Maintenance margin, as it relates to margin accounts and trading, refers to the necessary amount of funds an investor needs to maintain in their brokerage account in order to utilize margin. Margin accounts work differently than other trading accounts. Instead of allowing the trader to do regular trades, the margin account allows leveraged trades.
This means that the trader can buy securities including stocks, bonds, or options for more than the amount that they have in their account, paying only a deposit on the trade. They borrow the rest of the cash needed for the investment from the broker.
Key Points
• Maintenance margin represents the minimum balance required in a trader’s margin account to avoid a margin call and continue leveraged trading.
• The Financial Industry Regulatory Authority mandates a minimum maintenance margin of 25%, but individual brokerage firms often set higher requirements for added security.
• Margin trading carries significant risks, as traders can incur losses exceeding their account balance, leading to margin debt owed to brokers.
• If a trader’s account balance falls below the maintenance margin, the broker can issue a margin call, requiring additional funds or asset liquidation within a specified timeframe.
• Understanding the distinction between maintenance margin and initial margin is crucial, as the initial margin is the upfront deposit required to open a margin account.
Maintenance Margin Definition
In margin trading, the maintenance margin is the minimum amount of funds that a trader must hold in their portfolio to avoid being issued a margin call, for as long as they are actively involved in a trade. If a trade they enter decreases in value, the trader may owe money, which is taken from their account.
Minimum margin requirements for leveraged accounts are regulated by the government. Currently the Financial Industry Regulatory Authority (FINRA) sets the maintenance margin at 25% of the total value of securities that a trader holds in their margin account.
Specific brokerage firms also maintain their own requirements. It is common for brokerage requirements to be higher than the government required amount to provide the firm with greater financial security.
Margin maintenance requirements shift based on various factors, including market liquidity and volatility. And different stocks have differing maintenance requirements: if they are more likely to be volatile, the requirements may be higher.
Does a Maintenance Margin Mitigate Risk?
Maintenance margin doesn’t mitigate risk for traders. Margin investing is risky because traders can lose more money than they have in their account, creating a debt with the broker, called margin debt.
When a trader opens a margin account, they must sign an agreement and deposit a certain amount into the account before they can start trading. To pay off any debt from assets that have lost value, the trader will need to deposit additional funds, deposit securities, or sell off holdings.
Therefore, margin trading isn’t recommended for beginner traders, and it’s important for traders to understand the risks and how it works before trying it out.
💡 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.
Increase your buying power with a margin loan from SoFi.
Borrow against your current investments at just 12%* and start margin trading.
Let’s look at an example of how maintenance margin requirements work.
Let’s say a trader wants to purchase 100 shares of Company XYZ at $40 per share. They don’t have sufficient funds to purchase the entire number of shares. The trader can use a margin account which allows them to purchase the entire amount of shares but only deposit a percentage of the total price into the trade and also pay a financing fee. This deposit amount is known as the initial margin requirement.
In this example, the initial maintenance margin requirement is 40% of the purchase price of the trade. For the trader to purchase the full 100 shares, they need to maintain a balance of 40% of the trade purchase amount in their margin account.
When Maintenance Margin Requirements Aren’t Met
If the amount in their account dips below the minimum requirement, their broker will issue a margin call notification. Generally, the trader will have between 2-5 days to either add more funds to their account or sell some of the assets they are invested in to move enough cash funds back into their account.
If the trader doesn’t sell holdings or add funds to their account to meet the margin maintenance requirement, the broker may sell the trader’s securities without notifying them, and they have the right to decide which ones they sell. They are also allowed to charge the trader commissions and even sue the trader for losses.
A margin call can also be sent out if the brokerage firm changes their requirements, which they can do at any time.
Calculating Maintenance Margin
Each brokerage firm has their own maintenance margin requirements. The formula to calculate the maintenance margin is:
This can be used to determine the stock price that will trigger a margin call.
For example, a trader opens a margin account and deposits $20,000 into it, then borrows $10,000 from the broker in a margin loan in order to purchase 200 shares of stock at a price of $100 each. The broker’s maintenance margin is 30%. Here is what the calculation would be to figure out what account balance would trigger the margin call:
That means that if the trader’s account dips below $14,285.71, or if the price of the stock falls below $71.43 ($14,285.71 / 200 shares) then the broker will issue a margin call.
When traders open a margin account, there is an initial margin amount they are required to deposit before they can start trading. This is set by FINRA, and brokers may also have their own additional requirements. The initial margin required by FINRA is currently $2,000 in cash or securities.
After a trader starts buying on margin, they must meet the maintenance margin on their account — at least 25% of the market value of the securities in their account.
The Takeaway
A maintenance margin is a monetary buffer for traders with margin accounts. The maintenance margin is a minimum balance required to execute leveraged trades. If a trader’s margin account dips below the minimum set by FINRA and the broker, the broker will issue a warning, or margin call, so that the trader can add cash to their account or sell holdings to cover the gap.
Maintenance margins do not mitigate risks for traders, and if an investor is utilizing margin as a part of their investment strategy, they should know what they’re getting into. Margin accounts have their pros and cons, but it’s important to keep the risks in mind.
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 happens if you go below maintenance margin?
Generally, if a trader or investor’s account goes below the maintenance margin, their brokerage will send them a margin call, or otherwise warn them that they need to deposit funds or sell holdings.
What does current maintenance margin mean?
Current maintenance margin refers to the literal current maintenance margin set by financial regulators or by a specific brokerage. For example, it may be 25% of the value of an investor’s total holdings.
What is the difference between maintenance margin and minimum margin?
Minimum margin refers to the minimum amount of collateral needed in a margin account to execute leveraged trades, while maintenance margin is the total capital that needs to remain in the account as the investor continues to utilize a margin account.
Who sets the maintenance margin?
FINRA currently sets the maintenance margin, which is 25%. But specific brokerage firms can set their own beyond that, and often, at a higher threshold.
Why is my maintenance margin so high?
Maintenance margin requirements can be determined by a number of factors beyond regulatory minimums, such as market conditions and volatility, and the specific types of securities an investor is trading.
What does 25% maintenance margin mean?
Twenty-five percent maintenance margin means that an investor must hold 25% of the total value of their holdings in their account. It is the minimum amount of equity that must be maintained in their margin account.
Photo credit: iStock/StockRocket
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.
