InvestHL Archives | Page 23 of 52

Oct

2023

How Does High-Frequency Trading (HFT) Impact Markets?

By Inyoung Hwang | Growing Wealth, invest, Investing | Comments Off

High-frequency trading (HFT) firms use ultrafast computer algorithms to conduct big trades of stocks, options, and futures in fractions of a second. HFT firms also rely on sophisticated data networks to get price information and detect trends in markets.

A key characteristic of HFT trading — in addition to high speed, high-volume transactions — is the ultra-short time time horizon.

How high-frequency trading impacts markets is a controversial topic. Proponents of HFT say that these firms add liquidity to markets, helping bring down trading costs for everyone. HFT critics argue such firms are an example of how bigger, better-funded players have an advantage over smaller retail investors, and that HFT technology can be used for illegal purposes like front-running and spoofing.

What is High Frequency Trading?

Ultrafast speeds are paramount for high-frequency trading firms. Executing these automated trades at nanoseconds faster can mean the difference between profits and losses for HFT firms.

There are broadly two types of HFT strategies. The first is looking for trading opportunities that depend on market conditions. For instance, HFT firms may try to arbitrage price differences between exchange-traded funds (ETFs) and futures that track the same underlying index.

Futures contracts based on the S&P 500 Index may experience a price change nanoseconds faster than an ETF that tracks the same index. An HFT firm may capitalize on this price difference by using the futures price data to anticipate a price move in the ETF.

Another type of HFT is market making. Not all market makers are HFT firms, but market making is one of the businesses some HFT firms engage in.

A big market-making business for HFT firms is payment for order flow (PFOF). This is when retail brokerage firms send their client orders to HFT firms to execute. The HFT firms then make a payment to the retail brokerage firm.

💡 Quick Tip: Are self-directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

How HFT Works and Makes Money

High-frequency trading enables traders to profit from miniscule price fluctuations, and permits institutions to gain significant returns on bid-ask spreads. HFT algorithms can scan exchanges and multiple markets simultaneously, allowing traders to arbitrage slight price differences for the same asset.

Bid-Ask Spreads 101

High-frequency trading firms often profit from bid-ask spreads — the difference between the price at which a security is bought and the price at which it’s sold.

For instance, an HFT may provide a price quote for a stock that looks like this: $5-$5.01, 500×600. That means the HFT firm is willing to buy 500 shares at $5 each — the bid — while offering to sell 600 shares at $5.01 — the ask. The 1 cent difference is how the market maker makes a profit. While this seems small, with millions of trades, the profits can be sizable.

How wide bid-ask spreads are is also a marker of market liquidity. Bigger chunkier spreads are a sign of less liquid assets, while smaller, tighter spreads can indicate higher liquidity.

Recommended: What Is Quantitative Trading?

Payment For Order Flow 101

When it comes to payment for order flow, high-frequency traders can make money by seeing millions of retail trades that are bundled together.

This can be valuable data that gives HFT firms a sense of which way the market is headed in the short-term. HFT firms can trade on that information, taking the other side of the order and make money.

Background on High-Frequency Trading

High-frequency trading became popular when different stock exchanges started offering incentives to firms to add liquidity to the market. Liquidity is the ease with which trades can be done without affecting market prices.

Like momentum trading, the HFT industry grew rapidly as technology in the financial space began to take off in the mid-2000s.

Adding liquidity means being willing to take the other sides of trades and not needing to get trades filled immediately. In other words, you’re willing to sit and wait. Meanwhile, taking liquidity is when you’re seeking to get trades done as soon as possible.

During 2009, about 60% of the market was said to be HFT. Since then, that percentage has declined to about 50% as some HFT firms have struggled to make money due to ever-increasing technology costs and a lack of volatility in some markets. These days the HFT industry is dominated by a handful of trading firms.

Pros and Cons of High-Frequency Trading

HFT comes with certain pros and cons.

Pros of HFT

High-frequency trading is automated and efficient, thanks to its use of complex algorithms to identify and leverage opportunities.

HFT may create some liquidity in the markets.

Cons of HFT

Because high-frequency trades are conducted by institutional investors, like investment banks and hedge funds, these firms and their clientele tend to benefit more than retail investors.

Because high-frequency trades are made in seconds, HFT may only add a kind of “ghost liquidity” to the market.

Some HFT firms may also engage in illegal practices such as front-running or spoofing trades. Spoofing is where traders place market orders and then cancel them before the order is ever fulfilled, simply to create price movements.

