How market value can help you determine the true worth of company or asset

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A company’s market value is useful in eliminating the uncertainty behind what an asset is worth.

  • Market value is the value of an asset or company in the marketplace, according to what investors are willing to pay for it.
  • Investors use market value to analyze investment opportunities.
  • Market value is used interchangeably with market capitalization, but it is a more complex measurement based on a range of factors.
  • Visit Business Insider’s Investing Reference library for more stories.

Evaluating where a business stands in relation to its competitors and industry is a key step in deciding whether a stock is worth your investment.

Market value, or the value of a security in the eyes of the market, is one of the many metrics investors use to evaluate a company’s worth.

Most often used in tandem with book value, market value gives individuals a look at the bigger picture. If you’re looking for leg up to spot the right investing opportunities, understanding all the factors that comprise an asset’s market value is a must.

What is market value?

Market value, sometimes called open market valuation, is the value of a company’s stock in the marketplace. The metric is influenced by how investors view a company’s potential.

Market value is about a “company’s overall actual value” and factors in things like “how profitable the company is, how much debt it may have, and even the financial health of the sector of the economy it is in,” says Bobbi Rebell, Certified Financial Planner.

A company’s market value is useful in eliminating the uncertainty behind what an asset is worth. Buyers and sellers don’t always agree on a value of a product, and each side has different goals, with buyers hoping to pay less and sellers hoping to charge more. Market value provides a fair estimation of the value or worth of any given asset.

What factors impact market value?

Market value is a dynamic measurement that fluctuates considerably with time and takes numerous factors into account, such as: long-term growth potential, supply and demand of a business’s shares, and valuation ratios used to evaluate whether a stock is overpriced, underpriced, or priced fairly.

The most common market value ratios used to evaluate a company’s stock include:

  • Earnings per share: Because a higher earnings per share indicates a more profitable business, this metric can positively (or negatively) influence how investors view a company’s worth.
  • Book value per share: This number is found by dividing a company’s equity by total outstanding shares. Higher book values tend to mean that a stock is undervalued, and can therefore impact how the asset or company is perceived by the market.
  • Price-to-earnings ratio (P/E ratio): This ratio is the current price of a stock divided by its earnings per share. A high P/E ratio indicates that a stock’s price is high relative to its earnings and may be overvalued by the market.

Market values exist within a wide range, with smaller, more niche companies or industries valued considerably below their better-known, billion-dollar counterparts. The higher a company’s estimated worth, the greater its market value.

Calculating market value

Since it is determined by various metrics, there isn’t a single formula used to calculate market value.

If you’re looking for a quick way to calculate market value, you may be thinking of market capitalization, a similar, but wholly different metric used to determine a company’s financial standing.

For private companies that don’t publicly disclose its financials, it can be harder to assess market value. It’s typically done by comparing a private business’s value to publicly-traded ones in the same industry with similar sizes and growth rates, and calculating relevant ratios to contextualize its performance.

Market value vs. book value

When assessing whether an asset is appropriately valued, market value is typically analyzed side-by-side with book value. Book value is basically the value of a company according to its books, or balance sheet.

To get a company’s book value, you take the difference between a company’s total assets and total liabilities. Learn more about the difference between market value and book value.

Book value takes a little more work to calculate than market value. A stock is generally considered undervalued if its market value is well below its book value, since this means the stock is being traded at a discount. However, the opposite is not necessarily true.

Profitable companies often have higher market values than book values. This is because investors are optimistic about their potential for growth and expansion, and also because some companies have more earnings power, or ability to generate profit, than current assets. In some cases, however, a higher market than book value could, in fact, indicate that the asset is overvalued.

Market value vs. market capitalization

Market value is a term often used interchangeably with market capitalization, but wrongfully so.

Market capitalization is a much simpler measurement than market value. To arrive at a company’s market capitalization, you multiply the number of shares outstanding by the current price of a single share. Market capitalization solely measures the equity value of a company.

In contrast, market value paints a broader, more nuanced picture of a company’s financial standing. It isn’t set in stone, but varies depending on the state of the economy, falling during times of recession and rising during periods of expansion.

Market value is also more significantly influenced by market perception than market capitalization. Rebell says that because market value has so many subjective components, it has a lot in common with market perception.

“Perception, of course, can be anything including what journalists are writing about the company, or the perception of a company created by the founder’s tweets. A great example is Tesla. By many financial metrics, one might say the stock is overvalued. However, comments made by Elon Musk and the perception they create have factored into the stocks performance,” says Rebell.

This leads into one of market value’s limitations: how much it can fluctuate.

Limitations of market value

Market value is affected by factors like what industry the firm or asset belongs to, its overall profitability, and how much debt it’s taken on, among other factors. Here are some limitations of using market value as a guide for when to invest in an asset.

  • It fluctuates: A firm or stock’s market value can rise and fall considerably based on changing supply and demand, with a rise in demand met with a steady supply facilitating a temporary and misleading hike in market value.
  • It requires precedent data: It can be hard to determine the market value of a new firm or equity, because they don’t have an inherent market value. To this end, establishing market value requires historical pricing data to compare with or create realistic estimates of.

Market value calculations offer both sides of the equation a fair and transparent assessment of worth. However, because it can be so subjective, it’s important for investors to decide for themselves which metrics are most important in their own evaluation of an investment.

The financial takeaway

Market value illustrates an asset’s value to investors in the marketplace and is often used alongside other measurements to assess whether a firm or asset’s valuation is accurate.

This metric brings clarity and transparency to both buyers and sellers, but fluctuates with time, depending on factors like industry and economic conditions.

The price-to-book ratio is a way to determine if a company’s stock price accurately reflects its financial valueBook value vs. market value: Knowing the difference between these two measures can help investors pick stocksWhat is the P/E ratio? An analytical tool that helps you decide if a stock is a good buy at its current priceHow to invest in dividend stocks, a low-risk source of investment income

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What are the hours of the stock market? Here’s when major exchanges around the world open and close

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Knowing when the market opens and closes is important to know when to place your trades.

  • In the US, the New York Stock Exchange and the Nasdaq are open weekdays from 9:30 a.m. to 4 p.m. EST.
  • Extended-hours trading is available to both retail and institutional investors via electronic communications networks.
  • Trading outside of normal hours comes with risks, including price uncertainty, less liquidity and higher volatility.
  • Visit Business Insider’s Investing Reference library for more stories.

If regular trading hours on Wall Street run from 9:30 a.m. to 4 p.m., shouldn’t we stop hearing about market hikes and dives by dinner time?

Well, stock market hours aren’t that simple. Trading doesn’t stop when markets close, and it doesn’t necessarily start when they open either, thanks to pre-market and after-hours trading.

Trading outside of normal hours isn’t new, but it’s become more accessible for retail traders due to the rise of electronic communications networks, or ECNs. These digital systems facilitate trading beyond traditional hours, connecting buyers and sellers directly without an intermediary.

