May
18
2024
IRA Transfer vs Rollover
There are important differences between a rollover and a transfer when making a change to a retirement account.
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May
18
2024
Direct Listings vs. IPOs: How Are They Different?
Table of Contents
When you hear of a company “going public,” one route is via an initial public offering, or IPO — but a company can also go public through a direct listing, where no new shares are created and underwriters are not required.
Direct listings, also known as the direct listing process (DLP), direct placement, or direct public offering (DPO), are a way for companies to raise capital by selling existing shares without the complexity of engaging investment banks and other intermediaries.
While a direct listing is typically less expensive than an IPO, and typically there’s no lock-up period, there is a risk in direct listing shares without the support of underwriters.
Key Points
• Direct listings allow companies to go public by selling existing shares without underwriters.
• Initial Public Offerings (IPOs) involve issuing new shares and usually require underwriters.
• Direct listings can be less costly and avoid lock-up periods unlike IPOs.
• IPOs provide companies with support from underwriters, which can help stabilize share prices.
• Direct listings offer immediate liquidity for existing shareholders, allowing them to sell shares directly to the public.
What Is the Difference Between Direct Listings and IPOs?
A direct listing is one method by which a company can list shares of stock on a public exchange such as the New York Stock Exchange (NYSE) or Nasdaq directly, without using underwriters to create new shares, as you might with an IPO.
While some listing choices involve selling shares of stock to investors, IPOs and direct listings have many differences. The main difference between the two is that with an IPO a company issues and sells new shares of stock, while with a direct listing shareholders sell existing shares.
Comparing the Direct Listing and IPO Process
The differences between using a direct listing vs. an IPO to take a company public are pretty straightforward.
How a Direct Listing Works
If a private company is interested in going public, but doesn’t want the hassle of working with underwriters, they may choose to do a direct listing. With a direct listing, anyone who owns shares in the company can sell them directly to the public once the new company is listed on a public exchange. Shareholders may include investors, promoters, and employees.
By choosing a direct listing over an IPO, a company can avoid using an underwriter, which potentially saves money and time. Underwriters fulfill multiple roles in the IPO process, including working with the fledgling company to meet regulatory standards and set the initial price per share. These are important steps, but not necessary if a new company is only selling existing shares.
Further, because no new shares are created with a direct listing, existing shares won’t get diluted.
💡 Quick Tip: Access to IPO shares before they trade on public exchanges has usually been available only to large institutional investors. That’s changing now, and some brokerages offer pre-listing IPO investing to qualified investors.
How an Initial Public Offering Works
When a company offers shares of stock to the general public for the first time, it’s known as an initial public offering (IPO).
Before an IPO, a company is considered private, which means that shares of stock are not available for sale to the general public. Also, a private company is not generally required to disclose financial information to the public.
To have an IPO, a company must file a prospectus with the Securities and Exchange Commission (SEC). The company will use the prospectus to solicit investors, and it includes key information like the terms of the securities offered and the business’s overall financials.
Initial public offerings are a popular choice for companies looking to raise capital. The company works with an underwriter (typically part of an investment bank), who helps navigate regulations and figure out the initial price of the shares. They may also purchase shares from the company and sell them to investors (such as mutual funds, insurance companies, investment banks, and broker-dealers) who will in turn sell them to the public.
One benefit of working with an underwriter is the greenshoe option. This is an agreement that a company can enter into with the underwriter in which the underwriter has the right to sell a greater number of shares during the sale than they originally intended to, if there is a lot of market demand. This can help the company gain additional investment.
Working with an underwriter creates some security for the company, which is one reason so many companies go the route of the IPO.
Pros and Cons of Direct Listings
There are advantages and disadvantages for companies and investors when it comes to direct listings vs. IPOs.
Pros of a Direct Listing
Less expensive than an IPO for the company
Unlike IPOs, direct listings do not require underwriters, since no new shares are being created. Typically, an underwriter charges a fee between 3% and 7% per share. Depending on the scope of the IPO, these fees can add up to hundreds of millions of dollars.
