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Q: What is a Margin of Safety?

The purpose of calculating a margin of safety is to give investors a cushion for unexpected losses should their analysis prove to be off. This can be helpful because although estimating the intrinsic value of a stock is supposed to be an objective process, it’s done by humans who can make mistakes or inject their own bias.

Jul

2023

Understanding the Margin of Safety Formula and Calculation

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

The margin of safety formula provides a way for investors to calculate a safe price at which to buy a security. This method derives from the value investing school of thought. According to value investing principles, stocks have an intrinsic value and a market value. Intrinsic value is the price they ought to be trading at, while market value is its current price.

Figuring out the difference between these two prices, typically expressed as a percentage, is the essence of the margin of safety formula. Using it correctly can help protect investors from painful losses.

What Is a Margin of Safety?

A margin of safety, as it relates to investing, gives investors an idea of how much margin of error they have when evaluating investments. Making profitable investment decisions is largely about investment risk management. The risk involved in a trade needs to be balanced with the potential reward. In financial markets, taking greater risks often gives the potential for greater rewards but also for greater losses — a concept known as the risk-reward ratio.

There are actually two ways that margin of safety can be utilized. One is in the investing sphere, the other is in accounting.

Margin of Safety in Investing

As it relates to investing, the purpose of calculating a margin of safety is to give investors a cushion for unexpected losses should their analysis prove to be off. This can be helpful because although estimating the intrinsic value of a stock is supposed to be an objective process, it’s done by humans who can make mistakes or inject their own biases. Even the most experienced and successful traders, both institutional and retail investors — all don’t always make the right call.

To try and correct for this possibility, value investors can determine their margin of safety when entering a position.

Expressed as a percentage, this figure is intended to represent the amount of error that could go into calculating the intrinsic value of a stock without ruining the trade. In other words, the percentage answers the question, “By what margin can I be wrong here without losing too much money?”

Margin of Safety in Accounting

In accounting, margin of safety is a financial metric that calculates the difference between forecasted sales and sales at a break-even point. While this has obvious use in a business context, it’s not really applicable to investors.

💡 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.

Margin of Safety Formula

The margin of safety formula works like this:

Margin of safety = 1 – [Current Stock Price] / [Intrinsic Stock Price]

Example of Calculating Margin of Safety

Let’s look at an example of calculating margin of safety.

An investor wants to buy shares of company A for the current market price of $9 per share. After a thorough analysis of the company’s fundamentals, this investor believes the intrinsic value of the stock to be closer to $10. Plugging these numbers into the margin of safety formula yields the following results:

1 – (9/10) = 10%.

In this example, the margin of safety percentage would be 10%.

The idea is that an investor could be off on their intrinsic value price target by as much as 10% and theoretically not take a loss, or only a very small one.

Now an investor has determined their margin of safety. How might they use this figure?

To provide a substantial cushion for potential losses, an investor could plan to enter into a trade at a price lower than its intrinsic value. This could be done using the calculated margin of safety.

In the example above, say an investor decided that 10% wasn’t a wide enough margin, and instead wanted to be extra cautious and use 20%. They would then set a price target of $8, which is 20% lower than the stock’s estimated value of $10.

Who Uses the Margin of Safety Formula?

The margin of safety is typically used by investors of value stocks. Value investors look for stocks that could be undervalued, or trading at prices lower than they should be, to find profitable trading opportunities. The method for accomplishing this involves the difference between market value and intrinsic value.

The market value of a stock is simply what price it’s trading for at the moment. This fluctuates constantly and can extend well beyond intrinsic value during times of greed or fall far below intrinsic value during times of fear.

Intrinsic value is a calculation of what price a stock likely should be trading at based on fundamental analysis. There are several factors that determine a stock price and the analysis considers both quantitative and qualitative factors. That might include things like past, present, and estimated future earnings, profits and revenue, brand recognition, products and patents owned, or a variety of other factors.

💡 Quick Tip: How to manage potential risk factors in a self directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

How Investors Can Use Margin of Safety

After determining the intrinsic value of a stock, an investor could simply buy it if the current market price happens to be lower. But what if their calculations were wrong? That’s where a margin of safety comes in. And why it can be very important when investing in stocks.

Because no one can consider all of the appropriate factors and make a perfect calculation, factoring in a margin of safety can help to ensure investors don’t take unnecessary losses.

As mentioned, too, the margin of safety formula is also used in accounting to determine how far a company’s sales could fall before the company becomes unprofitable. Here we will focus on the definition used in investing.