The Debate Over High Frequency Trading

High-frequency trading is a controversial topic, and HFT firms have been involved in lawsuits alleging that they create an unfair advantage and potentially create volatility.

Criticism of HFT

One complaint about HFT is that it’s giving institutional investors an advantage because they can afford to develop rapid-speed computer algorithms and purchase extensive data networks.

Critics argue that HFT can add volatility to the market, since algorithms can make quick decisions without the judgment of humans to weigh on different situations that come up in markets.

For instance, after the so-called “Flash Crash” on May 6, 2010, when the S&P 500 dropped dramatically in a matter of minutes, critics argued that HFT firms exacerbated the selloff.

HFT critics also argue that such traders only provide a very temporary kind of liquidity that benefits their own trades, but not retail investors. A December 2020 paper published by the European Central Bank also argued that too much competition in the HFT industry can cause firms to engage in more speculative trading, which can harm market liquidity.

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

Defense of HFT

Defenders of high-frequency trading argue that it has improved liquidity and decreased the cost of trading for small, retail investors. In other words, it made markets more efficient.

This can be particularly important in markets like options trading, where there are thousands of different types of contracts that brokerages may have trouble finding buyers and sellers for. HFT can be helpful liquidity providers in such markets.

When it comes to payment for order flow, defenders of HFT also argue that retail investors have enjoyed price improvement, when they get better prices than they would on a public stock exchange.

The Takeaway

It’s tough to be an investor in many markets today without being affected by high-frequency trading. HFT firms are proprietary trading firms that rely on ultrafast computers and data networks to execute large orders, primarily in the stocks, options, and futures markets.

HFT proponents argue that their participation helps markets be more efficient. Critics argue that they have a big advantage over smaller investors, given how much they pay for information and data networks.

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FAQ

Is high-frequency trading profitable?

High-frequency trading aims to profit from micro changes in price movements through the use of highly sophisticated, ultrafast technology. That said, HFT investors are subject to losses as well as gains.

Is high-frequency trading illegal?

High-frequency trading has been the subject of lawsuits alleging that HFT firms have an unfair advantage over retail investors, but HFT is still allowed. That said, HFT firms have been linked to illegal practices such as front-running.

What is an example of high-frequency trading?

High-frequency trading can be used with a variety of strategies. One of the most common is arbitrage, which is a way of buying and selling securities to take advantage of (often) miniscule price differences between exchanges. A very simple example could be buying 100 shares of a stock at $75 per share on the Nasdaq stock exchange, and selling those shares on the NYSE for $75.20.

Photo credit: iStock/wacomka

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

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Oct

2023

What Is Pre-IPO Placement?

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

A pre-IPO placement involves the sale of unregistered shares in a company before they’re listed on a stock exchange for the first time. A pre-IPO placement usually occurs immediately before a company goes public.

Companies typically sell pre-IPO shares to hedge funds, private equity firms and other institutional investors that can purchase them in large quantities. It’s possible, however, to get involved in pre-IPO investing as an individual retail investor.

Investing in IPOs or pre-IPO stock could be profitable, if the company’s public offering lives up to or exceeds market expectations. But it’s also risky, since you never know how a stock will perform in the future.

How Does Pre-IPO Placement Work?

An IPO, or initial public offering, is an opportunity for private companies to introduce their stock to the market for the first time. A typical IPO requires a lengthy process, as there are numerous regulatory guidelines that companies must meet.

Once those hurdles are cleared, however, the company will have a date on which it goes public. Investors can then purchase shares of the company through the stock exchange where it lists.

Pre-IPO investing works a little differently. The end goal is still to have the company go public. But before that, the company sells blocks of shares privately, based on its IPO valuation. A successful pre-IPO gives the company attention, as well as capital from investors ahead of the actual IPO date.

For the most part, pre-IPO shares are restricted to high-net-worth investors, or accredited investors, i.e. those who can afford to invest large amounts of capital, and can afford to take on a certain amount of risk. A pre-IPO placement of shares could be made without a prospectus or even a guarantee that the IPO will occur.

Individual investors typically don’t have the funds required, or the stomach for that level of risk.

In return for that measure of uncertainty Pre-IPO investors get in on the ground floor and purchase shares before they’re available to the market at large. There may also be an added incentive. Because they’re buying such large blocks of shares, pre-IPO investors may get access to them for less than the projected IPO price.

