Sep
28
2023
How Dark Pools Operate – and Why They Exist

What Is a Dark Pool in Trading?

By | Growing Wealth, invest, Investing, Terminology | Comments Off on What Is a Dark Pool in Trading?

Dark pools, sometimes referred to as “dark pools of liquidity,” are a type of alternative trading system used by large institutional investors to which the investing public does not have access.

Living up to their “dark” name, these pools have no public transparency by design. Institutional investors, such as mutual fund managers, pension funds, and hedge funds, use dark pool trading to buy and sell large blocks of securities without moving the larger markets until the trade is executed.

Understanding the History of Dark Pools

The history of dark pools in the trading world starts in the 1980s, following changes at the Securities and Exchange Commission (SEC) which effectively allowed brokers to make trades in large share blocks. Later, in the mid-2000s, further SEC changes that were meant to cut trading costs and increase market competition led to an increase in dark pool trading.

Dark Pool Examples

There are many dark pools out there, and they can be operated by independent companies, brokers or broker groups, or stock exchanges themselves. An internet search would bring up names of specific dark pools.

But to get a sense of how a dark pool can be used to investors’ benefit, say there’s a mutual fund looking to sell 2 million shares of Stock X. Given that selling that amount of shares would create ripples in the market, the mutual fund may not want to sell them all at once. As such, they sell them in blocks of 10,000, 1,500, or 5,000 shares — and find buyers for the smaller blocks accordingly.

This method makes it less obvious that a huge number of shares are being sold, which could avoid Stock X’s shares losing value quickly.

Who Runs Dark Pools?

Investment banks typically run dark pools, but some other institutions run them as well, including large broker-dealers, agency brokers, and even some public exchanges. Some trading platforms, where individual investors buy and sell stocks, also use dark pools to execute trades using a payment for order flow.

Recommended: What Is a Market Maker?

The role of dark pools in the market varies over time. At times, dark pool trades comprise as much as half of all trading in a single day, while at other times, they make up significantly less of U.S. equity volume.

Because trades in a dark pool aren’t reflected in the prices on a public exchange, participants in a dark pool trade based on the prices offered on a public exchange, using the midpoint of the National Best Bid and Offer (NBBO) to set prices.


💡 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.

Why Institutions Use Dark Pools

Large, institutional investors such as hedge funds, may turn to dark pools to get a better price when buying or selling large blocks of a single stock. That’s because of the way that large trades impact the public markets.

As discussed, if a mutual fund manager, for example, wants to sell a million shares of a given stock because it’s underperforming or no longer fits their strategy, they’d need to use a floor trader to unload the position on a public exchange. Selling all those shares could impact the price they get, driving down the VWAP (volume weighted average price) of the total sale.

To avoid driving down the price, the manager might spread out the trade over several days. But if other traders identify the institution or the fund that’s selling they could also sell, potentially driving down the price even further.

The same risk exists when buying large blocks of a given security on a public market, as the purchase itself can attract attention and drive up the price.

Recommended: How to Identify an Underperforming Stock

New Risks

The risks of attracting attention from other traders have intensified with the rise of algorithmic trading and high-frequency trading (HFT). These strategies employ sophisticated computer programs to make big trades just ahead of other investors. HFT programs flood public exchanges with buy or sell orders to front-run giant block trades, and force the fund manager in the above example to get a worse price on their trade.

Dark Pool Benefits

Utilizing a dark pool and conducting a dark trade, institutional investors can sell a million shares of a stock without the public finding out because dark pool participants don’t disclose their trades to participants on the exchange. The details of trades within a dark pool only show up after a delay on the consolidated tape — the electronic system that collates price and volume data from major securities exchanges.

There are other advantages for an institutional trader. Because the buyers and sellers in a dark pool are other institutional traders, a fund manager looking to sell a million shares of a given stock is more likely to find buyers who are in the market for a million shares or more. On a public exchange, that million-share sale will likely need to be broken up into dozens, if not hundreds of trades.

Criticism of Dark Pools

As dark pools have grown in prominence, they’ve attracted criticism from many directions, and scrutiny from regulators. For instance, the lack of transparency in dark pools and the exclusivity of their clientele makes some investors uneasy. Some even believe that the pools give large investors an unfair advantage over smaller investors, who buy and sell almost exclusively on public exchanges.

The Takeaway

As discussed, dark pools are sometimes referred to as “dark pools of liquidity,” and are a type of alternative trading system used by large institutional investors to which the investing public does not have access. They’re typically run and utilized by large investment banks.

Given the nature of dark pools, they attracted criticism from some due to the lack of transparency, and the exclusivity of their clientele. While the typical investor may not interact with a dark pool, knowing the ins and outs may be helpful background knowledge.

