Aug
08
2024
In the Money (ITM) vs Out of the Money (OTM) Options

In the Money vs Out of the Money Options: Main Differences

By | Growing Wealth, invest, Investing | Comments Off on In the Money vs Out of the Money Options: Main Differences

In options trading, knowing the difference between being “in the money” (ITM) and “out of the money” (OTM) allows the holder of a contract to know whether they’ll enjoy a profit from their option. The terms refer to the relationship between the options strike price and the market value of the underlying asset.

“In the money” refers to options that have profit potential if exercised today, while “out of the money” refers to those that do not. In the rare case that the market price of an underlying security reaches the strike price of an option exactly at the time of expiry, this would be called an “at the money option.”

Key Points

•   Understanding the difference between “in the money” and “out of the money” options is crucial for options traders to gauge potential profitability.

•   Options classified as “in the money” have intrinsic value and can yield profits when exercised, while “out of the money” options lack intrinsic value and may expire worthless.

•   The potential for profit from options depends on the relationship between the strike price and the current market price of the underlying asset.

•   Higher volatility often leads to options being written “out of the money,” appealing to speculators due to lower premiums and potential for larger price swings.

•   Decisions to buy “in the money” or “out of the money” options should align with an investor’s goals, risk tolerance, and confidence in the underlying asset’s future performance.

What Does “In the Money” Mean?

In the money (ITM) describes a contract that would be profitable if its owner were to choose to exercise the option today. If this is the case, the option is said to have intrinsic value.

A call option would be in the money if the strike price is lower than the current market price of the underlying security. An investor holding such a contract could exercise the option to buy the security at a discount and sell it for a profit right away.

Put options, which are a way to short a stock, would be in the money if the strike price is higher than the current market price of the underlying security. A contract of this nature allows the holder to sell the security at a higher price than it currently trades for and pocket the difference.

In either case, an in the money contract has intrinsic value, so the options trader can exercise the option and make money doing so.


💡 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.

Example of In the Money

For example, say an investor owns a call option with a strike price of $15 on a stock currently trading at $16 per share. This option would be in the money because its owner could exercise the option to realize a profit. The contract gives the holder the right to buy 100 shares of the stock at $15, even though the market price is currently $16.

The contract holder could take shares acquired through the contract for a total of $1,500 and sell them for $1,600, realizing a profit of $100 minus the premium paid for the contract and any associated trading fees or commissions.

While call options give the holder the right to buy a security, put options give holders the right to sell. For example, say an investor owns a put option with a strike price of $10 on a stock that is trading at $9 per share. This would be an in the money option. The holder could sell 100 shares of stock at a price of $10 for a total of $1,000, even though it only costs $900 to buy those same shares. The contract holder would realize that difference of $100 as profit, minus the premium and any fees.

What Does “Out of the Money” Mean?

Out of the money (OTM) is the opposite of being in the money. OTM contracts do not have intrinsic value. If an option is out of the money at the time of expiration, the contract will expire worthless. Options are out of the money when the relation of their strike prices to the current market price of their securities are opposite that of in the money options.

For calls, an option with a strike price higher than the current price of the underlying security would be out of the money. Exercising such an option would result in an investor buying a security for a price higher than its current market value.

For puts, an option with a strike price lower than the current price of its security would be out of the money. Exercising such an option would cause an investor to sell a security at a price lower than its current market value.

In either case, contracts are out of the money because they don’t have intrinsic value – anyone exercising those contracts would lose money.

Example of Out of the Money

Say an investor buys a call option with a strike price of $15 on a stock currently trading at $13. This option would be out of the money. An investor might buy an option like this in the hopes that the stock will rise above the strike price before expiration, in which case a profit could be realized.

Another example would be an investor buying a put option with a strike price of $7 on a stock currently trading at $10. This would also be an out of the money option. An investor might buy this kind of option with the belief that the stock will fall below the strike price before expiration.


💡 Quick Tip: In order to profit from purchasing a stock, the price has to rise. But an options account offers more flexibility, and an options trader might gain if the price rises or falls. This is a high-risk strategy, and investors can lose money if the trade moves in the wrong direction.

What’s the Difference Between In the Money and Out of the Money?

The premium of an options contract involves two different factors: intrinsic value and extrinsic value. Options that have intrinsic value at the time they are written to have a strike price that is profitable relative to the current market price. In other words, such options are already in the money when written.

But not all options are written ITM. Those without intrinsic value rely instead on their extrinsic value. This value comes from speculative bets that investors make over a period of time. For this reason, assets with higher volatility often have their options contracts written out of the money, as investors expect there to be bigger price swings. Conversely, assets considered to be less volatile often have their options written in the money.

Options written out of the money are ideal for speculators because such contracts come with less expensive premiums and are often created for more volatile assets.

Recommended: Popular Options Trading Terminology to Know

Should I Buy ITM or OTM Options?

The answer to this question depends on an investor’s goals and risk tolerance. Options that are further out of the money can be more rewarding, but come with greater risk, uncertainty, and volatility. Whether an option is in or out of the money (and how far they’re out of the money), and the amount of time before the expiry of the option impacts the premium for that option, with riskier options typically costing more.

Whether to buy ITM or OTM options also depends on how confident an investor feels about the future of the underlying security. If a trader feels fairly certain that a particular stock will trade at a much higher price three months from now, then they might not hesitate to buy a call option with a very high strike price, making it out of the money.

Conversely, if an investor thinks a stock will fall in price, they can buy a put option with a very low strike price, which would also make the option out of the money.

Beginners and those with lower risk tolerance may prefer buying options that are only somewhat out of the money or those that are in the money. These options usually have lower premiums, meaning they cost less to buy. There are also generally greater odds that the contract will wind up in the money before expiration, as it will take a less dramatic move to make that happen.

Investors can also choose to combine multiple options legs into a spread strategy that attempts to take advantage of both possibilities.

Recommended: 10 Important Options Trading Strategies

The Takeaway

In options trading, “in the money” refers to options that have profit potential if exercised immediately, while “out of the money” refers to those that don’t. Options contracts don’t have to be exercised to realize a profit. Sometimes investors buy contracts with the intent of selling them on the open market soon after they become in the money for quick gains.

In either case, it’s important to consider if an option is in the money or out of the money when buying or writing options contracts, as well as when deciding when to execute them. Options trading is an advanced investing strategy, and investors should know what they’re doing before engaging with it – or should speak with a financial professional for guidance.

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

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

Photo credit: iStock/damircudic

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.