💡 Quick Tip: IPO stocks can get a lot of media hype. But savvy investors know that where there’s buzz there can also be higher-than-warranted valuations. IPO shares might spike or plunge (or both), so investing in IPOs may not be suitable for investors with short time horizons.

An Example of Pre-IPO Placement

Pre-IPO placements have gained popularity over the last decade, with more companies opting to offer them ahead of going public. Some of the companies that have offered pre-IPO stock include Uber and Alibaba, both of which have ties to e-commerce.

Alibaba’s pre-IPO offering was notable due to the fact that a single investor and portfolio manager purchased a large block of shares. The investor, Ozi Amanat, purchased $35 million worth of pre-IPO stock at a price that was below $60 per share.

He then distributed those shares among a select group of families. By the end of the first public trading day, Alibaba’s shares had risen to $90 each. Alibaba’s IPO delivered a 48% return to those pre-IPO shareholders due to higher-than-expected demand for the company’s stock.

In Uber’s case, PayPal agreed to purchase $500 million worth of the company’s common stock ahead of its IPO. PayPal then lost a large portion of its investment when the Uber stock price fell by about 30% following its IPO.

Pros and Cons of Pre-IPO Placement

There are benefits to pre-IPOs placements, but there are also some important drawbacks that investors should understand.

Pros of Pre-IPO Placement

From the perspective of the company, pre-IPO offerings can be advantageous if they help the company to raise much-needed capital ahead of the IPO. Offering private placements of shares before going public can help attract interest to the IPO itself, which could help make it more successful.

For investors, the benefits include:

• Access to shares of a company before the public.

• The potential ability to purchase shares of pre-IPO stock at a discount. So if a company’s IPO price is expected to be $30 a share, pre-IPO investors may be able to purchase it for $25 instead. This already gives them an edge over investors who may be purchasing shares the day the IPO launches.

• Purchasing shares at a discount can potentially translate to higher returns overall if the IPO meets or exceeds initial expectations. The higher the company’s stock price rises following the IPO, the more profits you could pocket by selling those shares later.

Cons of Pre-IPO Placement

While pre-IPO investing could be lucrative, there are some potential backs to consider. Specifically, there are certain risks involved that could make it a less attractive option for investors.

• The company’s IPO may not meet the expectations that have been set for it. That doesn’t mean a company won’t be successful later. Facebook, for example, is noteworthy for having an IPO described as a “belly flop”. A disappointing showing on the day a company goes public for the first time could shake investor confidence in the stock and bode ill for its future performance. That in turn could affect the returns realized from an investment in pre-IPO stock.

• The company may never follow through on its IPO and fails to go public. In that case, investors may be left wondering what to do with the shares they hold through a pre-IPO private placement. WeWork is an example of this in action. In 2019, the workspace-sharing company announced that it had scrapped its plans for an IPO, thanks to limited interest from investors and concerns over the sustainability of its business model. In 2021, the company did go public — but not through an Initial Public Offering. Instead, WeWork went public through a merger with a special acquisition company or SPAC.

• Pre-IPOs are less regulated than regular IPOs.

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

Summary of Pros and Cons of Pre-IPO Placement

Here’s a quick look at the benefits and drawbacks of pre-IPO placements:

Pre-IPO Private Placement Pros and Cons

Pros	Cons
• Investors have an opportunity to get into an investment ahead of the crowd • Pre-IPO investors may be able to purchase shares at a price that’s below the IPO price • Purchasing pre-IPO stock could yield higher returns if the IPO is successful	• Pre-IPO placements can be risky, as they’re less regulated than regular IPOs • There are no guarantees that an IPO will deliver the type of returns investors expect • Does not guarantee you’ll get the loan

Pros

Cons

• Investors have an opportunity to get into an investment ahead of the crowd

• Pre-IPO investors may be able to purchase shares at a price that’s below the IPO price

• Purchasing pre-IPO stock could yield higher returns if the IPO is successful

• Pre-IPO placements can be risky, as they’re less regulated than regular IPOs

• There are no guarantees that an IPO will deliver the type of returns investors expect

• Does not guarantee you’ll get the loan

How to Buy Pre-IPO Stock

Typically, only accredited investors can purchase pre-IPO placements. As of 2021, the Securities and Exchange Commission defines an accredited investor as anyone who:

• Earned income over $200,000 (or $300,000 if married) in each of the prior two years and reasonably expects to earn that same amount in the current year, OR

• Has a net worth over $1 million, either by themselves or with a spouse, excluding the value of their primary residence, OR

• Holds a Series 7, 65 or 82 license in good standing

If you meet these conditions for accredited investor status, then you may be able to purchase shares of pre-IPO stock through your brokerage account. Your brokerage will have to offer this service and not all of them do.