Socially responsible investing (SRI) strategies help investors put their capital into a range of securities — e.g., stocks, bonds, mutual funds — that focus on socially positive aims: e.g., clean energy, air and water; equitable employment practices, and more.
Despite market volatility driven by interest rate changes and geopolitical conflicts in recent years, SRI investing strategies have garnered steady interest from investors.
Various analyses of SRI funds suggest that the philosophy of doing well by doing some good in the world may have an upside worth exploring.
Key Points
• Socially responsible investing (SRI) involves allocating capital into securities that promote positive social and environmental outcomes, aiming for both impact and financial returns.
• The popularity of SRI has grown, with a notable increase in assets allocated to ESG-focused ETFs, rising from $5 billion in 2006 to $480 billion in 2023.
• Different investing strategies exist within the realm of SRI, including impact investing, ESG investing, and sustainable investing, each with distinct criteria and goals.
• Historical phases of SRI have evolved from exclusionary strategies to proactive investing, ultimately leading to a focus on measurable impacts and accountability.
• Recent data indicates that sustainable funds often perform on par with traditional funds, suggesting that ethical investing can also be financially advantageous.
What Is Socially Responsible Investing?
While SRI investing goes by many names — including ESG investing (for environmental, social, and government factors), sustainable, or impact investing — the fundamental idea is to channel capital into entities that are working toward specific environmental and/or social policies in the U.S. and worldwide. The aim of SRI is to generate both positive changes across various industries, while also delivering returns.
Generally, investors that embrace SRI strategies find ways to assess an organization’s environmental and social impact when deciding whether to invest in them. However, there are important distinctions between the various labels in this sector of investing.
Socially responsible investing can be seen as more of an umbrella term (similar to impact investing). Within SRI, some strategies focus specifically on companies that meet certain criteria — either by supporting specific practices (e.g., green manufacturing, ethical shopping) or avoiding others (e.g., reducing reliance on fossil fuels).
For that reason it’s incumbent on each investor to assess different SRI options, to make sure they match their own aims. This is no different from the due diligence required for anyone starting to invest.
Interest in SRI Investing Strategies
The tangible merits of socially responsible investing have always been subject to debate. But in the last couple of years there has been criticism of some of the underlying principles of SRI, as well as questions about the overall financial value of this investing approach.
Nonetheless, the value of global assets allocated to ETFs with an ESG focus have shown steady growth in the last two decades. As of November 2023, according to data from Statista, the value of these assets was $480 billion — a substantial increase since 2006, when the value of those assets was about $5 billion.
And according to a report published in 2023 by Morningstar, a fund rating and research firm, investors in conventional funds as well as SRI funds are likely to see returns over time.
Get up to $1,000 in stock when you fund a new Active Invest account.*
Access stock trading, options, alternative investments, 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.
SRI vs ESG vs Other Investing Strategies
While the various terms for SRI investing are often used interchangeably, it’s important for investors to understand some of the differences.
Impact Investing
Impact investing is perhaps the broadest term of all, in that it can refer to a range of priorities, goals, or values that investors may want to pursue. To some degree, impact investing implies that the investor has specific outcomes in mind: i.e. the growth of a certain sector, type of technology, or societal issue.
Impact investing may also refer to strategies that avoid certain companies, products, or practices. This could include so-called sin stocks (e.g. alcohol, tobacco), companies that adhere to principles that are in opposition to an investor’s or institution’s belief system, and more.
Socially Responsible Investing
SRI or socially conscious investing are two other broad labels, and they’re typically used to reflect progressive values of protecting the planet and natural resources, treating people equitably, and emphasizing corporate responsibility.
While SRI can be considered a type of impact investing, there may be impact investing strategies that are diametrically opposed to SRI, simply because they have different aims.
ESG Investing
Securities that embrace ESG principles, though, may be required to adhere to specific standards for protecting aspects of the environment (e.g. clean energy, water, and air); supporting social good (e.g. human rights, safe working conditions, equal opportunities); and corporate accountability (e.g. fighting corruption, balancing executive pay, and so on).
For example, some third-party organizations have helped create ESG metrics for companies and funds based on how well they adhere to various environmental, social, or governance factors.
Investors who believe in socially responsible investing may want to invest in stocks, bonds, or exchange-traded funds (ETFs) that meet ESG standards, and track ESG indexes.
Sustainable Investing
Sustainable investing is often used as a shorthand for securities that have a specific focus on protecting the environment. This term is sometimes used interchangeably with green investing, eco-friendly investing, or even ESG.
Unlike ESG — which is anchored in specific criteria having to do with a company’s actions regarding environmental, social, or governance issues — the phrase “sustainable investing” is considered an umbrella term. It’s not tied to specific criteria.
Corporate Social Responsibility (CSR)
Last, corporate social responsibility (CSR) refers to a general set of business practices that may positively impact society. Often, companies establish certain programs to support local or national issues, e.g. educational needs, ethical labor practices, workplace diversity, social justice initiatives, and more.
Ideally, CSR strategies work in tandem with traditional business objectives of hitting revenue and profit goals. But since CSR goals are specific to each company, they aren’t formally considered part of socially responsible, sustainable, or ESG investing.
A Focus on Results
Investors may want to bear in mind that, with the steady growth of this sector in the last 20 or 30 years, there are a number of ways SRI strategies can come together. For example, it’s possible to invest in sustainable pharmaceuticals and even green banks.
Either way, the underlying principle of these strategies is to make a profit by making a difference. By putting money into companies that embrace certain practices, investors can support organizations that embody principles they believe in, thereby potentially making a difference in the world, and perhaps seeing a financial upside as well.
Socially Responsible Investment Examples
These days, thousands of companies aim — or claim — to embrace ethical, social, environmental, or other standards, such as those put forth in the United Nations’ Principles of Responsible Investing, or the U.N.’s 17 Sustainable Development Goals. As a result, investors today can choose from a wide range of stocks, bonds, ETFs, and more that adhere to these criteria.
Understanding SRI Standards
In addition, there are also standards set out by financial institutions or other organizations which are used to evaluate different companies. It may be useful when selecting stocks that match your values to know the standards or metrics that have been used to verify a company’s ESG status.
Depending on your priorities, you could consider companies in the following sectors, or that embrace certain practices:
• Clean energy technology and production
• Supply chain upgrades
• Clean air and water technology, products, systems, manufacturing
• Sustainable agriculture
• Racial and gender equality
• Fair labor standards
• Community outreach and support
Exploring Different Asset Classes
Investors can also trade stocks of companies that are certified B Corporations (B Corps), which meet a higher standard for environmental sustainability in their businesses, or hit other metrics around public transparency and social justice, for example. B Corps can be any company, from bakeries to funeral homes, and may or may not be publicly traded.