In addition, underwriters often purchase shares below their agreed-upon market value, so companies don’t receive as much investment as they may have had they sold those shares directly to retail investors.
No lock-up periods for shares
If a company goes through an IPO, existing shareholders are generally not allowed to sell their shares to the public during the sale and for a period of time following the sale. These lock-up periods are required in order to prevent stock prices from decreasing due to an oversupply.
The direct listing model is essentially the opposite, in which existing shareholders sell their stock to the public and no new shares are sold.
Provides liquidity for existing shareholders
Anyone who owns stock in the company can sell their shares during a direct listing.
Cons of a Direct Listing
There are also some potential drawbacks when it comes to direct listings.
Risk that shares won’t sell
With a direct listing, the amount of shares sold is based solely on market demand. Because of this, it’s important for a company to evaluate the market demand for its stock before deciding to go the route of a direct listing.
Companies best suited to direct listings are those that sell directly to consumers and have both a strong, recognizable brand and a business model that the public can easily understand and evaluate.
No help from underwriters with marketing and sales
Underwriters provide guarantees, promotion, and support during the listing process. Without an underwriter involved, the company may find that shares are difficult to sell, there may be legal issues during the sale, and the share price may see extreme swings.
No guarantee of stock price
Just as there is no guarantee that shares will sell, there is also no guarantee of stock price. In contrast, having an underwriter can help manage potentially extreme price swings.
This chart outlines the main points covered above.
| Pros of Direct Listings | Cons of Direct Listings |
|---|---|
| Less expensive than an IPO | Potential for initial volatility |
| No lock-up periods | Risk that shares won’t sell |
| Liquidity for existing shareholders | No help from underwriters |
| No stock price guarantee |
The Takeaway
Direct listings are an appealing alternative to IPOs for private companies who want to go public, thanks in part to lower costs and reduced regulations. A direct listing may also be appealing to retail investors who want to purchase shares from companies that are going public.
Invest in what matters most to you with SoFi Active Invest. In a self-directed account provided by SoFi Securities, you can trade stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, options, and more — all while paying $0 commission on every trade. Other fees may apply. Whether you want to trade after-hours or manage your portfolio using real-time stock insights and analyst ratings, you can invest your way in SoFi's easy-to-use mobile app.
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FAQ
Why would a company do a direct listing?
A direct listing offers a more direct path to going public on a stock exchange. The company doesn’t have to issue new shares, as only existing shares get sold in a direct listing. This eliminates the need for intermediaries like underwriters.
Can anyone buy a direct listing stock?
Yes, investors can buy a direct stock listing as they would any other stock listed on an exchange.
Is a direct offering good for a stock?
Since direct listings bypass the middleman and eliminate the need for underwriters, they can be less expensive for a company vs. IPOs, but the lack of marketing support could hurt the stock price and initial sales.
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.
For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. This should not be considered a recommendation to participate in IPOs 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 more information on the allocation process please visit IPO Allocation Procedures.
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.
¹Probability of Member receiving $1,000 is a probability of 0.026%; If you don’t make a selection in 45 days, you’ll no longer qualify for the promo. Customer must fund their account with a minimum of $50.00 to qualify. Probability percentage is subject to decrease. See full terms and conditions.
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Read moreMay
18
2024
American Option vs European Option: What is the Difference?
Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Two of the most popular types of options are American and European. American and European options have a lot in common, but there are some key differences that are important for investors to understand.
Key Points
• American options offer the flexibility to exercise the buy or sell right on any trading day before expiration.
• European options can only be exercised on the expiration date, limiting flexibility.
• American options are often traded on exchanges, while European options are typically traded over-the-counter.
• The pricing of American options usually includes higher premiums due to their increased flexibility.
• European options are generally less expensive and settle in cash, often related to indices rather than specific stocks.
Options Basics
One of the reasons investors like options trading is that it provides the right, but not the obligation to the buyer, to buy an asset. Making the choice to buy (call) or sell (put) is known as exercising the option.