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.
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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08
2024
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Average Stockbroker Commission Percentage

By | Growing Wealth, invest, Investing | Comments Off on Average Stockbroker Commission Percentage

Moving money around and buying securities isn’t free, and on average, a stockbroker or brokerage will charge a commission between 1% and 2%. Investing in the stock market is usually alluring for those trying to grow their money. Stockbrokers often charge commissions and other fees for the use of their services, but note that these brokerage fees can vary widely.

Investors must pay attention to average brokerage fees when making investment decisions; finding the right broker can play a significant role in long-term financial outcomes. Before delving into how much stockbrokers typically charge for their services, it’s worth understanding their role in an individual’s investment strategy.

Key Points

•   Stockbrokers typically charge commissions ranging from 1% to 2% of the total transaction value, influencing long-term investment outcomes significantly.

•   There are two main types of stockbrokers: full-service, which offers comprehensive services and higher fees, and discount brokers, which charge lower, per-transaction fees.

•   Common brokerage fees include management fees, trading commissions, and retirement account fees, all of which can impact overall investment returns.

•   High brokerage fees can discourage investment and reduce long-term gains, making it essential for investors to understand and compare costs associated with different brokers.

•   Despite the costs, using a stockbroker can provide valuable resources and guidance for novice investors navigating complex financial markets.

What Does a Stockbroker Do?

A stockbroker, or investment broker, is an individual or firm that charges a fee or commission to buy or sell stocks and other securities on behalf of their clients. Using a stockbroker is relatively common for people looking to invest in the market.

Buying stocks isn’t like making other purchases because the channels through which stocks are bought and sold are fairly controlled. While an individual buying a computer could choose to purchase directly from a manufacturer, a store, or a friend, the channels for buying stocks are much more limited. Generally, purchases of stock are required to flow through a stockbroker.

However, there are some instances when someone may buy stocks without a broker, including buying and selling through direct stock and dividend reinvestment plans.

In addition to selling shares of companies, a stockbroker may also sell other traded securities such as mutual funds and exchange-traded funds (ETFs).

What Is the Average Stock Broker Commission Fee?

The amount charged by a brokerage firm for its services can vary greatly. Some firms may charge a flat fee for their services, while others may charge a percentage of the overall value of the transaction. The average fee charged by brokerage firms is typically between 1% and 2% of the total transaction value.

Full-Service vs Discount Stockbrokers

The main two categories of stockbrokers are full-service brokers and discount brokers. You want to understand the differences before opening a brokerage account.

A full-service brokerage firm offers a more hands-on service, helping clients balance their portfolios and providing other investment advice. Discount brokers allow an investor to buy and sell stock and other assets, but provide few add-ons but still. Commission rates and additional fees vary accordingly.

Because full-service stockbrokers provide an array of services, they typically base their commissions on a more all-inclusive model determined by the value of the investments they manage. While there may also be additional fees, the typical commission structure for a full-service broker is known as the percentage of assets under management. The cost is charged annually and is listed within fee schedules as “x%/AUM” (assets under management).

Discount brokers, on the other hand, typically charge a per-transaction flat stock trade fee, regardless of the type of stock or number of shares being bought or sold.

For example, if the stock trade fee is $5 per trade, that’s what an individual would pay whether they were buying five shares of a stock valued at $50 a share ($250) or 500 shares ($25,000).

However, many discount brokers do not charge commissions for trading stocks.

Get up to $1,000 in stock when you fund a new Active Invest account.*

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*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.

Common Brokerage Fees

Various investment fees and costs are associated with the buying and selling of investments. Investors should consider these brokerage fees when choosing a broker and deciding what investments to make.

Management Fees

An investment’s management fee is the fee the investment manager charges for its services. This fee is typically a percentage of the investment’s assets under management and is deducted from the investment’s returns.

If you use a full-service brokerage that offers money management services, they will often charge a management fee. Some charge as much as 2%, and others may charge less. Generally speaking, the more money you have invested with a broker or money manager, the lower your management fee will be.

Commission For Trading

Many brokerage firms charge a commission for making trades on behalf of clients. Fees and commissions vary widely depending on the type of transaction and broker. Again, those fees can be based on a percentage of the transaction’s value — usually between 1% to 2% — or they can be a flat fee.

The commissions for trading depend on whether an investor uses a full-service or discount broker. Because full-service brokers offer a wide range of advice and services, their commissions per trade may be higher than a discount or online brokerage might charge.

Discount brokers offer fewer advice and services, so they can charge a lower flat fee per trade, from less than $5 to more than $30. In recent years, the biggest online brokerage firms have offered no commission trading, partly due to competition and because they instead get paid through a practice known as payment for order flow.

Retirement Account Fees: 401(k)

If you have a 401(k) account through your employer, there are several fees to keep in mind when making your investments.

First, you’ll likely be charged an administration fee to maintain the plan. These fees may range from 0.5% to more than 2% of your 401(k) balance. The 401(k) provider charges this fee to your employer, and the cost is usually passed down to the employees.

Additionally, the actual investments in your 401(k), like mutual funds and ETFs, charge management fees that you’ll have to pay.

Mutual Fund Fees

Investors interested in buying and selling mutual funds must consider the fees associated with these investment vehicles.

Expense Ratio

The expense ratio is the yearly cost that mutual funds and ETFs charge investors to cover operating costs. The expense ratio measures the total costs as a percentage of the fund’s total assets. The fund’s costs may include management, custodial, marketing, and other expenses.

The average expense ratio for an actively managed mutual fund ranges from 0.5% to 1.0%, while passive funds have an average expense ratio of 0.2%.

The costs of operating the mutual fund are deducted from your investment, reducing your returns each year.

Sales Load

Mutual fund investors may pay sales loads — also known as sales charges — when they buy or sell shares of the fund. The sales load is how the broker or advisor gets paid for their service.

A sales load isn’t a flat transaction fee, however. Instead, it’s a percentage of the assets invested. FINRA caps mutual fund sales loads at 8.5%, though the common range is between 3% and 6%.

Brokerage Fee Impact on Investments Long-Term

Brokerage and investment fees and commissions can eat away at long-term gains. Thus, working with a brokerage that charges lower fees may help you achieve your long-term financial goals sooner, as you’ll be paying fewer fees.

To illustrate, if full-service brokerage charges a 1.5% annual management fee on a $50,000 portfolio, that costs $750 for the investor during a single year. While that charge doesn’t seem significant for one year, those fees will add up and eat into overall returns over time.

Brokerage Fee Pros

One of the benefits of using a brokerage is that you have access to valuable resources, research, and advice. These services may help you make better investment decisions, leading to better financial outcomes. So, you may get what you pay for, even if you think the fees may be steep.

