financial

Reviewed by Andy Smith

The world of distressed debt investing is unforgiving. Investors specifically seek out companies that are performing poorly or are on the brink of bankruptcy then they buy up the bonds and take control.

There are always companies in the market that look terrible but are likely to get back on the right track. The first instinct for the regular investor is to invest in a financially distressed company’s shares but the debt and bonds of these firms are often a much more attractive investment. Buying up large chunks of debt can cost millions of dollars but there are ways for little guys to cash in, too.

Key Takeaways

• Distressed debt investing involves buying the bonds of firms that have already filed for bankruptcy or are likely to do so.
• Funds known as “vulture funds” specialize in distressed debt.
• Owners of debt have priority over equity holders if the company must liquidate.
• The basic goal of debt investing is to buy assets for a price well below their intrinsic or fair values.

Buying Into Weak Companies

Distressed debt investing entails buying the bonds of firms that have already filed for bankruptcy or are likely to do so. Companies that have taken on too much debt are often prime targets. The aim is to become a creditor of the company by purchasing its bonds at a low price. This gives the buyer considerable power during either a reorganization or liquidation of the company, giving them a significant say in what happens to the company.

The Vultures Are Circling

Funds known as “vulture funds” specialize entirely in distressed debt. They often focus on government debt or public debt rather than that of companies. These funds are very controversial and are often hated by the governments or public bodies in question.

Many hedge funds also use distressed debt but differently from other investors. Hedge funds focus on purchasing liquid debt securities that they can sell at a profit in the short run. Private equity investors are interested in companies that need restructuring or are about to go bankrupt.

Important

These investments form only one component of many hedge funds. The funds have many other strategies, too, such as arbitrage, short selling, and trading options or derivatives.

Risk and the Nature of the Game

Owners of debt have priority over equity holders in the event of liquidation so it’s better to invest in the debt of a distressed company than in its stock.

The philosophy behind distressed investments is simple: There’s generally an expectation that the targeted company can and will be restructured successfully or brought back to life through a merger, a takeover, or some form of managerial re-engineering and rejuvenation. The asset values must substantially exceed the market valuation if it comes to bankruptcy.

These investments are risky by their very nature but they have one significant advantage like many other intrinsically high-risk investments: the lack of correlation with other stock market risks. This lack of correlation means that distressed debt can be a fine way to diversify.

Identifying Sick and Dying Companies

The basic goal is to buy assets for a price well below their intrinsic or fair values. This is where a scavenger’s keen senses come into play. The “vultures” must look carefully and meticulously at distressed companies to detect oversold securities or even specific kinds of accounting problems.

They track industries and corporations that are on the brink of collapse or that have already gone under. There may be an opportunity if the bonds of a company are trading well below what they seem to be worth. M&A activity and credit negotiations are also analyzed to find bargains.

Intelligence and information from various sources are combined with top-level legal and financial skills to identify money-making potential. What matters fundamentally is that the assets are undervalued and can be purchased at a significant discount but everyone wants a bargain so coming out ahead takes skill.

Famous Examples of Vulture Investors

Self-described vulture Martin Whitman first got into distressed debt investing in the 1970s because big bond houses such as Lehman Brothers considered it beneath their dignity to deal with bankrupt firms.

Whitman bought $14 million of debt and stock in Anglo Energy, an oil service firm that was struggling, in 1987. He then gained control of the company, put it into bankruptcy, and did a debt-for-equity deal with the other creditors. The company resurfaced from bankruptcy free of debt less than a year later and Whitman made a sizable gain.

A unit of Franklin Mutual Funds assisted in the saving of Canary Wharf, the London office complex built by the Reichmann family, the Canadian real estate developers, in 1995. Lending banks gained control of the project after the developer’s holding company went bankrupt. A group of investors that included Franklin’s Mutual Series funds bought back the development from the banks.