Like all derivatives, the value of options reflects the value of an underlying asset. The value of an option changes as its expiration approaches and according to the price of the underlying asset. Investors using a naked option trading strategy may not have the cash or assets set aside in their portfolio to meet the obligations of the contract.
If the value of the contract or the underlying asset doesn’t increase, the investor would choose to let it expire and they lose only the premium they paid to enter into the contract. Both put and call options contracts include a predetermined price to which the buyer and seller agree, and the contract is valid for a specified period of time.
After the contract ends on the expiration date, so does the option holder’s ability to buy or sell. There are many different options trading strategies that investors can use.
Recommended: Call vs Put Option: The Differences
What Are American Options?
America options are the most popular, with both retail investors and institutional investors using them. One of the reasons for their popularity is their flexibility. Traders can exercise their right to buy or sell the asset on any trading day during the term of the agreement.
Most often, American stock options contracts have an expiration period between three and twelve months.
American Option Example
Say an investor purchases an American call in March with a one-year expiry date. The contract states that the investor has the option to purchase stock in Company X for $25 per share. In options terminology, $25 would be known as the option’s strike price. As the price of the underlying stock asset changes, the value of the option also changes.
After the investor purchases the American call options, the value of the stock increases. Within a few months the price was $50. The investor decides to exercise their option to buy, purchasing 100 shares of the stock at the agreed upon strike price of $25/share, paying a total of $2,500. The investor then sells the shares at the current market price of $50/share, making a profit of $2,500 because their value had doubled, not including the premium paid.
Investors can also buy put options, which give them the right to sell instead of the right to buy. With put options the scenario is reversed in that the investor would exercise their right to sell if the asset decreased in value.
Finally, user-friendly options trading is here.*
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*Check out the OCC Options Disclosure Document.
What Are European Options?
European options are similar to American options, but holders can only exercise them on the expiration date (not before), making them less flexible.
European Options Example
Let’s say an investor purchases a European call option for 100 shares of Company X with a strike price of $25 and an expiration date six months from the time of purchase. Three months after the contract starts, the price of the stock increases to $50/share. The investor can’t exercise the right to buy because the contract hasn’t reached the expiration date.
When the option holder is able to exercise three months later, the stock is down to $30/share. So the investor can still exercise the option and make a profit by purchasing 100 shares at $25 and selling them for $30. The investor would also need to subtract the upfront premium they made, so this scenario wouldn’t be nearly as profitable as the American option scenario.
This is why European options are not as valuable or popular as American options. Options pricing reflects this difference. The premium, or price to enter into a European option contract is lower. However, traders can sell their European options at any point during the contract period, so in the example above the trader could have sold the option for a profit when the stock price went up to $50/share.
💡 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.
American Style Options vs European Style
American and European options are similar in that they have a set strike price and expiration date. But there are several key differences between American and European options. These include how they’re traded, associated premiums, and more.
Trading
One main difference between American and European options is traders typically buy and sell European options over-the-counter (OTC) and American options on exchanges.
Recommended: What Is the Eurex Exchange?
Premiums
American options typically have higher premiums than European options since they offer more flexibility. If the investor doesn’t exercise their right to buy or sell before the contract expires, they lose the premium.
Settlement
European options tend to relate to indices, so they settle in cash. American options, on the other hand, typically relate to individual stocks or exchange-traded funds and can settle in stock or cash.
Settlement Prices
With American options, the settlement price is the last closing trade price, while with European options the settlement price is the opening price of index components.
Volume
American options typically have a much higher trading volume than European options.
Exercising Options
Traders can only exercise European options at the expiration date, while they can exercise American options at any point during the contract period. Traders can sell either type of option before its expiration date.
Pricing Models
A popular pricing model for options is called the Black-Scholes Model. The model is less accurate for American options because it can’t consider all possible trading dates prior to the expiration date.
Underlying Assets
The underlying assets of most American options are related to equities, European options are typically pegged to indices.
Risks of Americans and European Options
American options are riskier to an options seller because the holder can choose to exercise them at any time.
