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May

2024

15 Technical Indicators for Stock Trading

7 Technical Indicators for Stock Trading

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing, Tools & Calculators | Comments Off

One way traders seek to profit from short-term movements in security prices is by using technical analysis.

While some stock analysis tools examine company fundamentals, technical stock indicators identify patterns in price and volume data to give investors and traders insights about how a stock might move in the future.

For that reason, although technical indicators can assist with trend identification, it’s best to combine different indicators when conducting stock analysis.

Table of Contents

How Do Stock Technical Indicators Work?
Reasons to Use Stock Market Indicators
Top 7 Stock Indicators for Technical Analysis
The Takeaway

How Do Stock Technical Indicators Work?

Technical analysis uses various sets of data and indicators, such as price and volume, to identify patterns and trends. This type of stock market analysis is different from fundamental analysis, which looks at company financials, industry trends, and macroeconomics.

Rather, technical analysis solely analyzes a stock’s performance. Stock technical indicators are often rendered as a pattern that can overlay a stock’s price chart to predict the market trend, and whether the stock would be considered “overbought” or “oversold.”

Two Main Types of Technical Indicators

Stock technical indicators generally come in two flavors: overlay indicators and oscillators.

Overlay Indicators

An overlay indicator typically overlays one trend onto another on a stock chart, often using different colors to distinguish between the lines.

Oscillator Indicators

An oscillator typically uses metrics such as a stock’s price or trading volume to determine momentum, or rate of change, over time. It uses this info to generate a signal, or trend line, whose fluctuations between two values in a range can indicate if a stock may be overbought or oversold.

If the trend line moves above the higher value of the range, it can indicate a stock is overbought, while dipping below the lower value can indicate it’s oversold. The movements of the trend line thus can help traders determine support and resistance in certain price trends, so they can decide whether to sell or buy (support being the price at which a downturn generally bounces back up, and resistance being the point at which rising prices generally start to fall).

Oscillator indicators can be leading or lagging:

• A leading indicator tracks current market movements to anticipate where the trend is headed next.

• A lagging indicator is based on recent history and seeks patterns that will indicate potential price movements.

The moving average is a common oscillator; it’s considered a lagging indicator as it measures specific intervals in the past.

Naturally, every stock indicator has its pros and cons. Various trading indicators can be used by investors to analyze supply and demand forces on stock price, to help shed light on market psychology, or to manage risk.

But while stock indicators and trading tools can help with buy and sell points, false signals can also occur.

Reasons to Use Stock Market Indicators

Knowing some of the most popular trading tools might benefit your investing strategy by providing you with easier-to-spot buy and sell signals. You don’t have to know every single technical indicator, and there are many ways to analyze stocks, but using multiple stock indicators may help you improve trading results.

You can also use these stock indicators to help you manage risk when you are actively trading.

Price trend indicators are some of the most important technical trading tools since identifying a security price’s trend is often a first step to forming a trading strategy. Long positions are often initiated during uptrends, while short sale opportunities can occur when prices are in a downtrend.

Volume trend indicators are also helpful to gauge the power or conviction of an asset’s price move. Some believe that the higher the stock volume on a bullish breakout or bearish breakdown, the more confident the move is. Higher volume could signal a lengthier trend continuation.

💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

7 Stock Indicators for Technical Analysis

It’s important to remember that these trading tools were developed based on the belief that mathematically derived patterns may be valuable as predictors of stock movements. Past performance, however, is not a guarantee of future results. So while it can be useful to employ stock technical indicators, they are best used in combination before deciding on a potential trade.

Also, many of these trading tools are lagging indicators, which can lead to an inaccurate reflection of current and future market conditions.

Following are seven of the most common technical stock indicators, along with their advantages and disadvantages.

Moving Averages (MA)
Moving Average Convergence Divergence (MACD)
Relative Strength Index (RSI)
Stochastic Oscillator
On-Balance Volume (OBV)
Accumulation / Distribution Line (ADL)
Standard Deviation

1. Moving Averages (MA)

A moving average (MA) is the average value of a security over a specific time. The MA can be:

• Simple Moving Average (SMA)

• Exponential Moving Average (EMA)

• Weighted Moving Average (WMA).

A moving average smooths stock price volatility, and is taken as an indicator of the direction a price may be headed. If the price is above the moving average, it’s considered an uptrend versus when the price moves below the MA, which can signal a downtrend.

Moving averages are typically used in combination with each other, or other stock indicators, to identify trends.

Pros

• Using moving averages can filter out the noise that comes from price fluctuations and focus on the overall trend.

• Moving average crossovers are commonly used to pinpoint trend changes.

• You can customize moving average periods: common time frames include 20-day, 30-day, 50-day, 100-day, 200-day.