The London property market recovered not long after and Canary Wharf listed on the stock exchanges in 1999, providing large returns on Franklin’s investment.

How Does Short Selling Work?

Short selling can be a tricky strategy. The trader is gambling that the price of a security will drop rather than increase. The trader effectively borrows the security via a margin account and subsequently sells it. In a perfect scenario, the price then falls. The trader buys it back at a lesser cost, returns it to the margin account, and earns a profit.

What Happens to Debt When a Company Liquidates?

A company’s assets are distributed to its creditors when a company is liquidated. Secured creditors typically claim the collateral that was pledged toward the loan or loans they provided. Unsecured creditors are ranked for repayment with government and tax debts given top priority. Shareholders are generally last in line to be paid.

What’s the Difference Between a Shareholder and a Creditor?

Both creditors and shareholders are sources of capital for a company because shareholders purchase the shares they ultimately own. This gives them partial ownership of the company and it can grant them voting rights on important issues. Creditors must be repaid the loans they’ve advanced to a company when possible plus any accrued interest.

The Bottom Line

It’s not particularly easy for private investors to get into distressed debt. The quickest way is to buy into a hedge fund that contains a prudent allocation of this debt but the minimum requirements of hedge funds make it impossible to invest in this manner for most investors. A few mutual funds and hedge funds are accessible to regular investors as well.

If the idea appeals to your more predatory instincts and you can access this market, bear in mind that this is a high-risk field. Risky but lucrative is certainly the name of the game.

Disclosure: This article is not intended to provide investment advice. Investing in securities entails varying degrees of risk and can result in partial or total loss of principal. The trading strategies discussed in this article are complex and should not be undertaken by novice investors. Readers seeking to engage in such trading strategies should seek extensive education on the topic.

Reviewed by David Kindness

Direct Costs vs. Variable Costs: An Overview

There are many inputs related to the production of goods and services, not to mention the associated production costs. These expenses can be divided into different categories. Direct costs and variable costs are two types of costs associated with the production of goods and services. Although they are similar in this respect, they have some distinct differences. Direct costs are expenses that can be directly traced to a product while variable costs change based on the level of production output.

Key Takeaways

• Direct costs are expenses that can be directly tied to the production of a product and can include direct labor and direct material costs.
• Direct costs can be fixed costs such as the rent for a production plant.
• Variable costs vary with the level of production output and can include raw materials and supplies for the machinery.
• Variable costs can also be indirect costs, such as electricity for the production plant since it can’t be tied to one specific product.

Direct Costs

A direct cost is a cost that is directly tied to the production of a good or service. Direct costs, which can also be referred to as specific costs, can be easily traced to their cost objects. Put simply, any costs or expenses that are directly related to the creation of goods and services are considered direct costs.

Cost objects can include goods, services, departments, or projects. Some of the most common types of direct costs include wages (tied to production), direct labor, and direct materials.

Direct costs can be but aren’t always fixed. This means they are the same in the frequency of use and price regardless of production levels. Some of the most common types of fixed cost include the rent for a production facility or the salaries of managers and supervisors.

In some cases, direct costs may also be variable. As such, the amount used and the price at which they’re purchased can change based on the production level of goods and services. We explore variable costs in more detail in the next section.

Note

Direct costs don’t necessarily need to be variable. Variable costs, on the other hand, often fall under the category of direct costs.

Variable Costs

Variable costs are expenses that vary as production increases or decreases. These costs depend on the company’s production volume. When a company’s production output level increases, variable costs increase. Conversely, variable costs fall as the production output level decreases.

Unlike direct costs, variable costs don’t have to be directly related to the product. In other words, a variable cost can be an indirect cost. For example, a company that produces smartphones with several production machines needs electricity to function. The cost of electricity is considered an indirect cost since it can’t be tied to the product or the specific machine. The cost of electricity, though, is variable since electricity usage increases as production levels rise.

In short, if the total cost associated with the cost object changes when the production amount changes, it’s likely a variable cost.