Other options for buying pre-IPO stock include purchasing it from the company directly. To do that, you may need to have a larger amount of capital at the ready. So if you’re not already an angel investor or venture capitalist, this option might be off the table.

You could also pursue pre-IPO placements indirectly by investing in companies that routinely purchase pre-IPO shares. For example, you might invest in a mutual fund or exchange-traded fund that specializes in private equity or late-stage companies preparing to go public. You won’t get the direct benefits of owning pre-IPO stock but you can still get exposure to them in your portfolio this way.

The Takeaway

For some high-net-worth or institutional investors, buying pre-IPO shares — a private sale of shares before a company’s initial public offering — might be possible. But it’s highly risky. For the most part, individual investors won’t have access to these kinds of private deals. But eligible investors may be able to trade ordinary IPO shares through their brokerage.

Whether you’re curious about exploring IPOs, or interested in traditional stocks and exchange-traded funds (ETFs), you can get started by opening an account on the SoFi Invest® brokerage platform. On SoFi Invest, eligible SoFi members have the opportunity to trade IPO shares, and there are no account minimums for those with an Active Investing account. As with any investment, it's wise to consider your overall portfolio goals in order to assess whether IPO investing is right for you, given the risks of volatility and loss.

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

Photo credit: iStock/filadendron

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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.

Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. IPOs offered through SoFi Securities are not a recommendation and investors should carefully read the offering prospectus to determine whether an offering is consistent with their investment objectives, risk tolerance, and financial situation.

New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For SoFi’s allocation procedures please refer to IPO Allocation Procedures.

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

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Oct

2023

How Many Companies IPO Per Year? 2021 Trends

How Many Companies IPO Per Year? 2023 Trends

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

An initial public offering, or IPO, represents the first time a company makes its shares available for trade on a public stock exchange. The number of IPOs per year varies, depending on market conditions and the ease with which companies can raise capital via other methods.

Private companies can use IPOs to raise capital and fuel future growth, and hundreds of companies go public most years, presenting an opportunity for interested investors.

IPO statistics can offer some perspective on how frequently companies decide to go public and which sectors tend to see the most significant launches.

Number of IPOs by Year

A look at IPO history shows that the number of initial public offerings fluctuates significantly by year and decade. Since 2000, there have been some 6,013 IPOs. Here’s a look at IPO filings by year for that time frame:

Year	Number of IPOs
2000	397
2001	141
2002	183
2003	148
2004	314
2005	286
2006	220
2007	268
2008	62
2009	79
2010	190
2011	171
2012	157
2013	251
2014	304
2015	206
2016	133
2017	217
2018	255
2019	232
2020	480
2021	1,035
2022	181
2023*	79

*As of June 30, 2023.

The number of IPOs in any given year tend to follow movements in the economic cycle. In 2008, for example, there were just 62 IPOs as the economy and stock market were in the midst of a historic downturn. IPO activity didn’t pick up the pace again until 2010, once the Great Recession had ended.

💡 Quick Tip: Access to IPO shares before they trade on public exchanges has usually been available only to large institutional investors. That’s changing now, and some brokerages offer pre-listing IPO investing to qualified investors.

Previous Year IPOs

Companies were more likely to go public in the 1980s and 1990s than in recent years. Between 1980 and 2000, an average of 311 firms went public each year.

IPO activity spiked in the mid-90s as entrepreneurs sought to join the growing dot-com bubble.

Meanwhile, an average of 187 firms went public annually between 2001 and 2011. In recent years, larger, more established companies are more likely to go public than smaller private firms.

However, a record number of companies — 1,035 — went public in 2021. Some analysts point to loose monetary policy and a booming stock market as reasons so many companies went public during the year.

Additionally, one of the factors driving IPOs during 2020 and 2021 was an increase in IPOs for special-purpose acquisition corporations (SPACs). SPACs are essentially holding companies that go public with the sole purpose of acquiring another company.

Recommended: What Is an IPO Pop?

Overview of IPOs in 2022 – 2023

Following the boom in IPOs in 2021, the number of companies that went public during 2022 and 2023 dramatically decreased, due to several factors, including tight monetary policy to combat inflation, and a dramatic decline in the stock market.