Ideal Margin of Safety

It’s difficult to say if there’s an ideal margin of safety for any particular investor. But we can say that the larger the margin of safety is, the more room an investor has to be wrong — which isn’t necessarily a bad thing. With that in mind, a larger or wider margin of safety is probably better for most investors.

How Important Is the Margin of Safety

With the idea in mind that a wider or larger margin of safety allows for more room to be wrong about investment choices or analyses, it can be fairly important for investors. But it really will come down to the individual investor, who considers their own personal risk tolerance and investment strategy, and how it meshes with their tolerance for being wrong.

While it may be important to a degree, there are likely other factors that eclipse it in terms of overall importance in an investing strategy. For example, investing regularly and often may be more important — but again, it’ll come down to the individual.

The Takeaway

In investing, the margin of safety formula is a way for investors to be extra careful when selecting an entry point in a security. By determining a percentage and placing a discount to a stock’s estimated value, an investor can find a mathematical framework with which they can try to be safer with their money.

It’s relatively easy to learn how to calculate one’s margin of safety. There are only two variables — the market value of a stock and the intrinsic value. Dividing the market value by the intrinsic value then subtracting the result from one equals the margin of safety.

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FAQ

What is the ideal margin of safety for investing activities?

There may not be an ideal margin of safety for investors, but as a general rule of thumb, the wider the margin, the more room they have to be wrong. Therefore, the bigger, the better, in most cases.

Is the margin of safety the same as the degree of operating leverage?

In accounting, the margin of safety refers to the difference between actual sales and break-even sales, whereas the degree of operating leverage is a different metric altogether. So, no, they’re not the same.

What is a good margin of safety percentage?

While there is no hard and fast answer, some experts might say that a good margin of safety percentage is somewhere in the 20% to 30% range.

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Jul

2023

How Can Investors Receive Compounding Returns?

By Krystal Etienne | Growing Wealth, invest, Investing | Comments Off

Compounding returns can help the money you’ve invested grow, as long as those returns are reinvested.

Compound returns depend on the rate of return–meaning how much the investment gains or losses over time. The most powerful effects of compounding returns take time, even decades. That’s why people are often encouraged to start investing at an early age, even with small amounts. The longer their money is invested, the more compounding it can do.

How can investors receive compounding returns? Here’s how the process works and steps to take to achieve it.

What Are Compounding Returns?

Compounding returns are the earnings you continuously receive from contributions you’ve made to an investment.

Compound returns can be achieved by any type of asset class that produces returns on both the initial amount–or the principal–as well as any profits or returns that are generated after the initial investment. Essentially, the money you put to work is doing additional work automatically for you.

💡 Quick Tip: If you’re opening a brokerage account for the first time, consider starting with an amount of money you’re prepared to lose. Investing always includes the risk of loss, and until you’ve gained some experience, it’s probably wise to start small.

How Does Compounding Interest Work?

Compound interest, on the other hand, refers to interest that accrues on savings accounts. (There isn’t such a thing as compound interest in stocks.) So, for instance, if you have a savings account that pays interest on the principal in the account, the interest you earn gets added to the principal. That means, your interest ends up earning interest–or compounding.

The Value of Compounding Returns

Here’s a hypothetical example that illustrates the idea of compound returns. (However, be aware that this is only for an investor making profits. In reality, an investor could also experience losses.)

Let’s say an investor buys a stock that costs $1,000. That’s the investment’s “principal.” In the first year, they earn a 10% return. The stock is now worth $1,100. Things start to get interesting in the second year, when the stock increases in value another 10%, bringing the stock’s value to $1,210.

That’s $110 in profit earned in the second year, compared to $100 in the first year. This happened even though they did not add any additional money to the investment, and they earned the same compound rate of return. The investment simply grew over the previous year, creating a larger base from which to earn more.

If the investor were to earn a 10% rate of return the third year, the profit would be even greater than in the previous two years. Working off a larger base—now $1,210—a 10% return will yield a profit of $121.

But keep in mind that investments that hold stocks may experience volatility. Take the example from above. Three consecutive years of precise 10% returns is highly unlikely. In fact, it’s also possible for investors to lose money on their investments, which is the case in almost any asset class. While helpful for understanding the concept of compound returns, it’s not necessarily reflective of the real-world experience.

How to Get Compound Returns

With compound returns, the reinvestment of interest may be done automatically or manually.

Here are some examples of investment types that can earn compound returns.

