invest Archives | Page 113 of 180

Aug

2023

Simple Moving Average (SMA): What Is a Simple Moving Average?

Simple Moving Average (SMA): Definition & How to Use It

By Austin Kilham | Growing Wealth, invest, Investing | Comments Off

Simple moving averages are one of the indicators that investors use in technical analysis to help them choose stocks. They’re the average of a range of the prices of a stock over a given time period.

Here’s how to calculate simple moving averages, what they represent, and how to use the information they provide.

What Is Simple Moving Average (SMA)?

A simple moving average is the average price of a stock, often its closing price, over a specific period of time. It’s called “moving” because stock prices always change. As a result, charts that track SMA move forward as each new data point is plotted. Investors use simple moving averages and other technical indicators to help them get an idea of the direction a stock price is moving based on previous prices.

While simple moving averages can give investors a sense of what could happen in the future, they have limitations. That’s because simple moving averages reflect past data, so they only represent past trends.

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Formula for Simple Moving Average

To calculate a simple moving average, Investors take the average closing price of a financial security and divide it by a set number of periods.

The formulas is as follows:

SMA = (P1 + P2 + P3…+ Pn)/n

P is price and n is the number of periods.

Let’s take a look at an example of stock price over a period of 10 days.

Day (n)	Closing price (P)
1	$40
2	$42
3	$47
4	$51
5	$46
6	$44
7	$40
8	$38
9	$37
10	$36

To arrive at the simple moving average, first total the closing prices and divide by the number of periods.

SMA = (40 + 42 + 47 + 51 + 46 + 44 + 40 + 38 + 37 + 36)/10 = 421/10 = $42.10

On day 11, if an investor wants to continue looking at a 10-day average, they would drop the first data point in the list above and add the closing price from the eleventh day, shifting the moving average forward by one data point. They would continue to do this for each subsequent day, and in this way, the average continues to move.

What Does SMA Show You?

Analysts often plot simple moving averages as a line on a chart of individual data points. The line helps smooth out movement, making it easier to identify trends. If the line representing the SMA is moving up, then the price of the stock is trending up. Conversely, if the SMA is moving down, prices are also trending downward.

For long-term trends investors typically look at SMA over 200 days, while intermediate trends may focus on a 50-day period. Short-term trends typically use fewer than 50 data points.

Longer-term SMAs can help smooth out stock volatility, but they also have the biggest lag when compared to current prices.

What Are Crossover Signals?

Investors may chart two SMAs — one relatively short and the other long — to generate crossover signals, points when the lines cross, which can help identify moments to buy or sell a stock.

When the shorter moving average crosses above the longer moving average, it is known as a “golden cross.” This is a bullish signal that tells investors that stock prices are trending in the upward direction. On the other hand, a bearish “death cross” occurs when the shorter moving average crosses below the longer moving average. This is a signal that prices are trending down.

What Are Price Crossovers?

Price crossovers are another signal investors may generate to help them identify moments to buy and sell. When a stock’s prices crosses over the moving average, it generates a bullish signal, and it generates a bearish signal when stock prices crosses under the moving average.

One Step Behind

Though analysts use SMAs to identify trends, they are still lagging indicators. SMAs reflect events that have already taken place, making it a “trend following” metric. In other words, they’ll always be a step behind what is happening in real time. As a result, SMAs do not predict future prices, but they can provide investors with some insight into where prices may be going.

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SMA vs Other Moving Averages

There are other moving averages investors may use when performing technical analysis on a stock. These help investors flesh out recent trends in stock price movement, but they also tend to be a bit more complicated to calculate.

SMA vs Weighted Moving Average

Like SMAs, weighted moving averages (WMAs) help establish the direction in which a stock price is likely moving. However, they put more emphasis on recent prices than SMAs.

Investors calculate a WMA by multiplying each data point by a weighting factor. That gives more weight to recent data and less weight to data farther in the past. The sum of the weighting must add up to 1, or 100%. Simple moving averages, on the other hand, assign an equal weight to each data point.

The formula for WMAs is:

WMA = Price1 x n + Price2 x (n-1) +…Pricen/[n x (n+1)]/2

Where n is the time period.

SMA vs Exponential Moving Average

An exponential moving average (EMA) also gives more weight to more recent prices. However, unlike WMAs, the rate increase between one price and the next is not consistent — it is exponential. Analysts typically use EMAs over a shorter period of time, making them more sensitive to price movements than SMAs are.