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 can you see dark pool trades?

Investors can access dark pool trading data through various securities information processors, and can be accessed through FINRA’s website as well.

Who regulates dark pools?

The Securities and Exchange Commission, or SEC, is the government body that regulates dark pools and dark pool trading.

What are dark pools in cryptocurrency?

A dark pool in cryptocurrency is more or less the same as a dark pool in other equities markets, and is a place that matches buyers and sellers for large orders outside of a public exchange or view.

How do dark pools differ from lit pools?

As many might surmise, lit pools are effectively the opposite of dark pools, in that they show trading data such as number of shares traded and bid/ask prices.

Photo credit: iStock/DNY59

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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Sep
27
2023
The Effects of Deadweight Loss

The Effects of Deadweight Loss

By | invest, Investing, Terminology | Comments Off on The Effects of Deadweight Loss

Deadweight loss is the term used to describe societal or economic losses caused out of inefficiencies. It’s an economic term, and refers specifically to losses created as a result of a lack of equilibrium in supply and demand models — or, in other words, when resources are not being used as efficiently as possible.

This can have larger impacts on the overall economy, which can trickle down and have an effect on the markets and on investors, too. As such, investors would do well to understand the concept, and how it may impact their portfolios.

What Is Deadweight Loss?

As noted, deadweight loss refers to inefficiencies created by a misallocation or inefficient allocation of resources, and is an important economic concept. Deadweight loss is often due to government interventions such as price floors or ceilings, or inefficiencies within a tax system.

To understand more fully, it can be helpful to think about how government interventions can impact the equilibrium between supply and demand.

First: How to Calculate Surplus

In order to know how to calculate deadweight loss, we must first be able to calculate surplus.

Typically, a business will only sell something if they can do so at a price that’s greater than what they paid for it themselves, and a consumer will only buy something if it’s at or less than the price they want to pay for it — the same principle as generating a stock profit.

Scenario A — The Equilibrium: Let’s imagine a store selling comic books for $10 each. The store buys the comic books from the wholesaler for $5 and sells them for $10, pocketing $5 of “producer surplus.” Before the store opened, comic book readers would go over to the other town to buy comic books for $15, the price they were willing to pay, but now can buy them for $10. This $5 difference between the price they’re willing to pay is the “consumer surplus”.

In this case, let’s say the store is able to sell 1,000 comic books, that means the combined producer and consumer surplus is $10,000.

Breakdown:

•  P1 = Producer’s Cost of a Comic Book = $5

•  P2 = Producer’s Price to Sell a Comic Book = $10

•  P3 = Price A Consumer Pays = $10

•  P4 = Price A Consumer Is Willing to Pay = $15

•  Units Sold = 1,000

•  Producer Surplus = (P2 – P1) * Units Sold = ($10 – $5) * 1,000 = $5,000

•  Consumer Surplus = (P4 – P3) * Units Sold = ($15 – $10) * 1,000 = $5,000

•  Total Surplus1 = Producer Surplus + Consumer Surplus = $5,000 + $5,000 = $10,000

Deadweight Loss Graph

Deadweight loss can be found on a supply and demand graph, or supply and demand curve. That graph generally shows the relationship between supply and demand with two lines that intersect at an equilibrium point, with a downward-sloping demand line and an upward-sloping supply line.

On such a graph, deadweight loss can be found to the left of the equilibrium point, comprising both the consumer surplus and consumer surplus.

Common Causes of Deadweight Loss

There can be several causes of deadweight loss, but some of the most common are government-mandated changes to markets. Examples include price floors, such as a minimum wage, which can create some inefficiencies in the labor market (there may be workers who would be willing to work for less than minimum wage). Price ceilings, also can create deadweight loss — an example could be rent control. Finally, taxes can create deadweight loss, too.


💡 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.

How to Calculate Deadweight Loss

To properly calculate deadweight loss, you need to be able to represent the supply and demand of the goods being sold graphically in order to determine prices. According to the laws of supply and demand, the higher a price goes, the fewer of that item will get sold; and vice versa.

Example of Deadweight Loss

Scenario B — Imposed Tax: Let’s go back to our comic book example and imagine that the town’s government imposes a $2 tax on comic books.

What happens to the price of comic books and the surplus generated by the sales of comic books? If consumers had to buy comic books to live (and for some, it may feel that way) and there were no other way to buy them, then the comic book seller could simply bump up prices $2 and sell 1,000 comic books for $12 each, maintaining his $5 of producer surplus on each comic book sold with $2 going to the government and consumer surplus of $3.