Companies issue green bonds to finance projects and business operations that specifically address environmental and climate concerns, such as energy-efficient power plants, upgrades to municipal water systems, and so on.
These bonds may come with tax incentives, making them a more attractive investment than traditional bonds.
Another option for investors who don’t want to pick individual SRI or ESG stocks is to consider mutual funds and exchange-traded funds (ETFs) that provide exposure to socially responsible companies and other investments.
There are a growing number of index funds that invest in a basket of sustainable stocks and bonds. These funds allow investors to diversify their holdings by investing in one security.
There are numerous indexes that investors use as benchmarks for the performance of socially responsible funds. Three of the most prominent socially responsible indexes include: the MSCI USA Extended ESG Focus Index; Nasdaq 100 ESG Index; S&P 500 ESG Index. (Remember, you cannot invest directly in an index, only in funds that track the index.)
The Growing Appeal of Socially Responsible Investments
While many investors find the idea of doing good or making an impact appealing, the question of profit has long been a point of debate within the industry. Do you sacrifice performance if you invest according to certain values?
Unfortunately, the lack of consistency in terms of what constitutes a sustainable or socially/environmentally responsible investment has made it difficult to compare SRI strategies to conventional ones. One financial company may use one set of criteria when developing its sustainable offerings; another company may use its own proprietary set of standards.
That said, as the universe of sustainable offerings continues to grow, it’s possible to create more apples-to-apples comparison sets. According to Morningstar data, sustainable equity funds saw median returns of 16.7% for 2023 versus 14.4% for traditional equity funds. The relative outperformance of SRI strategies was consistent across equity fund styles and most market caps, but particularly large-cap equities. Over 75% of SRI and conventional funds include large-cap equities.
In addition, sustainable fund assets under management (AUM) globally were up 15% over 2022, growing to $3.4 trillion.
The Evolution of Responsible Investing
Socially conscious investing is not a new concept: People have been tailoring their investment strategies for generations, for a number of reasons, not all of them related to sustainability. In fact, it’s possible to view the emergence of socially conscious investing in three phases.
Phase 1: Exclusionary Strategies
Exclusionary strategies tend to focus on what not to invest in. For example, those who embrace Muslim, Mormon, Quaker, and other religions, were (and sometimes still are) directed to avoid investing in companies that run counter to the values of that faith. This is sometimes called faith-based investing.
Similarly, throughout history there have been groups as well as individuals who have taken a stand against certain industries or establishments by refusing to invest in related companies. Non-violent groups have traditionally avoided investing in companies that produce weapons. Others have skirted so-called “sin stocks”: companies that are involved in alcohol, tobacco, sex, and other businesses.
On a more global scale, widespread divestment of investor funds from companies in South Africa helped to dismantle the system of racial apartheid in South Africa in the 1980s.
Phase 2: Proactive Investing
Just like exclusionary strategies, proactive strategies are values-led. But rather than taking an avoidant approach, here investors put their money into companies and causes that match their beliefs.
For example, one of the earliest sustainable mutual funds was launched in 1971 by Pax World; the founders wanted to take a stand against chemical weapons in the Vietnam war and encourage investors to support more environmentally friendly businesses.
This approach gained steady interest from investors, as financial companies launched a range of funds that focused on supporting certain sectors. So-called green investing helped to establish numerous companies that have built sustainable energy platforms, for example.
Phase 3: Investing With Impact
With the rise of digital technology in the last 30 years, two things became possible.
First, financial institutions were able to create screening tools and filters to help investors gauge which companies actually adhered to certain standards — whether ethical, environmental, or something else. Second, the ability to track real-time company behavior and outcomes helped establish greater transparency — and accountability — for financial institutions evaluating these companies for their SRI fund offerings.
By 2006, the United Nations launched the Principles for Responsible Investment (PRI), a set of global standards that helped create a worldwide understanding of Environmental, Social, and Governance strategies.
ESG became the shorthand for companies that focus on protecting various aspects of the environment (including clean energy, water, and air); supporting social good (including human rights, safe working conditions, equal opportunities); and fair corporate governance (e.g. fighting corruption, balancing executive pay, and so on).
Why Choose Socially Responsible Investing?
While the three phases of socially responsible investing did emerge more or less chronologically, all three types of strategies still exist in various forms today. But the growing emphasis on corporate accountability in terms of outcomes — requiring companies to do more than just green-washing their policies, products, and marketing materials — has shifted investors’ focus to the measurable impacts of these strategies.
Now the reasons to choose SRI strategies are growing.
Investors Can Have an Impact
The notion of values-led investing is that by putting your money into organizations that align with your beliefs, you can make a tangible difference in the world. The performance of many sustainable funds, as noted above, indicates that it’s possible to support the growth of specific companies or sectors (although growth always entails risk, and past performance is no guarantee of future results).
Socially Responsible Strategies May Be Profitable, Too
As discussed earlier, the question of whether SRI and ESG funds are as profitable as they are ethical has long been a point of debate. But that skepticism is ebbing now, with new performance metrics suggesting that sustainable funds are on par with conventional funds.
Socially Responsible Investing May Help Mitigate Risk
The criteria built into ESG investment standards may also help identify companies with poor governance practices, or those with exposure to environmental and social risks that could lead to financial losses.
Do Retirement Accounts Offer Socially Responsible Investments?
Generally speaking, individual retirement accounts may include socially responsible or ESG investment options. For example, when investing in different types of IRAs, e.g., a traditional, Roth, or SEP IRA, investors typically have access to all the securities offered by that financial institution, including stocks, bonds, and ETFs that may reflect ESG standards. The choice is up to individual investors.
That hasn’t always been the case with employer-sponsored 401k or 403b plans. But in 2023, the Department of Labor issued a rule allowing plan fiduciaries to consider ESG investment options for plan participants.
While some plans may now offer socially responsible or ESG investments, there is a push from some lawmakers to restrict or eliminate the availability of these funds. ERISA standards for retirement plans dictate that the investment options offered by employer-sponsored plans “must be based on risk return factors that the fiduciary prudently determines are material to investment value.” Some lawmakers argue that ESG funds are higher risk and not suitable for employees in company plans.