Brokerage Fee Cons

As noted above, brokerage fees can be expensive and eat into investment returns. This is especially a problem if you don’t do your homework and pay attention to all the fees charged by brokers and the kind of investments you make.

Additionally, high brokerage fees may discourage some people from investing, leading to poor long-term financial outcomes.

Is It Worth Using a Stockbroker?

Using a stockbroker, especially a full-service brokerage, can be ideal for investors intimidated by complicated financial markets. The idea of having a licensed professional guide novice investors through every investment decision and trade might seem like a good way to get more comfortable with the principles of investing. But as the above examples illustrate, the average full-service stockbroker commission can make the full-service approach expensive.

The Takeaway

A stockbroker or brokerage will charge a commission between 1% and 2%, but there are options on the market that charge no commissions at all, and other investment vehicles with similar fees or commission charges.

With long-term returns that have historically outpaced interest rates on savings, investing in the stock market can be a powerful strategy for financial growth. Even beginners may find investing less intimidating than they thought — and possibly steer clear of high stockbroker fees.

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

How do stock brokerage fees work?

Stock brokerage fees are typically a commission that a broker charges for executing trades on behalf of their clients. These fees can vary depending on the type of trade being executed, as well as the broker’s commission structure.

Are there any alternatives to a brokerage fee?

A brokerage fee is a charge assessed by a broker for their services, which typically include advice, transaction execution, and asset management. There are a variety of alternatives to brokerage fees, including flat fees, subscription fees, and performance-based fees.

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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2024
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Day Trading Strategies for Beginners

By | Growing Wealth, Investing | No Comments

Day trading is a type of active trading where an investor buys and sells stocks or other assets based on short-term price movements. Day trading is often thought to differ from a buy-and-hold strategy typically used by long-term investors.

With day trading, the investor is not necessarily looking for assets that will make money over the long-term. Instead, a day trader seeks to generate short-term gains.

Investors should know, though, that day trading is an incredibly risky strategy and there’s a high chance of losing money.

Key Points

•   Day trading involves buying and selling assets within short time frames to capitalize on price fluctuations, differing significantly from long-term investment strategies.

•   Various day trading strategies include technical analysis, swing trading, momentum trading, and scalping, each employing distinct methods to achieve short-term profits.

•   Successful day traders prioritize liquidity, volatility, and high trading volume, enabling rapid execution of trades while minimizing potential losses from price swings.

•   Risk management is crucial in day trading; investors should only risk capital they can afford to lose and remain disciplined to avoid emotional decision-making.

•   Understanding trading costs, tax implications, and regulations is essential for day traders to navigate the complexities of the market and optimize their strategies.

What Is Day Trading?

Day trading incorporates short-term trades on a daily or weekly basis in an effort to generate returns. The Securities and Exchange Commission (SEC) says that “day traders buy, sell and short-sell stocks throughout the day in the hope that the stocks continue climbing or falling in value for the seconds or minutes they hold the shares, allowing them to lock in quick profits.”

A long-term investor, conversely, may buy a stock because they think that the company will grow its revenue and earnings, creating value for itself and the economy. Long-term investors believe that that growth will ultimately benefit shareholders, whether through share-price appreciation or dividend payouts.

A day trader, on the other hand, likely gives little credence to whether a company represents “good” or “bad” value. Instead, they are concerned with how price volatility will push an asset like a stock higher in the near-term.

Day trading is a form of self-directed active investing, whereby an investor attempts to manage their investments and outperform or “beat” the stock market.

Recommended: A User’s Guide to Day Trading Terminology

7 Common Day Trading Strategies

Some common types of day trading strategies that you may want to research include technical analysis, scalping, momentum, swing trading, margin and so on. Here’s a closer look at them.

1. Technical Analysis

Technical analysis is a type of trading method that uses price patterns to forecast future movement. A general rule of thumb in investing is that past performance never guarantees future results. However, technical analysts believe that because of market psychology, history tends to repeat itself.

Support and resistance are price levels that traders look at when they’re applying technical analysis. “Support” is where the price of an asset tends to stop falling and “resistance” is where the price tends to stop climbing. So, for instance, if an asset falls to a support level, some may believe that buyers are likely to swoop in at that point.

2. Swing Trading

Swing trading is a type of stock market trading that attempts to capitalize on short-term price momentum in the market. The swings can be to the upside or to the downside and typically from a couple days to roughly two weeks.

Generally, a swing trader uses a mix of fundamental and technical analysis to identify short- and mid-term trends in the market. They can go both long and short in market positions, and use stocks, ETFs, and other market instruments that exhibit volatility.

3. Momentum Trading

Momentum trading is a type of short-term, high-risk trading strategy. While momentum trades can be held for longer periods when trends continue, the term generally refers to trades that are held for a day or several days, on average.

Momentum traders strive to chase the market by identifying the trend in price action of a specific security and extract profit by predicting its near-term future movement. Looking for a good entry point when prices fall and then determining a profitable exit point is the method to momentum trading.

4. Scalp Trading

In scalp trading, or scalping, the goal of this trading style is to make profits off of small changes in asset prices. Generally, this means buying a stock, waiting for it to increase in value by a small amount, then selling it. The theory behind it is that many small gains can add up to a significant profit over time.

5. Penny Stocks

Penny stocks — shares priced at pennies to up to $5 apiece — are often popular among day traders. However, they can be difficult to trade because many are illiquid. Penny stocks aren’t typically traded on the major exchanges, further increasing potential difficulties with trading. Typically, penny stocks sell in over-the-counter (OTC) markets.

6. Limit and Market Orders

There are types of orders that day traders quickly become familiar with. A limit order is when an investor sets the price at which they’d like to buy or sell a stock. For example, you only want to buy a stock if it falls below $40 per share, or sell it if the price rises to over $60. A limit order guarantees a particular price but does not guarantee execution.

With a market order, you are guaranteed execution but not necessarily price. Investors get the next price available at that time. This price may be slightly different than what is quoted, as the price of that underlying security changes while the order goes through.

7. Margin Trading

Margin accounts are a type of brokerage account that allows the investor to borrow money from the broker-dealer to purchase securities. The account acts as collateral for the loan. The interest rate on the borrowed money is determined by the brokerage firm.

Trading with this borrowed money — called margin trading — increases an investor’s purchasing power, but comes with much higher risk. If the securities lose value, an investor could be left losing more cash than they originally invested.

In the case that the investor’s holdings decline, the brokerage firm might require them to deposit additional cash or securities into their account, or sell the securities to cover the loss. This is known as a margin call. A brokerage firm can deliver a margin call without advance notice and can even decide which of the investor’s holdings are sold.

