daniel might set up a sell-stop order for, say, $130. If shares drop to $130, his broker automatically sells them.

Although Daniel wouldn’t be able to keep the full $500 he could have earned had he sold his shares at $150, he would still pocket $30 per share, or $300 total.

In the example of Daniel’s Stock X shares, he prevented losses. With his Stock Y shares, he’s locked in gains. When trading, you’ll probably hear the term “market order” pop up frequently. Know that a stop-loss order is not the same as a market order. When people place market orders, they buy or sell stocks at the current market price, whatever that may be. With a stop-loss order, people “schedule” a market order that is triggered once a predetermined price has been hit.

So once a stock hits its stop price, the stop-loss order becomes a market order. The stop price isn’t necessarily the same price that the shares will be sold at.

For example, Daniel’s stop price for his Stock Y shares is $130, but by the time they sell, they may have dropped to $125.

As a result, he loses more money than he’d anticipated. Or the share price could increase to $135 when they sell, so Daniel only loses $15 per share, even though he was prepared to lose $20.

Buy-stop Order

Knowing what a sell-stop order is, a buy-stop order is similarly exactly what it sounds like. Investors set up a buy-stop order to purchase a stock once shares hit a price higher than the current market price.

Buy-stop orders are placed under the assumption that once a stock starts to increase, it will gain momentum and continue to rise.

If Daniel knows that Stock S shares generally sell for between $20 and $25, he might set up a buy-stop order to purchase 10 shares once they reach $26. The computer system would buy 10 shares on his behalf, and he’d hope Stock S share prices would continue to rise.

Trailing Stop-loss Order

Regular sell-stop orders and buy-stop orders are set at a specific dollar amount. Trailing stop-loss orders are different.

When someone sets a sell trailing-stop order for a certain amount, it tracks (or “trails”) the stock and sells shares once they decrease by that amount. A buy trailing-stop order “trails” the stock and buys shares once they increase by that amount.

Let’s look at an example with real numbers to break it down.

Let’s say Daniel buys shares of Stock A for $40 each. He sets a sell trailing stop-loss order for $1. As long as the stock increases, he’ll hold onto his shares. But as soon as the share price dips by $1, Daniel’s broker will sell his shares of Stock A.

If Stock A’s share price drops from $40 to $39, Daniel’s broker will sell his shares. And if the share price gradually increases to $44 but then drops to $43, a sell trailing-stop order for $1 will cause his broker to sell shares at a stop price of $43. (But remember, because a stop-loss order turns into a market order, shares might be at a price other than $43 by the time they sell.)

Trailing-stop orders are useful for locking in gains. As long as share prices increase, investors keep their shares. Once it decreases by a predetermined amount, the stock is sold.

Advantages of Using Stop-Loss Orders

Stop-loss orders have a couple of primary advantages: Limiting losses, and locking in profits or gains.

Risk Management and Loss Limitation

The most obvious advantage of a stop-loss order is that it keeps people from losing too much money in the market. In the first example of Daniel’s shares of Roku, he set a sell-stop order so that even if he did lose money, he didn’t lose more than he was comfortable with or could afford.

Stop-loss orders aren’t just for preventing losses, though. People can also use them to secure a capital gain.

With Daniel’s stop-loss order for Stock Y, his shares increased from $100 to $150, and he set up a sell-stop order for $130 so that if the stock started to dip, he would pocket at least $30 per share, or $300 total.

If Daniel hadn’t set that sell-stop order for his Stock Y investment, he could have incurred a net loss. Hypothetically, let’s say the share price continued to drop to $90 before he finally sold. He would have lost $10 per share, or $100, rather than gained $300.

Using Stop-Loss Orders to Lock in Profits

Stop-loss orders can also lock in profits. That can lead to some peace of mind for some investors.

In other words, a stop-loss order can make the investment process less stressful. People don’t have to check in on their stocks three times per day, five days per week to track share prices and decide whether they want to buy or sell.

Stop-loss orders help remove other emotions from the process, too. It can be easy to make irrational or rash decisions when trading stocks.

Daniel might get emotionally attached to his Stock Y shares, so he holds onto it even when it becomes a bad investment. Or he tells himself he’ll sell once Stock Y shares drop 10%, but he has a hard time pulling the trigger.

Some people are the type to “set it and forget it.” They buy stocks and forget to check in on them at all. Daniel might say he’ll sell his Stock Y shares when the price decreases 10%, but he simply forgets to check the market for three months. Stock Y’s share price continues to drop, and he loses significant money.

Stop-loss orders can be ideal for investors who want to “set it and forget it” and they have the potential to reduce portfolio risk if used appropriately.

Disadvantages and Risks of Stop-Loss Orders

Stop-loss orders can have some drawbacks, too, just as they have potential advantages.

Potential Drawbacks and Market Impact

Stop-loss orders can work against investors when there’s a short-term drop in the share price, or drawback.

Consider this: Maybe Daniel buys 20 shares of Stock B for $30 per share. He sets a sell-stop order for $28.Monday, shares are at $30, but they fall to $28 on Tuesday, so his broker automatically sells all 20 shares. By Friday, shares have jumped up to $33, so Daniel has lost $60 in just a few days because there was a short-term dip.