The Takeaway
Socially responsible investing is a broad term that can mean different things to different groups, but no matter which term you use — socially conscious investing, impact investing, ESG investing — it comes down to the compelling idea that by investing your money in organizations that match your values, you can make a difference in the world.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
Invest with as little as $5 with a SoFi Active Investing account.
FAQ
Is socially responsible investing profitable?
Socially responsible investing can be profitable, as multiple reviews of fund performance have shown over the last several years. That said, some believe that the financial strength of ESG or SRI strategies is debatable. While any investment strategy has its own risks, it’s best to assess them according to your own aims.
What is the difference between ESG investing and socially responsible investing?
Socially responsible investing is considered a broad term that can encompass a range of practices and standards. ESG investing stands for environmental, social, and governance factors, is a set of principles that is often used to assess how well companies meet specific, measurable criteria. While there is no single industry-wide metric for ESG standards, investors can consider various proprietary tools.
How many socially responsible investment opportunities are there?
It’s impossible to say how many SRI opportunities there are, as the stocks, bonds, and other securities that embrace ESG standards continue to grow. More than 120 new sustainable funds entered the SRI landscape in 2021, in addition to 26 existing funds that took on a sustainable mandate.
What is the socially responsible investment theory?
The theory behind socially responsible investing can be summed up by the old saying about “Doing well by doing good.” In other words, by investing in companies that support positive social and environmental products and policies, it’s possible to help investors realize a profit.
How do you start socially responsible investing?
Investors who are interested in SRI or ESG investing can begin by getting to know companies that adhere to certain eco-friendly or socially responsible standards. In addition, many financial institutions offer clients a way to screen for stocks or mutual funds that have an ESG focus.
Photo credit: iStock/luigi giordano
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.
Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. 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.
An exponential moving average (EMA) is a commonly used average price calculation done for a specific time period that places more weight and importance on the most recent price data. Since it is weighted this way it reacts faster to recent price changes than a simple moving average (SMA) which is a type of average price calculation, which equally weights all data points within a time period.
Moving averages are technical analysis trading indicators used by traders to help them understand the direction, market trend, and strength of price movement of an asset. They measure the average price of a security by taking averages of the prices of the security over a specific period of time, and can be used to show traders the location of support and resistance levels. Read on to learn more about the meaning of EMA in stocks, the EMA formula, and how to calculate EMA.
Key Points
• An exponential moving average (EMA) gives more weight to recent price data, making it a useful tool for traders to gauge market trends and price movements.
• The formula for calculating EMA incorporates the current price, the previous EMA, and an exponential smoothing constant, allowing for dynamic adjustments based on market behavior.
• Calculating EMA involves determining the simple moving average first, then applying a weighting multiplier, and finally using the EMA formula to derive values.
• While EMAs can effectively indicate support and resistance levels, they have limitations, such as lagging indicators and the potential for false signals in flat markets.
• Traders often use EMA alongside other indicators to enhance their analysis, helping them make informed decisions about entry and exit points in their trading strategies.
What is EMA?
An EMA, exponentially weighted moving average, is a type of moving average (MA) used by traders to evaluate the potential trajectory of a financial security. Using the EMA calculation, the most recent price data has the greatest impact on the moving average, while older data has a lower impact. The previous EMA value is included in the calculation, so the current value includes all the price data.
As noted, it reacts faster to price changes than a simple moving average, which may be helpful to some investors.
EMA Formula
The formula for calculating EMA is:
EMA = (K x (C – P)) + P
Where:
C = Current Price
P = Previous Period’s EMA (for the first period calculated the SMA is used)
K = Exponential Smoothing Constant (this applies appropriate weight to the most recent security price, using the number of periods specified in the moving average. The most common smoothing constant is 2, but the higher it is the more influence recent data points have on the EMA)
💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).
Get up to $1,000 in stock when you fund a new Active Invest account.*
Access stock trading, options, alternative investments, 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.
How to Calculate EMA
Technical analysts follow three steps to calculating an EMA.
1. Calculate the simple moving average (SMA) to find the initial EMA data point. The SMA is used as the previous period’s EMA for the first calculated data point of the EMA. To calculate the SMA of the last 20 days, a trader would add the amounts of the last 20 closing prices of the security and then divide that sum by 20.
2. Calculate the weighting multiplier for the number of periods that will be used to calculate the EMA. The number of periods used for the EMA has a significant impact on the value of the weighting multiplier.
The formula for finding the weighting multiplier is:
EMA(current) = ((Price(current) – EMA (prev)) x Multiplier) + EMA(prev)
3. Calculate the EMA using the formula described above.
Some traders also use the open, high, low, or median price instead of the closing price for the EMA calculation.
Example of EMA
Taking the above into consideration and following the three steps to calculate EMA, here’s an example of how it might all come together.
Again, here’s the EMA formula: EMA = (K x (C – P)) + P
We’ll assume that the previous period’s EMA is 50, and that the current price is 60. We’ll also assume that our smoothing constant is 2, for simplicity’s sake.
So: EMA= (2 x (60 – 50)) + 50 = 70
What Does EMA Show You?
An EMA follows prices more closely than a SMA since it puts more weight on recent data points. This is helpful for determining when to enter and exit trades. EMA is a lagging indicator that shows market trends and directions and the strength of price movements. It’s best used in trending markets.
By looking at past trends traders can gain an understanding of what might happen with a security’s price in the future, which may help them identify investment opportunities. Although past performance is no guarantee of future performance.
Limitations of Using EMA
Although EMA is a very useful trading tool, it does have some constraints.
• Spotting trends and directions using EMA is difficult in a flat market.
• The EMA shows present market trends but is not a predictor of future trends and prices. It also doesn’t show exact highs and lows or precise entry and exit points.
• The EMA can show false signals and can show more short term price changes that aren’t trading indicators.
• Even though it is weighted toward recent prices, the EMA does rely on past price movements, so it is a lagging indicator. Because of this the optimal time to enter a trade may have already passed by the time the trend direction shows up in an EMA chart.
How Investors Can Use EMA
Usually traders look at the direction the EMA is going in and they trade in the direction of the trend. In addition to spotting market trends and direction, EMA can also identify spot reversals that occur when a security is overbought or oversold.
The EMA is a fairly accurate tool because stock prices typically only stray so far from the average before returning to test the average, creating support or resistance and continuing to rise or fall. Even beginning investors can use EMA to spot trends and gain an understanding of what direction the market is heading.