Cons

• A simple moving average may not help some traders as much as an exponential moving average (EMA), which puts more weight on recent price changes.

• Market turbulence can make the MA less informative.

• Moving averages can be simple, exponential, or weighted, which might be confusing to new traders.

2. Moving Average Convergence Divergence (MACD)

The Moving Average Convergence Divergence (MACD) helps investors gauge whether a security’s movement is bullish or bearish, and helps gauge the momentum of the trend. The MACD uses two different exponential moving averages (EMAs) to do so.

A 26-period EMA is subtracted from a short-term 12-period EMA to generate the MACD line. Then a signal line, based on a nine-day EMA, is plotted on top of the MACD to help reveal buy and sell entry points.

If the MACD line crosses above the signal line, that can signal a buy opportunity. If it crosses below the signal line, that could signal a price decline and an opportunity to sell or take a short position.

Pros

• The MACD, used in combination with the relative strength index (below) can help identify overbought or oversold conditions.

• It can be used to indicate a trend and also momentum.

• Can help spot reversals.

Cons

• The MACD might provide false reversal signals.

• It responds mainly to the speed of price movements; less accurate in gauging the direction of a trend.

3. Relative Strength Index (RSI)

The relative strength index or RSI is an oscillator tool that looks at price fluctuations in a given period and calculates average price losses and gains. It ranges from 0 to 100. Generally, above 70 is considered overbought and under 30 is thought to be oversold.

Traders often use the RSI in conjunction with the MACD to confirm a price trend. The RSI can sometimes identify a divergence, when the indicator moves in opposition to the price; this can show the price trend is weakening.

Pros

• An RSI can help investors spot buy or sell signals.

• It may also help detect bull market or bear market trends.

• It can be combined with moving average indicators to spot breakout trends or reversals.

Cons

• The RSI can move without exhibiting a clear trend.

• The RSI can remain at an overbought or oversold level for a long time, making this tool less useful.

• It does not give clues as to volume trends.

Recommended: 5 Bullish Indicators for a Stock

4. Stochastic Oscillator

Traders will often use the stochastic oscillator, which is a momentum indicator, to determine whether a given security is overbought or oversold. The stochastic oscillator allows traders to compare a specific closing price of a security to a range of its prices over a certain time frame.

By using a stochastic chart, traders can gauge the momentum of a security’s price with the aim of anticipating trends and reversals. A stochastic oscillator uses a range of 0 to 100 to determine if an asset is overbought (when the measurements are above 80) or oversold (when the measurement is below 20).

Pros

• Clearer entry/exit signals: The oscillator has a basic design and generates visual signals when it reaches the outer bounds of a price range. This can help a trader determine when it may be time to buy or to sell stocks.

• Frequent signals: For more active traders who trade on intraday charts such as the 5-, 10-, or 15-minute time frames, the stochastic oscillator generates signals more often as price action oscillates in smaller ranges.

• Easy to understand: The oscillator’s fluctuating lines are fairly clear for investors who know how to use them.

Cons

• Possible false signals: Depending on the time settings chosen, traders may misperceive a sharp oscillation as a buy or sell signal, especially if it goes against the trend. This is more common during periods of market volatility.

• Doesn’t measure the trend or direction: It calculates the strength or weakness of price action in a market, not the overall trend or direction.

💡 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.

5. On-Balance Volume (OBV)

OBV is a little different from the other indicators mentioned. It primarily uses volume flow to gauge future price action on a security or market. When there’s a new OBV peak, it generally indicates that buyers are strong, sellers are weak, and the price of the security may increase.

Similarly, a new OBV low is taken to mean that sellers are strong and buyers are weak, and the price is trending down.

The numerical value of the OBV isn’t important — it’s the direction that matters. In that respect it can be used as a trend confirmation tool. It can also signal divergences, when the price and the volume move in opposite directions.

Pros

• Volume-based indicator gauges market sentiment to predict a bullish or bearish outcome.

• OBV can be used to confirm price action and identify divergences.

Cons

• It can be hard to find definitive buy and sell price levels.

• False signals can happen when divergences and confirmations fail.

• Volume surges can distort the indicator for short-term traders.

Recommended: How to Find Portfolio Beta

6. Accumulation / Distribution Line (ADL)

The accumulation/distribution line (ADL) looks at the trading range for a certain stock, and uses price and volume data to gauge whether shares are being accumulated or distributed. Like OBV it also looks for divergences, so that if a price trend isn’t supported by volume flow it could indicate the trend is about to reverse.

Although this sounds similar to OBV, they are calculated differently, and the ADL gives more attention to price and volume data within a specified range.

Pros

• Traders can use the ADL to spot divergences in price compared with volume that can confirm price trends or signal reversals.