In this case the combined consumer and producer surplus is lower — $5 × 1,000 + $3 × 1,000 = $8,000. So there’s a missing $2,000 of what economics call “gains from trade.” But, the government is collecting $2,000, so the money does not disappear from the economy.

The government can buy things, hire people, and literally send money to people, via economic stimulus, meaning the tax revenue does not disappear from the economy.

But, despite how fervently people want them, comic books are not a necessity in the same way food is and remember that comic book store in the neighboring town? If the demand for comic books can not literally be unchanged by its price, that means the comic book seller may think twice about passing on the tax fully on to his customers and that any price increase will result in some comic books going unsold.

If he were to increase the price to $12, thus passing on the tax to his customers, he may not be able to sell enough comic books to maintain the revenue he needs to keep his store open, so he lowers the price to $11, thus splitting the tax between himself and his buyers but still reducing the number of total comic books sold. In this case, let’s say he sells 600 comic books instead of 1,000.

The combined consumer and producer surplus is $4,800 ($4 × 600 + 600 × $4) with $1,200 of tax collected (600 × $2) meaning there’s a total of $6,000 of consumer surplus, producer surplus, and government revenue. In this case the deadweight loss is $4,000.

Breakdown:

•  P1 = Producer’s Cost of a Comic Book = $5

•  P2 = Producer’s Price to Sell a Comic Book = $9

•  P3 = Price A Consumer Pays = $11

•  P4 = Price A Consumer Is Willing to Pay = $15

•  Units Sold = 600

•  Tax = $2/Comic Book

•  Producer Surplus = (P2 – P1) * Units Sold = ($9 – $5) * 600 = $2,400

•  Consumer Surplus = (P4 – P3) * Units Sold = ($15 – $11) * 600 = $2,400

•  Gains From Trade (Tax) = $2 * 600 = $1,200

•  Total Surplus2 = Producer Surplus + Consumer Surplus + Gains From Trade = $6,000

•  Deadweight Loss = Total Surplus1 – Total Surplus2 = $10,000 – $6,000 = $4,000

The higher price, created through taxation, has impacted the equilibrium between supply and demand and created a deadweight loss — the surplus that evaporates due to fewer transactions happening between the comic book seller and the readers.

While this is a rather extreme example of what happens when taxes force up prices, it’s a good way of thinking about how deadweight losses are more than just items getting more expensive. Rather, the deadweight loss formula can illustrate the evaporation of mutually beneficial economic transactions due to different types of taxes.

Deadweight loss of taxation refers specifically to deadweight loss that occurs due to taxes, but a similar impact can occur when a government puts price floors or ceilings on items.

Why Investors Should Care About Deadweight Loss

Deadweight loss can affect investors in a number of ways, and it’s important to consider it when looking at different types of investments. One of the most debated issues in economics is the effects that the tax system has on income, investment, and economic growth in the short and long run.

Some argue that income taxes, payroll taxes (the flat taxes on wages that fund Social Security and Medicare) and capital gains taxes work like the comic book tax described above, preventing otherwise beneficial transactions from happening and reducing the economic gains available to all sides. There’s evidence on all sides of this debate, and the effects of tax rates on overall economic growth are, at best, unclear.

As an investor, deadweight loss might matter when it comes to companies or sectors impacted by specific taxes, such as sales taxes or excise taxes on alcohol or cigarettes. Deadweight loss shows how taxes on specific items can not only reduce profitability by increasing a company’s tax bill, but also affect revenue by reducing overall sales or driving down prices that businesses can charge or receive from buyers. As an investor, this knowledge and insight can be useful when allocating capital between companies, sectors, or types of assets.

The Takeaway

Deadweight loss is the result of economic inefficiencies, and it can affect an investor’s portfolio if it results in slower sales and revenues for businesses. It’s a large economic concept, and may not have a day-to-day direct impact on the stock market. But it’s still good for investors to know the basics of deadweight loss and how it applies to them.

There are myriad economic concepts investors should pay attention to, and deadweight loss is merely one of them. Studying deadweight loss and related concepts can help investors plan for the future and work toward their financial goals.

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

Why does a monopoly cause a deadweight loss?

A monopoly can cause deadweight loss because competitive markets create competition and fairer prices. A monopoly distorts prices, leading to inefficiencies.

Can deadweight loss be a negative value?

No, deadweight loss cannot be a negative value, but it can be zero. Zero deadweight loss would mean that demand is perfectly elastic or supply is perfectly inelastic.

Is deadweight loss market failure?

Deadweight loss is not a market failure, but rather, the societal costs of inefficiencies within a market. Market failures can, however, create deadweight loss.