Like other indicators, It’s best to use EMA in conjunction with other tools such as relative strength index (RSI) and moving average convergence divergence (MACD) to get a more comprehensive and accurate picture of the market. There are a few ways investors can use EMA:
Trend Trading
Traders can use the EMA to discover and trade primary market trends. When the EMA rises this is a bullish indicator, a trader may buy when the stock price dips to hit the EMA line or just below it. When EMA goes down, a trader might sell their position when the stock price goes up to hit the EMA line or just above. If the stock has a closing price that crosses over the average line, the trader closes out their trade.
Support and Resistance
EMA lines can track support and resistance levels, another useful way to track price movements and trends. If EMA goes up, this is a support indicator, while if it goes down this shows resistance to the security’s price movement.
Buy and Sell Signals
Traders can set up fast and slow moving averages and then find buy and sell signals when the two lines cross each other.
💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.
The Takeaway
EMA is a useful tool for both advanced and beginner traders to understand market trends and directions. It’s a technical indicator that evaluates a stock’s price trend with a greater emphasis on recent price levels.
Whether you’re planning to use in-depth technical analysis or not, a great way to get started building a portfolio is by opening an investment account on the SoFi Invest® stock trading app. It lets you research, track, buy and sell stocks, exchange-traded funds, and other assets right from your phone.
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
Which EMA is best?
Day traders often use 8- and 20-day EMA periods, while long-term investors use 50- and 200-day EMA. Indicators such as the moving average convergence divergence (MACD) and percentage price oscillator (PPO) use 12- and 26-day periods. If a security passes over a 200-day EMA this is a technical sign that a trend reversal has occurred.
What’s the difference between EMA and SMA?
Both simple moving average and exponential moving average are used by traders to measure market trends. They both create a graphical line that smoothes out price fluctuations using calculated averages. But they weigh price data differently, and may have different sensitivities to price changes.
What is 5 EMA and 20 EMA?
There are different EMAs referring to different time periods that can identify trends. In that sense, 5 EMA and 20 EMA refers to the 5-day and 20-day EMA, a shorter and longer-term EMA measure.
Photo credit: iStock/South_agency
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.
By Brian Nibley |
Investing |
Comments Off on Shorting a Stock Defined and How Short Selling Works
Shorting a stock, also known as short selling, is one way to potentially profit from a stock’s price decline. When investors think a stock’s price will fall, they can sell borrowed shares, hope to buy them back at a lower price, and pocket the difference as profit. This strategy is popular among savvy, risk-tolerant investors with a knack for market research and predicting trends.
Short selling is one of the strategies that make it possible to make money in the market no matter how it moves — up, down, or sideways. For new investors, the idea of making trades that can be profitable even when the price falls may sound strange. After all, the traditional way to profit in financial markets is a buy-and-hold strategy: purchasing a security, holding it, and selling it later for a higher price. However, by understanding how short selling works, investors can utilize new strategies to bolster their financial portfolios.
Key Points
• Shorting a stock involves borrowing shares to sell at a high price, hoping to repurchase them later at a lower price for profit.
• The strategy can be risky, as potential losses are unlimited if the stock price rises instead of falling.
• A short squeeze occurs when a sudden price increase forces short sellers to buy shares back quickly, further driving up the stock price.
• Alternatives to short selling include purchasing put options, which allow investors to profit from stock price declines without borrowing shares.
• Short selling may serve as a hedge against other investments, but it requires careful consideration due to its high risk and potential costs.
What Is Shorting a Stock?
A trader shorts a stock when they think the stock price will fall. Shorting involves borrowing the stock from a brokerage, selling it, and then buying it when the price is lower than when they sold. The trader then returns the shares to the brokerage and pockets the profit.
Shorting a stock is a way for investors to bet that a particular stock’s future share price will be lower than its current price. It’s the opposite of going long a stock, where an investor buys shares with the expectation that the stock price will increase.
Short selling can be risky because if the stock price goes up instead of down, the investor will have to buy the shares at a higher price and may lose money.
Suppose an investor found a company that they think is overvalued, so its share price is likely to decline. They borrow 100 shares of stock in company A from their brokerage and sell the shares for $10 per share for a total of $1,000 (plus any applicable brokerage fees).
In scenario A, the investor made a spot-on prediction, and the price fell to $9 per share. The investor can buy back 100 shares for $9 per share for $900, return the borrowed shares, and pocket the leftover $100 as profit ($1,000 – $900 = $100).
In scenario B, the investor misses the mark, and the price rises to $11 per share. Now the investor has to buy back 100 shares for $11 per share for a total of $1,100, for a loss of $100 ($1,000 – $1,100 = -$100).
Why Short a Stock?
There are various reasons why traders might choose to short a stock. In general, traders might short a stock when they believe that the security’s price will fall in the future. This might be due to several factors, such as an overall bearish outlook on the market or specific concerns about a company’s financial health or prospects.
Some traders might also short a stock to hedge their portfolios. For example, if a trader is long a stock that they think will fall in value, they might short a similar stock to offset potential losses.
Whatever the reason, shorting a stock can be a risky proposition. If the stock price does not fall as expected, the trader will be forced to cover their position at a loss. As such, traders must be cautious when considering whether or not to short a stock.
Before you can short a stock, you will need to set up a margin account with your broker. Margin accounts are brokerage accounts that allow investors to borrow money or shares to make trades.
To short a stock, you will place a sell order for the number of shares you want to short. Your brokerage will often lend you the shares — a practice known as share lending — and allow you to complete the sale on the open market to another investor.
Ideally, when the stock price drops, you will buy back the same number of shares you borrowed, pocketing the difference between the sale and purchase costs, and returning the borrowed shares to the brokerage firm.
However, if the share price increases, you will have to buy the same shares for a higher price, potentially resulting in substantial losses,
In rare cases, the lender may request that you return the shares you borrowed, but it’s far more likely that you will close your position because the short is losing money. A short seller can hang onto their short position for as long as they can pay the required interest fees for borrowing stock and maintaining the margin amounts required by the brokerage firm.
Get up to $1,000 in stock when you fund a new Active Invest account.*
Access stock trading, options, alternative investments, 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.
What Are The Risks and Rewards of Short Selling?
Potential Risks of Short Selling
Selling a stock short involves significant risk — far surpassing the risk of “going long” on an investment. When holding a stock, there’s a limit to how low a stock can go, and investors can only lose as much as their initial investment.