Examples of Direct Costs and Variable Costs

Let’s take a look at some of the most common examples of direct and variable costs.

Direct Cost Examples

As noted above, wages related to the production of goods and services, direct labor, and direct materials are considered direct costs. The rent that a company pays for facilities along with management salaries are also considered direct costs.

Here are some other common direct costs that companies must pay:

• Manufacturing supplies
• Equipment rental and purchase
• Fuel and transportation
• Insurance
• Marketing costs

Variable Cost Examples

The packaging costs associated with a product would be a variable cost since the packaging costs would increase as sales increased. The raw materials used to make the product would also be variable costs since the cost of materials would rise and fall depending on the sales volume of the product.

Other examples of variable costs include:

• Some labor like piecework, which is the cost tied to the number of pieces produced or worked on by each employee
• Certain supplies, including oil for the machines or parts tied to production
• Hourly employees, such as those needed for the production facility or consulting
• Sales staff commissions—when they sell more goods, their commissions increase
• Merchant credit card fees
• The cost of shipping or delivery

What Are Indirect Costs?

Indirect costs are any expenses that companies incur that aren’t directly related to the production of goods and services. Some examples of indirect costs include indirect labor like wages for security and operational management, software costs, and administrative salaries.

What’s the Difference Between Fixed and Variable Costs?

Fixed and variable costs are two common types of costs incurred by companies. They can be direct or indirect, meaning they may or may not be related to the production of goods and services.

Fixed costs tend to remain the same regardless of whether production increases or decreases. Examples of fixed costs include rent and management salaries. Variable costs, on the other hand, fluctuate with production levels, so when production increases, variable costs follow suit. Conversely, if production drops, so too do variable costs. Some examples of variable costs include raw materials and hourly wages.

How Are Production Costs Determined?

Production costs must be directly related to the development and manufacturing of goods and services. As such, they are related to the generation of company revenue. Keep in mind that production costs can be direct and indirect. Production costs include raw materials, labor, and equipment costs among others.

The Bottom Line

There are different kinds of costs associated with the production of goods and services. These include direct and variable costs. Direct costs are directly related to production while variable costs fluctuate with production levels. Keep in mind that variable costs can be direct but not all direct costs have to be variable.

Reviewed by JeFreda R. Brown

Some view stock market investing as gambling, but experienced investors who do their homework usually profit by doing market analysis. Yet even experienced investors debate which type of analysis—fundamental or technical—provides higher returns. Do they result in the same picks? What does it mean when the two approaches contradict?

Key Takeaways

• Technical analysis and fundamental analysis are two ways of analyzing investments.
• While technical analysis focuses on price trends and patterns, fundamental analysis focuses on company financials and the potential for appreciation.
• Technical analysis is well-suited to short-term trading while fundamental analysis better serves longer investment horizons.
• The choice of analysis depends on your trading style, investment goals, and risk tolerance.

Fundamental vs. Technical Analysis

In a nutshell, fundamental analysis aims to determine an asset’s intrinsic value by assessing a business’s strength, financial performance, and the larger operating environment, including macroeconomic factors.

Technical analysis analyzes past market performance by looking at the chart activity of price movements, volume, moving averages, and the statistics of various outcomes. Fundamental analysis assumes the efficient market theory holds in the long run and attempts to take advantage of inefficiencies in the short run.

Technical analysis assumes fundamentals are already priced in and tries to find patterns that lead to outcomes with high probabilities of occurring.

Technical analysis also captures the psychological aspects of the market in the review of past patterns, whereas fundamental analysis fails to factor in investor psychology but believes fundamentals will rule in the long term, so short-term psychological blips will correct themselves.

In general, there are differences in the types of investors that gravitate toward a specific type of analysis. Technicians are usually more short-term traders by nature, contrasting with the long-term view fundamentalists generally take.