The formula for EMA is:

EMA = K x (Current Price – Previous EMA) + Previous EMA

K = 2/(n+1)

n = The selected time period.

For first-time EMA calculations, previous EMA is equal to SMA, an average of all prices over a number of periods, “n”.

Which Moving Average Is Better?

Each moving average has its own place in an investor’s tool belt. Investors may use WMAs and EMAs — which emphasize recent data — if they are worried that lags in data will reduce responsiveness. Some investors believe that the exponential weight given by EMAs makes them a better indicator of price trends than WMAs and SMAs.

Some more complicated indicators require a simple moving average as one input for calculations.

The Takeaway

If you’re just starting out as an investor, it can be hard to know which stocks to buy and when to buy them. Technical analysis strategies, such as moving averages, can help narrow your search and clue you in to potentially advantageous times to buy or sell.

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Aug

2023

Modern Monetary Theory, Explained

By Rebecca Lake | Financial Independence, Growing Wealth, invest, Investing | Comments Off

Money Monetary Theory or MMT is an alternative economic theory which says that governments that create and control their own currency should be able to do so without limits. More specifically, the heterodox theory argues that these governments shouldn’t fear incurring debt to further economic growth because they can not run out of money.

MMT emphasizes the creation of more money to meet a variety of economic needs, such as improving infrastructure, improving the quality of government-funded education, or expanding access to healthcare. While that may sound appealing, critics of the theory believe it could lead to an increase in inflation and skyrocketing national debt.

What Is MMT?

Modern Monetary Theory is an economic theory often associated with investment fund manager Warren Mosler, author of “The 7 Deadly Innocent Frauds of Economic Policy.” In the 2010 book, Mosler suggests governments that control their own currency can never run out of money or go bankrupt, since they can simply print more money.

Modern Monetary Theory challenges the idea that governments should pay for spending with taxes. Instead, the theory holds that taxes are a means of controlling inflation amid rising prices rather than funding the government’s spending initiatives. MMT can be seen as an extension of quantitative easing, in which a government’s central bank purchases long-term securities in order to boost the money supply.

Both seek to put more money into circulation, though Modern Monetary Theory doesn’t necessarily support the idea of resorting to negative interest rates to stimulate spending, which can occur with quantitative easing.

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Traditional Economics vs Modern Monetary Theory

In terms of its application, MMT economics is quite different from traditional economic theory. Specifically, it challenges the idea that printing more money to fund spending is inherently bad. Traditional economists view printing money as a less-than-ideal way to manage fiscal policy, since doing so can lead to rising inflation or a devaluation of currency.

Here’s a closer look at how traditional economic theories and modern economic theory compare.

Traditional Monetary Theory Explained: Key Concepts

• When the economy is struggling, the government can give it a boost using monetary and fiscal stimulus, or quantitative easing.

• Governments rely on interest rate policy to control inflation and the stability of currency values.

• Interest rate policy can also be used to stimulate spending during recessionary environments by encouraging borrowing while rates are low.

• Taxes and debt insurance are the two primary means by which governments fund their spending.

• Unlimited government spending and debt can lead to economic destabilization.

Modern Monetary Theory Explained: Key Concepts

• Governments that control their own currency effectively have access to unlimited spending, as they can always print more money.

• A country that follows MMT cannot go bankrupt or become insolvent unless it’s by political choice.

• Unlimited spending fuels economic growth and reduces unemployment.

• Taxes can curb inflation but they’re not their primary source of government funding.

• If a government incurs national debt, it can print more money to meet those obligations without fear of runaway inflation, deflation, or devaluing its currency.

In terms of inflation theory, MMT says the biggest risk is a government outspending its available supply of resources, such as raw materials or workers. But this scenario is rare, since it would require full employment or a shortage of supplies. If it did occur, MMT would dictate that the government could use taxation to manage inflation.

Modern Monetary Theory also states that governments don’t need to sell bonds to raise funds, since they can print their own money. Under this theory, the bond market becomes optional, rather than a requirement for maintaining government cash flows.

Modern Monetary Theory: Potential Benefits

While MMT is considered a radical theory in some circles, it has a simplistic appeal. If governments that control their currency can simply print more money as needed, then they have endless resources to promote economic growth. Deficits don’t disappear under this type of modern economic theory, rather they may grow.