For buyers, it’s easier to create a hedging strategy with European options since the holder knows when they can exercise their right to buy or sell. Day traders and others who invest in options realize that there are risks involved with all investing strategies, along with potential reward.
The Takeaway
Options are one commonly traded type of investment, and many traders use them to execute a trading strategy. However, it’s possible to build a portfolio without trading options as well. If you have questions about how options may fit into your investment strategy, it may be a good idea to speak with a financial professional.
SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.
With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.
Photo credit: iStock/AleksandarNakic
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.
For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
¹Probability of Member receiving $1,000 is a probability of 0.026%; If you don’t make a selection in 45 days, you’ll no longer qualify for the promo. Customer must fund their account with a minimum of $50.00 to qualify. Probability percentage is subject to decrease. See full terms and conditions.
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May
18
2024
What Is a Stock Split? How Does It Affect Investors?
Table of Contents
A skyrocketing share price is usually a good thing for a company; investors expect the company to continue growing in the future. However, a stock trading with a hefty price tag may frighten away smaller investors, who may perceive the stock as too rich for their blood. That means many investors might pass over the company’s stock for other stocks with a lower per share price tag.
To combat this, a company may conduct a stock split. This action brings down the price of the company’s stock so that shares look more attractive to more investors, even though the company’s value remains the same. The idea is that investors can invest, and the company gets more marketability and liquidity on the stock market.
Learn more about a stock split and how it works.
Key Points
• A stock split is when a company increases the number of its outstanding shares on the stock market, lowering the price per share.
• Stock splits can make shares more affordable to retail investors and increase liquidity in the market.
• There are different types of stock splits, including forward stock splits and reverse stock splits.
• Companies conduct stock splits to make their stock more accessible and increase marketability.
• Stock splits can have pros such as increased accessibility and liquidity, but also cons such as potential expenses and dilution of ownership.
What Is a Stock Split?
A stock split is when a company increases the number of its outstanding shares on the stock market, which lowers the price of its shares, but its market capitalization (sometimes referred to as market cap) stays the same. This is also known as a forward stock split.
For example, if an investor owns 10 shares of a company with a stock price of $100 and the company announces a 5-to-1 stock split, the investor will then own 50 shares of the stock trading at $20 per share after the stock split. Despite the split, the shareholder still owns $1,000 worth of stock.
A stock split may also be referred to as a one-time stock dividend, since the company is giving out additional shares to stockholders.
What Is a Reverse Stock Split?
In a reverse stock split, a company swaps each outstanding share of the company’s stock for a fraction of a share. A company often conducts a reverse stock split when the share price is low and the company is looking to increase the share price.
For example, in late July 2021, General Electric (GE) completed a 1-for-8 reverse split of its shares to boost the stock’s share price. The reverse split increased its share price from less than $13 pre-split to more than $100 post-split; the company replaced every eight shares held by an investor with one share.
💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.
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Types of Stock Splits
A number of different ratios can be used to split a stock. When the bigger number comes first in the ratio (such as 2 for 1) it means that the number of outstanding shares will increase—this is a forward stock split. In other words, the stock split ratio can reveal the number of new shares that will be created.
Here are some common stock split types and what they mean.
5 for 1 (5:1)
With a 5 for 1 stock split, for every one share of stock that currently exists, four new shares will be created, for a total of five shares. The share price will adjust downward accordingly, but the company’s market capitalization will stay the same.
2 for 1 (2:1)
In a 2 for 1 stock split, one new share of stock is created for every share that already exists, for a total of two shares. Again, the price for each share will adjust accordingly. A 2 for 1 stock split is one of the most common stock splits.
3 for 1 (3:1)
With a 3 for 1 split, for every share of existing stock, two more shares of stock are created, for a total of 3 shares.
3 for 2 (3:2)
Another fairly common stock split is the 3 for 2 split. In this case, one new share of stock is created for two already-existing shares, for a total of three shares.
Why Do Companies Conduct Stock Splits?
Companies will often split their stock when the share price gets too high. By splitting the stock, a company lowers its share price and makes it more affordable to retail investors, even though the company’s value stays the same.