Relationship Between Technicals and Fundamentals

Do fundamentals drive technicals or the other way around? In the short run, strong fundamentals do not always indicate strong technical patterns or vice versa. 

Often, technicals can continue to follow a strong or weak pattern when fundamentals are at turning points, which may lead them to be out of sync. Additionally, technicals can be out of sync with fundamentals when there is a shock to a stock, either positive or negative. 

Stocks tend to follow technicals in the short run unless there is an unforeseen shock. For example, there are times when stocks start moving before a new material disclosure becomes public.

Absent insider trading or improper disclosures by not following Regulation D, technical analysts say you can respond in real-time to a stock and not have to wait for the next reporting date or news disclosure, because the charts already interpret market sentiment, so following the charts will lead to higher profits. 

Note

Technical analysis is primarily used for short-term trading, such as day trading, while fundamental analysis is used for long-term investing, such as buy-and-hold strategies.

Technical analysts believe that stocks move even without disclosures because suppliers, competitors, employees, and all their family and friends, invest in companies and without needing inside information, get a sense of how the company is faring. 

These buying and selling activities define the stock chart and pattern and reflect the real-time stock behavior. 

At times when the market is surprised by a new disclosure, the charts may fail, at least initially, and reviewing the fundamentals may lead to long-run profits by taking advantage of short-term mispricing when a surprise causes the markets to overreact.

News is temporary and may positively or negatively impact the stock’s fundamentals, so following the fundamentals after a shock may be more prudent. Using technical analysis may provide the opportunity to take advantage of a correction or rebound after the news is absorbed.

Therefore, even if the two have been out of sync in the short run, technicals and fundamentals should be in sync in the long run. That’s because, in the long run, fundamentals should win and drive the technicals.

Time Horizon

Investment time horizon often dictates when technical or fundamental analysis makes sense. Since at points of inflection, it appears that technicals and fundamentals are often out of sync, investment time horizon often comes into play.

It is generally believed that short-term investors follow technicals while long-term investors are willing to withstand the day-to-day “blips” and follow fundamentals. 

For example, if you believe that genetically modified seeds are the future of farming, then you will probably invest in a relevant company—Monsanto, for example—and are willing to stay the course despite any short-term noise the stock may experience.

Curtailing Shortcomings

Critics argue that fundamental analysis can lead to improper valuations and thus improper investment decisions because the information is for the most part backward-looking. Financial statement analysis, 10Q and 10K commentaries, and macroeconomic environments focus on what already happened. Investors use this information to model expected future results.

The problem is that forecasting is very subjective, relies on the company management team’s expectations and disclosures, and can be in some ways a self-fulfilling prophecy. “Garbage in, garbage out” is a term often used in conjunction with the modeling associated with fundamental analysis’ intrinsic value determination.

On the other hand, critics of technical analysis think that chart patterns work until they fail, and the failure of the pattern may not always be predictable from following the past pattern, especially if there is an unforeseen shock.

Note

Popular technical analysis indicators include relative strength index (RSI), Bollinger Bands, moving average convergence divergence (MACD), and stochastic oscillator.

One way to curtail the shortcomings of the two methods is to use them together to capture the best aspects of both. Fundamental analysis should be used to determine which stocks or sectors are most likely to perform well based on a strong macroeconomic environment and company or sector-specific operations.

Technical analysis can then be used to decide when to buy or sell by giving entry and exit points based on moving averages, volume, and price trends.  By employing both strategies together, positions can be taken in fundamentally strong companies while avoiding buying into stocks that have already run up and are overvalued. 

Technical analysis can help you avoid buying high or selling low, a phenomenon that often occurs when psychology starts to rule trading.

Fundamental and technical analysis does not have to be contrary or held within bounds. At times there may be a single indicator that provides information for both the technician and fundamentalist.

For example, price volatility is an important technical indicator of risk—the greater the volatility, the greater the risk. This may be a leading indicator that the fundamentals are changing. As a result, both would agree on the buy/sell decision.