Stocks: There are two ways to make money on a stock. The first is through price appreciation, and the second is through dividend payments. When the value of a stock grows over time, an investor has the potential to earn compound interest if those profits are reinvested. With cash dividend payments, compound returns are not automatic, as they are paid out in cash, but an investor can add the payouts back in in order to potentially earn additional returns.

Mutual funds: Mutual funds are pools of stocks, bonds, or other investment types. For example, a mutual fund could invest in the U.S. stock market. Over time, the goal is that the mutual fund grows as the underlying investments grow. Many mutual funds give the option of automatic dividend reinvestment plans. This way, the investor can earn compound returns in both ways, on the price appreciation and the dividend payments.

Exchange-traded funds (ETFs): Similar to mutual funds, ETFs are pools of investments, like stocks. As the value of the ETF grows over time, returns will compound. Depending on which bank or institution where the ETF is purchased, it may or may not be possible to automatically reinvest dividends.

Remember, with all investments, a good return on investment is not guaranteed, even profits aren’t. Plus, investments that tend to earn a higher potential return may also come with higher risk.

💡 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.

Which Products Offer Compound Interest?

Here are some examples of the types of accounts that earn compound interest.

High-yield savings accounts: Some high-yield savings accounts pay interest on cash balances. With these accounts, it is possible to earn interest on top of interest earned in previous months, therefore earning compounding returns.

Money market accounts: These accounts combine features of both a savings and a checking account. For instance, you may be able to write checks or use a debit card with a money market account. You earn interest on the balance in the account.

CDs: With a CD, or Certificate of Deposit, you place your money in the account and leave it for a specified period of time, which is usually anywhere from three months to five years. While the money is in the account, it earns a guaranteed amount of interest that typically compounds.

Bonds: You can buy different types of bonds such as US Treasury Bonds. In return for buying the bonds, the issuer pays you compound interest over a certain period of time, which can be as long as 30 years until the bonds mature.

The Takeaway

Compound returns can be a powerful way for your money to grow over time. When you invest your money in stocks or other asset classes, you have the potential to earn compounded rates of return. And the longer you invest, the more time your returns may have to compound.

Invest with as little as $5 with a SoFi Active Investing account.

FAQ

Do stocks compound daily?

Compound return is a measure of a stock’s performance over time. Compounding often happens monthly, quarterly, semi-annually, or annually.

What is the average compound interest return?

The average compound interest return depends on the types of savings vehicles you have.

What is the difference between arithmetic and compounding returns?

With arithmetic returns, you take the difference between the ending value of an investment and the beginning value of the investment and divide it by the beginning value. Compound returns depend on the rate of return–meaning how much an investment gains or losses over time.

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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Jun

2023

What Is a Reverse Merger?

By Anna Davies | Growing Wealth, invest, Investing, Terminology | Comments Off

In a traditional merger, a company may acquire another that is in a similar or complementary business in order to expand its footprint or reduce competition. A “reverse merger” works quite differently, and investors are eyeing the assets of a private company.

The acquiring company in a reverse merger is called a public “shell company,” and it may have few to no assets. The shell company acquires a private operating company. This can allow the private company to bypass an initial public offering, a potentially lengthy, expensive process. In essence, the reverse merger is seen as a faster and cheaper method of “going public” than an IPO.

Reverse Merger Meaning

As mentioned, the meaning of the term “reverse merger” is when a group of investors takes over a company, rather than a competing or complementary business acquiring or absorbing a competitor. It’s a “reverse” of a traditional merger, in many ways, and appearances.

A reverse merger can also act as a sort of back door in. It can also be a way for companies to eschew the IPO process, or for foreign-based companies to access U.S. capital markets quickly.

What Is Investors’ Motivation?

Investors may purchase units or shares in a shell company, hoping their investment will increase once a target company is chosen and acquired. This can be good for values of stocks when companies merge, netting those investors a profit.

In other cases, investors may own stock in a publicly traded company that is not doing well and is using a reverse merger to boost share values for shareholders through the acquisition of a new company.

In either case, shareholders can vote on the acquisition before a deal is done. Once the deal is complete, the name and stock symbol of the company may change to represent that of the formerly private company.

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How Do Reverse Mergers Work?

A shell company may have a primary purpose of acquiring private companies and making them public, bypassing the traditional IPO process. These types of companies can also be called special purpose acquisition companies (SPACs) or “blank check companies,” because they usually don’t have a target when they’re formed.