It’s helpful to research how much a stock tends to fluctuate in a given amount of time to avoid these types of problems. Maybe Stock B’s share price regularly fluctuates by a few dollars at a time, so Daniel should have set his stop-loss order at a lower price.

If investors understand their stocks’ trends, they can probably set up stop-loss orders more strategically. However, research goes out the window when there is a “flash crash.” This is a sudden, aggressive drop in stock prices — but prices can jump back up just as quickly.

Flash crashes aren’t common, but they occasionally occur.

In this case, Daniel’s Stock B shares could drop from $30 to $15 in the morning, and because he set up a sell-stop order, they automatically sell. But the share price jumps to $32 by the time the closing bell sounds, and Daniel loses out on those gains because he had a sell-stop order.

Understanding Price Gaps and Slippage

Another drawback to consider is that once a stock hits its stop price, the stop-loss order becomes a market order, or an order to sell a stock at the current market price. When a stop-loss order becomes a market order, shares sell for the next available price — or, what’s often called a price gap.

If the difference between an investor’s stop price and the next available price is a few cents, it might not be a big deal. But if the market is volatile that day and the market price is several dollars below the stop price, someone could end up losing quite a bit of cash — especially in the case of a flash crash.

Granted, a stop-loss order turning into a market order could be either a pro or a con, depending on whether a share price increases or decreases. Regardless, some investors might consider it a disadvantage to not know what to expect.

When and Why to Use Stop-Loss Orders

Investors can choose to use stop-loss orders in a variety of scenarios, but they can likely be most beneficial if an investor feels that a security’s price is likely to fall in the near future, or if they’re particularly risk-averse and want to lock in their gains.

With that in mind, there may not necessarily be an ideal scenario in which a stop-loss order is best used or deployed — it’ll depend on the individual investor’s goals and concerns. Again, if they’re particularly risk-averse or at a point in their life where they can’t wait for the market to rebound, and want to lock in their gains, it may be a good idea to use one. If not, a stop-loss order may be less useful.

It may be a good idea to talk to a financial professional, too, about when or if using a stop-loss order is a good idea at a given point in time.

Strategic Considerations in Various Market Conditions

If you’re uncomfortable with the risks that come with stop-loss orders, you may choose not to use them. But know that a huge purpose of stop-loss orders is to minimize risk, and depending on market conditions, they may help ease your anxiety. Even so, it might be helpful to think about the trade-offs and whether the pros outweigh the cons, in your particular financial situation.


💡 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).

Setting Stop-Loss Order Levels

While each and every investor will have different considerations to make when setting stop-loss order levels, there are some things to broadly keep in mind.

Determining Price Levels for Stop-Loss Orders

There’s no exact science when determining price levels for stop-loss orders. It really comes down to an investor’s risk threshold — or, how much loss they’re willing to stomach before they want to bail on a position. Again, that will vary from investor to investor.

It may be helpful to think of that threshold in terms of a percentage. For instance, if a stock’s value declines by 10%, would you want to sell? How about 20%? These can be broad, general markers that many investors can utilize. But there are more advanced methods, too, like using moving averages to determine an acceptable stop-loss placement.

You could even use support and resistance levels to work as guidelines, too. It depends on how thorough or exact you’d like to be.

The Takeaway

Stop-loss orders are a type of market order that can be helpful to investors who want to preserve their gains, or who may want to limit their risk. There’s no exact science as to when and how to use them, but they can be an important and powerful tool in any investor’s kit — though there’s no obligation to ever necessarily use them.

If you’re unsure of whether you should start incorporating stop-loss orders into your strategy, it may be helpful to talk about it with a financial professional. Again, these are just one tool of many, and if you’re particularly risk-averse, they may be worth investigating further.

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FAQ

What’s the main difference between a limit stop-loss order and limit order?

The main difference between a limit stop-loss order and a limit order is that limit orders guarantee trades execute at a specified price, whereas stop orders can be used to limit potential losses. Limit orders specify the maximum price an investor is willing to pay, where a stop-loss order specifies the threshold at which an investor wishes to sell.

Do stop-loss orders always work?

Stop-loss orders do not always work, as there can be glitches within a trading platform’s system, low market liquidity, trading stoppages, and market gaps that can throw an investor’s plans out the window.

Is a stop-loss order better than a stop-limit?

A stop-loss order is not necessarily better than a stop-limit order, as they’re two different things that can or could be used together as a part of an overall investment strategy.

Is a stop-loss a good strategy?

Using stop-loss orders may be a good strategy for certain investors, but it’ll depend on the specific investor’s overall strategy, goals, and risk tolerance. What’s good for one investor may not necessarily be good for another.

What are stop-loss rules?

Stop-loss rules are specified by investors when inputting a stop-loss order. These rules specify the price at which an investor will want to vacate a position or sell their holdings — it’s a threshold at which they want to sell and maintain their gains.

What is the best way to set up stop-loss and make a profit?

There are many strategies and tactics that investors can use to set up stop-loss orders, which might help them maintain profit and value. Some investors, for example, use a percentage as a guideline, while others might use moving averages to determine stop-loss limits, and others could use support and resistance levels.


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