What Is Meant by Technical Analysis?

Technical analysis is a form of investment analysis that utilizes price data and chart patterns to help traders determine entry and exit points for making trades. Technical analysis focuses primarily on price movements rather than the financial condition of a company and is best suited for short-term traders seeking to take advantage of price changes. There are various technical indicators that traders employ to help them make trading decisions, such as the Aroon indicator and stochastic oscillators.

What Is the Best Way to Do Fundamental Analysis?

The best way to perform fundamental analysis is to understand a company’s financial statements. Read over and understand its balance sheet, income statement, and cash flow statement. This will provide guidance on a company’s liquidity, debt profile, and profitability. From there, use financial metrics to help make sense of the numbers. Common financial metrics include earnings per share (EPS), revenue growth, profit margin, and return on equity (ROE).

From there, look outside of the company, for example how the industry it is in is performing and how the overall economic conditions might affect the company. Qualitative factors, such as management experience and the business model, will also shed light on a company’s financial condition.

When Should I Use Fundamental Analysis vs. Technical Analysis?

Use fundamental analysis when trying to determine the intrinsic value of an investment, such as stocks. This allows you to understand the growth potential of the asset based on financial health and market conditions. It is ideally used for long-term investments where you’re seeking capital appreciation. Technical analysis should be used when you’re looking for short-term investments focused on price movements in volatile markets.

The Bottom Line

Sometimes investors like to pigeonhole themselves into one type of investment style, but being open to combining styles may provide the best opportunity to make the most profit. Technical and fundamental analyses do not have to be used alone but can be used together to draw a complete investment picture. 

Fundamentals may be used to identify appropriate targets, while technicals can be used to make trading decisions. Together, these methods can generate a confluence of information that should provide a better investment opportunity than either used alone.

Reviewed by Gordon Scott

Scalping in the forex market involves trading currencies based on a set of real-time analyses. The purpose of scalping is to make a profit by buying or selling currencies, holding the position for a very short time, and closing it for a small profit.

Many trades are placed throughout the trading day, often lasting only a few minutes or seconds. The method that traders use may be manual or automated but is often based on systemic decisions that follow signals derived from technical analysis charting tools.

These tools can generate a buy or sell signal for the trader. A forex scalper chooses a type of signal that occurs frequently enough to be worthwhile. With each trade they make, they target a relatively small profit.

Key Takeaways

• Forex scalping involves buying or selling currencies, holding the position for a very short time, and closing it for a small profit.
• Forex scalping involves placing many trades throughout the trading day.
• Trades are often automated based on a set of price signals derived from technical analysis charting tools.

Understanding Scalping As a Forex Trading Strategy

Forex scalping involves buying and selling foreign currencies with the goal of earning a profit on moves in exchange rates. The international currency market is the largest in the world with more than $7.5 trillion exchanged between currencies on a daily basis in April 2022 (latest information).

Traders and investors can take positions in currencies for a short period and book an offsetting trade. The difference between the exchange rate of the initial trade nets out with the exchange rate of the exit trade resulting in a gain or loss.

For example, if a U.S. trader initiated a buy position of euros at the euro-to-U.S. dollar exchange rate of $1.1050 and later sold the position at a rate of $1.1150, the profit would equal 0.0100 or 100 pips, which is approximately 1%.

A forex scalping trading strategy might involve a profit target of only 10 or 20 pips. However, the scalper would initiate many trades or add to the position size of each trade to maximize profits.

Popular Currency Exchange Rate Pairs

Although there are many exchange rate pairs available to trade, below are the major pairs that most traders use in their day-to-day trades.