As of June 30, 2023, there have been only 79 U.S. market IPOs so far — a 37% drop compared with the number of IPOs in 2022 by this time. There were 125 IPOs by June 30, 2022.

Of the 79 that debuted this year, about 46.8% — 37 companies — showed negative returns as of June 30, 2023, and 42 showed positive returns (bearing in mind that 11 companies IPO’d in June, and their prices may fluctuate in the coming quarters).

That said, the IPO proceeds in Q1 of 2022 similar to Q1 of 2023: $2.5 billion and $2.4 billion respectively. But company valuations were higher in 2022, and the 24 IPOs in Q1 generated almost as much in proceeds that year as the 33 IPOs in Q1 of 2023.

Evaluating the performance of stocks after a company goes public can give you an idea of how successful IPOs tend to be overall. However, it’s important to remember that it’s impossible to predict whether a stock will boom or bust in the months and years after it starts trading.

IPO stocks are considered highly volatile, high-risk investments, and while some companies may present an opportunity for growth, there are no guarantees. Like investing in any other type of stock, it’s essential for investors to do their due diligence.

💡 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.

The Takeaway

Looking at IPO statistics and IPOs by year can help you track trends and understand just how often companies go public, and why some years have more IPOs than others.

While the low interest rates and rising stock market of 2021 helped create a record year for 1,035 new companies, the climate now has changed: rates are higher, there’s more market volatility, and the slowing number of IPOs reflects that.

If you’re interested in adding IPOs to your portfolio, it’s also important to know which sectors tend to have the most and least IPO activity.

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

Photo credit: iStock/Inside Creative House

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

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Oct

2023

Cannabis Investing 101

By Amanda Holden | Growing Wealth, Investing | Comments Off

Investing in the cannabis industry is becoming a bigger area of interest for many investors, as marijuana becomes increasingly legal in different states around the U.S. As more states legalize cannabis use for recreational purposes, investors may be attracted to its growth potential – and the potential to drive returns for their portfolios.

But investing in cannabis carries some significant risks. It’s still a federally illegal substance, for one, and it’s unclear if there’s a path to national legalization. There’s a lot to take into consideration for investors.

Overview of Cannabis Legalisation

As of mid-2023, 23 states in the U.S., as well as the District of Columbia, Guam, and the Northern Mariana Islands, have legalized cannabis for recreational use. Many others have legal medical marijuana laws.

It’s likely that more states will legalize marijuana for recreational or medical use in the years ahead, too. Federal legalization is also a possibility, but for now, it’s uncertain. Given that over the past ten or so years recreational legalization has grown from zero to roughly half of states, though, investors see investing in cannabis as an opportunity.

Outside the U.S., Mexico legalized recreational marijuana in 2021, becoming the largest market for cannabis in the world. It followed Canada, which in 2018 made the same move.

💡 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.

How to Invest in Cannabis Stocks

The main ways investors can get exposure to marijuana businesses in their portfolios is by first, owning the individual stocks of cannabis-related companies. The other option is through cannabis-themed exchange-traded funds, or ETFs.

Cannabis Stocks

Historically, cannabis companies tended to remain private companies. But in Canada, medical use of marijuana has been legal since 2001, making the Toronto Stock Exchange and TSX Venture Exchange the listing venues for many cannabis-related businesses. Investors in the U.S. are able to trade Canadian stocks via American Depository Receipts (ADRs).

Then in 2018, medical marijuana company Tilray became the first cannabis company to directly list in the U.S., having its initial public offering (IPO) on the Nasdaq Stock Exchange. Since then, many other cannabis companies have gone public, including Cronos Group Inc., Canopy Growth Corporation, and Aurora Cannabis. There are also publicly-traded companies that offer cannabis or cannabis-related products or that are otherwise active in the cannabis space, such as Anheuser-Busch InBev, Altria Group, Molson Coors, and Scotts Miracle-Gro.

While a listing on a major exchange does not imply that an investment is good or bad, stocks that are listed on an exchange are held to higher regulatory and reporting standards. Those that don’t qualify to be listed on an exchange typically trade over-the-counter (OTC).

No matter where an investor purchases a stock – on an exchange or OTC – it’s wise to be cautious.

Get in on the IPO action at IPO prices.

SoFi Active Investing members can participate in IPO(s) before they trade on an exchange.

Different Types of Cannabis Companies

When investors think of cannabis stocks, they may think of marijuana growers. But this is not the only type of business available for investors to consider.

• Investors may be interested in biotech companies that are developing prescription drugs using the compounds found in marijuana (cannabinoids).