From a taxpayer perspective, Modern Monetary Theory also has benefits, since it may mean fewer tax hikes to pay for government funding initiatives. Just like deficits, taxes wouldn’t disappear. But there’d be less fear of the government introducing new tax measures solely as a means of managing its own spending or debt.

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Modern Monetary Theory Flaws

While MMT has many vocal supporters, it’s also drawn plenty of critics, including Federal Reserve Chair Jerome Powell and Kenneth Rogoff, former Chief Economist and Director of Research at the International Monetary Fund. The consensus, for the most part, is that Modern Monetary Theory poses too great of a risk to national economies. Specifically, critics raise these arguments:

• Unlimited spending is not a catch-all solution. While MMT gives governments leeway to print money as needed, doing so is not necessarily a foolproof solution for tackling problems like unemployment or rising inflation. Again, if there’s a scarcity of resources or full employment, governments still have to rely on taxation to bring inflation under control.

• Unchecked debt is problematic. When an economy experiences a boom cycle, the national deficit may receive less attention. But it can become a very real financial problem governments have to deal with when the economy enters a recession and printing more money may not be a realistic solution.

• Rising rates could trigger hyperinflation. If rising deficits are accompanied by rising interest rates, the scales could tip from inflation to hyperinflation. This means rapid, out-of-control price increases and steep declines in currency values. Both of those can contribute to an economic crisis or collapse.

Those who suggest MMT is problematic may point to countries like Venezuela and Zimbabwe as examples of how it can go wrong. Though neither country specifically subscribed to Modern Monetary Theory, both relied on the printing of currency to navigate economic troubles. In both cases, the end result was severe hyperinflation and financial crises.

The Takeaway

Money Monetary Theory (MMT) says that governments that create and control their own currency should be able to do so without limits. If applied to the U.S. economy, Modern Monetary Theory could potentially impact your investments in different ways. So it’s important to keep this theory in mind when building a portfolio.

For example, it’s important to consider how inflation might affect the value of your investments. If inflation rises or the government has to impose tax increases to fund spending, that could affect the profitability and spending of the companies you invest in. Investing in companies that are more inflation- or recession-proof may help to insulate your portfolio against those risks.

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Aug

2023

Relative Strength Index (RSI) Explained

By Rebecca Lake | Growing Wealth, invest, Investing | Comments Off

Relative Strength Index, or RSI, is a momentum indicator used to measure a stock’s price relative to itself and its past performance. Developed by technical analyst J. Welles Wilder, the Relative Strength Index focuses purely on individual stock price movements to identify trading trends for a specific security, based on the speed and direction of those price changes.

RSI allows swing investors to compare the price of something to itself, without factoring in the performance of other stocks or the market as a whole. Investors use RSI to pinpoint positive or negative divergences in price for a security or to determine whether a stock is overbought or oversold.

The RSI indicator is useful in technical analysis, which revolves around finding trends in stock movements to determine optimal entry and exit points. Understanding what the Relative Strength Index measures and how it works is central to a technical trading strategy.

What Is RSI in Stocks?

The Relative Strength Index is a rate of change or momentum oscillator that tracks stock price movements. You can visualize it as a line graph that moves up or down, based on a stock’s price at any given time. The Relative Strength Index operates on a scale from 0-100. Where the RSI indicator is within this range can suggest whether a stock has reached an overbought level or if it’s oversold.

RSI is not the same thing as Relative Strength analysis. When using a Relative Strength Comparison (RSC), you’re comparing two securities or market indexes to one another to measure their relative performance.

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How Does the RSI Indicator Work?

The Relative Strength Index operates on a range from 0-100. As stock prices fluctuate over time, the index can move up or down accordingly. Traders typically use the RSI to track price movements over 14 periods (i.e. trading days), though some may use shorter or longer windows of time.

When the RSI indicator reaches 70 or above, it could mean the underlying asset being measured is overbought. An RSI reading of 30 or below, on the other hand, suggests that the asset is oversold. The length of time a stock remains in overbought or oversold territory depends largely on the strength of the underlying trend that’s driving price movements.

The Relative Strength Index can throw off different patterns, depending on whether stocks are in a bull market or bear market. Investors compare the movements of the RSI indicator with actual price movements to determine whether a defined pricing trend actually exists and, if so, in which direction it might be heading. Analyzing moving averages for the stock can help determine the presence of a clear pricing trend.