If someone buys 10 shares of XYZ company at $10 per share, for example, and the share price goes to zero, they will lose $100. The price can’t go lower than zero, so someone can never lose more than what they had first invested.
However, when someone shorts a stock, they risk infinite losses because there is no upward limit on a stock’s share price. If the price keeps going up, they will keep losing money.
Additionally, there are significant costs associated with shorting a stock. For one, the margin interest in a required margin account can add up over time if an investor keeps the position open for a while. Also, a brokerage firm will charge interest on the borrowed shares, ranging from a few basis points to over 100%, depending on how difficult the shares are to borrow. These costs can make shorting a stock prohibitively expensive.
Potential Benefits of Short Selling
While risky, shorting a stock could be profitable. It’s possible to make a lot of money in a short period of time, as stocks sometimes experience rapid, steep declines.
When investing during a recession, for example, sudden drops in the share prices of many stocks across many different industries can occur. While this might cause many investors’ portfolios to decline, others may be profiting because of their short positions.
Investors might choose to short a stock to hedge against their long positions. The term “hedge” is used to refer to an investment that protects against losses in another asset. So, in this case, an investor may put on a short position to hedge or offset a potential loss in a long position.
What Happens in a Short Squeeze?
A short squeeze refers to the rapid flight of short sellers from a stock in order to limit losses — a situation that leads to a dramatic surge in the stock’s price.
Here’s how they typically occur: a sudden increase in the stock price causes investors to scramble to close their short positions by purchasing shares. This results in further gains in the stock, which in turn causes massive “covering” by other short sellers, bringing about a “squeeze.”
Famous cases include Volkswagen in 2008, after Porsche increased its stake in the German automaker, causing a short squeeze that briefly made Volkswagen the world’s most valuable stock by market cap.
More recently, in January 2021, the gains in GameStop (GME), a brick-and-mortar video-game retailer, were due to a massive short squeeze after retail investors piled into the stock, which hedge funds heavily shorted. Shares of movie-theater operator AMC Entertainment Holdings (AMC) and retailer Bed Bath & Beyond (BBBY) underwent similar experiences.
Is Shorting a Stock Wrong?
The practice of short selling is not without controversy. Shorting may have received a bad rap by being associated with the fear that shady investors will spread malicious rumors about a company to influence its share price.
But this kind of trickery can go both ways. There have also been investors who sought to manipulate the price of a stock upward by spreading bullish rumors that turned out to be false. Such tactics are considered market manipulation, and it is illegal. Anyone caught attempting to manipulate markets might be subject to regulatory punishment by the Securities and Exchange Commission (SEC).
Shorting can be a way of handling investing risks. For instance, shorting to hedge a position can be a type of risk management that helps investors minimize their losses, although doing so will also cap their gains.
Alternatives to Shorting a Stock
Shorting a stock is one of the several ways investors can bet on an asset’s price decline.
Put Options
If a brokerage account allows investors to trade options, buying a put option on a stock may allow the buyer to profit when it declines in price.
A put option is an options contract that gives the buyer the right to sell shares of an underlying asset at its strike price up until the option’s expiration date. The put option buyer pays a premium for the contract.
For example, imagine that an investor wants to short a stock that we’ll call ABC company. Shares of ABC are currently selling for $10. The investor believes the company is overvalued and the stock will soon head to $8 or lower.
So, they buy a put option for ABC with a strike price of $10 and an expiration date of three months in the future. The investor pays a $1 premium for the put. If ABC stock falls under $10 during that time, this option holder could exercise the contract to make money on the put option.
Suppose the stock falls below $8, as the put option buyer forecasted. They could sell it for an increased premium to someone else. If an investor were to exercise the option, they’d profit from being able to sell shares for $10 that are worth $8, pocketing the $2 difference, minus the $1 premium, leaving them with $1. Since each option contract is usually worth 100 shares, the total profit would be $100.
Buying put options is just one of the several options trading strategies investors can utilize if they have a bearish outlook on a stock. Options trading strategies can be profitable, but they are risky. Trading them requires more knowledge than trading stocks or exchange-traded funds (ETFs).
Inverse ETFs are another way to make a bearish trade. These investment vehicles aim to provide returns that are opposite the performance of an underlying index. Investors can buy inverse ETF shares just like ordinary stock.
Investors must understand that inverse ETFs are designed to be held and traded during a single trading day. Kept for longer, inverse ETFs may not achieve the exact -1x return of the underlying index. That’s because of how returns get compounded.
Let’s look at the S&P 500 Index and a hypothetical inverse ETF that tracks it. The S&P 500 is at 2,000 on a given day, while the inverse ETF is trading at $20 a share. If the S&P 400 Index falls 1%, its new level would be 1,980. Meanwhile, the inverse ETF’s price would rise to $20.20 since it’s supposed to move in the opposite direction of the S&P 500.
If the S&P 500 rose 2% the next day, however, the index would climb to 2,019.60. The index’s total gain over the two days would be 0.98%. Meanwhile, prices of the inverse ETF would fall to about $19.796 — so a loss of -1.02% over two days.
While the difference between 0.98% and -1.02% appears small, such discrepancies can add up over time, causing the inverse ETF to deliver returns that aren’t the mirror opposite of its underlying index. Therefore, investors should not assume that just because a market falls 5% in a week, its corresponding inverse ETF will rise 5% in that same period.
The Takeaway
Shorting a stock is when investors bet that the price of a specific stock or ETF will fall. Sophisticated investors with a bearish view of the market will often use short sales to profit from falling share prices. Short positions also help investors mitigate losses during widespread market downturns or hedge losses from another holding.
While shorting can be a useful investment tool, it’s also very risky. That’s because there’s no limit to how high a stock can go, meaning there’s also no limit to the losses a short seller can potentially book. Add to that the risk of a short squeeze — when there’s a massive rush by bearish investors to exit their short positions — and it’s fair to say that shorting can lead to painful losses.
SoFi Invest®️ offers access to financial planners and educational resources in order for investors to make better informed decisions. A SoFi Invest online brokerage account lets investors trade an array of stocks, ETFs or fractional shares. For a limited time, funding an account gives you the opportunity to win up to $1,000 in the stock of your choice. All you have to do is open and fund a SoFi Invest account.
Build your portfolio with SoFi Active Investing.
FAQ
What is naked short selling, and why is it illegal?