For example, retail investors may be more likely to buy a chunk of shares of a stock trading at $20 rather than shares trading at $100 or more. This move to reduce the individual share price helps increase the stock’s liquidity in the market.
Pros and Cons of Stock Splits
There are several potential benefits of stock splits, but there are some possible disadvantages of the practice as well.
Pros
Some advantages of a stock split include:
The stock may become more accessible to more investors.
If a stock’s price is very high, smaller investors may be less likely to buy it. Splitting the stock and making it more affordable can result in more investors purchasing the stock.
The stock may have greater liquidity.
Creating more outstanding shares of the stock can make it easier to buy and sell it. For many investors, greater liquidity means they can more readily access their money by selling the stock if they need the funds. Liquidity is typically an important consideration when building a portfolio.
The stock’s price may rise.
Companies that undergo a stock split often do so because their stock price is rising, signaling investor confidence in the company. So, the announcement of a stock split is an indication that the company is doing well. Investors may want to put money into the company, pushing the share price up even before the stock split.
Following the stock split, the stock’s share price may go up because the lower price makes it more affordable to smaller retail investors that may not be able to purchase shares at, say, a $1,000 price. There becomes an increased demand for the lower share price.
Cons
Stock splits can also have drawbacks, such as:
Expensive and complicated.
In order to conduct a stock split, a company must get legal oversight of the process and meet regulatory requirements, which can be costly. A stock split does not change the company’s market cap, so the company must determine whether a split is worth the expense involved.
May attract too many investors.
A company may prefer to keep ownership of its shares exclusive. However, with a stock split, many more investors may be able to afford to buy the stock, meaning the shares would lose their exclusive equity ownership.
Potential for the share price to drop in the future.
It’s possible that once a stock is split and its share price is reduced, the price might drop even lower in the future, which lowers the value of the stock. For instance, if a company’s performance suffers, the face value of the stock might drop more in response.
Examples of Stock Splits Throughout History
Here are some notable stock splits from the last couple of decades:
• Apple (AAPL): The computer giant split its stock by a 4-to-1 ratio in August 2020. Prior to the split, the stock was trading at around $500. After the split, the stock traded at about $124.
• Netflix (NFLX): The entertainment company announced a 7-to-1 stock split in July 2015. Before the split, the stock was trading at nearly $800 per share. After the split, the stock traded at about $114.
• Nike (NKE): The sports apparel company split its stock by a 2-to-1 ratio in December 2015. Prior to the split, the stock was trading at around $128 per share. After the split the stock traded at about $64 per share.
• Nvidia (NVDA): The technology company engaged in a 4-to-1 stock split in July 2021. Before the split, Apple’s stock was trading at around $750, and after the split, the shares were priced near $187.
• Tesla (TSLA): The electric car manufacturer split its stock by a 5-to-1 ratio in August 2020. Before the split, the stock was trading at around $2,200. After the split, the stock traded at around $440. Tesla’s shares rallied during the next two years, so the company declared a 3-to-1 stock split in August 2022, bringing the stock price down to around $300 from nearly $900 per share.
💡 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.
What Happens When a Stock You Own Splits?
If an investor owns stock in a company that announces a split, it will not materially affect the investment. As mentioned above, if an investor owns $1,000 worth of stock and a company splits its stock, an investor will still own $1,000 worth of stock after the split.
The additional shares at the lower share price will be automatically added to an investor’s account by the broker.
A stock split does not dilute the ownership of existing shareholders like a new stock issue may do. After a stock split, an investor still owns the same percentage of the company.
Recommended: Understanding Stock Dilution
The Takeaway
When a company announces a stock split, it can be tempting for investors to buy the stock because it will be more affordable on a per share basis. However, investors should be wary of making rash decisions simply because a stock may look more affordable and attractive. After all, the value of the company is still the same.
For most investors, it’s wise to make financial decisions that line up with their long-term investment and wealth-building goals, regardless of a stock’s price tag.