• The ADL can be used as an indicator of the flow of cash in the market.

Cons

• It doesn’t capture trading gaps or factor in their impact.

• Smaller changes in volume are hard to detect.

7. Standard Deviation

Standard deviation measures the extent to which a data point deviates from an expected value, i.e. the mean return. When used as a technical indicator, standard deviation is a common stock volatility measure; it refers to how far a stock’s performance varies from its average.

Investors often measure an investment’s volatility by the standard deviation of returns compared with a broader market index or past returns.

Pros

• Standard deviation mathematically captures the volatility of a stock’s movements, i.e. how far the price moves from the mean.

• It provides technicians with an estimate for expected price movements.

• It can be used to measure expected risk and return.

Cons

• It does not provide precise buy and sell signals.

• It must be used in conjunction with other indicators.

The Takeaway

Technical analysis tools use past price and volume data to help traders identify price trends and make buy and sell decisions. It’s important to know that technical analysis does not use fundamentals to assess the underlying companies, their industries, or any macroeconomic trends that might drive their success or failure. Rather, technical analysis solely analyzes the movement and volume inherent in a stock’s performance.

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FAQ

What is the most popular technical indicator for stocks?

Traders typically combine technical indicators, so it’s difficult to point to one as being a top choice. That said, many traders use the moving average indicators in combination with others to gauge price trends.

What is the most accurate indicator of the stock market?

There is no single indicator that can anticipate overall stock market performance. In fact, it’s an important factor to keep in mind when using technical indicators: For every successful price prediction or winning trade, there are countless others that don’t pan out. There are no crystal balls.

Which indicator gives buy and sell signals?

Different traders favor different indicators when looking for signals about how to place a trade. That said, the stochastic oscillator is relatively clear-cut in that it can help traders identify buy and sell opportunities based on price closes and trends within a certain range.

Photo credit: iStock/staticnak1983

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May

2024

How to Read a Profit & Loss (P&L) Statement

By AJ Smith | Growing Wealth, invest, Investing, Terminology | Comments Off

As its name indicates, a profit and loss statement (P&L) shows a company’s profits and losses — i.e. revenue vs. expenses and other costs — over a certain period of time, like a quarter or year.

A profit and loss statement is also called an “income statement,” is one of a business’s most important accounting tools, as it provides important insights into operations, and the company’s ability to generate income and manage losses — with an eye toward profitability.

Investors can also use the P&L to assess certain aspects of company performance and compare it to other companies in the same industry.

What Is a Profit and Loss Statement?

A profit and loss report shows how much revenue a company earned over a specific period, and then subtracts how much money was spent, which results in a net profit (or loss). It’s the final line in the calculation, commonly known as the bottom line.

While a profit and loss statement provides contextual insight into a company’s financials, these figures only tell us what has happened in the past, and not what will happen in the future. Given that, this information alone is not able to determine whether a company is a “good” investment, but it’s one of the many pieces of information needed to value a stock.

What Is a P&L Statement Used For?

Profit and loss statements are a particularly useful tool for looking into the operations of a company and identifying important trends in that business, often providing insights into where (and maybe why) a company is making or losing money. For example:

• Where is most of the revenue being spent?

• Are there expenses that could be trimmed?

• Are gross sales covering the cost of production?

The P&L report is also useful when used to compare two or more time periods, or when comparing companies within the same industry.

An Aid to Analysis

As with almost any accounting report, the P&L can spark important questions. What changed from last year (or last quarter)? What has improved? What has not? In particular, has the company been able to decrease expenses or increase revenue in order to secure more profit?

Most important, the P&L report may provide additional clues as to the financial inner workings of the company. It can help identify problem areas as well as growth opportunities.

For example: Perhaps a company is profitable in one period but not the next, because of an increase in research and development (R&D) costs. This is valuable information, as it may indicate a crucial investment for a new product — which can lead to an evaluation of this investment and a more sophisticated analysis.

Is this a wise use of capital, and will it pay off in terms of a new product’s success? Could the money be better spent elsewhere, or is there a more efficient way to develop the new product line?

💡 Recommended: Comparing Operating Income and EBITDA

How to Read a P&L

When learning how to read a profit and loss statement, investors should know that they generally follow a similar format.

Each begins, at the top of the page, with total revenue. This is how much money a company earned through sales. Next, costs and expenses are subtracted. Finally, at the bottom of the page, is the company’s bottom line: profit or loss.

Although a company’s “top line” revenue is a compelling figure, a company’s bottom line is typically a better indicator of whether it will be an enduring, successful business.

To illustrate the point, consider a simple example of two companies. The first company posted revenue of $10,000,000 last year, but incurred the same amount in expenses (– $10,000,000). They had high revenue, but earned no profit.