Photo credit: iStock/akinbostanci

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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Sep
21
2023
The Basics of How Umbrella Insurance Works

The Basics of How Umbrella Insurance Works

By | Terminology | Comments Off on The Basics of How Umbrella Insurance Works

Umbrella insurance is a type of insurance policy that extends the personal liability coverage you probably already have through your homeowners or auto insurance. In other words, it’s a policy that helps protect your assets if you ever get sued for a whole lot of money.

Although most people won’t face a multi-million dollar lawsuit in their lifetimes, if you are the unlucky exception, an umbrella policy can help you avoid financial ruin. This is a relatively affordable kind of insurance coverage, too — although there are some additional costs it can require, which we’ll get into below.

Here’s what you need to know about umbrella insurance and how to decide if it’s right for you.

What Is Umbrella Insurance?

Certain types of insurance include liability coverage, which is insurance coverage that protects your finances and assets in case you get sued. You likely already have this kind of coverage, to some extent, through your homeowners or car insurance policy.

An umbrella insurance policy adds additional liability coverage on top of whatever coverages you might already have. That can be a lifesaver if you get sued for an amount of money large enough to exceed your existing liability insurance.

For example, say your auto insurance covers $25,000 in bodily injury liability per person and up to $50,000 in bodily injury liability per accident. It also covers up to $20,000 in property damage liability per accident. In total, you have a total of up to $70,000 per accident in coverage.

If you get into a fender bender, or even a moderately severe collision, that coverage might be sufficient. But say you get into a catastrophic accident that involves several cars and more than two people. That $70,000 isn’t going to be enough to cover multiple totaled vehicles or the medical bills for several hospital stays. If you’re sued for those losses and damages, you could lose your retirement savings, liquid savings and checking accounts, and potentially even your home.

If you have an umbrella insurance policy, that’s when it would kick in to cover the overage that your auto insurance policy doesn’t meet. Which is to say: umbrella insurance, as its name suggests, can protect you from a seriously rainy day.

But as with all insurance policies, it’s important to read the fine print.

💡 Quick Tip: Saving money on your fixed costs isn’t always easy. One exception is auto insurance. Shopping around for a better deal really can pay off.

What Does Umbrella Insurance Cover — or Not?

Although umbrella insurance is specifically meant to extend your existing liability coverages, it’s important to understand that these policies don’t cover everything. (Notably, umbrella insurance does not cover your personal property. It’s all about making sure your assets are covered when other people incur losses and damages.)

Although it’s always important to consult the specifics of the policy you’re considering for the full details, here’s a basic breakdown of what umbrella insurance typically does and does not cover.

What Umbrella Insurance Generally Covers

The good thing about umbrella coverage is that it’s an inclusive policy rather than an exclusive one. That means that instead of listing named perils, the way homeowners insurance does, umbrella insurance covers most liabilities with certain named exceptions.

But again, umbrella insurance is all about protecting you from the financial fallout of a lawsuit. It isn’t about protecting your physical home, car, or person from physical dangers. That’s why you still need homeowners, auto, and health insurance products.

Generally speaking, umbrella insurance covers liabilities related to:

•   Injuries

•   Property damage

•   Lawsuits

•   Other personal liability situations

Additionally, umbrella insurance usually extends to household members beyond you, the policyholder, and the incident doesn’t necessarily have to involve your personal property or vehicle to be eligible for umbrella coverage. Your umbrella policy might also cover you worldwide, with some exceptions. Again, consult your individual plan paperwork or insurance representative for full details.

What Umbrella Insurance Does Not Cover

Umbrella insurance is broad and inclusive, but it doesn’t cover every liability. Notable exceptions include:

•   Injuries sustained by you or your family or damages to your own property

•   Intentional actions that result in losses or damages (for example, if you get into a fight and punch somebody in the face)

•   Actions classified as criminal

•   Liabilities you agreed to assume in a contract you signed

•   Liabilities you incurred in your business or professional life. These require business liability insurance, which is a separate product

•   Liabilities caused by war or armed conflicts

What About Deductibles?

It’s also important to understand that even with umbrella insurance, you might still be responsible for paying a deductible when a claim is filed, whether it’s through the underlying insurance policy or the umbrella policy itself.

For example, imagine someone is injured during a party you throw in your home and they sue you for their medical costs and lost wages. Say your homeowners insurance policy covers up to $100,000 in personal liability, but your guest wins a lawsuit to the tune of $500,000.

If your homeowners insurance deductible is $1,000, you’ll need to pay that amount out of pocket before the homeowners coverage kicks in to pay for $99,000 toward the judgment. Then, your umbrella insurance would pay the additional $400,000, as well as any separate legal expenses related to the court proceedings.