• There are companies that provide products and services to the cannabis industry itself, such as distribution, packaging, energy and lighting systems (for greenhouse growth), banking, and hydroponics – a plant-growing method that involves no soil.

• Another way to look at investing in marijuana businesses is via companies that do the majority of their business in other markets, but have growing cannabis-related arms.

Marijuana ETFs

An ETF is a basket of securities, such as stocks or bonds, that’s packaged into a single share that investors can find listed on stock exchanges. Many ETFs mirror the moves of an underlying index, like the S&P 500 Index or Nasdaq 100 gauge.

In general, ETFs have been lauded for their ability to help investors get exposure to a broad array of investments at a low cost. Similarly, a cannabis ETF could potentially allow an investor to diversify their stocks holdings, while avoiding pricey management or transaction fees and the research required when picking individual stocks.

Cannabis ETFs generally have higher expense ratios than those of the most popular, non-cannabis, low-cost ETFs. This is largely due to the fact that investing in individual marijuana stocks remains expensive, and the active management involved in curating stocks to include in the ETF.

Cannabis ETFs may also hold fewer stocks than more traditional ETF. This is typical of so-called thematic ETFs, ones that allow investors to wager on more niche trends. While such funds allow for more targeted bets, investors are also exposed to fewer names, making it more likely that a big move in one company will impact the price of the ETF as a whole.

Potential Risks of Cannabis Investing

Marijuana stocks have tended to be more volatile than the overall market. In addition, pot stocks have also been a target for short sellers – investors who bet shares of a company will fall. Investors who aren’t comfortable with such stock volatility may want to forgo investing in cannabis stocks.

Legal & Regulatory Risks

Because marijuana is still prohibited on the federal level in the U.S., there can be a legal risk to investing in pot-related companies. For instance, cannabis-related businesses in the U.S. are shut out from the banking system in many respects.

In addition, even if the U.S. were to pass federal legalization, that doesn’t mean growers and retailers will be able to sell their products immediately under a streamlined regulatory structure. Some states may put in place new regulation that makes pot sales and usage onerous.

After Canada legalized marijuana in 2018, many people thought that the move would lead to quick sales and profits. But in reality, the opening and licensing of cannabis stores took place slowly. Plus, illegal pot sales continued to thrive and compete with the legal marketplace.

In the first year after legalization, the stock value of Canada’s six largest marijuana companies plummeted by more than 50% on average.

New Industry and Market

Because the legal marijuana industry is relatively young, so are many of the companies within it. Many of these companies have untested business models.

From a stock investment standpoint, many of the stocks that are currently for sale in the OTC market qualify as microcap stocks and penny stocks. Many of these companies have yet to post positive earnings and bear no track record. Microcaps typically experience a high rate of failure and are often highly volatile.

Separately, unexpected developments and news reports may hit a new industry like cannabis. For instance, in 2019, many pot stocks took a dive amid concerns that vaping was tied to a serious respiratory disease.

Fraud

In addition to the general market risk that comes with investing in a new industry, fraud often attaches itself to new, exciting, and less-regulated industries.

In a 2018 investor bulletin, the Securities and Exchange Commission (SEC) alerted investors that their office regularly receives complaints about marijuana-related investments. “Scam artists often exploit ‘hot’ industries to trick investors,” the regulator said.

The SEC said investors should particularly be wary of risks related to investment fraud and market manipulation. Investment fraud includes unlicensed, unregistered sellers; guaranteed returns; and unsolicited offers. Meanwhile, market manipulation can involve suspended trading in shares, changes to a company name or type of business, and false press releases.

💡 Quick Tip: Are self directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

The Takeaway

Hunting for the next big marijuana investment may seem like an exciting endeavor. But investors should keep in mind that the cannabis industry may continue to encounter obstacles even if legalization on a broader scale occurs in the near future.

And outside the regulatory challenges, cannabis-related businesses tend to be newer, untested, and not yet profitable, posing greater risks for investors. The marijuana market may turn out to be an area of growth for stocks, but investors should weigh the considerable risks associated with it, too.

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.

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

SOIN0723028

Oct

2023

What is a Cash Account? Margin vs Cash Account

Cash Account vs Margin Account: Key Differences

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

When opening a brokerage account to invest in securities, investors can choose between a margin account or a cash account. The main difference between the two accounts is that with a margin account an investor can borrow from their broker, whereas with a cash account, they can’t.