They may set a funding goal, but the managers of the SPAC will have control over how much money they will use during an acquisition.

A SPAC can be considered a sort of cousin of private equity in that it raises capital to invest in privately traded companies. But unlike private equity firms, which can keep a private company private for however long they wish, the SPAC aims to find a private company to turn public.

During its inception, a SPAC will seek sponsors, who will be allowed to retain equity in the SPAC after its IPO. There’s a lot to consider here, such as the differences and potential advantages for investors when comparing an IPO vs. acquisition via SPAC.

The SPAC may have a time limit to find a company appropriate to acquire. At a certain point during the process, the SPAC may be publicly tradable. It also may be available for investors to buy units of the company at a set price.

Once the SPAC chooses a company, shareholders can vote on the deal. Once the deal is complete, managers get a percentage of the profits from the deal, and shareholders own shares of the newly acquired company.

If the SPAC does not find a company within the specified time period — or if a deal is not voted through — investors will get back their money, minus any fees or expenses incurred during the life of the SPAC. The SPAC is not supposed to last forever. It is a temporary shell created exclusively to find companies to take public through acquisition.

Are Reverse Mergers Risky?

Investing in a SPAC can be risky because investors don’t have the same information they have from a publicly traded company. The lack of transparency and standard analytical tools for considering investments could heighten risk.

The SPAC itself has little to no cash flow or business blueprint, and the compressed time frame can make it tough for investors to make sure due diligence has been done on the private company or companies it plans to acquire.

Once a deal has gone through, the SPAC stock converts to the stock of the formerly private company. That’s why many investors rely on the reputation of the founding sponsors of the SPAC, many of whom may be industry executives with extensive merger and acquisition experience.

💡 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.

What Are the Pros and Cons of Reverse Mergers for Investors?

For investors, reverse mergers can have advantages and disadvantages. Here’s a rundown.

Pros of Reverse Mergers

One advantage of a reverse merger — being via SPAC or some other method — is that the process is relatively simple. The IPO process is long and complicated, which is one of the chief reasons companies may opt for a reverse merger when going public.

As such, they may also be less risky than an IPO, which can get derailed during the elongated process, and the whole thing may be less susceptible to the overall conditions in the market.

Cons of Reverse Mergers

Conversely, a reverse merger requires that a significant amount of due diligence is done by investors and those leading the merger. There’s always risk involved, and it can be a chore to suss it all out. Further, there’s a chance that a company’s stock won’t see a surge in demand, and that share values could fall.

Finally, there are regulatory issues to be aware of that can be a big hurdle for some companies that are making the transition from private to public. There are different rules, in other words, and it can take some time for staff to get up to speed.

Pros and Cons of Reverse Mergers for Investors
Pros	Cons
Simple	Homework to be done
Lower risks than IPO	Risk of share values falling
Less susceptibility to market forces	Regulation and compliance

An Example of a Reverse Merger

SPACs have become more common in the financial industry over the past five years or so, and were particularly popular in 2020 and 2021. Here are some examples.

Snack company UTZ went public in August 2020 through Collier Creek Holdings. When the deal was announced, investors could buy shares of Collier Creek Holdings, but the shares would be converted to UTZ upon completion of the deal. If the merger was successful, shareholders had the option to hold the stock or sell.

But sometimes, SPAC deals do not reach completion. For example, casual restaurant chain TGI Fridays was poised to enter a $380 million merger in 2020 through acquisition by shell company Allegro Merger — a deal that was called off in April 2020 partially due to the “extraordinary market conditions” at the time.

Allegro Merger’s stock was liquidated, while the owners of TGI Fridays — two investment firms — kept the company.

Investor Considerations About Reverse Mergers

Some SPACs may trade in exchange markets, but others may trade over the counter.

Over-the-counter, or off-exchange, trading is done without exchange supervision, directly between two parties. This can give the two parties more flexibility in deal terms but does not have the transparency of deals done on an exchange.

This can make it challenging for investors to understand the specifics of how a SPAC is operating, including the financials, operations, and management.

Another challenge may be that a shell company is planning a reverse merger with a company in another country. This can make auditing difficult, even when good-faith efforts are put forth.

That said, it’s a good idea for investors to perform due diligence and evaluate the shell company or SPAC as they would analyze a stock. This includes researching the company and reviewing its SEC filings.

Not all companies are required to file reports with the SEC. For these non-reporting companies, investors may need to do more due diligence on their own to determine how sound the company is. Of course, non-reporting companies can be financially sound, but an investor may have to do the legwork and ask for paperwork to help answer questions that would otherwise be answered in SEC filings.