• EUR/USD is the euro (of the Eurozone) to the U.S. dollar 
• USD/JPY is the U.S. dollar to Japanese yen 
• GBP/USD is the British pound to the U.S. dollar
• USD/CHF is the U.S. dollar to Switzerland’s Swiss franc
• USD/CAD is the U.S. dollar to the Canadian dollar
• AUD/USD is the Australian dollar to the U.S. dollar

Forex Scalping Tools

A forex scalping trading strategy can be either manual, where the trader looks for signals and interprets whether to buy or sell. However, many scalpers use automated trading systems when booking their trades with their brokers. The trader instructs the system on what signals to look for and what action to take once a signal has been triggered.

Using the earlier example of the U.S. trader that initiated a buy position of euros at the euro-to-U.S. dollar rate of $1.1050 and sold for a profit at $1.1060, the trader could have automated the take-profit order. In other words, a trade could have automatically been triggered when the EUR/USD rate moved just 10 pips higher, closing the position for a profit.

The trader could have also automated a stop-loss order in case the rate moved against the position. So, if the stop-loss order was set at $1.1030, an exit trade would be initiated automatically once the exchange rate fell 20 pips lower.

This protects the trader’s capital from further loss. Stop-loss orders are critical for managing risk with scalping strategies since they limit trading losses.

The timely nature of technical analysis makes real-time charts the tool of choice for forex scalpers. Technical analysis uses volume, price momentum, and volatility to identify trading opportunities.

Currency prices that break out of a recent range or break higher or lower than the previous day’s close are also used in technical trading. Quite often, forex scalping trading strategies use a combination of automated trades that are triggered using signals from technical analysis and charting.

Note

Exchange rate risk is the potential for loss due to the fluctuations in the value of one currency relative to another.

The Pros of Scalping

As a result of the low barriers to entry into the world of forex trading, scalping has become a viable strategy for retail forex traders. Scalping is popular with newcomers since the strategy requires less knowledge of the market and established trading theories.

Since the forex market is large and liquid, traders can get in and out of trading positions easily.

Scalping is a good choice for those who hate waiting for a trade to close. Positions are generally held for a very brief timeframe, and that allows for a lower chance of reversals that can harm a trading position.

The Cons of Scalping

It’s important to note that the forex scalper usually requires a larger deposit that can handle the amount of leverage the investor must take on to make the short and small trades worthwhile. Leverage is a form of margin in which the position is magnified since the trader borrows from the broker to expand the position size. However, just as leverage can magnify gains, it also can magnify losses.

The profits are smaller on each trade, which makes it challenging to reach a trader’s financial goals. A “5-pip” yield on a trade might be insufficient for many traders.

As a result of the small amount of profit per trade, one trading loss can obliterate any gains from several successful trades. Good trades can yield a 1:1 risk to reward or less.

The volatility or wild swings in the currency market can add to scalping gains and profits but also exacerbate losses. Forex scalping can be risky and wipe out a trader’s brokerage account.

For example, a trader might not have an exit strategy or a stop-loss trade in which the trade is automatically unwound. If the trade moves adversely, the forex trader can incur frequent and significant losses. As a result, newcomers to forex trading should understand the ins and outs of forex scalping before initiating their first trade.

Pros

• Scalping requires less market knowledge–helping newcomers.

• Forex scalping has low barriers to entry, making it good for retail forex traders.

• The liquid forex market means trades can be entered and exited easily.

• Since trades are held for a short period, losses from reversals can be reduced.

Cons

• Leverage with forex scalping can magnify gains but also magnify losses.

• The small profit-per-trade makes it challenging to reach a trader’s financial goals.

• One large trading loss can wipe out the gains from many profitable trades.

• Forex scalping can be risky due to market volatility.

Is Scalping Forex Illegal?

No, scalping forex is not illegal in the United States. It is a legitimate and legal trading strategy. It is, however, regulated by the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) in order to ensure fair trading practices. Individual brokers may have their own rules on scalping that traders need to be aware of.

Why Are Currency Pairs Important?