However, just because extended-hours trading is an option doesn’t necessarily mean it’s one you should take. Trading outside of regular hours comes with risks like less liquidity and higher prices.

What time does the stock market open?

The two major US exchanges are the New York Stock Exchange (NYSE) and the Nasdaq. They are both based in New York and are open Monday through Friday from 9:30 a.m. to 4 p.m. EST.

Beyond regular trading hours, stock markets close for only nine federal holidays. On early-closure days, typically the days preceding and following a market holiday, regular trading ends at 1 p.m.

You may think trading stops outside of normal stock market hours, but there’s more to the story. Most stock futures, which are contracts traders use to speculate an underlying asset’s price and trade in the direction of that index, start trading at 6 p.m. EST on Sundays. This is why it’s not unusual to see a stock-market-related headline over the weekend.

Stock market trading hours around the world

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The Toronto Stock Exchange operates from 9:30 a.m. to 4:00 p.m. EST.

For individuals who wish to invest in international exchanges, that’s an option, but time disparities can present a challenge. Many international exchanges have the same hours in local time as those of the US. And although traders can place orders before opening, the trades have to be executed during the hours in which that market operates.

Here are the regular trading hours for some of the biggest stock exchanges in the world:

  • Canada: The Toronto Stock Exchange has a market capitalization of $2.1 trillion and operates from 9:30 a.m. to 4:00 p.m. EST.
  • China: The Shanghai Stock Exchange has a market capitalization of $4.9 trillion and operates locally from 9:30 a.m. to 3 p.m., or 9:30 p.m. to 3 a.m. EST.
  • Hong Kong: The Hong Kong Stock Exchange has a market capitalization of $4.4 trillion and operates locally from 9:30 a.m. to 4 p.m., or 9:30 p.m. to 4 a.m. EST.
  • India: The Bombay Stock Exchange has a market capitalization of $1.7 trillion and operates locally from 9 a.m. to 4 p.m., or 11:30 p.m. to 6:30 a.m. EST.
  • Japan: The Tokyo Stock Exchange is the largest Japanese exchange and the second largest globally, with a market capitalization of $5.7 trillion. It operates locally from 9 a.m. to 3 p.m., or 8 p.m. to 2 a.m. EST.
  • Netherlands: Euronext is based in the Netherlands and is the largest stock exchange in Europe, with a market capitalization of 3.9 trillion. It operates locally from 8 a.m. to 4:40 p.m., or 2 a.m. to 10:40 a.m. EST.
  • United Kingdom: The London Stock Exchange considers itself the most international global exchange, featuring more than 3,000 listings and a market capitalization of $3.2 trillion. It operates locally from 8 a.m. to 4:30 p.m., or 3 a.m. to 11:30 a.m. EST.

Investing through foreign exchanges can be done by setting up an international account through most major stock brokerages, but individuals should consider the complexities of foreign currency exchange, as well as the tax implications of trading globally before opting to go this route.

What is extended-hours trading?

Extended trading occurs when the market closes and an investor buys or sells a security outside of regular trading hours.

Extended-hours trading is performed via electronic communications networks, and includes both pre-market and after-hours trading. However, volume on these trades is limited since there are fewer participants.

Investors typically seek to trade outside of normal hours when major news, like an earnings release, inspires them to buy or sell, but comes after the exchange has closed or before it opens.

After-hours trading can be a strong indicator of which direction the market will open, and it should be noted that most extended-hour trades happen close to normal trading hours, since relevant news is usually released either right before markets open or soon after they close.

The three stock trading sessions

  • Pre-market: Runs from as early as 4 a.m. to market open at 9:30 a.m. EST.
  • Regular market hours: Spans from 9:30 a.m. to 4 p.m.
  • After-hours: Begins at 4 p.m. and can run until 8 p.m. EST, but trading volume tends to slow down considerably by around 6pm.

Risks of extended trading

Though extended trading allows investors to act fast and beat the rest of the market, it comes with some risks to be aware of.

  • Less liquidity: Extended-hours trading has lower trading volume than traditional hours, and some stocks can’t be traded at all outside of traditional hours. This makes it harder to execute trades and causes lower liquidity.
  • Higher volatility: Due to lower trading volume, trades during extended hours often come with larger spreads, or differences between an equity’s bid and ask price. This can make it harder for investors to carry out transactions at the desired price and can facilitate drastic price movements.
  • Price uncertainty: In the same vein as above, high volatility makes it harder to predict a stock’s price outside of traditional trading hours, and an equity’s price during extended hours doesn’t always closely align with its price during normal trading hours.

Where there’s risk, there’s room for reward. Trading outside of normal hours comes with the major perk of allowing investors to react to news, like poor earnings, immediately after it’s announced instead of having to wait for an exchange to open, by which time a stock’s price may already have dropped drastically.

The financial takeaway

The main US stock exchanges – the NYSE and the Nasdaq – are open from 9:30 a.m. to 4 p.m on weekdays, but individuals can trade outside of these hours, too. Extended-hours trading allows investors to act fast following news that might affect a stock’s price.

Trading beyond normal hours can be risky, since stocks are less liquid and more volatile, but can also be worth it.

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What is a stock market correction? How to make sense of sudden drops in the market

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Market corrections are normal part of investing.

  • A stock market correction is a brief 10%-20% dip in the value of individual stocks or the overall market from its most recent peak.
  • Market corrections occur on a regular basis and are important for preventing artificially inflated stock prices.
  • They are nothing to worry about in most cases, as long as you’re investing long-term.
  • Visit Insider’s Investing Reference library for more stories.

There’s nothing quite like the rush of watching your investments gain value. The same could be said about the moment of panic when you see them start to take a tumble.

However, it’s common to see plenty of ups and downs in the market. And a dip isn’t always necessarily bad.

Many of these dips are stock market corrections, and understanding what that means can help you better manage your portfolio and protect your wealth.

Here’s what you need to know about stock market corrections and why they matter.

What is a stock market correction?

A stock market correction is a brief dip of 10%-20% in the market or individual stock that occurs to correct artificially inflated stock prices and unsustainable growth. They typically last a few months, although some last only a few days.

To help you understand the difference of a few key ways investors describe the market, here’s a brief rundown:

  • Correction: A temporary decline in the market
  • Crash: An unforeseen and sudden drop in stock prices, often signaling wider economic turmoil
  • Bear market: A widespread and prolonged decline of 20% or more in market prices
  • Bull market: When the market condition is on an upward trend for a sustained period of time

A stock market correction can occur for a number of reasons. Many investors chase market trends, so if people are buying a stock because they believe it will rise in value, others are likely to follow suit. This causes the price of that stock to rise. As this happens, some investors who hold that stock may begin to sell in order to turn a profit while the price is high, as will others, causing the stock price to dip temporarily.

