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What Is the Spot Market & How Does It Work?

The spot market of a commodity is a market where buyers meet sellers and make an immediate exchange. In other words, delivery takes place at the same time payment is made. This is the simplest spot market definition available.

Commodity markets are somewhat different from the markets for stocks, bonds, mutual funds, and ETFs, all of which trade exclusively through brokerages. Because they represent a physical good, commodities have an additional market — the spot market. This market represents a place where the actual commodity gets bought and sold right away.

Spot Markets Definition

If you’re trying to define the spot markets, it may be helpful to think of it as a public financial market, and one on which commodities are bought and sold. They’re also bought and sold for immediate, or quick, delivery. That is, the asset being traded changes hands on the spot.

Prices quoted on spot markets are called the spot price, naturally.

One example of a spot market is a coin shop where an individual investor goes to buy a gold or silver coin. The prices would be determined by supply and demand. The goods would be delivered upon receipt of payment.

Understanding Spot Markets

Spot markets aren’t all that difficult to understand from a theoretical standpoint. There can be a spot market for just about anything, though they’re often discussed in relation to commodities (perhaps coffee, corn, or construction materials), and specific things like precious metals.

But again, an important part of spot market transactions is that trades take place on the spot — immediately.

Which Types of Assets Can Be Found on Spot Markets

As noted, all sorts of assets can be found on spot markets. That ranges from food items or other consumables, construction materials, precious metals, and more. If you were, for instance, interested in investing in agriculture from the sense you wanted to trade contracts for oranges or bananas, you could likely do so on the spot market.

Some financial instruments may also be traded on spot markets, such as Treasurys or bonds.

How Spot Market Trades Are Made

In a broad sense, spot market trades occur like trades in any other market. Buyers and sellers come together, a price is determined by supply and demand, and trades are executed — usually digitally, like most things these days. In fact, a spot market may and often does operate like the stock market.

You may be surprised to learn that stock markets are, in fact, spot markets, with financial securities trading hands instantly (in most cases).

💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.

What Does the Spot Price Mean?

As mentioned, the spot price simply refers to the price at which a commodity can be bought or sold in real time, or “on the spot.” This is the price an individual investor will pay for something if they want it right now without having to wait until some future date.

Because of this dynamic, spot markets are thought to reflect genuine supply and demand to a high degree.

The interplay of real supply and demand leads to constantly fluctuating spot prices. When supply tightens or demand rises, prices tend to go up, and when supply increases or demand falls, prices tend to go down.

The Significance of a Spot Market

The spot market of any asset holds special significance in terms of price discovery. It’s thought to be a more honest assessment of economic reality.

The reason is that spot markets tend to be more reliant on real buyers and sellers, and therefore should more accurately reflect current supply and demand than futures markets (which are based on speculation and can be manipulated, as recent legal cases have shown. More on this later.)

Types of Spot Markets

There’s only one type of spot market — the type where delivery of an asset takes place right away. There are two ways this can happen, however. The delivery can take place through a centralized exchange, or the trade can happen over the counter.

Over-the-counter

OTC trades are negotiated between two parties, like the example of buying coins at a coin shop.

Market Exchanges

There are different spot markets for different commodities, and some of them work slightly differently than others.

The spot market for oil, for example, also has buyers and sellers, but a barrel of oil can’t be bought at a local shop. The same goes for some industrial metals like steel and aluminum, which are bought and sold in much higher quantities than silver and gold.

Agricultural commodities like soy, wheat, and corn also have spot markets as well as futures markets.

Spot Market vs Futures Market

One instance that makes clear the difference between a spot market and a futures market is the price of precious metals.

Gold, silver, platinum, and palladium all have their own spot markets and futures markets. When investors check the price of gold on a mainstream financial news network, they are likely going to see the COMEX futures price.

COMEX is short for the Commodity Exchange Inc., a division of the New York Mercantile Exchange. As the largest metals futures market in the world, COMEX handles most related futures contracts.

These contracts are speculatory in nature — traders are making bets on what the price of a commodity will be at some point. Contracts can be bought and sold for specific prices on specific dates.

Most of the contracts are never delivered upon, meaning they don’t involve delivery of the actual underlying commodity, such as gold or silver. Instead, what gets exchanged is a contract or agreement allowing for the potential delivery of a certain amount of metal for a certain price on a certain date.

For the most part, futures trading only has two purposes: hedging bets and speculating for profits. Sophisticated traders sometimes use futures to hedge their bets, meaning they purchase futures that will wind up minimizing their losses in another bet if it doesn’t go their way. And investors of all experience levels can use futures to try to profit from future price action of an asset. Predicting the exact price of something in the future can be difficult and carries high risk.

The spot market works in a different manner entirely. There are no contracts to buy or sell and no future prices to consider. The market is simply determined by what one party is willing to purchase something for.