The second business earned $1,000,000, but incurred $700,000 in expenses — resulting in a $300,000 profit. The second company brought in less revenue, but was more profitable than the first.

Recommended: How to Buy Stocks: A Step-by-Step Guide

Understanding Each Section of the P&L

To really make sense of a P&L, you need to understand what each line item stands for and its relevance to the company’s overall operations.

Revenue (or sales)

To recap, one would find the total revenue at the top. This number is also called gross sales and it’s usually broken out by source. (A gross figure is one calculated before expenses are taken out.)

Net Revenue

On certain sales, a company may ultimately receive a modified amount. For example, items that are returned or are discounted must be accounted for. Therefore, the next line in the statement may include a figure that represents what a company actually expects to collect on overall sales, i.e. net revenue. (Net refers to a figure after the necessary deductions are made.) This is a more accurate picture of what incoming cash flow looks like.

Cost of Goods Sold (COGS)

Moving down the statement, direct costs or cost of goods sold usually comes next. This is what the company spent directly on the production of goods or services that were sold during that period. For example, if a company produces shoes, it would include money spent on supplies, labor, packaging, and shipping (but not rent, for example, as that’s not a direct cost).

Gross Profit

After COGS is subtracted from revenue, there may be a line titled gross profit or gross margin. This indicates the profit made on the goods sold before operating expenses.

Operating Expenses

Operating expenses include everything the company spent money on to stay in business: from IT to sales and marketing expenses to facilities costs and so on. These categories are often broken out into subcategories for specific expenses within each (for example, employee expenses might include payroll and benefits).

Total operating expenses are deducted from gross profit to get net operating income.

Net Operating Income

Net operating income, also known as EBITDA (earnings before interest, taxes, depreciation, and amortization are taken out), is a crucial part of the income statement. It reveals how much the company has after all the expenses are covered. If the number is positive, the company is able to cover the cost of doing business; if it’s negative, it means the company is operating at a loss. While that’s not uncommon, spending more than you earn is typically a red flag calling for some adjustments.

Interest Income and Expense

Interest income is money earned in interest-bearing bank accounts or other investment vehicles. Interest expense is the cost of borrowing money and paying a rate of interest on that debt. These numbers may or may not be combined into one figure.

Depreciation and Amortization

Depreciation is defined as the reduction in the value of an asset with the passage of time, due in particular to wear and tear (e.g. the depreciating value of computer systems or vehicles). Businesses are able to treat this depreciation as an expense.

Amortization is the distribution of a business expense over time (e.g. the ongoing cost of a certain software program over a few years).

Tax

Finally, any tax the company paid is also deducted. Typically, this is the last deduction before the final line in the statement: the net profit or the bottom line.

The bottom line represents the net profit or the net loss, and answers the question: During this accounting period, was this company able to turn a profit, or did they operate at a loss?

Note that profit is just one way to evaluate a company and its stock — and it’s not the same as cash on hand. To understand how much actual cash a company has in the bank, you have to read the cash-flow statement.

💡 Quick Tip: It’s smart to invest in a range of assets so that you’re not overly reliant on any one company or market to do well. For example, by investing in different sectors you can add diversification to your portfolio, which may help mitigate some risk factors over time.

Earnings Per Share

A profit and loss statement may also include an earnings per share (EPS) calculation. This is a representation of how much money each shareholder would receive if all net profit was paid out. EPS is calculated by dividing the total net profit by the number of shares a company has outstanding.

The EPS is a hypothetical calculation used by investors to assess the amount of profit created by a company. Do companies actually distribute total earnings? Not generally. Companies will typically keep some or all profits, and may make some payments to shareholders in the form of dividend payments. (The profit and loss statement may also include information on dividend payments.)

A large or a growing EPS is generally preferable but yet again, this metric alone is not sufficient in deciding whether a stock is a good investment. EPS should also be compared to the price of that stock. A company could boast a robust EPS, for example, but if the cost of the stock is relatively expensive, it might not be a good value.

For a deeper look into the correlation between earnings and price, investors can consider the price-to-earnings (P/E) ratio, which divides the price of a stock by the EPS.

The Takeaway

A profit and loss statement can give an investor a look at a company’s bottom line in terms of earnings — and also allows them to compare statements from companies in the same industry, as well as statements from the same company over different time periods. Learning how to read a profit and loss statement can be an important part of researching a company in which one might want to invest.

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May

2024

Short Squeezes Explained

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

After three years of relative inaction, shares of GameStop, the video game retailer, surged in May 2024 after an influential trader posted to social media for the first time in several years. Roaring Kitty, the online moniker of Keith Gill, whose own posts about GameStop helped inspire the meme-stock movement of 2021, posted an image of a man leaning forward, a popular meme among gamers signifying “things are getting serious.”