Naked short selling is a type of short selling where the seller does not have the borrowed securities in their possession at the time of the sale. This practice is illegal because it creates a potential for manipulation and fraud.
Why do short sellers have to borrow shares?
When a trader wants to sell a stock short, they must first borrow it from somebody else. They have to borrow shares because when you sell something, you have to have it to sell. The trader then hopes to repurchase the stock at a lower price so they can return the shares to the person they borrowed them from and pocket the difference.
Can I sell short in my brokerage account?
Many brokerages allow short selling in a regular account, but some require the investor to have a margin account. Your broker can tell you what kind of account you have and the requirements for short selling.
How is short selling different from regular investing?
Short selling is selling a borrowed security and hoping to repurchase it at a lower price to realize a profit. With regular investing, the investor buys the security and hopes to sell it at a higher price.
What is the opposite of shorting a stock?
The opposite of shorting a stock would be going long on a stock, meaning that the investor would purchase shares of the stock with the hope that the stock price would increase so that they could then sell the shares at a higher price and profit from the difference.
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.
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.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
Liquid assets are any assets that can be easily and quickly converted into cash. In fact, people often refer to liquid assets as cash or cash equivalents, because they know that the asset can be exchanged for actual cash without losing value.
Here’s a closer look at the topic and how liquid assets can contribute to your financial wellbeing.
Key Points
• Liquid assets are easily convertible to cash, allowing quick access to funds without significant loss in value, essential for financial flexibility during emergencies.
• Common examples of liquid assets include cash in bank accounts, stocks, bonds, mutual funds, and money market funds, which can be readily sold for cash.
• Non-liquid assets, such as real estate and collectibles, require more time and effort to convert into cash, often leading to potential value loss during the process.
• Maintaining liquid assets is important for calculating net worth, applying for loans, and ensuring a business can handle emergencies or market fluctuations effectively.
• Building liquid assets involves creating an emergency fund with three to six months’ worth of expenses, allowing for better financial security and investment opportunities.
What Makes an Asset Liquid?
Liquidity means that you can readily access an asset as cash. While you might own any number of valuable assets (e.g., your home, retirement accounts, collectibles) and these can be considered part of your overall net worth, only liquid assets can generate cash quickly, when circumstances demand it. If you needed cash quickly, you likely would not be able to sell your home overnight to get money.
For an asset to be considered liquid, it must be traded on a well-established market with a large number of buyers and sellers. It also must be relatively easy to transfer ownership. Think: stocks, bonds, mutual funds and other marketable securities.
Generally, you can sell stocks and obtain cash readily. By contrast, you probably couldn’t sell your vintage watch collection that fast, and even if you could, there are a number of factors that might influence how much cash value you might obtain from the sale.
Worth noting: Although liquid assets (aka cash and cash equivalents) pose very little risk of loss, they also have little or no capacity for growth.
What Investments Are Considered Liquid Assets?
As you can see, the primary advantage of liquid assets is that they can be converted to cash in a short period of time. For example, stock trades must be settled within two days, according to Securities and Exchange Commission rules. Here, you’ll learn more about what are considered liquid assets.
Examples of Liquid Assets
Here are some specifics about what a liquid asset is.
• Stocks. Stocks are often considered liquid assets because they can be converted into cash when you sell them. Keep in mind, though, that the most liquid stocks might be the ones that many people want to buy and sell. You may have a more difficult time liquidating stocks that are in lower demand.
• U.S. Treasuries and bonds. These instruments are relatively easy to buy and sell, and these processes are usually done in high volume. They have a wide range of maturity dates, which helps you to figure out when you want to liquidate them. Because U.S. Treasuries are often considered relatively safe and dependable, the interest rates are somewhat lower and could be a good fit for investors who are looking to mitigate risk.
• Mutual funds.Mutual funds are pooled investment vehicles that hold a diversified basket of stocks, bonds, or other investments.
◦ Open-end mutual funds are considered more liquid than closed-end funds because they have no limit on the number of shares they can generate. Also, investors can sell their shares back to the fund at any time.
◦ Closed-end mutual funds, on the other hand, are less common. These funds raise capital from investors via an IPO; after that, the number of shares are fixed, and no new shares are created. Instead, closed-end funds shares can only be bought and sold on an exchange, and thus are considered less liquid than open-end fund shares because they’re more subject to market demand.
• Exchange-traded funds and index funds. Like mutual funds, exchange-traded funds (ETFs) and index funds allow individuals to invest in a diversified basket of investments. ETFs are traded like stocks, throughout the day on the open market, which makes them somewhat more liquid than index funds, which only trade at the end of the day.
• Money market assets. There are two main types of money market assets:
◦ A money market fund is a type of mutual fund that invests in high-quality short-term debt, cash, and cash equivalents. It’s considered low-risk and offers low yields. It is therefore thought of as a relatively safe vs. risky investment. You can cash in your chips at any time, making money-market funds a liquid investment.
◦ Money market funds are different from money market accounts, which are a type of savings account that’s insured by the Federal Deposit Insurance Corporation (FDIC).
• Certificates of deposit. If you have money in a certificate of deposit or CD, this might be considered semi-liquid because your money isn’t available until the official withdrawal date. You can withdraw money if you need it, but if you’re doing so before the maturity date, you’ll likely pay a penalty.
Get up to $300 when you bank with SoFi.
No account or overdraft fees. No minimum balance.
Up to 4.20% APY on savings balances.
Up to 2-day-early paycheck.
Up to $2M of additional FDIC insurance.
What Assets Are Considered Non-Liquid?
There are, of course, many assets that are not easy to liquidate quickly. These assets typically take a relatively long time to sell or for the deal to close. You’ll get your money, but most likely not right away, and there may be time or costs associated with the conversion to cash that could impact the final amount. That’s why assets like these are considered illiquid or non-liquid assets.
Examples of Non-Liquid Assets
• Collectibles. Items like jewelry and artwork, as well as hobby collections like stamps and baseball cards, may be hard to value and difficult to sell.
• Employee stock options. While employee stock options can be a valuable form of compensation, they may also be highly non-liquid. That’s because employees must typically remain with a company for years before their options vest, they exercise them, and they finally own the stock.
• Land and real estate. These investments often require negotiation and contracts that can tie up real estate transactions for weeks, if not months.
• Private equity. There are often strict restrictions about when you can sell shares if you’ve invested in private equity assets such as venture capital funds.