Even if your underlying insurance doesn’t have a deductible, or if you use your umbrella policy to pay for a liability that other insurance policies don’t cover, you’d probably still be responsible for some of the cost. You’d likely be asked to pay a self-insured retention before the umbrella policy kicked in to cover the rest of the claim.

How Much Does Umbrella Insurance Cost?

Umbrella insurance is a relatively affordable policy, which makes it an attractive option for those seeking peace of mind in a “lawsuit happy” world. A $1 million umbrella policy costs about $150 to $300 per year, according to the Insurance Information Institute, and you can purchase even more coverage than that for less than $100 per million.

That said, because their products kick in after regular insurance is used, most umbrella insurers will require you to carry a decent amount of coverage already through your baseline policies. You’ll likely need to buy a minimum of $250,000 in liability insurance on your auto policy and $300,000 in liability insurance on your homeowners policy in order to qualify, which means you’ll probably be spending more on insurance overall.

💡 Quick Tip: Next time you review your budget, consider making room for additional insurance coverage. Think of it as an investment that can help protect you from a major financial loss.

Is It Worth Having Umbrella Insurance?

Learning how umbrella policies work is one thing. But how do you decide whether or not you need this coverage?

At the end of the day, as with so many financial matters, it comes down to your personal choice and level of risk tolerance. After all, anyone can get sued. That said, there are some people who are at higher risk of getting sued than others.

For example, if you regularly have large, raucous gatherings on property you own, you run a decent risk of someone getting injured, which could result in serious medical bills. Ditto if your home has a trampoline or pool. If you’re the owner of a dog or the parent of a teenage driver, you might consider umbrella insurance in case of accidental damages. Celebrities and public figures also often take out umbrella policies.

The Takeaway

Umbrella insurance is an extended liability insurance product that can help protect you in case of a lawsuit. Depending on how likely you are to be sued and your level of risk aversion, you may want to add umbrella insurance to your list of coverages. It’s important to remember, however, that umbrella insurance doesn’t cover all contingencies. And whether or not you take out an umbrella insurance policy, you need basic insurance products like homeowners, auto, and renters insurance.

When the unexpected happens, it’s good to know you have a plan to protect your loved ones and your finances. SoFi has teamed up with some of the best insurance companies in the industry to provide members with fast, easy, and reliable insurance.

Find affordable auto, life, homeowners, and renters insurance with SoFi Protect.

Insurance not available in all states.
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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.

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Sep
20
2023
financial charts

What Is Operating Leverage?

By | Growing Wealth, invest, Investing, Terminology | Comments Off on What Is Operating Leverage?

Operating leverage looks at the relationship between a company’s fixed costs (e.g. rent), its variable costs (e.g. shipping), and revenue. The higher a company’s fixed costs relative to its variable costs indicates a high operating leverage.

Knowing whether a company’s operating leverage is high or low is important because those two factors, when taken into account with revenue, have an impact on profitability. A company with higher fixed costs has a higher degree of operating leverage (DOL), which then determines how much revenue is needed after costs are met — i.e. after the break-even point — to make a profit.

Operating Leverage Definition

The definition of operating leverage is fairly straightforward: It’s the amount of a company’s fixed costs relative to its variable costs. But the impact of operating leverage is best understood in relation to revenue.

That’s because a company with lower fixed costs has a lower break-even point before revenue begins to generate a profit. A company with higher fixed costs, i.e. higher operating leverage, has to work harder to cover its fixed costs and reach that break-even point. What are some of those costs?

Fixed Costs and Variable Costs

Many people are familiar with the idea of a fixed expense vs. a variable expense, as these apply to everyday life as they do in business.

•   Fixed expenses. These are certain business expenses that rarely vary, like commercial rent, for example. It doesn’t matter how much a company earns or loses in a given month, the amount of rent owed on their lease is set at a fixed rate until the contract expires.

Fixed expenses tend to be related to time: e.g. X salaries per year for X employees, the cost of liability insurance, loan payments.

•   Variable expenses. These expenses are related to the selling of a product or service, e.g. inventory and shipping costs, or marketing and sales. Another would be a “work for hire” employee who may or may not stay with the company.

Recommended: How to Read Financial Statements: The Basics

Examples of Hybrid Semi-variable and Semi-fixed Costs

Sometimes costs blend together to create semi-fixed or semi-variable costs. For instance, a business may promise a plant supervisor a weekly salary of $1,500, plus 1% of the cost price for every widget produced under that manager’s supervision.