This can happen on a larger scale as confidence in the market waxes and wanes. Good news can artificially inflate stock prices, and sometimes the market reaches a point when demand for stocks goes down, forcing investors who want to sell to lower prices.

What are the effects of a market correction?

In these situations, the market dips to correct itself to avoid a market crash. This typically occurs during an overall period of growth.

Historically speaking, most market corrections have not gone beyond a 20% decline, and they often resulted in a bounce back to normalcy or even a bull market – that is, a period of significant growth.

However, it is possible for a market correction to transform into more dire conditions. If a decline surpasses 20% and lasts for a sustained period of time, it transforms into what’s known as a bear market. These periods of market decline are often accompanied by economic stagnation and increasing rates of unemployment. Sometimes they can lead to a recession.

While this describes the effect on the market as a whole, it’s important to note that not all stocks react to a correction equally. High-growth and more volatile stocks tend to be the most reactive, while non-cyclical stocks, such as defensive stocks will be less impacted.

Why do market corrections matter?

Market corrections can impact the performance of your stocks so it’s always a good idea to know when it’s happening.

In general, market corrections impact most long-term investors minimally, as long as it doesn’t evolve into a recession. A brief dip isn’t troubling as long as your portfolio continues on a general upward trend, so time will likely be on your side.

This is even more true if you’ve diversified your portfolio by holding stocks in a wide range of sectors. This includes non-cyclical stocks, also known as defensive stocks, which tend to perform well even under slowed market conditions.

But for short-term investors such as day traders and others attempting to “time the market,” market corrections can present both significant opportunities and obstacles.

On the one hand, a market correction can be a good time to purchase valuable stocks at discounted prices. On the other hand, this is quite risky, as stocks could continue to dip further. Being forced to sell during a dip can be an expensive mistake.

Some investors will attempt to predict market corrections using market analysis and by comparing market indexes to purchase at a low. But it’s difficult to know for sure when it will happen and what the end result will be. For this reason, it’s generally a better idea to keep your portfolio diversified and rely on long-term growth rather than short-term gains.

As you near retirement age, you can rebalance your portfolio regularly and shift your investments toward more stable assets such as bonds. This will protect your portfolio from losing value at a point when you don’t have enough time left for it to recover.

The financial takeaway

Stock market corrections can be scary, but they’re a natural part of how the market behaves. If there’s one rule to follow in investing, it’s not to make impulsive decisions based when the market declines.

Knowing what a stock market correction is and how it works can help you better understand the nature of your investments so you can manage them more efficiently.

Some may use corrections in an attempt to time the market, but you’re more likely to benefit by simply using this knowledge to remain steadfast when your portfolio takes a hit rather than selling at a loss. When it comes to the stock market, having patience and ensuring you have a diverse portfolio during dips is the best way to go.

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What is a unit investment trust? An easy way to build diversification while earning steady income

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UITs can offer you access to a wide range of asset classes and investment strategies through a single purchase.

  • A unit investment trust (UIT) is a type of investment fund that offers a fixed portfolio of stocks, bonds, and other assets for a set period of time.
  • UIT portfolios are typically fixed and not actively managed or traded.
  • UITs are particularly popular as diversification tools for hands-off investors and the retirement community, where stability is prized.
  • Visit Insider’s Investing Reference library for more stories.

If you’ve avoided mutual funds because of high management fees or how frequently they can be traded, you might benefit from a closer look at the unit investment trust, or UIT.

Like mutual funds, UITs pool investor funds to purchase a series of assets, which are then bundled and offered up as a single unit – making them great for portfolio diversification.

Unlike mutual funds, UITs are designed to be bought and held until a specific maturity date, with extremely limited trading in the meantime. Because of this, the funds tend to be particularly popular with buy-and-hold investors where stability is more highly valued.

As of December 2020, the Investment Company Institute (ICI) reported that there were 4,310 outstanding UITs, representing $77.85 billion invested, so a booming industry awaits the interested investor.

What is a UIT?

A UIT is one of three basic types of investment companies. The other two types of investment companies are open-end funds and closed-end funds, which we’ll cover later.

UITs offer investors a fixed portfolio that can include stocks, bonds, or other securities in the form of redeemable units. They’re public investments that are bought and sold directly through the company issuing them, or through a broker working as an intermediary. Investors can redeem UITs after a set period of time passed, known as the maturity date.

How does a UIT work?

The goal of a UIT is that the passively held assets it contains will provide capital appreciation or dividend income throughout the life of the trust. And while that outcome isn’t guaranteed, UITs are regulated through the Securities and Exchange Commission (SEC), so concerned investors can breathe easier. Every UIT must register through the commission, which then enforces requirements about everything from where the fund can invest to under what circumstances trades can be made.

The average UIT is typically made up of mostly stocks and bonds, but can also contain assets like mortgages, real estate investment trusts (REITs), master limited partnerships (MLPs), hybrid instruments like preferred shares, and beyond. These assets are often fixed around a broad theme, like American stocks offering historically high dividends, or corporate bonds from companies in a specific sector.

Money managers select assets for inclusion at the creation of the trust, aiming for securities they think will offer the most capital appreciation over time. They also set the maturity date for the fund, which can be anywhere between 15 months and 30 years. After that, the fund remains largely undisturbed until its maturity date.

A prosperous UIT will earn its investors income in two different ways: in the form of quarterly or monthly dividends throughout the life of a fund, and as capital appreciation when the fund matures. Once your UIT expires, you have the option of taking delivery of the underlying assets into your own brokerage account, reupping into a similar or identical trust, or liquidating your holdings, which would give you the current cash value.

UITs vs. mutual funds

Mutual funds and UITs are similar in that they’re pooled funds overseen by a professional money manager, and are subject to SEC regulation. Here’s how the two assets diverge:

  • Mutual funds are actively managed and UITs are not: The ability to buy and sell assets within a mutual fund increases the potential for capital gains – and, of course, losses. Since UITs don’t actively trade, fees are lower, and as fixed income investments, their underlying securities do not change except in rare cases like bankruptcy or merger.
  • Mutual funds and UITs structure dividends differently: While mutual funds are designed to reinvest your dividends, UIT investors can miss out during market upswings, as the latter doesn’t allow for the purchase of additional shares.
  • UITs have a maturity date, while mutual funds do not: Much like bonds or CDs, UITs have defined lifespans and set metrics to hit before their expiration. This makes UITs, by their nature, a more long-term investment than mutual funds.
  • Mutual funds and UITs offer different ways to invest: If you have the cash to invest in a mutual fund, you can purchase shares on demand, as their quantity is limitless. But since UITs have a set limit or shares released upon its initial public offering (IPO), you have to invest within that window or be subject to the whims of the secondary market.

Each investment type has its own limits. But by and large, the reason you’d see a portfolio organized as a UIT instead of a mutual fund is to minimize both short-term and long-term expenses.