Investing With SoFi

Understanding reverse mergers can be helpful as SPACs become an increasingly important component of the IPO investing landscape. It can also be good to know how investments in reverse merger companies can fit financial goals.

Many investors get a thrill from the “big risk, big reward” potential of SPACs, as well as the relatively affordable per-unit price or stock share that may be available to them.

Due diligence, consideration of the downsides, and a well-balanced portfolio may lessen risk in the uncertain world of reverse mergers. If you’re interested in learning how they could affect your portfolio or investing decisions, it may be a good idea to speak with a financial professional.

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

What is an example of a reverse merger?

A SPAC transaction is an example of a reverse merger, which would be when a SPAC is founded and taken public. Shares of the SPAC are sold to investors, and then the SPAC targets and acquires a private company, taking it public.

Why would a company do a reverse merger?

A reverse merger can be a relatively simple way for a company to go public. The traditional path to going public, through the IPO process, is often long, expensive, and risky, and a reverse merger can offer a simpler alternative.

How are reverse mergers and SPACs different?

The term “reverse merger” refers to the action being taken, or a company being taken public through a transaction or acquisition. A SPAC, on the other hand, is a vehicle or business entity used to facilitate that acquisition.

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Jun

2023

What Is the Difference Between Trading Halts and Trading Restrictions?

Trading Halts vs Trading Restrictions

By Matthew Warholak | Growing Wealth, invest, Investing | Comments Off

Investors, at one point or another, may find that a security they’re interested in trading or investing in is the subject of a trading halt or trading restrictions. The two are similar, but distinct – and it can be beneficial to understand the differences. A trading halt, for instance, is a temporary pause in trading, whereas trading restrictions are put in place by regulators to suspend trading by individuals who may be bending the rules.

Again, it can be helpful to understand the differences, so if investors do find themselves dealing with a trading halt or trading restrictions, they can make wise decisions about their next moves.

What Is the Difference Between a Trading Halt and a Trading Restriction?

A trading halt is a market event in which the trading of a particular asset or an entire stock exchange is temporarily suspended, whereas a trading restriction is a trading limitation enforced by the Securities Exchange Commission (SEC) and/or investing brokerages that prevent investors from participating in frequent and short-term trading activities at larger scales.

In other words, trading halts are reactionary and trading restrictions are preventative. To better understand, we’ll take a closer look at both trading halts and trading restrictions.

💡 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.

What Is a Trading Halt?

A trading halt can be stock-specific or market-wide, affecting traders of all sizes, backgrounds, and geographic locations. The duration of a trading halt can vary, freezing securities of various types or entire markets for minutes or even hours at a time.

Trading halts are artificial, meaning they are not a natural part of markets—however, they have been in existence for some time. Stock market halts date back to 1987, when the SEC mandated the creation of market-wide circuit-breakers (MWCBs) to prevent a repeat of the Oct. 19, 1987 market crash, also known as “Black Monday,” which was one of the worst days for the market in history.

Reasons for Trading Halts

Trading halts are a method of pausing market action to prevent volatility from snowballing in response to unexpected stimuli.

Trading halts are designed only to be triggered when a certain market event occurs that is extreme, unprecedented, or otherwise affects market trading. Halts may be triggered by severe price rises or drops, commonly referred to as “circuit breakers” or “curbs.” Halts are implemented for a variety of reasons, including the following.

1. Anticipation of a Major News Announcement: Code T1: Pending News

A trading halt might be called during the day to allow a company to make an announcement. If the announcement is pre-market, it might result in a trading delay rather than a halt. A trading halt or delay allows investors time to assess the news’ impact.

2. Severe Price Drop: Code LUDP: Volatility Trading Pause

The NYSE also imposes trading halts based on the severity of price moves or stock volatility, applying to both upside and downside swings in short amounts of time. Whereas news-induced trading halts are usually one hour in duration, stocks can get halted for five to 10 minutes for increasing or decreasing rapidly in price over a short period, typically exceeding 10% in a five minute period.

3. Market-Wide Circuit Breakers

There are also three tiers of market-wide circuit breakers that pause trading across all U.S. markets when the benchmark indices the S&P 500, the Dow Jones 30, and the Nasdaq exceed pre-set percentages in terms of price from the prior day’s closing price:

• Level 1: 15-minute halt when the S&P 500 falls 7% below the previous day’s closing price between 9:30am EST and 3:24pm EST.