The fixed cost is the manager’s weekly salary of $1,500. That remains the same from pay period to pay period.

The variable cost is the 1% unit production percentage paid to the manager as an income incentive. That 1% payout is largely unknowable when the promise is made, making it a variable cost.

In another example, a company may pay its corporate finance manager a salary, which represents a fixed cost. Yet that same company may also pay its line workers on a production basis, based on a per-product wage formula. In that scenario, the same company may have dual fixed and variable costs in the same cost pipeline (i.e., salaries and wages), making those costs semi-variable and semi-fixed costs.

When trying to understand a business’s profitability and scalability, combining different metrics with operating leverage, like the asset turnover ratio, may also be helpful.

💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.

Understanding the Degree of Operating Leverage (DOL)

Since every business deals with a combination of fixed and variable expenses, understanding the degree of operating leverage is the next step in gauging a company’s path to profitability.

When a company has higher fixed costs, the break-even point is also higher. But once that point is reached, every additional dollar in revenue has the potential to generate more profit because fixed costs stay the same, regardless of changes in production (volume).

When a company’s variable costs are higher the break-even point may be lower, but additional revenue also potentially drives up the variable costs (because those costs rise as volume rises). This impacts profitability.

High Operating Leverage and Low Operating Leverage: A Comparison

Some industries tend to have a higher DOL and some tend to have a lower DOL. Those with higher fixed costs often include leases for land or buildings, or heavy R&D. Retailers are among those with lower fixed costs vs. their much higher variable costs (merchandise is pretty variable).

High Degree of Operating Leverage

 Low Degree of Operating Leverage
Airlines and automotive Food services (e.g. restaurants)
Energy Retailers (e.g. fashion)
Telecommunications Professional services
Pharmaceuticals Ecommerce

For example an airline has high fixed costs: It has to maintain a fleet of aircraft, pay fuel, salaries, insurance, and so on. A consulting firm has higher variable costs — i.e. the salaries and commissions of its consultant staff.

Recommended: How Fundamental Analysis Can Help Your Investing Strategy

Operating Leverage Formula

The operating leverage formula is a useful way to compare companies within the same industry.

Mathematically, the formula for operating leverage looks like this:

Operating Leverage = [Quantity (Price – Variable Cost per Unit)] / Quantity (Price – Variable Cost per Unit) – Fixed Operating Cost

Example Scenario and Calculation

For example, say Firm ABC has sold 1,000,000 hammers for $12 each. Firm ABC also has $10,000,000 worth of fixed costs, for expenses for machinery, office equipment, employees, among other costs. With unit sales at $12 each and $10 million in fixed costs, Firm ABC pays $0.10 per unit to make each hammer.

Here’s what that equation looks like in mathematical terms, and what the operational leverage outcome winds up being:

Operating Leverage = [1,000,000 x ($12 – $0.10)] / 1,000,000 x ($12 – $0.10) – $10,000,000 = $11,900,000/$1,900,000 = 6.26 or 626%

Based on that calculation, a 10% increase in revenue will result in a 62.6% operating income (i.e. profit) increase for Firm ABC.

But if you ran the numbers for Company XYZ, another hammer manufacturer, with different fixed costs and different variable costs, the amount of profit generated by an increase in revenue would also be different — and this could provide an important point of comparison for investing in one company vs. another.

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

How to Use Operating Leverage

Operating leverage helps to determine a few things. First, it’s used to measure the break-even point for a company. That’s the point at which expenses are covered and profit is zero — knowing this can help set appropriate per-unit prices.

That’s because changes in revenue naturally impact operating income, but calculating the DOL can reveal what that means for individual companies: i.e. how much will a 10% change in revenue affect profit? A high DOL company might see higher profits once fixed costs are covered. But if revenue decreases, there would be downward pressure on its margins.

Knowing the DOL can also help assess whether a company is getting the most out of its fixed-cost assets (e.g. the cost of the factory, machinery, maintenance), or are there efficiencies that might help generate higher operating income (profit)? By managing fixed cost items better, a company might increase profits without needing to move other levers like price or number of units sold.

The Takeaway

Operating leverage is an important metric in business. It can help analysts or investors better understand a company’s fixed costs relative to its variable costs, and how revenue will impact profit owing to the difference in break-even points.

For example, a company with higher fixed costs has higher operating leverage than a company with higher variable costs. So the higher DOL company will see a substantive change in profits as sales increase past the break-even point.

A company with higher variable costs (and lower operating leverage) will see a smaller profit on each sale — but because it has lower fixed costs, it likely won’t need to increase sales as much to cover those items.

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FAQ

What does it mean to have high operating leverage?