There are reasons for choosing either account, and it’s important for investors to understand them both in order to make the best decision for their own financial goals.

What Is a Cash Account?

A cash account is an investment account with a brokerage firm that requires investors to purchase securities using the cash balance in that account at the time of settlement. With a cash account, investors can’t borrow money from the broker, and they can’t take short positions on margin.

If they don’t have cash available they can also sell securities in their account to purchase different ones. Investors have two business days to pay for securities they buy with their cash account, according to the Federal Reserve’s Regulation T.

How Does a Cash Account Work?

Cash accounts allow both institutional and retail investors to buy securities using whatever amount of money they put into their account. For instance, if they deposit $3,000 into their account, they can purchase $3,000 worth of securities.

Pros and Cons of a Cash Account

The main advantage of a cash account is that investors can’t go into debt to their broker using one, as they might with a margin account. They have no borrowing ability, and thus, can only lose what they have deposited in cash. Using a cash account can provide a much simpler experience for beginner investors as well.

As for the downsides, a cash account does not allow investors to utilize leverage (as they would with a margin account) to potentially generate outsized gains. Investors are more or less tied to their cash balance, and may be limited in what they can do without using margin.

Cash Account Regulations to Be Aware Of

There are several regulations that investors should keep in mind when it comes to cash accounts, pertaining to having enough cash in their account to pay for securities.

Cash Liquidation Violations

Transactions can take a few days to settle, so investors should always sell securities before purchasing new ones if they are using that money for the purchase. If there is not enough cash in the account to pay for a purchase, this is called a “cash liquidation violation.”

Good Faith Violation

A Good Faith Violation occurs when an investor buys a security, buys another security, then sells it to cover the first purchase when they don’t have enough cash in their account to cover the purchase.

Free Riding Violation

In this type of violation, an investor doesn’t have cash in their account, and they attempt to purchase a security by selling the same security.

Benefit of a Cash Account: Lending

One benefit of cash accounts is that investors can choose to lend out money from their account to hedge funds, short sellers, and other types of investors. The account holder can earn interest or income from lending, known as securities lending or shares lending.

If a cash account holder wants to lend out cash or shares, they can let their broker know, and the broker will provide them with a quote on what borrowers will pay them. Securities that earn the highest interest rates are those in low supply and high demand for borrowers.

These tend to be securities with a lower trading volume or market capitalization. If an investor lends out shares of securities, they can earn interest while continuing to hold the security and earn on it as it increases in value. Account holders may need to meet minimum lending requirements.

💡 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.

What Is a Margin Account and How Does It Work?

Using a margin account, an investor can deposit money but they can also borrow money from their broker. This allows investors to use leverage to buy larger amounts of securities than a cash account allows, but if the value of securities goes down, the investor will owe the broker additional money and lose the initial amount of funds they deposited into the account.

Margin accounts also charge interest, so any securities purchased need to increase above the interest amount for the investor to start seeing profits. Different brokers charge different interest rates, so it’s a good idea for investors to compare before choosing an account.

Usually there is no deadline to repay a margin loan, but the debt accrues interest each month, so the longer an investor waits the more they owe. The securities held in the account act as collateral for the margin loan, so if needed they can be used to pay it off.

Recommended: What is Margin Trading?

Increase your buying power with a margin loan from SoFi.

Borrow against your current investments at just 12%* and start margin trading.

*For full margin details, see terms.

Other requirements generally associated with margin accounts include:

Minimum Margin

Investors must deposit a minimum amount of cash into their account before they can start investing and borrowing. Each broker may have a different minimum, but the Financial Industry Regulatory Authority (FINRA) requires investors to have either $2,000 or 100% of the purchase amount of any securities the investor wants to buy on margin, whichever amount is lower.

Initial Margin

Usually investors can only borrow up to 50% of the purchase amount of securities they want to buy. For example, if an investor with $3,000 in their account, can borrow $3,000, allowing them to purchase $6,000 worth of securities.

Maintenance Margin

Both before and after purchasing securities, investors must hold a certain amount in their account as collateral. The investor must own at least 25% of the assets (cash or securities) in their account when they have taken out a margin loan. If the amount in the account dips below this level, the investor may receive a margin call, requiring them to either deposit more cash into their account or sell some of their securities. This could occur if the investor withdraws too much from their account or if the value of their investments decreases. This is one of the main risks of margin accounts.