Since then, the retailer’s stock price has rallied, renewing interest in GameStop as well as a number of other so-called “meme stocks,” including AMC, Koss Corp., and BlackBerry. Gill’s profile initially rose in 2021 in the midst of day traders organizing on Reddit to “squeeze” GameStop short sellers.

A short squeeze is an orchestrated effort to drive up shares of a stock that’s being shorted. In this highly risky maneuver, short sellers are essentially forced to try to exit their bearish position quickly in order to minimize losses amidst the dramatic surge in the share price. Read on to learn everything you need to know about short squeezes.

Key Points

• A short squeeze may occur when short sellers rapidly close their positions, which can help drive up a stock’s price.

• This typically follows a sudden increase in a stock’s price, prompting a rush among those shorting the stock to “cover” or close their position.

• Short sellers buying back shares to close their positions further drives up the stock price.

• Benefits of investing in REITs include tax advantages, tangibility of assets, and relative liquidity compared to owning physical properties.

• Short selling poses extreme risks, with the potential for dramatic — and potentially unlimited — osses.

What Is a Short Squeeze?

As mentioned, a short squeeze is an event in the market that involves short sellers having to quickly close out their positions. Because these investors have to actually buy back shares they’ve lent out, this may drive dramatic gains in the share price.

There are many investors, both retail and institutional, who use short selling to bet that a given stock will go down over a fixed period of time. But short selling is incredibly risky as stock prices have historically tended to drift upward. And timing a bearish position can also be picky. Even if an investor has good reason to believe that a company’s shares will fall, it could be some time before they actually do.

What Causes Short Squeezes?

To understand how short squeezes occur, we first have to understand how shorting a stock works. To sell a stock short, an investor must first borrow the shares. They then consequently sell in the open market. At an agreed-upon time, the investor will buy back the shares in order to return them to the original lender.

If the stock goes down between the time they borrow the stock and when they return it the investor makes money. That’s because they pocket the difference between what they sold the stock for and what they purchased it for when it came time to return it.

And if those short investors borrow a stock that goes up instead of down, they lose money.

Example of Short Selling

Let’s look at a hypothetical case of a short sale. Let’s say an investor borrows a stock that’s trading at $10 with an agreement to pay back the shares in 90 days.

The investor then sells the stock for $10. Then 90 days later, if the stock is trading at $5, they can buy back the number of shares they borrowed and return them to the lender, capturing the $5 per share profit (often minus interest and fees).

Example of Short Squeeze

Now, let’s use this example to look at a short squeeze. Let’s say the investor borrows the stock again that’s trading at $10 with an agreement to pay back the shares in 90 days.

This time however, the share price shoots up to $15. The investor still has to buy the shares they borrowed and return them to the lender. But other investors are also trying to cover their shorts as well, so there’s a shortage of shares in the market to buy back.

The shortage causes the stock’s price to jump even higher to $20, which in turn triggers other short sellers to close their positions. They have to now also purchase back shares, and hence a buying frenzy and short squeeze occurs.

Theoretically, there’s no limit to how much money short sellers can lose. When an investor is long a stock but wrong, the share prices can only go down as low as $0. But when an investor is short and wrong, the share prices can go infinitely higher, making it possible losses can be limitless for the short-selling investor.

Recommended: How Low Can a Stock Go?

Famous Short Squeezes

One famous example of a short squeeze was that of GameStop, which first occurred in 2021, when electronics retailer GameStop saw its shares jump more than 1,000% in a few weeks as a wide range of investors looked to take advantage of the high number of short sellers in the stock. This was perhaps one of the most well-known “meme stock phenomena” that overtook the market that year, but it wasn’t the only one. Shares of AMC, Bed Bath & Beyond, Koss Corp., and other company’s stocks spiked upward during the meme-stock frenzy that year.

Another example occurred in 2008, when automaker Volkswagen briefly became the world’s most valuable stock by market cap when it became known that Porsche was increasing its stake in its fellow German carmaker.

What’s a Long Squeeze?

By contrast, a long squeeze is when short sellers drive down the price of a stock or asset until the bullish investors begin to sell their positions in response, driving the price lower still. It can be helpful to review short positions vs long positions to get a deeper understanding of a long squeeze.

What Was the MOASS?

The “MOASS” is an acronym for the “Mother of all short squeezes.” And it’s more or less exactly what it sounds like: A monstrous short squeeze event in the market.