Recommended: 5 Bullish Indicators for a Stock

RSI Formula

Here’s what the Relative Strength Index formula looks like:

RSI = 100 – (100 / (1 + RS))

In this formula, RS represents the ratio of the moving average of the tracking period’s gains divided by the absolute value of the moving average of the tracking period’s losses.

Here’s another way you might see the Relative Strength Index formula displayed:

RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ) ) ]

The RSI formula assumes that you’re able to follow a stock’s pricing changes over your desired tracking period. More importantly than that, however, is knowing how to make sense of Relative Strength Index calculations, which investors often display via a stock oscillator.

Interpreting RSI Results

Reading the Relative Strength Index isn’t that difficult when you understand how the different ranges work. Depending on where the RSI indicator is for a particular stock or market index, it can tell you whether the market is bullish or bearish. You can also use the RSI, along with other technical analysis indicators, to determine the best time to buy or sell.

Above 70

An RSI reading of 70 or higher could indicate that a stock is overbought and that its price might move back down. This could happen through a reversal of the current price movement trend or as part of a broader correction. It’s not unusual for stocks to have an RSI in this range during bull market environments when prices are rising. If you believe that the stock’s price has reached or is approaching an unsustainable level, an RSI of 70 or higher could suggest it’s time to exit.

Below 30

When a stock’s RSI reading is 30 or below, it typically means that it’s oversold or undervalued by the broader market. This could signal a buying opportunity for value investors but it could also indicate the market is turning bearish. It’s more common to see RSI readings of 30 or below during downtrends when stock prices may be in decline across the board.

40 to 90 Range

During bull markets, it’s not uncommon to see the Relative Strength Index for a stock linger somewhere in the 40 to 90 range. It’s less common to see the RSI dip to 30 or below when prices are steadily moving up. An RSI reading of 40 to 50, roughly the middle of the 0-100 scale can indicate support for an upward trend.

10 to 60 Range

In bear markets, or those filled with fear, uncertainty, and doubt, it’s more common to see the Relative Strength Index hover somewhere in the 10 to 60 range. It’s not unusual for stocks to reach 30 or below when the market is already in a downward trend. The middle point of the RSI can act as a support point, though the range shifts slightly to between 50 and 60.

Common RSI Indicators

Relative Strength Index indicators can help investors spot pricing trends. That includes identifying up and down trends, as well as sideways trends when pricing levels consolidate. The reliability of these indicators often hinges on the current phase of a stock or the market as a whole. When reading RSI indicators, it’s important to understand divergence and swing rejections.

Divergence

A divergence represents a variation or disagreement between the movement of the RSI indicator and the price movements on a stock chart. For example, a bullish divergence means the indicator is making higher lows while the price movement is establishing lower lows. This type of divergence can hint at increasing bullish momentum with a particular stock or the greater market.

A bearish divergence, on the other hand, happens when the indicator is making lower highs while prices are establishing higher highs. This could indicate that investor sentiment is becoming less bullish.

Swing Rejections

A swing rejection is a specific trading technique that involves analyzing RSI movements when pushing above 30 or below 70. Swing rejections can be bullish in nature or bearish.

For example, a bullish swing rejection has four parts or steps:

• RSI is at an oversold level

• RSI moves above 30

• A dip is recorded without rating as oversold

• RSI passes its recent high

Meanwhile, a bearish swing rejection also has four parts or steps:

• RSI reaches an overbought level

• RSI drops below 70

• RSI hits new highs without dropping back to overbought levels

• RSI passes recent lows

Swing rejections make it possible to utilize divergence indicators to spot bullish or bearish trends in their earliest stages.

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Is RSI a Good Indicator to Use?

Yes, in certain circumstances. Relative Strength Index can be a good indicator to use in technical analysis, as it can make it easier to detect when a stock or the broader market is overbought or oversold. Understanding how to interpret RSI and its correlation to price movements could help you spot buy or sell signals and detect bull market or bear market trends.

That said, RSI also has some limitations. For example, the RSI can produce false positives or false negatives when bullish or bearish trends don’t align with the way a stock’s price is moving. Like other technical analysis indicators, it’s not an exact way to gauge the market’s momentum. So if stocks are hovering somewhere in the 40 to 60 range, it may be difficult to decipher whether the mood is bearish or bullish.