Best Securities For Day Trading

Day traders can work across asset classes and securities: company stocks, fractional shares, ETFs, bonds, fiat currencies, cryptocurrencies, or commodities like oil and precious metals. They can also trade options or futures — different types of derivatives contracts.

But there are some commonalities that day-trading markets tend to have, including liquidity, volatility, and volume.

Liquidity

Liquidity refers to how quickly an asset can be bought and sold without causing a significant change in its price. In other words, how smoothly can a trader make a trade?

Liquidity is important to day traders because they need to move in and out of positions quickly without having prices move against them. That means prices don’t move higher when day traders are buying, or move down when they’re starting to sell.

Volatility

Market volatility can often be considered a negative thing in investing. However, for day traders, volatility can be essential because they need big price swings to potentially capture profits.

Of course, volatility could mean big losses for day traders too, but a slow-moving market typically doesn’t offer much opportunity for day traders.

Volume

High stock volume may indicate that there is a lot of interest in a security, while low volume can indicate the opposite. Elevated interest means there’s a greater likelihood of more liquidity and volatility — which are, as discussed, two other characteristics that day traders look for.

💡 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.

Day Trading Basics — How to Get Started

Before starting to day trade, some investors set aside a dollar amount they’re comfortable investing — and potentially losing. They need to figure out their personal risk tolerance, in other words.

Getting the hang of day trading can take some time, so newbie day traders may want to start with a small handful of stocks. This will be more manageable and give traders time to hone their skills.

Recommended: How Many Stocks Should I Own?

Good day traders can benefit from staying informed about events that may cause big price shifts. These can range from economic and geopolitical news to specific company developments.

Here’s also a list of important concepts or terms every prospective day trader should know.

1. Trading Costs

If you’re utilizing day trading strategies, it’s wise to consider the cost. Many major brokerage firms accommodate day trading, but some charge a fee for each trade. This is called a transaction cost, commission, mark up, mark down, or a trading fee. Some firms also charge various other fees for day trading or trading penny stocks.

Some platforms are specifically designed for day trading, offering low-cost or even zero-cost trades and a variety of features to help traders research and track markets.

2. Pattern Day Trader

A pattern day trader is a designation created by the Financial Industry Regulatory Authority (FINRA). A brokerage or investing platform will classify investors as pattern day traders if they day trade a security four or more times in five business days, and the number of day trades accounts for more than 6% of their total trading activity for that same five-day period.

When investors get identified as pattern day traders, they must have at least $25,000 in their trading account. Otherwise, the account could get restricted per FINRA’s day-trading margin requirement rules.

3. Freeriding

In a cash account, an investor must pay for the purchase of a security before selling it. Freeriding occurs when an investor buys and then sells a security without first paying for it.

This is not allowed under the Federal Reserve Board’s Regulation T. In cases where freeriding occurs, the investor’s account may be frozen by the broker for a 90-day period. During the freeze, an investor is still able to make trades or purchases but must pay for them fully on the date of the trade.

4. Tax Implications of Trader vs Investor

The IRS makes a distinction between a trader and an investor. Generally, an investor is someone who buys and sells securities for personal investment. A trader on the other hand is considered by the law to be in business. The tax implications are different for each.

According to the IRS, a trader must meet the following requirements below. If an individual does not meet these guidelines, they are considered an investor.

•   “You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation;

•   Your activity must be substantial; and

•   You must carry on the activity with continuity and regularity.”

5. Capital Gains Taxes

Another important tax implication to note is that the IRS differentiates between short-term and long-term investments for capital gains tax rates. Generally, investments held for over a year are considered long-term and those held for under a year are short-term.

While long-term capital gains may benefit from a lower tax rate, short-term capital gains are taxed at the same rate as ordinary income.

A capital loss occurs when an investment loses value. In certain circumstances, when a capital loss exceeds a capital gain, the difference could potentially be applied as a tax deduction. Some brokerages may also offer automated tax loss harvesting as a way to strategically offset investment profits.

6. Wash Sale Rule

While capital losses can sometimes be taken as a tax deduction, there are certain regulations in place to prevent investors from abusing those benefits. One such regulation is the wash sale rule, which says that investors cannot benefit from selling a security at a loss and then buy a substantially identical security within the next 30 days.

A wash sale also occurs if you sell a security and then your spouse or a corporation you control buys a substantially identical security within the next 30 days.

Get up to $1,000 in stock when you fund a new Active Invest account.*

Access stock trading, options, auto investing, IRAs, and more. Get started in just a few minutes.

*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.

Which Day Trading Strategy Is Best for Beginners?

There’s no single answer that’s going to be correct for every trader. But investors might want to stick to the simpler strategies to get a hang of day trading. For instance, they could take a try at technical analysis to try and determine which trades may end up being profitable. Or, they could stick with swing trades to test the waters, too.

Perhaps the most important thing to keep in mind is that day trading is, as mentioned, incredibly risky.

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

Best Times to Day Trade

As mentioned, day traders seek high liquidity, volatility and volumes. That’s why when it comes to stocks, the first 15 minutes of the trading day, after the equity market opens at 9:30am, may be one of the active stretches for day traders.

The stock market tends to be more volatile during this time, as traders and investors try to figure out the market’s direction and prices react to company reports or economic data that was released before the opening bell. Volume also tends to pick up before the closing bell at 4pm.

For futures, commodities and currencies trading, markets are open 24 hours so day traders can be active around the clock. However, they may find less liquidity at night when most investors and traders in the U.S. aren’t as active.

Day Trading Risk Management

The SEC issued a stern warning regarding day trading in 2005, and that message still holds value today. They noted that most people do not have the wealth, time, or temperament to be successful in day trading.

If an individual isn’t comfortable with the risks associated with day trading, they shouldn’t delve into the practice. But if someone is curious, here are some steps they can take to manage the risks that stem from day trading:

1.    Try not to invest more than you can afford. This is particularly important with options and margin trading. It’s crucial for investors to understand how leverage works in such trading accounts and that they can lose more than they originally invested.

2.    Investors and traders often benefit from tracking and monitoring volatility. One way to do this is by finding one’s portfolio beta, or the sensitivity to swings in the broader market. Adjusting one’s portfolio so it’s not too sensitive to sweeping volatility may be helpful.

3.    Day traders often benefit from picking a trading strategy and sticking with it. One struggle many day traders contend with is avoiding getting swept up by the moment and deviating from a plan, only to lock in losses.

4.    Don’t let your emotions take the driver’s seat. Fear and greed can dominate investing and sway decisions. But in investing, it can be better to keep a cool head and avoid reactionary behavior.