When a company has higher fixed costs it’s said to have a higher degree of operating leverage. This means the break-even point for that company is also higher. After that point, every additional dollar in revenue has the potential to generate more profit because fixed costs stay the same, regardless of changes in production (volume).

What does it mean to have low operating leverage?

When a company’s variable costs are higher, it has lower operating leverage (i.e. lower fixed costs). In that case the break-even point for that company is lower, and a lower proportion of additional revenue will go toward profit, because variable costs go up as sales rise.

How do you improve operating leverage?

One way to improve operating leverage is to reduce fixed costs where possible. This will lower the break-even point for a company and potentially increase profits. That said, different companies are structured differently, and improving operating leverage may require changes in variable costs versus a company that will benefit by lowering its fixed costs.

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

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Sep
20
2023
Are Scholarships Taxable?

Are Scholarships Taxable?

By | Financial Independence, student_loan, Terminology | Comments Off on Are Scholarships Taxable?

Generally, scholarships used to pay for qualified educational costs at an eligible educational institution aren’t considered taxable income. The same goes for any grants used to pay for college tuition and fees.

However, there are some cases in which scholarship or grant money may be taxable. For example, if you have money left over after covering your qualified education expenses and use it for other costs (such as room and board or school supplies not required by your program), these funds typically count as taxable income.

If you or your student received scholarship funding, it can be helpful to know ahead if it will contribute to your tax liability. Here’s what you need to know about identifying taxable scholarships and handling filing requirements.

Scholarships That Are Tax-Free

Students can be exempt from paying taxes on their college scholarships if they satisfy certain criteria. For one, they must be enrolled at an accredited college, university, or educational institution that maintains regular attendance.

Additionally, scholarship funds must be used to pay for qualified education expenses — a determination made by the IRS. Under this definition, qualified education expenses include the following:

• Tuition

• Mandatory fees (e.g., athletic and tech fees)

• Textbooks

• Equipment and supplies (e.g., lab equipment)

When it comes to textbooks, equipment, and supplies, anything that is required by your school to complete coursework would be free from taxes. If you use the funding towards an extra-curricular activity, such as a club or intramural sport, however, the amount you spend would be considered taxable.

If the scholarship is used for a certificate or non-degree program, the entire amount is taxable whether or not funds are used for qualified education expenses.

It’s important to note that any scholarship funds leftover after paying for qualified education expenses would become taxable income.

Scholarships Considered Taxable Income

How are scholarships taxable? According to the IRS, scholarships used for expenses outside the scope of qualified education expenses must be reported in gross income — making them taxable.

Scholarship funds used for the following costs are considered taxable by the IRS:

• Room and board

• Travel

• Medical expenses

• Optional equipment (e.g., new computer)

But are scholarships taxable income in any other situations?

Scholarships that are awarded in exchange for services like teaching or research, often known as fellowships, are classified as taxable compensation in most cases. Students would have to pay taxes even if their fellowship money is used to pay for tuition and other qualified education expenses.

However, there are a few exceptions when education-related payments could be tax-exempt. Specifically, students do not have to pay taxes on funds received for required services through the following scholarship programs:

• National Health Service Corps Scholarship Program

• Armed Forces Health Professions Scholarship and Financial Assistance Program

• Student work-learning-service programs operated by a work college

Other forms of financial aid could be considered taxable income as well.

Earnings through the Federal Work-Study program are subject to federal and state payroll taxes. If you stay below 20 hours a week while enrolled full-time, you won’t have to pay FICA (taxes for Medicare and Social Security) taxes.

Even Pell Grants — a federal aid program for students with significant financial need — are taxable if they’re not used for qualified education expenses.

Making it Legal: Reporting Taxable Awards

If a college scholarship is considered taxable, the student would need to report the scholarship (or portion of the scholarship) on their tax return.

Some students may receive a W-2 form from the scholarship provider outlining the taxable amount. Otherwise, they may need to calculate and enter the amount on their own tax return.

The student would report any taxable amount of a scholarship, grant, or fellowship as follows:

• If filing Form 1040 or Form 1040-SR, you would include the taxable portion in the total amount reported on Line 1a of your tax return. If the taxable amount wasn’t reported on Form W-2, enter it on Line 8 of Schedule 1 (and attach the form).

• If filing Form 1040-NR, you would report the taxable amount on Line 8 and fill out and attach a Schedule 1.

If you have questions about whether or not any portion of your scholarship money is taxable and how to report those funds on your tax return, it’s a good idea to consult a tax professional for personalized guidance.

How Education Tax Credits Fit in

Students and their family members may be eligible to claim the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Credit (LLC) if they paid for college and related costs in the past year. Take note that you can’t use both tax credits for the same student in the same year.