Invest in what matters most to you with SoFi Active Invest. In a self-directed account provided by SoFi Securities, you can trade stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, options, and more — all while paying $0 commission on every trade. Other fees may apply. Whether you want to trade after-hours or manage your portfolio using real-time stock insights and analyst ratings, you can invest your way in SoFi's easy-to-use mobile app.
FAQ
Are stock splits a good thing?
Generally, a stock split is considered to be a good thing. It typically happens when the price of a company’s stock is high. The high price and value of the stock tends to be a positive sign reflecting that the company is doing well. Splitting the stock may encourage more investment in it, which could then drive up the price of the stock and be beneficial.
Do stocks do better after a split?
It is possible that a stock might do better after a split, but this isn’t always the case. The stock may be bought by more investors, which could drive up its share price. But even after a stock split, the company’s market capitalization doesn’t change. And it’s possible that a stock could drop in price after a split.
Is a stock split bullish or bearish?
A forward stock split, in which more shares of stock are created, is generally considered bullish, since it typically indicates that the company is performing well. However, a reverse stock split, which reduces the total number of shares of a stock, is usually considered bearish, since it may indicate that a company has underperformed.
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.
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
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.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
SoFi Invest is a trade name used by SoFi Wealth LLC and SoFi Securities LLC offering investment products and services. Robo investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser. Brokerage and self-directed investing products offered through SoFi Securities LLC, Member FINRA/SIPC.
For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.
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Read moreMay
15
2024
7 Technical Indicators for Stock Trading
One way traders seek to profit from short-term movements in security prices is by using technical analysis.
While some stock analysis tools examine company fundamentals, technical stock indicators identify patterns in price and volume data to give investors and traders insights about how a stock might move in the future.
For that reason, although technical indicators can assist with trend identification, it’s best to combine different indicators when conducting stock analysis.
Table of Contents
How Do Stock Technical Indicators Work?
Technical analysis uses various sets of data and indicators, such as price and volume, to identify patterns and trends. This type of stock market analysis is different from fundamental analysis, which looks at company financials, industry trends, and macroeconomics.
Rather, technical analysis solely analyzes a stock’s performance. Stock technical indicators are often rendered as a pattern that can overlay a stock’s price chart to predict the market trend, and whether the stock would be considered “overbought” or “oversold.”
Two Main Types of Technical Indicators
Stock technical indicators generally come in two flavors: overlay indicators and oscillators.
Overlay Indicators
An overlay indicator typically overlays one trend onto another on a stock chart, often using different colors to distinguish between the lines.
Oscillator Indicators
An oscillator typically uses metrics such as a stock’s price or trading volume to determine momentum, or rate of change, over time. It uses this info to generate a signal, or trend line, whose fluctuations between two values in a range can indicate if a stock may be overbought or oversold.
If the trend line moves above the higher value of the range, it can indicate a stock is overbought, while dipping below the lower value can indicate it’s oversold. The movements of the trend line thus can help traders determine support and resistance in certain price trends, so they can decide whether to sell or buy (support being the price at which a downturn generally bounces back up, and resistance being the point at which rising prices generally start to fall).
Oscillator indicators can be leading or lagging:
• A leading indicator tracks current market movements to anticipate where the trend is headed next.
• A lagging indicator is based on recent history and seeks patterns that will indicate potential price movements.
The moving average is a common oscillator; it’s considered a lagging indicator as it measures specific intervals in the past.
Naturally, every stock indicator has its pros and cons. Various trading indicators can be used by investors to analyze supply and demand forces on stock price, to help shed light on market psychology, or to manage risk.
But while stock indicators and trading tools can help with buy and sell points, false signals can also occur.
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Reasons to Use Stock Market Indicators
Knowing some of the most popular trading tools might benefit your investing strategy by providing you with easier-to-spot buy and sell signals. You don’t have to know every single technical indicator, and there are many ways to analyze stocks, but using multiple stock indicators may help you improve trading results.
You can also use these stock indicators to help you manage risk when you are actively trading.
Price trend indicators are some of the most important technical trading tools since identifying a security price’s trend is often a first step to forming a trading strategy. Long positions are often initiated during uptrends, while short sale opportunities can occur when prices are in a downtrend.