• Level 2: 15-minute halt when the S&P 500 falls 13% below the previous day’s close between 9:30am EST to 3:24pm EST. Level 1 and 2 circuit breakers do not halt trading between 3:25pm EST and 4:00pm EST.

• Level 3: Trading is closed for the remainder of the day until 4pm EST when the S&P 500 falls 20% below the previous day’s close.

4. Correct an Order Imbalance

Non-regulatory halts or delays occur on exchanges such as the NYSE when a security has a disproportionate imbalance in the pending buy and sell orders. When this occurs, trading is halted, market participants are alerted to the situation, and exchange specialists communicate to investors a reasonable price range where the security may begin trading again on the exchange. However, a non-regulatory trading halt or delay on exchange does not mean other markets must follow suit with this particular security.

5. Technical Glitch: Code T6: Extraordinary Market Activity

Trading is halted when it’s determined that unusual market activity such as the misuse or malfunction of an electronic quotation, communication, reporting, or execution system is likely to impact a security’s market.

6. Regulatory Concerns

A trading halt may be placed on a security when there is uncertainty over whether the security meets the market’s listing standards. When this halt is placed by a security’s primary markets, other markets that offer trading of that security must also respect this halt. These include:

• Code H10: SEC Trading Suspension: A five minute trading halt for a stock priced above $3.00 that moves more than 10% in a five minute period. H10s are commonly imposed by the SEC onto penny stocks and other over-the-counter stocks suspected of stock promotion or fraud.

• Code T12: Additional Information Requested: A trading halt that occurs when a stock has rallied significantly without any clear impetus. This can be common among orchestrated pump-and-dumps or short squeezes, and in many cases when the halt is lifted, the stock reverts back down because there are no underlying fundamentals supporting the drastic rise in price.

How Long Do Trading Halts Last?

Trading halts are typically no longer than an hour, the remainder of the trading day, or on rare occasions up to 10 days. However, if the SEC deems appropriate, the regulatory body may revoke a security’s registration altogether.

Example of Trading Halts

Stock Volatility

Amid the late-January 2021 Gamestop vs Wall Street meme stock spectacle, Gamestop’s stock saw huge capital inflows over the course of a couple weeks, leading the NYSE in terms of daily volume. The stock’s intraday volume was so high that it triggered the volatility circuit breaker dozens of times over the last week of January and again on February 2, 2021, when it dropped 42%.

Pending News

On February 1, 2021, Adamas Pharmaceuticals’ trading was halted for news pending linked to the day being the FDA action date for the company’s marketing application for Gocovri (amantadine) to treat OFF episodes in Parkinson’s disease patients receiving levodopa-based therapy.

Regulatory Concerns

In June 2020, bankrupt car rental company Hertz’s stock trading was halted pending news around a planned controversial stock sale. The stock was trading down about half a percent to under $2.00 when the SEC told Hertz that the regulator had issues with the company’s stock sale plan.

Market-wide circuit breakers

MWCBs were triggered four times in March 2020 in response to the global COVID-19 pandemic lockdowns that caused two of the six largest single-day drops in market history. This was the first occurrence of market-wide circuit breakers since 1997.

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

What is a Trading Restriction?

Trading restrictions are trading limitations imposed by the SEC to restrict day trading of U.S. stocks and stock markets. Trading restrictions attempt to prevent “pattern day traders” from operating in the markets unless they maintain a minimum equity balance of $25,000 in their trading account.

Trading restrictions ensure a minimum standard is met by all market participants to trade assets to the fullest extent to which they have access. Margin requirements, pattern day trading, and occasionally limited market hours narrows the potential pool of traders to those with the designated criteria deemed necessary to effectively play by market rules at a certain scale.

Pattern Day Trading

The SEC defines a day trade as “the purchasing and selling or the selling and purchasing of the same security on the same day in a margin account.” Accordingly, the SEC defines a pattern day trader as anyone who executes four or more trades within five trading days. In other words, opening and closing one trade per day is enough to classify a trader as a pattern day trader, applying the $25,000 minimum equity capital restrictions.

In addition to the SEC, some stockbrokers may impose even more stringent definitions of a pattern day trader, classifying pattern day trading as making two or three day trades in a five-day period, thus imposing the $25,000 minimum equity balance on anyone who meets this criteria.