Is It Difficult To Make Money Day Trading?

While it may feel like it’s easy to make a couple of lucky moves and turn a profit from some trades, it isn’t easy to make money day trading. Again, it’s very, very risky, and new traders would do well not to assume they’re going to make any money at all. That said, there are professional traders out there, but they use professional-grade tools and experience to help inform their decisions. New traders shouldn’t expect to emulate a professional trader’s success.

The Takeaway

Day trading involves making short-term stock trades in an effort to generate returns. It can be lucrative, but is extremely risky, and prospective traders would likely do well to practice and learn some tools of the trade before giving it a shot. They’ll also want to closely consider their risk tolerance, too.

Again, while stock investing can be an important way to build wealth for individuals, it’s crucial however to know that the consequences of risky day trading can be catastrophic. Investors need to be disciplined, cautious and put in the time and effort before delving into day trading strategies.

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 day trading and how does it differ from other trading strategies?

Day trading involves making short-term trades with stocks or other securities in an effort to make a profit. Other strategies may involve longer-term investments, which are not bought and sold on a daily or weekly (or monthly) basis.

Are there any risk management techniques specific to day trading strategies?

Traders can do many things to try and limit their risks, and that can include working with different brokers or platforms, incorporating thinking patterns or rituals before making trades, setting up stop-losses, and diversifying their portfolios.

Are day trading strategies suitable for all types of markets, such as stocks, forex, or cryptocurrencies?

Day trading can be done in many asset classes and markets, which can include stocks, forex, and even crypto. But each asset is different, and the markets may not behave the same ways, either. As such, traders may want to do some homework before jumping in.

How much capital is typically required to implement day trading strategies?

It’s generally recommended that traders start with at least $25,000 in their brokerage accounts before day trading.

Are there any specific timeframes or market conditions that are more favorable for day trading strategies?

Perhaps the best times of the day for day traders are immediately after the markets open, and shortly before they close. There may also be more market action on certain days of the week (Mondays, for instance) which create good conditions for day traders.

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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2024
The Ultimate List of Financial Ratios

The Ultimate List of Financial Ratios

By | Growing Wealth, invest, Investing | Comments Off on The Ultimate List of Financial Ratios

Financial ratios are numerical calculations that illustrate the relationship between one piece or group of data and another. Business owners use financial statement ratios to performance, assess risk and guide decision-making. For investors, these calculations can provide meaningful data that reflects a company’s liquidity and financial health.

The use of financial ratios is often central to a quantitative or fundamental analysis approach, though they can also be used for technical analysis. For example, a value investor may use certain types of financial ratios to indicate whether the market has undervalued a company or how much potential its stock has for long-term price appreciation. Meanwhile, a trend trader may check key financial ratios to determine if a current pricing trend is likely to hold.

With either strategy, informed investors must understand the different kinds of commonly used financial ratios, and how to interpret them.

Key Points

•   Financial ratios serve as essential tools for evaluating a company’s performance, risk, and overall financial health, assisting both business owners and investors in decision-making.

•   Key financial ratios include Earnings Per Share (EPS), Price-to-Earnings (P/E), and Debt to Equity (D/E), each providing insights into profitability, valuation, and leverage.

•   Liquidity ratios, such as the Current Ratio and Quick Ratio, help assess a company’s ability to meet short-term obligations, crucial for evaluating newer firms.

•   Profitability ratios, including Gross Margin and Return on Assets, gauge how effectively a company generates income from its operations and assets.

•   Coverage ratios, like the Debt Service Coverage Ratio and Interest Coverage Ratio, measure a company’s capacity to manage its debt obligations, providing insights into financial stability.

What Are Financial Ratios?

A financial ratio is a means of expressing the relationship between two pieces of numerical data. When discussing ratios in a business or investment setting, you’re typically talking about information that’s included in a company’s financial statements.

Recommended: How to Read Financial Statements

Financial ratios can provide insight into a company, in terms of things like valuation, revenues, and profitability. They can also aid in comparing two companies.

For example, say you’re considering investing in the tech sector, and you are evaluating two potential companies. One has a share price of $10 while the other has a share price of $55. Basing your decision solely on price alone could be a mistake if you don’t understand what’s driving share prices or how the market values each company. That’s where financial ratios become useful for understanding a company’s inner workings.


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Key Financial Ratios

Investors tend to use some financial ratios more often or place more significance on certain ratios when evaluating business or companies. Here are some of the most important financial ratios to know.

1. Earnings Per Share (EPS)

Earnings per share or EPS measures earnings and profitability. This metric can tell you how likely a company is to generate profits for its investors. A higher EPS typically indicates better profitability, though this rule works best when making apples-to-apples comparisons for companies within the same industry.

EPS Formula:

EPS = Net profit / Number of common shares

To find net profit, you’d subtract total expenses from total revenue. (Investors might also refer to net profit as net income.)

EPS Example:

So, assume a company has a net profit of $2 million, with 12,000,000 shares outstanding. Following the EPS formula, the earnings per share works out to $0.166.

2. Price-to-Earnings (P/E)

Price-to-earnings ratio or P/E helps investors determine whether a company’s stock price is low or high compared to other companies or to its own past performance. More specifically, the price-to-earnings ratio can give you a sense of how expensive a stock is relative to its competitors, or how the stock’s price is trending over time.

P/E Formula:

P/E = Current stock price / Current earnings per share

P/E Example:

Here’s how it works: A company’s stock is trading at $50 per share. Its EPS for the past 12 months averaged $5. The price-to-earnings ratio works out to 10, meaning investors would have to spend $10 for every dollar generated in annual earnings.

3. Debt to Equity (D/E)

Debt to equity or D/E is a leverage ratio. This ratio tells investors how much debt a company has in relation to how much equity it holds.

D/E Formula:

D/E = Total liabilities / Shareholders equity

In this formula, liabilities represent money the company owes. Equity represents assets minus liabilities or the company’s book value.

D/E Example:

Say a company has $5 million in debt and $10 million in shareholder equity. Its debt-to-equity ratio would be 0.5. As a general rule, a lower debt to equity ratio is better as it means the company has fewer debt obligations.

4. Return on Equity (ROE)

Return on equity or ROE is another financial ratio that’s used to measure profitability. In simple terms, it’s used to illustrate the return on shareholder equity based on how a company spends its money.

ROE Formula:

ROE = Net income – Preferred dividends / Value of average common equity

ROE Example:

Assume a company has net income of $2 million and pays out preferred dividends of $200,000. The total value of common equity is $10 million. Using the formula, return on equity would equal 0.18 or 18%. A higher ROE means the company generates more profits.