When using RSI, it’s helpful to incorporate other technical analysis indicators to create a comprehensive picture of the market. Exponential moving average (EMA), for example, is a type of moving average that uses the weighted average of recent pricing data to draw conclusions about the market.

Traders often use RSI in conjunction with other trend indicators, such as the Moving Average Convergence Divergence, the Stochastic Oscillator, or the Volume-Weighted Average Price.

RSI vs MACD

Moving Average Convergence Divergence (MACD) is a technical analysis indicator that investors may use alongside RSI. This indicator can help them determine when to buy or sell, based on the correlation between two moving averages for the same security.

Specifically, it requires looking at a 12-period moving average and a 26-period moving average. To find the MACD line, you’d subtract the 26-period from the 12-period, resulting in a main line. The next step is creating a trigger line, which is the nine-period exponential moving average of the main line. The interactions between these two lines can generate trading signals.

For example, when prices are strongly trending in a similar direction the main line and trigger line tend to move further apart. When prices are consolidating, the lines move closer together. If the main line crosses the trigger line from below, that can produce a buy signal. If the main line crosses the trigger line from above, that can be construed as a signal to sell.

While RSI and MACD are both trend indicators, there are some differences. Relative Strength Index measures the distance between pricing highs and lows. So you’re looking at the average gain or loss for a security over time, which again usually means 14 periods. The MACD, on the other hand, focuses on the relationship between moving averages for a security. It’s a trend-following signal that, like RSI, can indicate momentum.

RSI vs Stochastic Oscillator

The stochastic oscillator is a momentum indicator for technical analysis that shows where a stock’s closing price is relative to its high/low pricing range over a set period of time. The stochastic oscillator can also be used to track pricing for a market index.

Central to the use of the stochastic oscillator is the idea that as a stock’s price increases, the closing price inches closer to the highest point over time. When the stock’s price decreases, the closing price lands closer to the lowest low. Investors use this indicator to determine entry and exit points when making trades.

However, investors interpret RSI and stochastic oscillator readings differently. For example, with a stochastic oscillator, a reading of 20 or below generally means a stock is oversold, versus the 30 or below range for RSI readings. When used together, Relative Strength Index and stochastic oscillators can help with timing trades to maximize profit potential while minimizing the risk of losses.

Can You Use RSI to Time the Crypto Market?

Stocks are not the only asset class for which investors use the RSI. Investors also use the Relative Strength Index to assess conditions in the crypto markets and whether it’s time to sell or continue to HODL.

Cryptocurrency traders may use RSI to gauge momentum for individual currencies. Again, they’re looking at the highs and lows to get a sense of which way prices are moving at any given time. The RSI indicator can help with choosing when to buy or sell, based on previous price movements.

The same rules apply to crypto that apply to stocks: An RSI reading of 70 or above means overbought while a reading of 30 or below means oversold. Likewise, a reading above 50 signals a bullish trend while a reading below 50 can signal a bearish trend. Investors can also use a bearish divergence or bullish divergence to spot a pullback or an upward push.

As with stocks, however, it’s important to remember that RSI is not 100% accurate.

The Takeaway

RSI can be used to pinpoint positive or negative divergences in price for a stock or to determine whether it’s overbought or oversold. If you’re interested in technical analysis and trending trading, RSI can be a useful metric for making investment decisions.

The RSI is just one tool that you can use to devise a strategy for your portfolio. There are other less technical tools you can use as well when you’re starting to build a portfolio.

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

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.

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.

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Aug

2023

What Happens If a Stock Goes to Zero?

By Laurel Tincher | Growing Wealth, invest, Investing, Terminology | Comments Off

As any long-term investor in the market can attest, stocks rise and fall — influenced by a mix of economic trends and supply and demand.

Given the inherent volatility of stock values, there are periods when the market is down, and times when it’s gaining steam. So, how low can a stock go? Well, in some cases, stock prices can fall all the way to zero.

What happens when a stock goes to zero? Watching a stock in free fall can induce fear and panic in investors, causing some to sell their holdings. While most every investor aims to buy low and sell high, timing the stock market is very challenging and doesn’t guarantee that investors will see gains.

Sometimes when a stock goes down in value it can present an investment opportunity, but in other cases the stock could fall to zero and never recover. In the latter case, it may benefit investors to sell before the stock price falls all the way down to zero.