Liquid Assets in Business
If you’re running a business, accounts receivable — the money you’re owed from clients — are often considered to be a liquid asset, because you can typically expect to be paid within one or two months of billing.
Any inventory you have on hand, such as office furniture or a product you’re selling, can also be considered liquid, because you could sell them for cash if need be. The liquid assets on your company balance sheet usually list cash first, followed by other assets that are considered liquid, in order of liquidity.
Having more liquid assets is desirable because it indicates that a company can pay off debt more easily. When businesses need to determine how cash liquid they are, they often look at the amount of their net liquid assets. When all current debts and liabilities are paid off, whatever remains is considered their liquid assets.
Are Retirement Accounts like IRAs and 401(k)s Liquid Assets?
Retirement accounts, such as individual retirement accounts (IRAs) and 401(k)s are not really liquid until you’ve reached age 59 ½. Withdraw funds from your account before then, and you may face taxes and a 10% early withdrawal penalty.
What’s more, you can hold a variety of assets inside retirement accounts. For example, if you hold a money market fund inside your IRA, that is a liquid asset. But you could also hold real estate, which very much isn’t.
Reasons Why Liquid Assets Matter
Other than the most obvious reason, which is that cash gives you a great deal of flexibility and can be essential in a crisis, liquid assets serve a number of purposes.
• Calculating net worth: To calculate your net worth, subtract your liabilities (your debt) from your assets (what you own, which can include your liquid assets).
• Applying for loans: Lenders might look at your liquid assets when you apply for a mortgage, car loan, or home equity loan. If your liquid assets are high, you may get better terms or lower interest rates on your loans. Lenders want to know that if you were to lose your job and/or your income, you would be able to continue to pay back the loan using your liquid assets.
• Business interests: Having liquid assets on your balance sheet is a signal that your business is prepared for an emergency or a market shift that could require a cash infusion.
Are All Liquid Assets Taxable?
While income is money you earn or receive, an asset is something of value you possess that can be converted to cash at some point in the future. While owning an asset doesn’t make it taxable, converting it to actual cash would, in most cases.
The IRS, or Internal Revenue Service, has many rules around how the proceeds from the sale of assets can be taxed.
The IRS considers taxable income to include gains from stocks, interest from bonds, dividends, alimony, and more. Gains on the sale of a home might be taxed, depending on the amount of the gain and marital status. If you aren’t sure whether income from the sale of an asset is taxable, it might be wise to consult a tax professional.
Is It Smart to Keep Cashing In Liquid Assets?
The point of maintaining a portion of your assets in liquid investments is partly for flexibility and also for diversification. The more access to cash you have, the more prepared you are to navigate a sudden change in circumstances, whether an emergency expense or an investment opportunity.
Having a portion of your portfolio in cash or cash equivalents can also be a hedge against volatility.
Thus, it may be worth keeping a mix of both liquid and non-liquid assets to help you reach your short-term financial goals as well as longer-term ones. And while cashing in liquid assets might be necessary, it’s also prudent to keep some cash on hand in case you need it. You may want to focus on gathering at least three to six months’ worth of expenses in the form of liquid assets as an emergency fund.
How Liquid Are You?
To figure out how liquid you are, make a list of all your monthly expenses, from rent/mortgage on down, including even your streaming service subscription. Then, make a list of all your liquid assets and investments (being careful to pay attention to the definition of liquid assets vs. illiquid assets, as it can be confusing).
Then, total all your monthly expenses, and compare that sum to the liquid assets in your possession.
Does your total savings cover six months’ worth of monthly expenses? If so, congrats! If not, you’re not very liquid. Don’t despair, though. There are ways to build up more liquidity by growing your emergency fund.
Where to Start Building Liquid Assets
As you start to build your liquid assets, first consider saving a cash cushion in the form of an emergency fund, which should be enough to cover any unexpected expenses that might come along.
Envision what you might need in the event of a crisis (e.g., a job loss, divorce, health event, and so on). In terms of how much to save in an emergency fund, aim to accumulate three to six months’ worth of expenses to cover basic bills, repairs, insurance premiums and copays, as well as any other personal or medical expenses.
One good way to build liquidity is to set money aside every week or month. Or you might have a set savings amount auto-deducted from each paycheck. You could keep the funds in a high-yield savings account to help them grow.
From there, you may consider opening a retirement account or a taxable brokerage account where you can invest in potentially more lucrative (but risky) liquid investments, such as stocks, bonds, mutual funds, and ETFs.
The Takeaway
Liquid assets are assets that can be converted into cash relatively easily — typically with little or no loss in value. Liquid assets can include cash in a checking or savings account, money market accounts, or marketable securities like stocks, bonds, mutual funds, and ETFs.
Liquid investments can play a surprisingly important role in your financial wellbeing. Having ready access to cash can help you pay off debt, cover a crisis, or be able to invest in new opportunities.
Having the right banking partner can help you keep your cash secure and earning interest.
Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.
Better banking is here with SoFi, NerdWallet’s 2024 winner for Best Checking Account Overall.* Enjoy up to 4.20% APY on SoFi Checking and Savings.
FAQ
What’s the definition of a liquid asset?
A liquid asset is an asset that is readily converted into cash, such as money in the bank, stocks, or a certificate of deposit (although you might owe a penalty when you liquidate it).
What does non-liquid asset mean?
Non-liquid assets are resources that can’t be quickly converted to cash, such as real estate, employee stock options, or collectibles (such as artwork or jewelry) that would have to be sold, which can take time and the price may fluctuate.
Is a 401(k) considered a liquid asset?
Retirement accounts, such as a 401(k) are not really considered liquid until you are over the age of 59 ½. Before that age, you would face a 10% early withdrawal penalty, as well as taxes, meaning you would take a loss on the value.
SoFi members with direct deposit activity can earn 4.20% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Direct Deposit means a recurring deposit of regular income to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government benefit payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, or are non-recurring in nature (e.g., IRS tax refunds), do not constitute Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate. SoFi members with direct deposit are eligible for other SoFi Plus benefits.
As an alternative to direct deposit, SoFi members with Qualifying Deposits can earn 4.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant. SoFi members with Qualifying Deposits are not eligible for other SoFi Plus benefits.
SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.20% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.
SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.
Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.
Interest rates are variable and subject to change at any time. These rates are current as of 10/31/2024. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.
*Awards or rankings from NerdWallet are not indicative of future success or results. This award and its ratings are independently determined and awarded by their respective publications.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