Liquidity Ratios

Liquidity ratios can give you an idea of how easily a company can pay its debts and other liabilities. In other words, liquidity ratios indicate cash flow strength. That can be especially important when considering newer companies, which may face more significant cash flow challenges compared to established companies.

5. Current Ratio

Also known as the working-capital ratio, the current ratio tells you how likely a company is able to meet its financial obligations for the next 12 months. You might check this ratio if you’re interested in whether a company has enough assets to pay off short-term liabilities.

Formula:

Current Ratio = Current Assets / Current Liabilities

Example:

Say a company has $1 million in current assets and $500,000 in current liabilities. It has a current ratio of 2, meaning for every $1 a company has in current liabilities it has $2 in current assets.

6. Quick Ratio

The quick ratio, also called the acid-test ratio, measures liquidity based on assets and liabilities. But it deducts the value of inventory from these calculations.

Formula:

Quick Ratio = Current Assets – Inventory / Current Liabilities

Example:

Quick ratio is also useful for determining how easily a company can pay its debts. For example, say a company has current assets of $5 million, inventory of $1 million and current liabilities of $500,000. Its quick ratio would be 8, so for every $1 in liabilities the company has $8 in assets.

7. Cash Ratio

A cash ratio tells you how much cash a company has on hand, relative to its total liabilities. Essentially, it tells you how easily a company could pay its liabilities with cash.

Formula:

Cash Ratio = (Cash + Cash Equivalents) / Total Current Liabilities

Example:

A company that has $100,000 in cash and $500,000 in current liabilities would have a cash ratio of 0.2. That means it has enough cash on hand to pay 20% of its current liabilities.

8. Operating Cash Flow Ratio

Operating cash flow can tell you how much cash flow a business generates in a given time frame. This financial ratio is useful for determining how much cash a business has on hand at any given time that it can use to pay off its liabilities.

To calculate the operating cash flow ratio you’ll first need to determine its operating cash flow:

Operating Cash Flow = Net Income + Changes in Assets & Liabilities + Non-cash Expenses – Increase in Working Capital

Then, you calculate the cash flow ratio using this formula:

Formula:

Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities

Example:

For example, if a company has an operating cash flow of $1 million and current liabilities of $250,000, you could calculate that it has an operating cash flow ratio of 4, which means it has $4 in operating cash flow for every $1 of liabilities.

Solvency Ratios

Solvency ratios are financial ratios used to measure a company’s ability to pay its debts over the long term. As an investor, you might be interested in solvency ratios if you think a company may have too much debt or be a potential candidate for a bankruptcy filing. Solvency ratios can also be referred to as leverage ratios.

Debt to equity is a key financial ratio used to measure solvency, though there are other leverage ratios that are helpful as well.

9. Debt Ratio

A company’s debt ratio measures the relationship between its debts and its assets. For instance, you might use a debt ratio to gauge whether a company could pay off its debts with the assets it has currently.

Formula:

Debt Ratio = Total Liabilities / Total Assets

Example:

The lower this number is the better in terms of risk. A lower debt ratio means a company has less relative debt. So a company that has $25,000 in debt and $100,000 in assets, for example, would have a debt ratio of 0.25. Investors typically consider anything below 0.5 a lower risk.

10. Equity Ratio

Equity ratio is a measure of solvency based on assets and total equity. This ratio can tell you how much of the company is owned by investors and how much of it is leveraged by debt.

Formula:

Equity Ratio = Total Equity / Total Assets

Example:

Investors typically favor a higher equity ratio, as it means the company’s shareholders are more heavily invested and the business isn’t bogged down by debt. So, for example, a company with $200,000 in total equity and $200,000 in total assets has an equity ratio of 0.80. This tells you shareholders own 80% of the company.


💡 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.

Profitability Ratios

Profitability ratios gauge a company’s ability to generate income from sales, balance sheet assets, operations and shareholder’s equity. In other words, how likely is the company to be able to turn a profit?

Return on equity is one profitability ratio investors can use. You can also try these financial ratios for estimating profitability.

11. Gross Margin Ratio

Gross margin ratio compares a company’s gross margin to its net sales. This tells you how much profit a company makes from selling its goods and services after the cost of goods sold is factored in.

Formula:

Gross Margin Ratio = Gross Margin / Net Sales

Example

A company that has a gross margin of $250,000 and $1 million in net sales has a gross margin ratio of 25%. Meanwhile, a company with a $250,000 gross margin and $2 million in net sales has a gross margin ratio of 12.5% and realizes a smaller profit percentage per sale.

12. Operating-Margin Ratio

Operating-margin ratio measures how much total revenue is composed of operating income, or how much revenue a company has after its operating costs.

Formula:

Operating Margin Ratio = Operating Income / Net Sales

Example:

A higher operating-margin ratio suggests a more financially stable company with enough operating income to cover its operating costs. For example, if operating income is $250,000 and net sales are $500,000, that means 50 cents per dollar of sales goes toward variable costs.

13. Return on Assets Ratio

Return on assets or ROA measures net income produced by a company’s total assets. This lets you see how good a company is at using its assets to generate income.

Formula:

Return on Assets = Net Income / Average Total Assets

Example:

Investors typically favor a higher ratio as it shows that the company may be better at using its assets to generate income. For example, a company that has $10 million in net income and $2 million in average total assets generates $5 in income per $1 of assets.

Efficiency Ratios

Efficiency ratios or financial activity ratios give you a sense of how thoroughly a company is using the assets and resources it has on hand. In other words, they can tell you if a company is using its assets efficiently or not.

14. Asset Turnover Ratio

Asset turnover ratio is a way to see how much sales a company can generate from its assets.

Formula:

Asset Turnover Ratio = Net Sales / Average Total Assets

A higher asset turnover ratio is typically better, as it indicates greater efficiency in terms of how assets are being used to produce sales.

Example:

Say a company has $500,000 in net sales and $50,000 in average total assets. Their asset turnover ratio is 10, meaning every dollar in assets generates $10 in sales.

15. Inventory Turnover Ratio

Inventory turnover ratio illustrates how often a company turns over its inventory. Specifically, how many times a company sells and replaces its inventory in a given time frame.

Formula:

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

Example:

Investors use average inventory since a company’s inventory can increase or decrease throughout the year as demand ebbs and flows. As an example, if a company has a cost of goods sold equal to $1 million and average inventory of $500,000, its inventory turnover ratio is 2. That means it turns over inventory twice a year.

16. Receivables Turnover Ratio

Receivables turnover ratio measures how well companies manage their accounts receivable. Specifically, it considers how long it takes companies to collect on outstanding receivables.