What Causes a Stock to Fall to Zero?

When a stock falls to zero, it doesn’t mean that the company is worth nothing. Some companies with very low stock values are still earning money or possess assets. And, some investors buy penny stocks that have extremely low prices.

What happens to a company when stock prices fall to zero? If a company continuously spends more money than it earns, and investors sell off the stock, ultimately, that can lead to the company going bankrupt. Most companies file for either Chapter 7 or Chapter 11 bankruptcy before their stock reaches $0.00.

Chapter 7 Bankruptcy

With a Chapter 7 bankruptcy filing, the company must sell off its assets until it can repay lenders and creditors. The order that stakeholders get paid is: creditors, bondholders, preferred stockholders, common stockholders.

This means that if the asset sale doesn’t bring in enough money to pay everyone, it’s likely that common shareholders won’t receive a dime. In this case, stockholders lose all the money they had invested in that stock.

Under Chapter 7, stock trading and all business activities must be put on hold.

Chapter 11 Bankruptcy

Under a Chapter 11 bankruptcy, the company negotiates loan terms with its creditors in order to avoid selling off assets. With Chapter 11, companies can still conduct business and their stock can be traded.

Once a company files for Chapter 11, it is likely that the stock will continue to fall, since many investors won’t have much faith in the business. Sometimes shares are canceled with a Chapter 11 filing. In that case, investors lose all the money they had put into the stock.

Even if a company files for bankruptcy before its stock falls to zero, their attempts to salvage the business may ultimately fail and the stock could become worthless. However, it can take a strong team and business model to go public and get listed on stock exchanges in the first place, so some bankrupt companies may have the potential to make a comeback.

Some companies with very low stock prices get acquired by larger companies before their stock falls to zero. Even a company with a low stock might have a promising product or service that a larger company is able to sell successfully. One example of this is when Alphabet acquired FitBit in 2021.

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What Happens to a Company When Stock Prices Fall to Zero?

Some stock exchanges delist stocks if they fall below a certain level. For example, the New York Stock Exchange will remove a stock if its share price falls below $1 for 30 days in a row.

And, as mentioned above, if a company files for Chapter 7 bankruptcy, its stock will be delisted temporarily.

Can a stock go negative? Fortunately, it is not possible for a stock’s price to go into the negative territory — under zero dollars in value, that is.

Still, if an investor short sells or uses margin trading, they may lose more than they invested. For this reason, margin trading and short selling are risky investment strategies.

Short selling is when an investor predicts that a stock is going to decrease in value. So, rather than buying the stock, they ‘bet’ that it will go down. If the stock does in fact go down, they make money.

But, if the stock ends up increasing in value, they lose money. Potentially, an investor in this scenario could lose more money than they put into the initial short sell.

Margin trading is when an investor borrows money from the brokerage firm to trade stocks. If the investor makes a trade that doesn’t go in their favor, they can end up owing the brokerage firm money.

How Low Can a Stock Go?

Stock prices can fall all the way down to zero. That means the stock loses all of its value and a shareholder’s earnings are typically worthless. In this case, the investor loses what they invested in the stock.

Reasons for a Stock Losing Value Down to Zero

What makes a stock fall to zero? The are a number of reasons that may come into play, including:

• Losses in the company’s revenue or earnings, especially if the losses are persistent

• A perception in the market that the stock is overvalued

• Management issues, shake-ups in the company’s leadership positions, scandal, fraud — in short, anything that can make investor sentiment turn negative

For investors, these are all signs a stock is underperforming and red flags to watch out for.

Types of Stocks Likely to Fall to Zero

What is a stock that falls to zero? Every stock comes with risks, but some are more risky than others. Besides companies on the brink of bankruptcy, there are certain types of businesses that have a higher chance of becoming worthless.

Knowing what to look for and researching and evaluating stocks before buying is key to building a resilient portfolio. Some of these higher risk stocks might include:

Companies With Weak Business Models

Even if a stock is currently performing well, it may fall in the future if the business model is fundamentally flawed. For this reason, many investors prefer to research a company’s practices, team composition, and business model before investing in its stock.

Penny Stocks

Stocks that trade below $5 are known as penny stocks. These low price stocks tend to be very volatile, as the companies that issue them have low or no profit.

Sometimes penny stocks can even turn out to be scams.