The short squeeze involving GameStop shares in 2021 is perhaps the best and most recent example of a MOASS, though companies such as AMC and Koss Corp., mentioned above, experienced similar phenomena at the time. Many institutional investors had shorted GameStop stock, anticipating that its value would fall, but groups of day traders worked together to drive up demand of the stock, and its value. This “squeezed” the short sellers, and caused many big firms to lose significant amounts of money on their positions.

How to Trade a Short Squeeze

Given the chance for dramatic returns, many investors have taken an interest in getting in on the winning side of a short squeeze.

To invest in a short squeeze, traders start by surveying the markets for stocks that have garnered substantial interest from short sellers. This factor is often called “short interest,” and as a metric, it represents the number of a company’s shares that have been sold short, but not yet returned to the lender. Traders know that the short sellers of all those shares will have to buy back shares — at any price — to return them to the lender.

There are two ways to understand short interest. One is short interest percentage, which shows how many of a company’s overall shares are currently shorted. A higher number means that more short sellers will be bidding up the stock to buy it back. The second metric is short interest ratio, which shows how much short sellers are responsible for a stock’s daily trading volume. A higher ratio means it’s likely that short sellers will help drive up the stock’s price once it starts to rise.

Another key metric has to do with when the short sellers will have to deliver those shares to the lender. It’s known as “days to cover,” and it’s the ratio comparing the total short-selling interest in a stock with the average daily shares that trade. As a metric, it gives traders a sense of how long until short sellers buy back the stocks they borrowed for their short positions.

Stocks with a high short-interest number and a high days-to-cover number are vulnerable to a short squeeze. Once these traders find stocks that seem like short-squeeze candidates, they buy the stocks outright, and watch those key metrics, along with the news, to decide when to sell. Short squeezes can make a stock shoot up, but those returns often evaporate quickly.

Short Squeezes vs Naked Shorts

As discussed, shorting typically involves borrowing shares to create tenable positions. Naked shorts, often involving naked options, are a type of short selling, but it involves not borrowing, or otherwise securing possession of, shares before making a trade or taking a short position. This leaves the trader “naked” in the event that a trade goes south.

Risks of a Short Squeeze

While short squeeze investments can produce eye-popping returns in the short term, they come with real risks for individual investors, and institutions.

Risks for Investors

For investors, perhaps the biggest risk of a short squeeze is that they’ll get caught on the wrong side of one, and lose some money. Obviously, that’s a risk for institutions as well, but individual investors likely don’t have as many resources on hand to try and recover.

Similarly, investors may misread the room — that is, not quite understand what’s happening in the market, and misjudge their position. They’ll also need to be vigilant in watching their positions to make sure they change those positions at the right time.

Risks for Institutions

Most of the risks involved with short squeezes for individual investors hold true for institutions, too.

For instance, the risks involved with stocks themselves include the fact that stocks with a high short-interest number may be undervalued or misunderstood, or they may simply be failing businesses. And if there is no good news, or market interest, they may continue to sink.

At the same time, the price increases caused by short squeezes are short-lived. Once the short-sellers have paid back their lenders, the market runs out of buyers who will pay any price for that stock. And the share prices often fall as quickly as they rose. The danger to traders in a short squeeze is that they’ll get in too late and stay in too long and lose money.

Long-term investors may try their hands at winning a short-squeeze trade here and there. But it requires deep research, constant monitoring and the ability to move in and out of a stock quickly — something that institutions may have access to more so than individuals.

Investing With SoFi

A short squeeze is a market event in which investors inadvertently bid up the price of a heavily shorted stock, while trying to get out of their bearish positions. In order to buy the stocks that investors borrow to sell short, those investors must buy the stock at ever-increasing values.

Short squeezes involving short positions and financial derivatives are relatively high-level concepts and may involve a skilled hand in navigating. For that reason, it may be worth discussing them, and their risks, with a financial professional.

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FAQ

Are short squeezes legal?

Short squeezes are a natural occurrence in the stock market, but market manipulation is illegal. As the SEC says, “abusive short sale practices are illegal,” and that may play into short squeezes. As such, it’s a gray area.

What is the biggest short squeeze of all time?

While the Volkswagen short squeeze in 2008 was one of the largest of all time, the 2021 short squeezes of GameStop, along with AMC, Koss, and others, were, perhaps, some of the most dramatic and notable short squeezes in history.

How high can a short squeeze go?

Theoretically, there is no limit on how high a stock can go, and accordingly, how high a short squeeze can go.

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

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May

2024

What Is a Revolving Letter of Credit & How Does It Work?

By Austin Kilham | Credit, money, Terminology | Comments Off

A revolving letter of credit is a financial instrument often used in international trade to facilitate transactions between buyers and sellers. It is a type of letter of credit that allows the buyer to make multiple drawdowns (or “draws”) within a specified period, typically a year, up to a certain limit.