Formula:

Receivables Turnover Ratio = Net Annual Credit Sales / Average Accounts Receivable

Example:

If a company has $100,000 in net annual credit sales, for example, and $15,000 in average accounts receivable its receivables turnover ratio is 6.67. The higher the number is, the better, since it indicates the business is more efficient at getting customers to pay up.

Coverage Ratios

Coverage ratios are financial ratios that measure how well a company manages its obligations to suppliers, creditors, and anyone else to whom it owes money. Lenders may use coverage ratios to determine a business’s ability to pay back the money it borrows.

17. Debt Service Coverage Ratio

Debt service coverage reflects whether a company can pay all of its debts, including interest and principal, at any given time. This ratio can offer creditors insight into a company’s cash flow and debt situation.

Formula:

Debt Service Coverage Ratio = Operating Income / Total Debt Service Costs

Example:

A ratio above 1 means the company has more than enough money to meet its debt servicing needs. A ratio equal to 1 means its operating income and debt service costs are the same. A ratio below 1 indicates that the company doesn’t have enough operating income to meet its debt service costs.

18. Interest Coverage Ratio

Interest-coverage ratio is a financial ratio that can tell you whether a company is able to pay interest on its debt obligations on time. This is also called the times earned interest ratio.

Formula:

Interest Coverage Ratio = EBIT ( Earnings Before Interest and Taxes) / Annual Interest Expense

Example:

Let’s say a company has an EBIT of $100,000. Meanwhile, annual interest expense is $25,000. That results in an interest coverage ratio of 4, which means the company has four times more earnings than interest payments.

19. Asset-Coverage Ratio

Asset-coverage ratio measures risk by determining how much of a company’s assets would need to be sold to cover its debts. This can give you an idea of a company’s financial stability overall.

Formula:

Asset Coverage Ratio = (Total Assets – Intangible Assets) – (Current Liabilities – Short-term Debt) / Total Debt

You can find all of this information on a company’s balance sheet. The rules for interpreting asset coverage ratio are similar to the ones for debt service coverage ratio.

So a ratio of 1 or higher would suggest the company has sufficient assets to cover its debts. A ratio of 1 would suggest that assets and liabilities are equal. A ratio below 1 means the company doesn’t have enough assets to cover its debts.

Market-Prospect Ratios

Market-prospect ratios make it easier to compare the stock price of a publicly traded company with other financial ratios. These ratios can help analyze trends in stock price movements over time. Earnings per share and price-to-earnings are two examples of market prospect ratios. Investors can also look to dividend payout ratios and dividend yield to judge market prospects.

20. Dividend Payout Ratio

Dividend payout ratio can tell you how much of a company’s net income it pays out to investors as dividends during a specific time period. It’s the balance between the profits passed on to shareholders as dividends and the profits the company keeps.

Formula:

Dividend Payout Ratio = Total Dividends / Net Income

Example:

A company that pays out $1 million in total dividends and has a net income of $5 million has a dividend payout ratio of 0.2. That means 20% of net income goes to shareholders.

21. Dividend Yield

Dividend yield is a financial ratio that tracks how much cash dividends are paid out to common stock shareholders, relative to the market value per share. Investors use this metric to determine how much an investment generates in dividends.

Formula:

Dividend Yield = Cash Dividends Per Share / Market Value Per Share

Example:

For example, a company that pays out $5 in cash dividends per share for shares valued at $50 each are offering investors a dividend yield of 10%.

Ratio Analysis: What Do Financial Ratios Tell You?

Financial statement ratios can be helpful when analyzing stocks. The various formulas included on this financial ratios list offer insight into a company’s profitability, cash flow, debts and assets, all of which can help you form a more complete picture of its overall health. That’s important if you tend to lean toward a fundamental analysis approach for choosing stocks.

Using financial ratios can also give you an idea of how much risk you might be taking on with a particular company, based on how well it manages its financial obligations. You can use these ratios to select companies that align with your risk tolerance and desired return profile.

The Takeaway

Learning the basics of key financial ratios can be a huge help when constructing a stock portfolio. Rather than focusing on a stock’s price, you can use financial ratios to take a closer look under the hood of a company.

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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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08
2024
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What Is Dividend Yield?

By | Growing Wealth, invest, Investing, Terminology | Comments Off on What Is Dividend Yield?

Dividend yield concerns how much an investor realizes from their investments over the course of a year as a result of dividends. Dividends, which are payouts to investors as a share of a company’s overall profit, can help investors generate bigger returns, and some investors even formulate entire strategies around maximizing dividends.

But it’s important to have a good understanding of dividends, dividend yields, and other related concepts before going too far into the weeds.

Key Points

•   Dividend yield represents the annual dividend paid to shareholders relative to the stock price, expressed as a percentage, which helps investors assess potential returns.

•   Investors can calculate dividend yield by dividing the annual dividend per share by the stock’s current price, providing insight into a company’s attractiveness as an investment.

•   A higher dividend yield may signal an established company, but it can also indicate slower growth or potential financial troubles, requiring careful evaluation.

•   Considering the history of dividend growth and the dividend payout ratio can provide additional insights into a company’s financial health and dividend sustainability.

•   Understanding the difference between dividend yield and dividend rate is essential, as dividend yield is a ratio while dividend rate is expressed in dollar amounts.

What Is Dividend Yield?

A stock’s dividend yield is how much the company annually pays out in dividends to shareholders, relative to its stock price. The dividend yield is a financial ratio (dividend/price) expressed as a percentage, and is distinct from the dividend itself.

Dividend payments are expressed as a dollar amount, and supplement the return a stock produces over the course of a year. For an investor interested in total return, learning how to calculate dividend yield for different companies can help to decide which company may be a better investment.

But bear in mind that a stock’s dividend yield will tend to fluctuate because it’s based on the stock’s price, which rises and falls. That’s why a higher dividend yield may not be a sign of better value.

How Does Dividend Yield Differ From Dividends?

It’s important to really drive home the difference between dividend yield and dividends in general.

Dividends are a portion of a company’s earnings paid to investors and expressed as a dollar amount. Dividends are typically paid out each quarter (although semi-annual and monthly payouts are common). Not all companies pay dividends.

Dividend yield, on the other hand, refers to a stock’s annual dividend payments divided by the stock’s current price, and expressed as a percentage. Dividend yield is one way of assessing a company’s earning potential.

How to Calculate Dividend Yield

Calculating the dividend yield of an investment is useful for investors who want to compare companies and the dividends they pay. For investors looking for investments to help supplement their cash flow, or even to possibly live off dividend income, a higher dividend yield on a stock would be more attractive than a lower one.