Leverage/Margin

Day traders in the U.S. are permitted to trade on up to 4:1 leverage, meaning day traders can open positions up to four times the amount of cash in their trading account. For example, if a trader has $25,000 in their account, they can open up positions up to $100,000 for the day. However, traders that hold positions overnight are limited to 2:1 leverage, or up to double the amount of cash in their trading account.

Since day traders’ positions are intraday and each trade is less likely to experience larger price swings compared to positions held longer, day traders are allowed to have more leverage. If a trader exceeds their allowed margin, then the day trader’s broker will issue them a margin call, a demand for additional funds to maintain a certain account ‘margin’ requirement. Margin calls are usually brought on by a position decreasing sharply in value or an overleveraged position decreasing enough to fall below the margin requirement.

Recommended: What Is Leverage in Finance?

Examples of Trading Restrictions

PDT Suspended Trading

If Trader Smith has $20,000 in their trading account — $5,000 less than the minimum equity requirement for pattern day, they may only open and close three total trades in a week. If Smith opens and closes five total trades in one week with their same $20,000 account, they will be flagged as a pattern day trader.

Because their account’s equity doesn’t meet the minimum PDT margin requirement, their account may be suspended from trading until they add additional funds to their account to meet the $25,000 minimum equity requirement — or wait five or so days for the suspension to end. All margin and leverage is suspended during a PDT trading suspension, however some brokers may allow for cash account transactions while in PDT suspension.

Margin Calls

A late February 2021 25%+ selloff in the crypto markets was believed to have been started by margin calls that were liquidated, thereby creating a snowball of market sell orders that cascaded lower to then trigger lower liquidation levels and stop-loss orders, creating a feedback loop of selling.

The initial margin calls were triggered when a trader’s leveraged long trade came under pressure during a pullback, at which point the position was liquidated, force-sold after not meeting the margin requirements.

The Takeaway

Trading halts and trading restrictions are similar but different, and can both affect any trader at one time or another. From an individual perspective, there are minimum capital requirements to sign up for trading, especially for those intent on day trading. If a trader doesn’t maintain a certain level of margin, their trading account can be suspended or be limited to trading only with cash available.

Even if traders follow all the rules and maintain their margin requirements, there are certain trading days when trading of particular stocks pauses due to reasons outside of any one person’s control — whether it’s pending news, volatility, suspected fraud, or even a technical error. On rare occasions, the entire market may be halted or shut down for the day due to severe drops.

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

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Jun

2023

The Risks and Rewards of Naked Options

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

A naked, or “uncovered,” option is an option that is issued and sold without the seller setting aside enough shares or cash to meet the obligation of the option when it reaches expiration.

Investors can’t exercise an option without the underlying security, but they can still trade the option to make a profit, by selling the option for a premium.

When an option writer sells an option, they’re obligated to deliver the underlying securities (in the case of a call option) or cash (in the case of a put) to the option holder at expiration.

But because a naked writer doesn’t hold the securities or cash, they need to buy it or find it if the option they wrote is in the money, meaning that the investor exercises the option for a profit.

What is a Naked Option?

When an investor buys an option, they’re buying the right to buy or sell a security at a specific price either on or before the option contract’s expiration. An option to buy is known as a “call” option, while an option to sell is known as a “put” option.

Investors who buy options pay a premium for the privilege. To collect those premiums, there are investors who write options. Some hold the stock or the cash equivalent of the stock they have to deliver when the option expires. The ones who don’t are sometimes called naked writers, because their options have no cover.

Naked writers are willing to take that risk because the terms of the options factor in the expected volatility of the underlying security. This differs from options based on the price of the security at the time the option is written. As a result, the underlying security will have to not only move in the direction the holder anticipated, but do so past a certain point for the holder to make money on the option.

Recommended: A Guide to Options Trading

The Pros and Cons of Naked Options

There are risks and rewards associated with naked options. It’s important to understand both sides.

Naked Writers Often Profit

The terms of naked options have given them a track record in which the naked writer tends to come out on top, walking away with the entire premium. That’s made writing these options a popular strategy.

Those premiums vary widely, depending on the risks that the writer takes. The more likely the broader market believes the option will expire “in the money” (with the shares of the underlying stock higher than the strike price), the higher the premium the writer can demand.

But Sometimes the Options Holder Wins

In cases where the naked writer has to provide stock to the option holder at a fixed price, the strategy of writing naked call options can be disastrous. That’s because there’s no limit to how high a stock can go between when a call option is written and when it expires.