If you’re in the business of importing and exporting, or any type of buying and selling, a revolving letter of credit can allow for smoother transactions. Once in place, it allows both buyers and sellers to be more confident in their business arrangements. It also helps to ensure that goods arrive — and all payments are made — on time.

Here, we’ll look at the specifics of revolving letters of credit. We’ll dive into:

• What is a revolving letter of credit

• How a revolving letter of credit works

• The different types of revolving letters of credit

• Limitations of revolving letters of credit

• The pros and cons of a revolving letter of credit

What Is a Revolving Letter of Credit?

When you hear the phrase “revolving credit,” it may sound familiar from personal finance tools you’ve used, such as credit cards and home equity lines of credits. These revolving credit accounts have a credit limit, which represents the maximum amount that you can spend. You can draw on the account up to the limit. Then, as you pay back the amount you owe, the amount of credit will rise back to its original value.

Like the revolving credit you use in your personal finances, revolving letters of credit help streamline financial transactions. However, they work in a different way.

Revolving letters of credit offer convenience and added flexibility for buyers and sellers engaged in ongoing trade relationships, as they eliminate the need to establish a new letter of credit for each transaction. More specifically, they are used to facilitate the regular shipments of goods or the delivery of services between buyers and sellers. You often see them in international trade, in which the buyer and seller are operating in two different places and/or regulatory environments.

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How Does a Revolving Letter of Credit Work?

Here’s a step-by-step look at how revolving letters of credit work work in the business world.

• Opening the letter of credit: The buyer and seller agree to use a revolving letter of credit for their transactions. The buyer applies for the letter of credit from their bank (called the issuing bank) and specifies the terms and conditions, including the amount and validity period.

• Issuance: The issuing bank issues the letter of credit, which serves as a guarantee to the seller that they will receive payment for the goods or services as long as they comply with the terms and conditions of the letter of credit.

• Shipment and presentation of documents: The seller ships the goods or provides the services to the buyer and prepares the necessary documents as specified in the letter of credit, such as invoices and packing lists.

• Drawdown: Upon shipment, the seller presents the required documents to the issuing bank through their own bank (called the advising bank) to request payment. The issuing bank examines the documents and, if they comply with the terms of the letter of credit, makes payment to the seller.

• Revolving feature: After the first drawdown, the letter of credit does not expire. The buyer can continue to make additional drawdowns up to the specified limit and within the validity period of the letter of credit without the need for the issuing bank to issue a new letter of credit.

• Payment and settlement: The buyer is required to repay the issuing bank for the amount of each drawdown, typically on a predetermined schedule. The buyer can also choose to pay the entire outstanding balance at once.

• Renewal: Once the specified period or limit is reached, the letter of credit can be renewed by the buyer and the issuing bank if both parties agree.

Recommended: How to Build Credit Over Time

Types of Revolving Letters of Credit

Revolving letters of credit can generally be subdivided into two main categories, one based on value and the other based on time.

Time-Based Revolving Letter of Credit

Some revolving letters of credit are based on time. This means a specific payment amount can be drawn down over a set time period. For example, an importer could have a revolving letter of credit worth $120,000 drawn to cover a six-month period. During that time, payments of $20,000 could be made to an exporter each month. At the end of the six-month period, the revolving letter of credit expires.

Cumulative Revolving Letter of Credit

The time-based resolving letter of credit can be subdivided again into two different subcategories: cumulative and non-cumulative revolving letters of credit. If the revolving letter of credit is cumulative, then previously unused limits can be shifted ahead and used in subsequent time periods. In the example above, if the exporter doesn’t ship any goods in the second month, then it could ship $40,000 worth of goods in month three.

This type of set-up provides the seller with a certain amount of flexibility. However, it can be riskier for the buyer who isn’t receiving goods regularly.

Recommended: How Many Lines of Credit Should I Have?

Non-Cumulative Revolving Letter of Credit

The other type of time-based revolving letter of credit is non-cumulative. This means that previous unused amounts of credit cannot be rolled over into a subsequent month. So, if the exporter in the example above doesn’t ship any goods in the second month, only $20,000 worth of goods can be shipped in each of the subsequent months.

This set-up is less risky for the buyer, because it locks the seller into shipping goods within a narrower time period and under more specific conditions. If the seller doesn’t supply the promised goods within a certain period, they cannot carry that over into a subsequent period.

Value-Based Revolving Letter of Credit

The other main type of revolving letter of credit is the value-based revolving letter of credit. It’s much like its time-based counterpart. The biggest difference is payment from the buyer is only released when they receive goods worth a certain value.