UITs come with much lower expense ratios and also come with favorable tax terms. Because of the way capital gains taxes are structured, it’s possible to lose money on a mutual fund and pay taxes on gains you never actually appreciated. For example, if the shares were sold right before you got your hands on them, you could find yourself with a shared tax liability for someone else’s capital gains.

But that won’t happen with a UIT. Because the securities are bundled when you place the order and not before, the original value – or cost basis, as it’s termed – is specific to you and can’t burn you down the road.

Who should buy UITs?

UITs have benefits to offer every investor, but they’re particularly compelling for those who aren’t interested in building a portfolio security by security, or who don’t want to pay the high expense ratios on actively managed mutual funds. Plus, the lower buy-ins on UITs make them more accessible for newer investors or those with less capital.

UITs are also quite popular with those at or close to retirement age because they tend to be more stable investment vehicles. While UITs might not have the growth potential of a different asset class, their buy-and-hold strategy is lighter on risk as well. From the very start, you’ll know exactly where you’re invested, how long that investment will last, and roughly how much income you can expect from your investment, all without having to wait to pore over a prospectus.

If you’re looking to join the ranks of UIT investors, these funds can be purchased directly from the issuer, or bought and sold on the stock exchange. Talk to your financial adviser about which UIT might be a match for you and your situation.

The financial takeaway

As an investment, UITs are a different option from mutual funds or closed-end funds that offer a winning combination of low costs, reliability, tax protection, and fairly predictable gains.

There are certain pitfalls, of course, like a lack of flexibility and a potential cap on earnings, since dividends can’t be reinvested. But if you’re nearing retirement or simply trying to stretch a dollar, UITs can prove to be a plum choice for the (semi) conservative investor looking to diversify their portfolio.

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What is a municipal bond? How to earn tax-free income by investing in projects that impact your community

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State and local governments issue municipal bonds to help pay for a wide range of projects including roads, schools and hospitals.

  • Municipal bonds are debt securities issued by local governments to fund public projects like schools, hospitals, or highways.
  • Investors buy municipal bonds because interest earned is exempt from federal income taxes, and in some cases, from state and local taxes.
  • Because they are tax-efficient investment, municipal bonds are best for taxable accounts as opposed to tax-advantaged retirement accounts.
  • Visit Insider’s Investing Reference library for more stories.

Imagine a relatively safe, long-term investment that generates income, allows you to save on taxes, and funds public projects crucial a community.

That’s essentially what happens when you invest in municipal bonds, which allow you to invest in the infrastructure of state and local communities while adding diversity and tax efficiency to your portfolio.

Here’s what you need to know about municipal bonds, from why they’re popular among tax-smart investors to how they can benefit your portfolio.

What are municipal bonds?

A municipal bond, or “muni” for short, is a type of bond issued by a state or municipality to help fund necessary public works projects.

Munis are popular with investors because of their tax advantages. Interest earned on municipal bonds is usually exempt from federal income tax. If you purchase a muni in the state you live, it could also be exempt from state and local taxes. Earning tax-free income is especially attractive to investors in higher tax brackets.

Investors also like the inherent safety of municipal bonds. In most cases, because you are investing in a bond used to help finance infrastructure backed by a local government, you can usually count on getting your principal back at maturity.

How do municipal bonds work?

At its most basic level, a bond is a loan made by an investor to a borrower. Whereas treasury bonds are issued by the US government and corporate bonds are issued by companies, municipal bonds are issued by local and state governments.

State and local governments issue municipal bonds to help pay for a wide range of projects including roads, schools and hospitals. Investors who purchase these bonds lend money to the municipality in return for regular interest payments (usually semiannual) for a set amount of time.

Principal is repaid when the bond matures, or when the loan ends. Munis have a wide maturity range of one to 30 years.

It’s important to pay special attention to the type of account you use to purchase these bonds. In a traditional IRA or 401(k) retirement account, earnings already grow tax-free. Most investors find holding munis in taxable brokerage accounts help make the most of munis’ tax-free status.

In rare cases, municipal bond interest may not be exempt from federal taxes if they are used to fund an activity not qualified for tax-exempt status under IRS rules, like paying pension fund liability. It is usually obvious to you, your broker or your advisor when a muni is not exempt from federal taxes.

Investors who buy and sell municipal bonds may be liable for capital gains tax on profits from those sales or for bonds purchased at a discount price. In addition, if you are subject to the alternative minimum tax, you may be required to pay some taxes on municipal bond interest.

Are municipal bonds safe investments?

Municipal bonds are considered relatively safe investments because they have lower default rates and higher credit ratings than corporate bonds. Plus, many munis are backed by insurance that guarantees payment in the event of a default.

That’s not to say munis are immune from default. For example, during the Puerto Rican debt crisis and the Detroit city bankruptcy, there were several muni bonds that could no longer make payments.

If municipal bonds pique your interest, it’s important to understand credit ratings. There are three major credit ratings agencies – Standard & Poor’s (S&P), Moody’s and Fitch – all of which rate the issuers of municipal bonds based on their ability to meet their financial obligations. This makes it easier for investors to evaluate risk.

Although many munis receive the highest ratings from the agencies, such as AA+ or Aa1, it’s important to remember that ratings can be downgraded during the life of the bond if a municipality’s financial situation changes.

Like all bonds, munis also carry interest rate risk. When interest rates fall, prices for existing bonds paying higher rates will rise. In turn, when interest rates rise, prices on existing bonds paying lower rates will decline. If you hold muni bonds to maturity, price risk is not a factor. You only experience the ups and downs if you are buying and selling muni bonds.

How much will I earn from municipal bonds?

In return for safety and the tax advantages, investment-grade municipal bonds often yield less than their taxable counterparts, such as corporate and government-issued bonds.

High-yield munis, or munis that come from less-creditworthy issuers, can have significantly higher yields than investment-grade munis ,but they come with more investment risk. Investors in high-tax brackets may find that the tax advantages of investing munis help bridge the gap between muni and taxable bond rates.

How to buy municipal bonds

In most cases, you buy and sell municipal bonds through a broker. There are three main ways you can invest in munis:

  • Individual bonds bought through a broker require you to do your own research and decide whether to buy new issues or bonds sold through the secondary market, where you can buy munis already issued to other investors. You’ll also need to investigate credit risk carefully, since your own portfolio of muni bonds will likely not be as diversified as a mutual fund or ETF.
  • Municipal bond mutual funds invest in a wide-range of muni bonds, offering investors the diversity they can’t get on their own, while still providing the federal tax advantages on income and in some cases some limited state and local tax breaks. If the upside is instant diversification and professional management, the downside is recurring management fees. You’ll also be subject to capital gains tax when you sell your shares.
  • Mutual bond ETFs are a good way to invest in a diverse array of municipal bonds. Like mutual funds, income is exempt from federal taxes and some interest earned may also be tax exempt at the state and local level, depending on where you live.