To claim either tax credit, you’ll need Form 1098-T from your college. This form shows any reportable transaction for an enrolled student.

To qualify for the AOTC or LLC, you could have paid educational expenses out of pocket or with student loans. Expenses that were paid for by tax-free scholarships are not eligible for a tax credit.

The AOTC and LLC differ in scope and eligibility, so it’s helpful to compare both to see which may apply and provide a greater tax return.

American Opportunity Tax Credit (AOTC)

The AOTC can be used for qualified education expenses — tuition, fees, textbooks, and necessary supplies — for a student’s first four years of college.

The maximum credit currently stands at $2,500 a year for eligible students. This is calculated as 100% of the first $2,000 in qualified education expenses paid for an eligible student plus 25% of the next $2,000 in qualified education expenses.

If the AOTC reduces your taxes to zero, it’s possible to have 40% of the remaining credit (up to $1,000) refunded.

Eligibility for the AOTC is based on the tax filer’s modified adjusted gross income (MAGI). If you’re filing separately, your MAGI must be $80,000 or less to qualify for the full AOTC credit. The threshold is $160,000 for married filing jointly.

It’s possible to receive a reduced AOTC amount if filing separately with MAGI between $80,000 and $90,000 or $160,000 and $180,000 for married filing jointly.

Recommended: 23 Tax Deductions for College Students and Other Young Adults

The Lifetime Learning Credit (LLC)

The LLC can apply to a broader range of expenses than the AOTC. It can be used to claim up to $2,000 for tuition and related educational expenses for undergraduate, graduate, or professional degree courses. Costs of non-degree programs that improve job skills are also eligible for the LLC.

This credit does not have a limit on the number of years it can be claimed on your tax return. However, the LLC has stricter income requirements.

For Tax Year 2022, the amount of your LLC is gradually reduced (phased out) if your MAGI is between $80,000 and $90,000 ($160,000 and $180,000 if you file a joint return).

You can’t claim the credit if your MAGI is $90,000 or more ($180,000 or more if you file a joint return).

Recommended: Can You Deduct Your Child’s Tuition from Taxes?

Don’t Forget Deductions

If you’re paying interest on a student loan, you may be eligible to deduct up to $2,500 of that interest with the student loan interest deduction. To be eligible, interest payments must be legally obligated and your filing status can’t be married filing separately.

There are also income requirements, which can vary annually, to factor in for the deduction calculation. For the tax year 2022, the filer’s MAGI must be less than $85,000 (or $170,000 if filing jointly) to be eligible for the full $2,500 deduction.

If your MAGI is between $70,000 and $85,000 (or $140,000 and $170,000 if filing jointly), you could qualify for a reduced deduction.


💡 Quick Tip: Need a private student loan to cover your school bills? Because approval for a private student loan is based on creditworthiness, a cosigner may help a student get loan approval and a lower rate.

The Takeaway

Scholarships, grants, and fellowships can help make college more affordable. Not only that, the funds you receive typically aren’t taxable.

A general rule is that your college scholarship is tax-free when it is used to pay for “qualified education expenses.” Exceptions include any part of the scholarship or grant you used to pay for supplemental things (not required for a course) or as payment for work or services you performed.

If scholarships, grants, other aid, and federal student loans are enough to cover the cost of your college education, you may want to consider applying for a private student loan. Loan limits vary by lender, but you can often get up to the total cost of attendance. Interest rates may be fixed or variable and are set by the lender. Generally, borrowers (or cosigners) who have strong credit qualify for the lowest rates.

Keep in mind, though, that private loans may not offer the borrower protections — like income-based repayment plans and deferment or forbearance — that automatically come with federal student loans.

If you’ve exhausted all federal student aid options, no-fee private student loans from SoFi can help you pay for school. The online application process is easy, and you can see rates and terms in just minutes. Repayment plans are flexible, so you can find an option that works for your financial plan and budget.


Cover up to 100% of school-certified costs including tuition, books, supplies, room and board, and transportation with a private student loan from SoFi.

Photo credit: iStock/pixelfit

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Please borrow responsibly. SoFi Private Student Loans are not a substitute for federal loans, grants, and work-study programs. You should exhaust all your federal student aid options before you consider any private loans, including ours. Read our FAQs. SoFi Private Student Loans are subject to program terms and restrictions, and applicants must meet SoFi’s eligibility and underwriting requirements. See SoFi.com/eligibility-criteria for more information. To view payment examples, click here. SoFi reserves the right to modify eligibility criteria at any time. This information is subject to change.

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.

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