Volume trend indicators are also helpful to gauge the power or conviction of an asset’s price move. Some believe that the higher the stock volume on a bullish breakout or bearish breakdown, the more confident the move is. Higher volume could signal a lengthier trend continuation.
💡 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.
7 Stock Indicators for Technical Analysis
It’s important to remember that these trading tools were developed based on the belief that mathematically derived patterns may be valuable as predictors of stock movements. Past performance, however, is not a guarantee of future results. So while it can be useful to employ stock technical indicators, they are best used in combination before deciding on a potential trade.
Also, many of these trading tools are lagging indicators, which can lead to an inaccurate reflection of current and future market conditions.
Following are seven of the most common technical stock indicators, along with their advantages and disadvantages.
1. Moving Averages (MA)
A moving average (MA) is the average value of a security over a specific time. The MA can be:
• Exponential Moving Average (EMA)
• Weighted Moving Average (WMA).
A moving average smooths stock price volatility, and is taken as an indicator of the direction a price may be headed. If the price is above the moving average, it’s considered an uptrend versus when the price moves below the MA, which can signal a downtrend.
Moving averages are typically used in combination with each other, or other stock indicators, to identify trends.
Pros
• Using moving averages can filter out the noise that comes from price fluctuations and focus on the overall trend.
• Moving average crossovers are commonly used to pinpoint trend changes.
• You can customize moving average periods: common time frames include 20-day, 30-day, 50-day, 100-day, 200-day.
Cons
• A simple moving average may not help some traders as much as an exponential moving average (EMA), which puts more weight on recent price changes.
• Market turbulence can make the MA less informative.
• Moving averages can be simple, exponential, or weighted, which might be confusing to new traders.
2. Moving Average Convergence Divergence (MACD)
The Moving Average Convergence Divergence (MACD) helps investors gauge whether a security’s movement is bullish or bearish, and helps gauge the momentum of the trend. The MACD uses two different exponential moving averages (EMAs) to do so.
A 26-period EMA is subtracted from a short-term 12-period EMA to generate the MACD line. Then a signal line, based on a nine-day EMA, is plotted on top of the MACD to help reveal buy and sell entry points.
If the MACD line crosses above the signal line, that can signal a buy opportunity. If it crosses below the signal line, that could signal a price decline and an opportunity to sell or take a short position.
Pros
• The MACD, used in combination with the relative strength index (below) can help identify overbought or oversold conditions.
• It can be used to indicate a trend and also momentum.
• Can help spot reversals.
Cons
• The MACD might provide false reversal signals.
• It responds mainly to the speed of price movements; less accurate in gauging the direction of a trend.
3. Relative Strength Index (RSI)
The relative strength index or RSI is an oscillator tool that looks at price fluctuations in a given period and calculates average price losses and gains. It ranges from 0 to 100. Generally, above 70 is considered overbought and under 30 is thought to be oversold.
Traders often use the RSI in conjunction with the MACD to confirm a price trend. The RSI can sometimes identify a divergence, when the indicator moves in opposition to the price; this can show the price trend is weakening.
Pros
• An RSI can help investors spot buy or sell signals.
• It may also help detect bull market or bear market trends.
• It can be combined with moving average indicators to spot breakout trends or reversals.
Cons
• The RSI can move without exhibiting a clear trend.
• The RSI can remain at an overbought or oversold level for a long time, making this tool less useful.
• It does not give clues as to volume trends.
Recommended: 5 Bullish Indicators for a Stock
4. Stochastic Oscillator
Traders will often use the stochastic oscillator, which is a momentum indicator, to determine whether a given security is overbought or oversold. The stochastic oscillator allows traders to compare a specific closing price of a security to a range of its prices over a certain time frame.
By using a stochastic chart, traders can gauge the momentum of a security’s price with the aim of anticipating trends and reversals. A stochastic oscillator uses a range of 0 to 100 to determine if an asset is overbought (when the measurements are above 80) or oversold (when the measurement is below 20).