    ETFs trade like stocks on the market with prices fluctuating throughout the day, so you may experience more volatility with an ETF than a mutual fund. Like mutual funds, you’ll be subject to capital gains tax when you sell your shares.

Whatever investment you choose, be sure to pay attention to the account you are using to purchase muni bonds. You likely don’t want them as part of your tax-deferred retirement accounts such as traditional IRAs or 401(k)s where you won’t get the full force of the tax exemptions. Better to put them in a taxable brokerage account.

The financial takeaway

Municipal bonds can offer a relatively safe, tax-advantaged way to diversify your fixed-income portfolio. While yields may not be as high as taxable bonds, the tax exemptions on interest earned can help even the playing field. Investors in high-tax brackets looking to diversify their taxable investment accounts may be best suited to municipal bond investing.

A zero-coupon bond is a discounted investment that can help you save for a specific future goalBonds vs. CDs: The key differences and how to decide which income-producing option is better for youA corporate bond provides companies with cash and investors with income – here’s how to evaluate the risks and rewardsWhat are junk bonds? A risky yet high-yield investment that can bring rewards if you’re willing to take the chance

Read the original article on Business Insider

Beginner’s guide to investing in marijuana stocks and the booming cannabis industry

GettyImages 1178310599
As cannabis goes mainstream, the budding industry is poised to grow.

  • As the legal cannabis market grows in the US, there are several ways for investors to gain exposure to the marijuana industry.
  • In addition to investing in individual stocks, marijuana ETFs allow you to invest in a range of companies across the industry. 
  • Due to legal uncertainties on the federal level, marijuana investments remain risky and volatile.
  • Visit Insider’s Investing Reference library for more stories.

When it comes to investing in the legal marijuana industry,  they dont call it the “green rush” for nothing. 

Many analysts are projecting massive growth for the cannabis industry. New Frontier, a Washington DC-based cannabis research firm, expects total US legal cannabis sales to exceed $35 billion by 2025.  

In light of such tremendous growth potential, many see marijuana as a golden investment opportunity – but not without risk. It’s important to remember that the use and sale of marijuana, despite state laws, is still illegal under federal law.

Here’s what you need to know about investing in the legal cannabis industry, including the risks and challenges, the biggest companies to watch, and why ETFs could be the safest way to add marijuana stocks to your portfolio. 

Basics of the cannabis industry

With each election, more states are voting to legalize some form of marijuana use. A total of 36 states have legalized medical marijuana, with 15 states and Washington DC legalizing cannabis for recreational adult use. 

Broadly speaking, there are two markets in the marijuana industry: recreational and medical. While each cater to different markets, both represent growth potential. Whereas medical marijuana stocks involve companies dedicated to the medicinal and therapeutic benefits of the drug, recreational cannabis companies cover products for personal enjoyment. 

On the medical side, there’s also a growing market for CBD products. CBD, short for cannabidiol, is the legal, non-psychoactive compound found in cannabis plants that’s taken to ease chronic pain, anxiety, and other ailments. 

The growing acceptance of cannabis is not just happening in the US, but all over the world. Grandview Research projects that the global market size for the cannabis industry will reach $73.6 billion by 2027.

“Investors have the opportunity to get in on the ground floor of an emerging industry,” says Michael Shea, CFP at Applied Capital, adding that by getting in early, investors could “capture outsized returns as the industry grows and develops.”

Types of marijuana investments 

Currently, the medical marijuana market offers strong short-term income potential. But the recreational side continues to attract investors as more states pass legislation. 

There are four major categories of marijuana stocks related to different facets of the cannabis industry:

  • Growers: Companies that own marijuana farms and actively cultivate the plant.
  • Retailers: This includes dispensaries in states where residents can purchase marijuana and cannabis-related products such as edibles, oils, and more. 
  • Manufacturers: Companies that provide ancillary support to the industry and are involved in cannabis extraction, product preparation, packaging, and labeling.
  • Drugmakers: Pharmaceutical companies that use biotech to create drugs derived from the cannabis plant.

It should be noted that some companies that are tangentially connected to the marijuana industry may still benefit from its growth. An example would be companies that develop hydroponic technologies, such as GrowGeneration (GRWG).

Risks of investing in marijuana 

One of the biggest risks of marijuana investing is that it’s rising popularity makes it a prime target for scam artists. In fact, the SEC has issued a warning that lists several various marijuana-related fraudulent investment schemes including unlicensed sellers, unsolicited investment offers, and market manipulation. 

Other risks of investing in marijuana to consider:

  • Business risk: As long as marijuana is federally illegal, it will continue to be difficult for marijuana companies to open US bank accounts. Sean van der Wal, Managing Partner at Drawing Capital, explains that this not only makes it more difficult to secure funding, but also means that “many marijuana producers rely on cash,” which “poses a significant risk from a liability and accounting perspective.”
  • Legislative risk: The industry’s growth is tied to legislation. Surprisingly, there’s even some risk involved with the legalization of marijuana. Kenny Polcari, founder and Managing Partner of Kace Capital Advisors, says future taxation is a big question mark. “Right now you can buy marijuana and pay no sales tax.” But “taxes will increase the price of marijuana for the end user.” And, if too high, those added costs could push some consumers away.
  • Valuation risk: Many of the companies that are involved in producing or selling marijuana are young. What should their valuations be?  It’s hard to tell. Polcari warns that “if valuations end up too high as the excitement builds, the potential exists that the market will correct and prices will decline.”
  • Demand risk: As more companies enter the market, supply could outpace demand for cannabis products. Van der Wal also says that “enthusiasts may be compelled to produce their own product in small batches for personal consumption” as legalization spreads. This could especially be true if high excise taxes are applied to marijuana sales. And, in these ways, he says “analysts may overstate the total addressable market.”
  • Volatility risk: Marijuana stock prices often swing wildly up and down in short periods of time. This is less likely to be a concern if you plan to hold onto your investments for 10-30 years or more. But if you have a shorter investment horizon, you may want to stay away from volatile investments like marijuana stocks.

How to invest in marijuana

Much like investing in any stock, you’ll need a broker to invest in marijuana. You’ll also want to do your due diligence before choosing investments, which means taking the time to research each company and staying up to date with the latest regulations. 

There are two main types of marijuana investments: individual stocks and marijuana ETFs. ETFs allow you to spread your investment among companies across the entire marijuana industry.  

If you’re a trader looking to take advantage of short-term price shifts, Polcari says that individual stocks may be the way to go. Otherwise, he prefers ETFs since they don’t require you to pick and choose and run the risk of picking the wrong company.

Marijuana ETFs

Some ETFs seek to provide investment results that correspond to an underlying index while others are actively managed. The advantage of index ETFs is that they tend to have lower expense ratios. But actively managed funds may be able respond faster to marijuana stock news – both positive and negative.