Margin Account vs Cash Account

There are some similarities between margin accounts and cash accounts, but there are some key differences in terms of the monetary requirements for investors to consider when choosing which type of brokerage account works best for them. The type of account you choose will have an impact on the amount of money you’re able to invest, and the risk level that accompanies it.

The accounts can be equated to a debit card vs. a credit card. A debit card requires the user to have funds available in their account to pay for anything they buy, while a credit card allows a user to spend and pay back the expense later.

Similarities Between Margin and Cash Accounts

Both are brokerage accounts that allow investors to purchase securities, bonds, funds, stocks, and other assets in addition to holding cash. (You typically can’t have a margin account in a retirement account such as an IRA or Roth IRA.)

Differences Between Margin and Cash Accounts

Margin accounts allow investors to borrow from their broker and typically require a minimum deposit to get started investing, while cash accounts don’t. However, margin accounts usually don’t come with additional fees.

On the other hand, cash account holders may only purchase securities with cash or settled funds, and cash accounts don’t allow short selling, or ‘shorting’ stocks.

Should You Choose a Margin Account or a Cash Account?

Although being able to borrow money with a margin account has benefits in terms of potential gains, it is also risky. For this reason, cash accounts may be a better choice for beginner investors.

Cash accounts may also be better for long-term investors, since investments in a margin account may go down and force the investor to have to sell some of them or deposit cash to maintain a high enough balance in their account. This could result in an investor being forced to sell a security at a loss and missing its potential price recovery.

With a cash account, the value of securities can rise and fall, and the investor doesn’t have to deposit any additional funds into their account or sell securities at a loss. Investors may also choose a cash account if they want to “set it and forget it,” meaning they invest in securities that they don’t want to keep an eye on all the time since they will never owe the broker more money than they invested – as discussed.

The risk level on a cash account will always be lower than with a margin account, and there are less risky ways to increase returns than by using margin.

On the other hand, for investors interested in day trading, margin accounts may be a great choice, since they allow the investor to double their purchasing power. They also allow investors to short trade. Margin account holders can borrow money to withdraw to pay for any life expenses that need to be paid off in a rush.

Since there is no deadline to pay off the loan, the investor can pay it back when they can, unless the value of the stocks fall. Traders can also borrow money to buy stocks when the market is down or to prevent paying capital gains taxes, but this requires more experience and market knowledge.

Margin accounts provide flexibility for investors, who can choose to use them in exactly the same way as a cash account.

💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

The Takeaway

The main difference between cash accounts and margin accounts is that margin accounts allow investors to borrow money from their brokers, extending their trading abilities and the use of leverage as a part of their strategy. This can have advantages and disadvantages, and depending on their specific strategy and goals, investors should consider everything before deciding to use one or the other.

Both cash and margin accounts are commonplace in the investing space, and investors are likely to run across both – and figure out which is a best fit for their strategy. It may be beneficial to speak with a financial professional for guidance.

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

Can you trade options on cash and margin accounts?

It will depend on the specific broker, but there are some types of options that require a margin account to trade. An example would be futures contracts – but again, it’ll depend on the specific brokerage or platform.

Should a beginner use a cash or margin account?

It may be better for a beginner to start out using a cash account to invest, as they’re simpler and involve less risk than a margin account. If a beginner uses a margin account without a proper understanding of margin, they could find themselves owing their broker money.

Can you have a cash account and a margin account at the same time?

Yes, you can have cash and margin accounts at the same time, often at the same brokerage. It’s possible to also have different types of accounts at different brokerages or on different investment platforms.

Photo credit: iStock/PeopleImages

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.

*Borrow at 12%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
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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Cash Account vs Margin Account: Key Differences

What Is a Cash Account?

How Does a Cash Account Work?

Pros and Cons of a Cash Account

Cash Account Regulations to Be Aware Of

Cash Liquidation Violations

Good Faith Violation

Free Riding Violation

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What Is a Margin Account and How Does It Work?

Increase your buying power with a margin loan from SoFi.

Borrow against your current investments at just 12%* and start margin trading.

Minimum Margin

Initial Margin

Maintenance Margin

Margin Account vs Cash Account

Similarities Between Margin and Cash Accounts

Differences Between Margin and Cash Accounts

Should You Choose a Margin Account or a Cash Account?

The Takeaway

FAQ

Can you trade options on cash and margin accounts?

It will depend on the specific broker, but there are some types of options that require a margin account to trade. An example would be futures contracts – but again, it’ll depend on the specific brokerage or platform.

Should a beginner use a cash or margin account?

Can you have a cash account and a margin account at the same time?

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