Pros
• Clearer entry/exit signals: The oscillator has a basic design and generates visual signals when it reaches the outer bounds of a price range. This can help a trader determine when it may be time to buy or to sell stocks.
• Frequent signals: For more active traders who trade on intraday charts such as the 5-, 10-, or 15-minute time frames, the stochastic oscillator generates signals more often as price action oscillates in smaller ranges.
• Easy to understand: The oscillator’s fluctuating lines are fairly clear for investors who know how to use them.
Cons
• Possible false signals: Depending on the time settings chosen, traders may misperceive a sharp oscillation as a buy or sell signal, especially if it goes against the trend. This is more common during periods of market volatility.
• Doesn’t measure the trend or direction: It calculates the strength or weakness of price action in a market, not the overall trend or direction.
💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.
5. On-Balance Volume (OBV)
OBV is a little different from the other indicators mentioned. It primarily uses volume flow to gauge future price action on a security or market. When there’s a new OBV peak, it generally indicates that buyers are strong, sellers are weak, and the price of the security may increase.
Similarly, a new OBV low is taken to mean that sellers are strong and buyers are weak, and the price is trending down.
The numerical value of the OBV isn’t important — it’s the direction that matters. In that respect it can be used as a trend confirmation tool. It can also signal divergences, when the price and the volume move in opposite directions.
Pros
• Volume-based indicator gauges market sentiment to predict a bullish or bearish outcome.
• OBV can be used to confirm price action and identify divergences.
Cons
• It can be hard to find definitive buy and sell price levels.
• False signals can happen when divergences and confirmations fail.
• Volume surges can distort the indicator for short-term traders.
Recommended: How to Find Portfolio Beta
6. Accumulation / Distribution Line (ADL)
The accumulation/distribution line (ADL) looks at the trading range for a certain stock, and uses price and volume data to gauge whether shares are being accumulated or distributed. Like OBV it also looks for divergences, so that if a price trend isn’t supported by volume flow it could indicate the trend is about to reverse.
Although this sounds similar to OBV, they are calculated differently, and the ADL gives more attention to price and volume data within a specified range.
Pros
• Traders can use the ADL to spot divergences in price compared with volume that can confirm price trends or signal reversals.
• The ADL can be used as an indicator of the flow of cash in the market.
Cons
• It doesn’t capture trading gaps or factor in their impact.
• Smaller changes in volume are hard to detect.
7. Standard Deviation
Standard deviation measures the extent to which a data point deviates from an expected value, i.e. the mean return. When used as a technical indicator, standard deviation is a common stock volatility measure; it refers to how far a stock’s performance varies from its average.
Investors often measure an investment’s volatility by the standard deviation of returns compared with a broader market index or past returns.
Pros
• Standard deviation mathematically captures the volatility of a stock’s movements, i.e. how far the price moves from the mean.
• It provides technicians with an estimate for expected price movements.
• It can be used to measure expected risk and return.
Cons
• It does not provide precise buy and sell signals.
• It must be used in conjunction with other indicators.
The Takeaway
Technical analysis tools use past price and volume data to help traders identify price trends and make buy and sell decisions. It’s important to know that technical analysis does not use fundamentals to assess the underlying companies, their industries, or any macroeconomic trends that might drive their success or failure. Rather, technical analysis solely analyzes the movement and volume inherent in a stock’s performance.
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FAQ
What is the most popular technical indicator for stocks?
Traders typically combine technical indicators, so it’s difficult to point to one as being a top choice. That said, many traders use the moving average indicators in combination with others to gauge price trends.
What is the most accurate indicator of the stock market?
There is no single indicator that can anticipate overall stock market performance. In fact, it’s an important factor to keep in mind when using technical indicators: For every successful price prediction or winning trade, there are countless others that don’t pan out. There are no crystal balls.
Which indicator gives buy and sell signals?
Different traders favor different indicators when looking for signals about how to place a trade. That said, the stochastic oscillator is relatively clear-cut in that it can help traders identify buy and sell opportunities based on price closes and trends within a certain range.
Photo credit: iStock/staticnak1983
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