The list below of popular marijuana ETFs includes a mixture of actively managed and index options:

ETF Net Assets
ETFMG Alternative Harvest ETF (MJ) $1.44 billion
AdvisorShares Pure US Cannabis ETF (MSOS) $582.68 million
AdvisorShares Pure Cannabis ETF (YOLO) $265.07 million
The Cannabis ETF (THCX) $91.59 million
Global X Cannabis ETF (POTX) $84.36 million

Marijuana stocks

Because US marijuana companies are engaged in activities that are illegal on the federal level, there aren’t many publicly-listed US cannabis stocks on major exchanges. By contrast, Canadian cannabis companies – where recreational use of cannabis was legalized in 2018 – are able to list on major stock US exchanges like the Nasdaq and the New York Stock Exchange. 

The distinction is important to know because US cannabis companies looking to raise capital are forced to list on the secondary market, or trade over-the-counter (OTC). OTC stocks can be dangerous as they lack public financial records and are often more susceptible to price manipulation. 

The good news is that the number of publicly-listed marijuana stocks is growing. As you’re evaluating your options, the first thing to consider is the company’s market cap. The larger the market cap, the better the chance that the company will have the financial stability to survive over the long haul. 

Here’s a list marijuana stocks that have a market cap of at least $1 billion:

Company Market Cap Type
Canopy Growth Corp (CGC) $15.86 billion Grower/Retailer/Drugmaker
Curaleaf (CURLF) $7.74 billion Retailer/Drugmaker
GW Pharmaceuticals (GWPH) $6.77 billion Drugmaker
Green Thumb Industries Inc (GTBIF) $6.55 billion Manufacturer/Retailer
Tilray Inc (TLRY) $5.49 billion Drugmaker
Cronos Group (CRON) $4.70 billion Manufacturer
Village Farms International, Inc. (VFF) $1.41 billion Grower

The financial takeaway

Marijuana investing isn’t for everyone, especially for retail investors who prefer to minimize risk. But investors with a higher risk tolerance may find that the growth promise of marijuana stocks and ETFs make them a worthy addition to their portfolios.

From ETFs to over-the-counter stocks, here’s how to invest in the booming cannabis industry, according to 2 expert investorsHow to invest in healthcare, a massive market sector that offers unparalleled diversification for portfoliosAll the states where marijuana is legal – and 5 more that voted to legalize it in NovemberVolatility measures how dramatically stock prices change, and it can influence when, where, and how you invest

Read the original article on Business Insider

Bonds can be taxable or tax-free – here’s your guide to the different types and calculating what’s due on them

Bonds are divided into two classes: taxable and tax-exempt. While their capital gains are always taxable, the interest they earn may not be.

All investments generate income in one way or another – sometimes as you hold them, sometimes only when you sell them for a profit. And that investment income tends to be taxable.

Bonds are no exception. But as an asset class, they’re a particularly diverse group. And so is the way they’re taxed. Some bonds are fully taxable, some partially taxable, and some not at all. 

And because they generate income in a few different ways, their tax rates vary too. 

Let’s examine bonds and taxes in more detail.

How are bonds taxed?

Bonds and bond funds generate two different types of income: interest and capital gains


Bonds are a type of debt instrument. When you buy a bond, you’re loaning money to the government or company that issued it; in return, that entity pays you interest. Most bonds pay a fixed, predetermined rate of interest over their lifespan. 

That interest income may be taxable or tax-free (more on the types of bonds that generate tax-free income later). For the most part, if the interest is taxable, you pay income taxes on that interest in the year it’s received. 

The rate you’ll pay on bond interest is the same rate you pay on your ordinary income, such as wages or income from self-employment. There are seven tax brackets, ranging from 10% to 37%. So if you’re in the 37% tax bracket, you’ll pay a 37% federal income tax rate on your bond interest.

Capital gains

If you buy a bond when it’s first issued and hold it until maturity – the full length of its lifespan – you generally won’t recognize a capital gain or loss. The money you get back is considered a return of your principal – what you originally invested in it.

However, after they’re issued, bonds often trade on financial exchanges, just like stocks. If you sell them before their maturity date on the secondary market, the bonds can generate capital gains and losses, depending on how its current price compares to your original cost. Bond funds can also generate capital gains and losses as the fund manager buys and sells securities within the fund.

So, the profit you make from selling a bond is considered a capital gain. Capital gains are taxed at different rates depending on whether they’re short-term or long-term.

Short-term capital gains apply if you hold the bond for one year (365 days) or less. Then the gain is taxed at your ordinary income tax rates.

Long-term capital gains apply if you hold the bond for more than one year. Then you can benefit from reduced tax rates, ranging from 0% to 20%, depending on your filing status and total taxable income for the year.

capital gains

Are all bonds taxed?

Bonds are divided into two classes: taxable and tax-exempt. 

A bond’s tax-exempt status applies only to the bond’s interest income. Any capital gains generated from selling a bond or bond fund before its maturity date is taxable, regardless of the type of bond. 

Taxable bonds

The interest income from taxable bonds is subject to federal, state (and local, if applicable) income taxes.

Taxable bonds include:

  • Corporate bonds
  • Mortgage-backed securities
  • Global bond funds
  • Diversified bond funds

Tax-exempt bonds

Municipal bonds, aka munis, are the main type of tax-exempt bonds. 

Munis are issued by states, counties, cities, and other government agencies to fund major capital projects, such as building schools, hospitals, highways, and other public buildings.

Interest income from muni bonds is generally not subject to federal income taxes. It can also be exempt from state or local income taxes if your home state or city issues the bond. Interest income from muni bonds issued by another state or city is taxable on your state or local income tax return. 

Fast fact: Muni bonds exempt from federal, state, and local taxes are known as “triple tax exempt.”

US Treasuries, bonds issued by the US Dept. of the Treasury, and savings bonds are also tax-exempt – to a degree. If you own them, you owe federal income tax on them. However, they are generally free from state and local income taxes. 

How can I avoid paying taxes on bonds?

Here are a few strategies for avoiding – or at least reducing – the taxes you pay on bonds.

  • Hold the bond in a tax-advantaged account. When you invest in bonds within a Roth IRA or Roth 401(k), the returns are tax-free, as long as you follow the withdrawal rules. Bond income and profits from sales earned within a traditional IRA or 401(k) are tax-deferred, meaning you don’t pay taxes until you withdraw the money in retirement.
  • Use savings bonds for educational purposes. Consider using Series EE or Series I savings bonds to save for education. When you redeem the bond, the interest paid is tax-exempt as long as you use the money to pay for qualified higher education expenses and meet other qualifications
  • Hold bonds until maturity. Holding a bond until maturity, instead of selling it early on the secondary market can help you avoid paying taxes on capital gains. However, you still owe tax on any taxable interest generated by the bond while you owned it.

The financial takeaway

Minimizing the tax consequences of bonds comes down to investing in tax-exempt bonds, such as muni bonds and US Treasuries, and using tax-advantaged accounts where your money can grow on a tax-free or tax-deferred basis.