Recommended: 10 Options Strategies You Should Know

How to Use Naked Options

While there are some large institutions whose business focuses on writing options, some qualified individual investors can also write options.

Because naked call writing comes with almost limitless risks, brokerage firms only allow high-net-worth investors with hefty account balances to do it. Some will also limit the practice to wealthy investors with a high degree of sophistication. To get a better sense of what a given brokerage allows in terms of writing options, these stipulations are usually detailed in the brokerage’s options agreement. The high risks of writing naked options are why many brokerages apply very high margin requirements for option-writing traders.

Generally, to sell a naked call option, for example, an investor would tell their broker to “sell to open” a call position. This means that the investor would write the naked call option. An investor would do this if they expected the stock to go down, or at least not go any higher than the volatility written into the option contract.

If the investor who writes a naked call is right, and the option stays “out of the money” (meaning the security’s price is below a call option’s strike price) then the investor will pocket a premium. But if they’re wrong, the losses can be profound.

This is why some investors, when they think a stock is likely to drop, are more likely to purchase a put option, and pay the premium. In that case, the worst-case scenario is that they lose the amount of the premium and no more.

How to Manage Naked Option Risk

Because writing naked options comes with potentially unlimited risk, most investors who employ the strategy will also use risk-control strategies. Perhaps the simplest way to hedge the risk of writing the option is to either buy the underlying security, or to buy an offsetting option. The other risk-mitigation strategies can involve derivative instruments and computer models, and may be too time consuming for most investors.

Another important way that options writers try to manage their risk is by being conservative in setting the strike prices of the options. Consider the sellers of fifty-cent put options when the underlying stock was trading in the $100 range. By setting the strike prices so far from where the current market was trading, they limited their risk. That’s because the market would have to do something quite dramatic for those options to be in the money at expiration.

💡 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 Takeaway

With naked options, the investor does not hold a position in the underlying asset. Because this is a risky move, brokerage firms may allow their high-net-worth investors to write naked options.

Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.

Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.

With SoFi, user-friendly options trading is finally here.

SoFi Invest®

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

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Understanding the Margin of Safety Formula and Calculation

What Is a Margin of Safety?

Margin of Safety in Investing

Margin of Safety in Accounting

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Margin of Safety Formula

Example of Calculating Margin of Safety

Who Uses the Margin of Safety Formula?

How Investors Can Use Margin of Safety

Ideal Margin of Safety

How Important Is the Margin of Safety

The Takeaway

FAQ

What is the ideal margin of safety for investing activities?

Is the margin of safety the same as the degree of operating leverage?

What is a good margin of safety percentage?

How Can Investors Receive Compounding Returns?

What Are Compounding Returns?

How Does Compounding Interest Work?

The Value of Compounding Returns

How to Get Compound Returns

Which Products Offer Compound Interest?

The Takeaway

FAQ

Do stocks compound daily?

What is the average compound interest return?

What is the difference between arithmetic and compounding returns?

What Is a Reverse Merger?

Reverse Merger Meaning

What Is Investors’ Motivation?

How Do Reverse Mergers Work?

Are Reverse Mergers Risky?

What Are the Pros and Cons of Reverse Mergers for Investors?

Pros of Reverse Mergers

Cons of Reverse Mergers

An Example of a Reverse Merger

Investor Considerations About Reverse Mergers

Investing With SoFi

FAQ

What is an example of a reverse merger?

Why would a company do a reverse merger?

How are reverse mergers and SPACs different?

Trading Halts vs Trading Restrictions

What Is the Difference Between a Trading Halt and a Trading Restriction?

What Is a Trading Halt?

Reasons for Trading Halts

1. Anticipation of a Major News Announcement: Code T1: Pending News

2. Severe Price Drop: Code LUDP: Volatility Trading Pause

3. Market-Wide Circuit Breakers

4. Correct an Order Imbalance

5. Technical Glitch: Code T6: Extraordinary Market Activity

6. Regulatory Concerns

How Long Do Trading Halts Last?

Example of Trading Halts

Stock Volatility

Pending News

Regulatory Concerns

Market-wide circuit breakers

What is a Trading Restriction?

Pattern Day Trading

Leverage/Margin

Examples of Trading Restrictions

PDT Suspended Trading

Margin Calls

The Takeaway

The Risks and Rewards of Naked Options

What is a Naked Option?

The Pros and Cons of Naked Options

Naked Writers Often Profit

But Sometimes the Options Holder Wins

How to Use Naked Options

How to Manage Naked Option Risk

The Takeaway

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