Buying the Dip

Rather than selling stocks when the market declines, some investors believe it can be a good idea to buy while the market is low. By buying the dip, as it’s known, investors pay less for stocks.

And, since these stocks still have the potential to go up in value as the market recovers after the decline, they can be preferred by long-term investors who may have more time to let their portfolio go back up in value.

However, if a company is going bankrupt or otherwise likely to fall to zero, it’s unlikely to offer a strong return on investment.

It’s also very difficult to time the market, so a trader might buy in when they think the market has hit bottom, only to watch it continue to go down.

Generally, building a diversified portfolio can offer higher returns on average over time than trying to time the market based on shorter-term trends or dips.

Examples of Stocks That Fell to Zero

There are two particularly infamous examples of stocks that fell to zero:

Enron

In the 1990s, Enron, an energy company, hid massive losses by using accounting tricks. At one point, its stock price was over $90. In 2001, analysts and investors became suspicious and began asking questions. That same year, the company reported huge losses, and its stock plummeted to $0.26 right before it declared bankruptcy.

World Com

This telecom company falsely inflated its cash flow and net income by listing expenses as investments to hide losses. Its stock price fell from more than $60 a share to less than $1 before the company declared bankruptcy in 2002.

💡 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.

How to Prevent Holding a Stock that’s Falling Lower

While it’s true that the market is impossible to predict, there are some measures that investors can take to protect themselves from losses — especially in the case of a stock spiraling towards zero. Below are some common preventative investment measures.

Stop Losses

Knowing when to sell a stock is important. Investors can set up a trade to automatically sell shares if a stock reaches a specific price. This type of trade is called a stop loss. It’s a strategy that could help prevent losses in the case of an individual stock or overall market drop.

There are multiple types of stop losses, including trailing stops and hard stops. Trailing stops move the stop level up as the stock rises in value, but stay in place if the stock falls. Hard stops are fixed at a specific price and will execute if the stock falls to that price.

Limit Orders

Limit orders allow investors to set the price at which they want to buy a stock. An investor selects the price and the number of shares they wish to buy. In practice, the order only executes if the stock then hits that price.

This is one way for traders to step away without worrying that they’ll be buying in at a price they didn’t want.

Put Options

A put option is a type of order that gives traders the option to sell or short-sell a specific amount of stock at a specific price, within a certain time frame. If a stock decreases in value in this case, the trader can still sell it at a higher price than it previously held.

Diversifying Asset Holdings

In an effort to prevent losses, investors may want to diversify their portfolios into a mix of non-correlated assets — dividing their holdings between assets at a higher and lower risk of fluctuating in value.

In a diversified portfolio, if one asset class decreases in value, the other types may not. Over time, the ups and downs of each asset could possibly balance the losses in each.

Setting Up a Stock Portfolio

By researching companies and setting up a portfolio according to one’s personal risk tolerance, and then keeping tabs on the assets in that portfolio to monitor their performance, it may be possible to help hedge against a stock sinking down to zero.

FAQ

At what point does a stock become worthless?

A stock becomes worthless when it falls to zero and has no value. In this case, an investor loses the money they invested in the stock.

How low can a stock go before being removed?

Some stock exchanges delist stocks if they fall below a certain level. The New York Stock Exchange will remove a stock if its share price falls below $1 for 30 days in a row, for instance.

Do you owe money if a stock goes negative?

No. A stock price can’t go negative, or, that is, fall below zero. So an investor does not owe anyone money. They will, however, lose whatever money they invested in the stock if the stock falls to zero.

Image credit: iStock/MicroStockHub
Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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

SoFi Invest®

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

Aug

2023

How Does the Iron Butterfly Spread Work?

What Is an Iron Butterfly Option Strategy?

By Colin Dodds | Growing Wealth, invest, Investing | Comments Off

An iron butterfly spread is a type of options trade involving four separate options contracts. It’s a complicated and advanced options trade, meaning that many beginner investors will likely never use it — they may not have even heard of it.

Iron butterfly spreads can be used as a part of a larger options trading strategy, however, so long as investors understand the ins and outs of how it works, and most importantly, the risks involved.

What Is an Iron Butterfly?

An iron butterfly spread, sometimes called an “Iron Fly” or a “Butterfly Spread” is a trade involving four separate options contracts.