If you invest in bonds outside of tax-advantaged accounts, you’ll receive a Form 1099 from the bank or brokerage holding your investments around January 31 of each year. Hold on to these forms, as you’ll need them to report bond interest and capital gains on your tax return. The IRS also gets a copy of those 1099s.

 If you miss reporting any income, they’ll be sure to let you know.

Related Coverage in Investing:

A corporate bond provides companies with cash and investors with income – here’s how to evaluate the risks and rewards

Fixed-income investing is a strategy that focuses on low-risk investments paying a reliable return

Bonds vs. CDs: The key differences and how to decide which income-producing option is better for you

What are junk bonds? A risky yet high-yield investment that can bring rewards if you’re willing to take the chance

How to buy treasury bonds, one of the safest ways to invest for income

Read the original article on Business Insider

Investment income is taxed in a variety of ways – here’s how to estimate what you’ll owe and tips to minimize it

investment income
Your investment income may be taxed as ordinary income, at certain special rates, or not at all, depending on the type of investment it is and the sort of investment account it’s in.

  • Investment income can be taxed as ordinary income or at special rates, depending on the type it is. 
  • Capital gains and some dividends receive preferential tax rates. Interest and annuity payouts are taxed as ordinary income. 
  • All investments earn income tax-free while they remain in tax-advantaged accounts.
  • Visit Business Insider’s Investing Reference library for more stories.

You probably know that you have to pay taxes on just about all your income. But while the taxes on your work income is fairly straightforward – based on your tax bracket, and often automatically withheld from your paycheck – the tax on investment income can be more complex. 

Not all investment income is taxed equally.

In fact, your investments are taxed at different rates, depending on the type of investment you have. Some investments are tax-exempt, some are taxed at the same rates as your ordinary income, and some benefit from preferential tax rates.

When you owe the tax can also vary. Some taxes are due only when you sell the investment at a profit. Other taxes are due when your investment pays you a distribution. 

And finally, where you hold the investments matters. If the asset is in a tax-deferred account, such as an IRA, 401(k), or 529 plan, you won’t owe taxes on the earnings until you withdraw money from the account – or, depending on the type of account, ever.

See what we mean by complex? Never fear – here’s everything you need to know about the taxes on investment income, and the tax rates on different investments. 

What is investment income?

Investment income comes in four basic forms:

  • Interest income derives from the Interest earned on funds deposited in a savings or money market account, or invested in certificates of deposit, bonds or bond funds. It also applies to interest on loans you make to others.
  • Capital gains. Capital gains come from selling an investment at a profit. When you sell an investment for less than you paid for it, it creates a capital loss, which can offset capital gains.
  • Dividend income. If you own stocks, mutual funds, exchange-traded funds (ETFs), or money market funds, you may receive dividends when the board of directors of the company or fund managers decides to distribute the excess cash on hand to reward their investors.
  • Annuity payments. When you purchase an annuity, a contract with an insurance company, you pay over a lump sum. The insurance company invests your money, and converts it into a series of periodic payments. A portion of these payments can be taxable.

How is investment income taxed?

With so many variables, how can you estimate the tax bite on your investments? Here are the tax rates for different types of investment income.

Interest income

For the most part, interest income is taxed as your ordinary income tax rate – the same rate you pay on your wages or self-employment earnings. Those rates range from 10% to 37%, based on the current (2021) tax brackets. 

Some interest income is tax-exempt, though. Interest from municipal bonds is generally tax-free on your federal return; when you buy muni bonds issued by your own state, the interest is exempt from your state income tax as well.

Another exception is granted US Treasury bonds, bills, and notes, as well as US savings bonds. They are exempt from state and local taxes, though not federal taxes. 

Capital gains

The tax rate you’ll pay on capital gains depends on how long you owned the investment before selling it.

You have a short-term capital gain if you own the asset for one year (365 days) or less before selling it. Short-term capital gains are taxed at the same rate as your ordinary income.

You have a long-term capital gain if you hold on to the investment for more than one year before selling it. Long-term gains are taxed at preferential rates, ranging from 0% to 20%, depending on your total taxable income.

Capital gains are not taxable while the funds remain within a tax-advantaged IRA, 401(k), HSA, or 529 plan.

capital gains

Dividend income

The rate you pay on dividends from stock shares or stock funds depends on whether the dividend is qualified or unqualified. 

Qualified dividends are taxed at the same rates as long-term capital gains. Unqualified dividends are taxed at the same rates as ordinary income.

To count as qualified, you must have owned the dividend-producing investment for more than 60 days during the 121-day period that started 60 days before the security’s ex-dividend date. The ex-dividend date is the date after the dividend’s record date, which is the cut-off date the company uses to determine which shareholders are eligible to receive a declared dividend.

Annuity payments

The taxation of annuity payments is a little more complex. While you may earn interest, dividends, and capital gains within your annuity, you don’t owe any taxes on this income until you actually start receiving your annuity payouts. You only have tax due on the sums you receive each year.

What you owe also depends on whether you purchased the annuity with pre-tax or after-tax dollars. If you purchase an annuity with pre-tax dollars (by rolling over money from your 401(k) or IRA), payments from the annuity are fully taxable.

But if you purchase an annuity with after-tax dollars – that is, you didn’t use retirement account money, you only pay taxes on the earnings portion of your withdrawal. The rest is considered a return of principal (the original lump sum you paid into the annuity). 

 When you receive your 1099-R from your insurance company showing your annuity payouts for the year, it will indicate the total taxable amount of your annuity income.

Whether you pay tax on 100% of the annuity payments or only the earnings portion of your withdrawal, all annuity payments are taxed at the ordinary-income rate.

How do I avoid taxes on investment income?

Most investment income is taxable, but there are a few strategies for avoiding – or at least minimizing – the taxes you pay on investment returns. 

  • Stay in a low tax bracket. Single taxpayers with taxable income of $40,400 or less in 2021 qualify for a 0% tax rate on qualified dividends and capital gains. That income limit doubles for married couples filing jointly. If you can take advantage of tax deductions that will keep your taxable income below that amount, you may be able to avoid paying taxes on a significant portion of your investment income.
  • Hold on to your investments. Hanging on to stocks and other investments can help ensure you take advantage of preferential rates for qualified dividends and long-term capital gains.
  • Invest in tax-advantaged accounts. Interest, dividends, capital gains – almost all forms of investment income are shielded from annual taxes while they remain in one of these accounts. With a traditional IRA or 401(k), the money is only taxable once you withdraw funds from the account. Money earned in a Roth IRA is never taxable, as long as you meet the withdrawal requirements. Interest income from a health savings account (HSA) or 529 plan is not taxable as long as you use the money to pay for qualified medical or educational expenses, respectively.
  • Harvest tax losses. Tax loss harvesting involves selling investments that are down in order to offset gains from other investments. If you have investments in your portfolio that have poor prospects for future growth, it could be worth it to sell them at a loss in order to lower your overall capital gains. Many robo-advisors and financial advisors will take care of harvesting for you, trying to net out the winners and the losers.