What Is the Dividend Yield Formula?

The dividend yield formula is more of a basic calculation than a formula: Dividend yield is calculated by taking the annual dividend paid per share, and dividing it by the stock’s current price:

Annual dividend / stock price = Dividend yield (%)

Dividend Yield Formula

How to Calculate Annual Dividends

Investors can calculate the annual dividend of a given company by looking at its annual report, or its quarterly report, finding the dividend payout per quarter, and multiplying that number by four. For a stock with fluctuating dividend payments, it may make sense to take the four most recent quarterly dividends to arrive at the trailing annual dividend.

It’s important to consider how often dividends are paid out. If dividends are paid monthly vs. quarterly, you want to add up the last 12 months of dividends.

This is especially important because some companies pay uneven dividends, with the higher payouts toward the end of the year, for example. So you wouldn’t want to simply add up the last few dividend payments without checking to make sure the total represents an accurate annual dividend amount.

Example of Dividend Yield

If Company A’s stock trades at $70 today, and the company’s annual dividend is $2 per share, the dividend yield is 2.85% ($2 / $70 = 0.0285).

Compare that to Company B, which is trading at $40, also with an annual dividend of $2 per share. The dividend yield of Company B would be 5% ($2 / $40 = 0.05).

In theory, the higher yield of Company B may look more appealing. But investors can’t determine a stock’s worth by yield alone.

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Dividend Yield: Pros and Cons

Pros

 Cons
Can help with company valuation. Dividend yield can indicate a more established, but slower-growing company.
May indicate how much income investors can expect. Higher yield may mask deeper problems.
Yield doesn’t tell investors the type of dividend (ordinary vs. qualified), which can impact taxes.

For investors, there are some advantages and disadvantages to using dividend yield as a metric that helps inform investment choices.

Pros

•   From a valuation perspective, dividend yield can be a useful point of comparison. If a company’s dividend yield is substantially different from its industry peers, or from the company’s own typical levels, that can be an indicator of whether the company is trading at the right valuation.

•   For many investors, the primary reason to invest in dividend stocks is for income. In that respect, dividend yield can be an important metric. But dividend yield can change as the underlying stock price changes. So when using dividend yield as a way to evaluate income, it’s important to be aware of company fundamentals that provide assurance as to company stability and consistency of the dividend payout.

Cons

•   Sometimes a higher dividend yield can indicate slower growth. Companies with higher dividends are often larger, more established businesses. But that could also mean that dividend-generous companies are not growing very quickly because they’re not reinvesting their earnings.

Smaller companies with aggressive growth targets are less likely to offer dividends, but rather spend their excess capital on expansion. Thus, investors focused solely on dividend income could miss out on some faster-growing opportunities.

•   A high dividend yield could indicate a troubled company. Because of how dividend yield is calculated, the yield is higher as the stock price falls, so it’s important to evaluate whether there has been a downward price trend. Often, when a company is in trouble, one of the first things it is likely to reduce or eliminate is that dividend.

•   Investors need to look beyond yield to the type of dividend they might get. An investor might be getting high dividend payouts, but if they’re ordinary dividends vs. qualified dividends they’ll be taxed at a higher rate. Ordinary dividends are taxed as income; qualified dividends are taxed at the lower capital gains rate, which typically ranges from 0% to 20%. If you have tax questions about your investments, be sure to consult with a tax professional.

The Difference Between Dividend Yield and Dividend Rate

As noted earlier, a dividend is a way for a company to distribute some of its earnings among shareholders. Dividends can be paid monthly, quarterly, semi-annually, or even annually (although quarterly payouts tend to be common in the U.S.). Dividends are expressed as dollar amounts. The dividend rate is the annual amount of the company’s dividend per share.

A company that pays $1 per share, quarterly, has an annual dividend rate of $4 per share.

The difference between this straight-up dollar amount and a company’s dividend yield is that the latter is a ratio. The dividend yield is the company’s annual dividend divided by the current stock price, and expressed as a percentage.

What Is a Good Dividend Yield?

dividend yield of sp500 vs dividend aristocrats

Two companies with the same high yields are not created equally. While dividend yield is an important number for investors to know when determining the annual cash flow they can expect from their investments, there are deeper indicators that investors may want to investigate to see if a dividend-paying stock will continue to pay in the future.

A History of Dividend Growth

When researching dividend stocks, one place to start is by asking if the stock has a history of dividend growth. A regularly increasing dividend is an indication of earnings growth and typically a good indicator of a company’s overall financial health.

The Dividend Aristocracy

There is a group of S&P 500 stocks called Dividend Aristocrats, which have increased the dividends they pay for at least 25 consecutive years. Every year the list changes, as companies raise and lower their dividends.

Currently, there are 65 companies that meet the basic criteria of increasing their dividend for a quarter century straight. They include big names in energy, industrial production, real estate, defense contractors, and more. For investors looking for steady dividends, this list may be a good place to start.

Dividend Payout Ratio (DPR)

Investors can calculate the dividend payout ratio by dividing the total dividends paid in a year by the company’s net income. By looking at this ratio over a period of years, investors can learn to differentiate among the dividend stocks in their portfolios.

A company with a relatively low DPR is paying dividends, while still investing heavily in the growth of its business. If a company’s DPR is rising, that’s a sign the company’s leadership likely sees more value in rewarding shareholders than in expanding. If its DPR is shrinking, it’s a sign that management sees an abundance of new opportunities abounding. In extreme cases, where a company’s DPR is 100% or higher, it’s unlikely that the company will be around for much longer.

Other Indicators of Company Health

Other factors to consider include the company’s debt load, credit rating, and the cash it keeps on hand to manage unexpected shocks. And as with every equity investment, it’s important to look at the company’s competitive position in its sector, the growth prospects of that sector as a whole, and how it fits into an investor’s overall plan. Those factors will ultimately determine the company’s ability to continue paying its dividend.

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The Takeaway

Dividend yield is a simple calculation: You divide the annual dividend paid per share by the stock’s current price. Dividend yield is expressed as a percentage, versus the dividend (or dividend rate) which is given as a dollar amount. The dividend yield formula can be a valuable tool for investors, and not just ones who are seeking cash flow from their investments.

Dividend yield can help assess a company’s valuation relative to its peers, but there are other factors to consider when researching stocks that pay out dividends. A history of dividend growth and a good dividend payout ratio (DPR), as well as the company’s debt load, cash on hand, and credit rating can help form an overall picture of a company’s health and probability of paying out higher dividends in the future.

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