As a strategy that earns investors money when stocks or futures prices make moves within a defined range, it’s especially popular with traders who expect a decrease in implied volatility. To succeed with an iron butterfly spread, traders will try to forecast when option prices will likely decline, usually when the broader markets are in a holding pattern, or gradually moving upwards.

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

How Does an Iron Butterfly Trade Work?

An Iron Butterfly is a four-legged options spread, since an investor buys four options contracts, two calls and two puts. The call options allow the investor to buy a stock at a given price, and the put options allow the investor to sell a stock at a given price.

In the trade, the calls and puts have three strike prices, but the same expiration date.

In a put or call option, the strike price is the price an investor can sell the underlying security when it is exercised. With a call option, the strike price is the price at which the investor can buy the security. With a put, the strike price is the value at which they can sell the security.

The three strike prices consist of one in the middle, called the options straddle, and two other strike prices, called the strangle, positioned above and below that price. As a trade, the Iron Butterfly has the propensity to deliver profits when the option’s underlying stock hits its expiration date at the middle strike price.

Example of an Iron Butterfly

For the strategy to work, the call and put options that sit on either side of the target stock price should be far enough apart that they can still make money regardless of the unexpected price movement of the stock between the time when the trade is executed, and the expiration of the options.

As an example, you’re an investor with a sense that a stock would reach $50 in the next month, and that it would be at least within a range of $10 above or below the target price. To make an Iron Butterfly trade, you’d buy a call and a put option with a strike price of $50. Then you’d buy a call option ten dollars higher, followed by a put option ten dollars lower than the target price, or saddle price, of $50.

The theory behind the Iron Butterfly strategy is that there’s a high likelihood that the eventual price of the stock targeted in the strategy will trade within a profitable range by the time the strike price of the options arrives.

Pros and Cons of Iron Butterfly Spreads

There is a limit to the maximum profit that an investor can earn by using the Iron Butterfly. That’s because of the cost of the options they have to buy to make money on their bet, as well as the cost of the options they purchase to protect themselves in the event that their hunch is wrong.

In the strategy, the most money the investor can make becomes possible when the underlying stock reaches the stock price at which they’ve purchased the saddle options. But even in this best-case scenario, at least half of the options expire worthless.

While this limited return may seem like a downside, it also comes with limited risk. As long as the stock rises or falls — at the time of the options’ expiration — between the target price and the strike prices of the outlying call and put options, then the trade will not lose money. But the closer it is to the target price, the more money it will make.

The biggest risk in an Iron Butterfly strategy is that the stock trades outside of the strangle, making all of the options worthless.

Recommended: What Is Your Risk Tolerance?

How to Sell out of an Iron Butterfly Spread

The investor will have at least one option that is in the money, and possibly two options that are in the money, when the options expire. They will exercise those options, and make money on the trade.

Traders realize that it’s unrealistic that any given trade will reach its expiration date exactly at the strike price, or straddle price, that they choose. But with a smart spread on the outer range of the call and put options in the trade, the strategy can deliver returns on the capital put at risk that are consistently in the 15-20% range.

What Is the Difference Between Iron Condor and Iron Butterfly?

An Iron Butterfly is similar to another option strategy known as an Iron Condor. The strategies differ in terms of their strike prices and premiums. In an Iron Condor the strike prices are different and in an Iron Butterfly they’re the same. The premiums are higher in an Iron Butterfly than an Iron Condor.

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

The Takeaway

The Iron Butterfly is a trading strategy that investors use when they believe that a stock price will trade within a specific range. Rather than buying the stock itself, an Iron Butterfly involves purchasing four options based on the investor’s price prediction for a certain security.

Again, trading options is an advanced investment strategy that requires a good amount of background knowledge and market experience. It may not be a good idea for beginning investors to wade into options, or advanced moves like the Iron Butterfly. However, speaking with a financial professional may help get you prepared for trading options.

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

Photo credit: iStock/ponla1975

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

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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.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

SOIN0723046

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FAQ

At what point does a stock become worthless?

How low can a stock go before being removed?

Do you owe money if a stock goes negative?

What Is an Iron Butterfly Option Strategy?

What Is an Iron Butterfly?

How Does an Iron Butterfly Trade Work?

Example of an Iron Butterfly

Pros and Cons of Iron Butterfly Spreads

How to Sell out of an Iron Butterfly Spread

What Is the Difference Between Iron Condor and Iron Butterfly?

The Takeaway

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