The financial takeaway

A few tax-exempt assets aside, investment income is taxable. And it’s taxed in two basic ways: at ordinary income rates or at a lower preferential rate, generally known as the capital gains rate.

All assets accrue income tax-free while they remain in tax-advantaged accounts.

While it’s never a good idea to make investment decisions based solely on the tax implications, it is wise to consider the tax consequences of any investment moves you make. Taxes might not be the only reason you choose one investment over another, but tax breaks can be a bonus on any well-thought-out investment strategy.

Related Coverage in Investing:

Dividends are taxed in different ways – here’s how to figure what you owe on your stocks’ payouts

Interest income from your investments is taxable – here’s how to calculate what you owe and ways to lower it

Bitcoin taxes: Understanding the rules and how to report cryptocurrency on your return

Capital gains are the profits you make from selling your investments, and they can be taxed at lower rates

A variable annuity can provide you with more retirement income since its payouts rise with the stock market

Read the original article on Business Insider

Long call options vs. long put options – what ‘going long’ in options trading means

long option1
In options trading, a long position means buying either a long call option or a long put option. The long call option reflects an optimistic feeling that a stock price will rise.

  • In options trading, going long means owning one of two types of options: a long call and a long put.
  • A long call option gives you the right to buy stock at a preset price in the future. A long put option lets you sell it.
  • Long positions hedge risk: If the stock doesn’t move as hoped, the option expires at little cost to you.
  • Visit Business Insider’s Investing Reference library for more stories.

A long position in investing basically means to buy or own a stock. Generally, you do so because you expect it to increase in value in the future – hence, you’re holding it for the long-term. 

But a long position also has a specialized meaning, having to do with options and options trading. It refers to buying a specific kind of option, based on your belief as to where the price of a stock (or another asset) is headed.

Let’s examine how a long position in options, or “going long” as the traders say, works.

What is a long position in options?

In the options-trading world, taking a long position, or going long, means you’re purchasing an option. An option is a contract that gives you the right to buy or to sell shares for a preset price (or “strike price”) on or before a future date, usually within the next nine months. It’s an opportunity to do this trade, but not a commitment – so, an option.

There are two types of long options, a long call and a long put. 

  • A long call option gives you the right to buy, or call, shares of a named stock for a preset price at a later date.
  • A long put option does the opposite: It gives you the right to sell, or put, shares of that stock in the future for a preset price.

How a long call option works

If you believe a certain stock is going to go up in price in the coming days, weeks, or months, you can purchase a long call option to buy that stock for today’s price sometime in the future and make a profit by selling it on the stock market at the then- higher price.

Example: You believe ABC stock, selling today for $100 a share is going to be worth more in a couple of months. You purchase a long call option contract for 100 shares, set to expire in three months, at a strike price (a preset price) of $100 per share, and a premium (fee) of $3 per share for the option itself.

ABC does as you expect and in two months shares are worth $150 apiece. You exercise your option, buy 100 shares at $100 each, sell them for $150 each, and you’ve made a tidy profit of $4,700.

How a long put option works

If you believe a company’s stock is due for a drop, you would purchase a long put option contract giving you the right to sell shares of that stock in the future for today’s (higher) price.

Example: You believe ABC is going to decline in a couple of months. You purchase a long put option contract for 100 shares, set to expire in three months, with a strike price of $100 per share, and a premium of $3 per share.

ABC does as you expected and in two months shares are selling for $50. You buy 100 shares at $50 each, exercise your option, and sell them for $100 each, and you’ve made a tidy profit of $4,700.

Exercising your long call or long put option

Whether you buy a long call or a long put, you can’t make money unless you exercise your option. Exercising your option means to buy or sell before the expiration date set in the option contract. 

Naturally, you’d exercise the option if things go the way you expect – the stock moves in the manner you thought it would, so you get to buy it (with a call) or sell it (with a put) at a price that’s better than the current market rate.

Why would you let the option expire without exercising it? Simple: The price of the stock goes against your prediction, moving in an opposite direction from the strike price. If that happens, the option becomes worthless. You let it expire, and you lose the premium you paid. 

The good news is, that’s all you lose.

Why take a long position in options?

Going long lets you take chances with less risk. Both long calls and long puts limit your loss to the premium, the cost of the options contract. You don’t have to buy the stock (in a call) or sell the stock (in a put) unless you expect to profit – by the shares moving as you anticipated before the contract ends.

In contrast, in regular investing, you’re committed to an actual purchase. And that could cause you to lose a lot of money if the stock doesn’t move in the direction you expected.

In addition to being less risky, long options also include an unlimited profit potential to the upside in the case of a long call option or the downside with a long put option. As long as the stock is above or below your option’s strike price – for the call or the put, respectively – you stand to win.

Both types of options are considered long, in the sense that both are buy positions and both let you make money on the direction of the underlying stock. However, the long call is the more bullish sentiment, because you’re betting that the stock price will rise. 

The long put option is a more bearish view because you’re anticipating, and hoping to profit from, a fall in the stock price. 

A long put option can also serve as a hedge, or insurance, against a bad outcome with a long call option or an outright purchase of stock. Yes, you’re betting against yourself, in a way, but at least you stand to benefit a bit if the stock falls instead of rises, mitigating your overall loss. 

The financial takeaway

With options, going long refers to a position in which you buy:

  • a long call option, meaning that you expect the underlying asset to increase in price, which increases the value of the option. This option is bullish on both the underlying stock and the option itself.
  • a long put option, meaning you expect the underlying asset to decline in price, which increases the value of the put option. A long put option is bearish on the underlying stock but bullish on the outcome of the option.

Long option positions require less investment, or cash down, than outright investments. Instead of spending thousands on a stock, you just spend a few hundred on the option, giving you more leverage for less money.

Of the two options, long calls are more common – or at least, what’s more commonly thought of as a long options position. And, like buying stock outright, they are essentially optimistic. Long puts, pessimistic bets that a stock will fall, are more often used as insurance against a bad outcome with a long call, or with an actual ownership position.

But in a way, both long options can be considered bullish: Both are buy positions, affording you a chance to make money on the moves of the underlying stock.

Related coverage in Investing:

A short squeeze happens when a stock suddenly spikes – a bind for traders who bet borrowed money it would drop

Margin trading means buying stocks with borrowed funds – it’s riskier than paying cash, but the returns can be greater

‘Buy the dip’ means purchasing a promising stock when its price drops, assuming a fast rebound and future profits

What is a bear market? How to make sense of a prolonged period of decline in the stock market and invest wisely

A bull market means that stocks are rising, but it pays to understand how it works before you charge

Read the original article on Business Insider