Spot Market vs Futures Market

Spot Market

Futures Market

No contracts to buy or sell Contracts are bought and sold outlining future prices
Trades occur instantly Trades may never actually occur at all
Non-speculative Speculative by nature

Another important concept to understand is contango and backwardation, which are ways to characterize the state of futures markets based on the relationship between spot and future prices. Some background knowledge on those concepts can help guide your investing strategy.

Note, too, that some investors may be confused by the concepts of margin trading and futures contracts. Margin and futures are two different concepts, and don’t necessarily overlap.

💡 Quick Tip: Distributing your money across a range of assets — also known as diversification — can be beneficial for long-term investors. When you put your eggs in many baskets, it may be beneficial if a single asset class goes down.

Example of a Spot Market

Consider the spot and futures markets for precious metals.

Precious-metal prices that investors see on financial news networks will most often be the current futures price as determined by COMEX. This market price is easy to quote. It’s the sum of all futures trading happening on one central exchange or just a few central exchanges.

The spot market is more difficult to pin down. In this case, the spot market could be generally referred to as the average price that a person would be willing to pay for a single ounce of gold or silver, not including any premiums charged by sellers.

Sometimes there is a difference between prices in the futures market and spot market. The difference is referred to as the “spread.” Under ordinary circumstances, the difference will be modest. During times of uncertainty, though, the spread can become extreme.

Futures Market Manipulation

To fully answer the question “What does the spot price mean?” it’s important to include one final note on futures markets. This will illustrate a key difference between the two markets.

Recent high-profile cases brought by government enforcement agencies like the Securities and Exchange Commision and Commodities and Futures Trading Commission highlight the susceptibility of futures markets to manipulation.

Some large financial institutions have been convicted of engaging in practices that artificially influence the price of futures contracts. Again, we can turn to the precious-metals markets for an example.

During the third quarter of 2020, JP Morgan was fined $920 million for “spoofing” trades in the gold and silver futures markets and lying about it to COMEX.

Spoofing involves creating large numbers of buy or sell orders with no intention of fulfilling the orders.

Because order book information is publicly available, traders can see these orders, and may act on the perception that big buying or selling pressure is coming down the pike. If many sell orders are on the books, traders may sell, hoping to get ahead of the trade before prices fall. If many buy orders are on the books, traders may buy, thinking the price is going to rise soon.

Cases like this show that futures markets can be heavily influenced by market participants with the means to do so.

Spot markets, on the other hand, are much more organic and more difficult to manipulate.

3 Tips for Spot Market Investing

For those interested in trying their hand in the spot market, here are a few things to keep in mind.

1. Know What’s Going On

Often, prices in the spot market can change or be volatile in relation to the news or other current events. For that reason, it’s important that investors know what’s happening in the world, and use that to assess what’s happening with prices for a given asset or commodity.

2. Keep Your Emotions in Check

Emotional investing or trading is a good way to get yourself into financial trouble, be it in the spot market, or any other type of trading or investing. You’d likely do well to keep your emotions in check when trading or investing on the spot market, as a result.

3. Understand the Market

It’s also a good idea to do some homework and make a solid attempt at trying to understand the market you’re trading in. There may be jargon to learn, terms to understand, price discovery mechanisms that could otherwise be foreign to even a seasoned investor — do your best to do your due diligence.

Spot-on Investing

Spot markets are where commodities are traded, instantly. There are numerous types of spot markets, and there are numerous types of commodities that might be traded on them. Investors would be wise to know the basics of how they work, and come armed with a bit of background knowledge about the given commodity they’re trading, in order to reach their goals.

Spot market trading can be a part of an overall trading strategy, but again, investors should know the ropes a bit before getting in over their heads. It may be a good idea to speak with a financial professional before investing.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

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

FAQ

What is spot market vs a futures market

Trades on a spot market occur instantly, on the spot. Trades in the futures market involve contracts for commodities with prices outlined for some time in the future — if they occur at all.

What does spot market mean?

The term spot market refers to a financial market where commodities are bought and sold by traders. The trades occur on the spot, or instantly, for immediate delivery.

What is the difference between spot market and forward market?

Forward markets involve trading of futures contracts, or transactions that take place at some point in the future, whereas spot market trades occur instantly, often for cash.


SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Understanding the Margin of Safety Formula and Calculation

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.

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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.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

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

FAQ

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.


SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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How Can Investors Receive Compounding Returns?

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.

Recommended: A Beginner’s Guide to Investing in Your 20s

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.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

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

FAQ

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.

SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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What Is a Reverse Merger?

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.


💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

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.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

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

FAQ

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.


SoFi Invest®

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

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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

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.


Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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What Is the Difference Between Trading Halts and Trading Restrictions?

Trading Halts vs Trading Restrictions

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.

Recommended: Understanding the Different Stock Order Types

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.

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.

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

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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