Say, for example, a revolving letter of credit is issued for $120,000 over six months for goods worth $20,000 each month. The exporter can only ship and receive payment for goods worth $20,000 each month. If, for example, they are only able to produce $15,000 worth of goods in one month, they cannot ship the goods to the seller, and the seller won’t provide payment. In this case, the value is very specific, and it really matters.

Advantages of Revolving Letters of Credit

So why issue a letter of revolving credit? Here’s a look at some of the benefits they offer:

• It can save time and money.

• Because it is revolving, the letter of credit does not need to be reissued for each transaction during a set period.

• It helps facilitate regular trade between a buyer and a seller.

• It can help build trust between buyers and sellers.

• It can incentivize sellers to manufacture a consistent level of goods, especially for non-cumulative and value-based letters.

• It can provide flexibility in terms of the types of agreements buyers and sellers can enter into.

Disadvantages of a Revolving Letter of Credit

Despite the advantages listed above, there are some limitations and drawbacks to consider:

• Letters of credit tend to be limited to one supplier only.

• They don’t apply to one-time transactions.

• Changes, such as changes to tax law, customs rules, or product design may require amendments to the agreement.

• Bank fees may make revolving letters of credit costly, especially for applicants.

The Takeaway

If you run an importing business and you’re buying goods from overseas — especially from an exporter that represents a new business relationship — a revolving letter of credit can make things easier. It can remove some of the risk of the transactions as you build trust with this new supplier. Of course, if you’re an exporter, the same applies.

That said, it’s important to consider the limitations of using a letter of credit, in particular the cost, and weigh that against the benefits. Before agreeing to a revolving letter of credit, it’s important to explore how this financial instrument fits into your company’s overall needs and goals.

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FAQ

When should a revolving letter of credit be used?

Generally, a revolving letter of credit should be used when there is an ongoing business relationship between a buyer and a seller, and the buyer needs to make multiple transactions over a period of time. It can be particularly useful for businesses that have regular import or export requirements and want to streamline the payment process.

Who issues the revolving letter of credit?

The revolving letter of credit is issued by the buyer’s bank.

What is an irrevocable revolving letter of credit?

An irrevocable revolving letter of credit is a type of revolving letter of credit that cannot be changed unless all parties involved agree to the modifications of the contract. This provides a high level of assurance to the seller that they will receive payment as long as they meet the terms and conditions of the letter of credit.

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SOBK-Q224-1874449-V1

May

2024

Corporate Social Responsibility (CSR), Explained

By Michael Flannelly | Growing Wealth, invest, Investing, Terminology | Comments Off

What is corporate social responsibility — and does it matter for your investment strategies? Read on to learn more.

7 Technical Indicators for Stock Trading

How Do Stock Technical Indicators Work?

Two Main Types of Technical Indicators

Overlay Indicators

Oscillator Indicators

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Reasons to Use Stock Market Indicators

7 Stock Indicators for Technical Analysis

1. Moving Averages (MA)

Pros

Cons

2. Moving Average Convergence Divergence (MACD)

Pros

Cons

3. Relative Strength Index (RSI)

Pros

Cons

4. Stochastic Oscillator

Pros

Cons

5. On-Balance Volume (OBV)

Pros

Cons

6. Accumulation / Distribution Line (ADL)

Pros

Cons

7. Standard Deviation

Pros

Cons

The Takeaway

FAQ

What is the most popular technical indicator for stocks?

What is the most accurate indicator of the stock market?

Which indicator gives buy and sell signals?

How to Read a Profit & Loss (P&L) Statement

What Is a Profit and Loss Statement?

Other Key Documents

What Is a P&L Statement Used For?

An Aid to Analysis

How to Read a P&L

Understanding Each Section of the P&L

Revenue (or sales)

Net Revenue

Cost of Goods Sold (COGS)

Gross Profit

Operating Expenses

Net Operating Income

Interest Income and Expense

Depreciation and Amortization

Tax

Earnings Per Share

The Takeaway

Short Squeezes Explained

What Is a Short Squeeze?

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What Causes Short Squeezes?

Example of Short Selling

Example of Short Squeeze

Famous Short Squeezes

What’s a Long Squeeze?

What Was the MOASS?

How to Trade a Short Squeeze

Short Squeezes vs Naked Shorts

Risks of a Short Squeeze

Risks for Investors

Risks for Institutions

Investing With SoFi

FAQ

Are short squeezes legal?

What is the biggest short squeeze of all time?

How high can a short squeeze go?

What Is a Revolving Letter of Credit & How Does It Work?

What Is a Revolving Letter of Credit?

How Does a Revolving Letter of Credit Work?

Types of Revolving Letters of Credit

Time-Based Revolving Letter of Credit

Cumulative Revolving Letter of Credit

Non-Cumulative Revolving Letter of Credit

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