Currency pairs are important because they represent the value of one currency to another, influencing rates, economic policies, and the global financial markets. Currency pairs are important for global financial trade, investment, and financial transactions, as they determine the cost of buying goods and services in other countries. Additionally, they are used in hedging currency risk, allowing investors, companies, and other market participants to reduce losses due to exchange rate fluctuations.

Why Is Leverage So Risky?

Leverage is risky because you are trading with borrowed money. While this may amplify your gains, it can also amplify your losses. If the trade moves against you, you may lose more than your initial investment.

For example, if you have $10,000 to invest but utilize leverage of 2:1, you are trading with $20,000, $10,000 of which is borrowed. If your investment decreases in value, the loss is calculated on the total trade value ($20,000), not your initial investment ($10,000). If the investment drops by 50%, the total investment value falls to $10,000. The investor has lost the $10,000 they invested and still owes the $10,000 they borrowed. Not only are they out the initial $10,000 but now are in debt of an additional $10,000.

The Bottom Line

Forex scalping is a high-frequency trading strategy that seeks to take advantage of short currency trades using real-time data and technical analysis. Forex scalping comes with certain risks, including amplified losses from leverage and market volatility.

To manage risks, traders can employ automated systems and stop-loss orders. As the small profit margins necessitate high-volume trading, scalping is best suited for those with a tolerance for high risk and market unpredictability, as well as fast-paced trading.

Reviewed by Akhilesh Ganti

All investors must re-evaluate and refine their investing styles and strategies from time to time. As we gain investing experience and knowledge, our view of the market is likely to change and may broaden how we envision our financial goals.

Those who want to try to outperform the market—that is, realize returns greater than the market average—might consider an active trading strategy, even if only for a portion of their portfolio.

Key Takeaways

• Active trading focuses on short-term market trends to outperform the market, which stands in contrast to buy-and-hold strategies that seek long-term gains.
• Active traders utilize technical analysis to identify trades, which helps them time their entry and exit points.
• Leveraging, which is borrowing money, amplifies gains but also losses, making it a risky strategy but with the potential for high profits for skilled traders.
• Risks involved with active trading include higher fees, rapid losses, and annual taxes on market gains.

What Is Active Trading?

The best way to understand active trading is to differentiate it from buy-and-hold investing, which is based on the belief that a good investment will be profitable in the long term. This means ignoring day-to-day market fluctuations.

Using a buy-and-hold strategy, this kind of investor is indifferent to the short-term for two reasons: first, because one believes any momentary effects of short-term movements really are minor compared to the long-term average, and second, because short-term movements are nearly impossible to exactly predict.

An active trader, on the other hand, isn’t keen on exposing investments to the effect of short-term losses or missing the opportunity for short-term gains. It’s not surprising then, that active traders see an average long-term return not as an insurmountable standard but as a run-of-the-mill expectation.

To exceed the standard (or outperform the market), the trader realizes that they must look for the profit potential in the market’s temporary trends, which means trying to perceive a trend as it begins and predict where it will go in the near future.

Below is a chart that demonstrates the difference between the long- and short-term movements of the market. Note that even though the security moves upward over time, it experiences many smaller trends in both directions along the way.

Focus on Short-Term Performance

Traders are “active” because for them the importance of the market’s short-term activity is magnified—these market movements offer opportunities for accelerated capital gains. A trader’s style determines the time frame within which trends are identified.

Some look for trends within a span of a few months, some within a few weeks, and some within a few hours. Since a shorter period will see more definitive market movements, a trader analyzing a shorter time frame will also be more active, executing more trades.

A greater number of trades doesn’t necessarily equal greater profits. Outperforming the market doesn’t mean maximizing your activity, but maximizing your opportunities with a strategy. An active trader will strive to buy and sell (or vice versa in the case of shorting) at the two extremes of a trend within a given time frame.

When buying a stock, a trader may try to buy it at the lowest point possible (or an upward turning point, otherwise known as a bottom), and then sell it when there are signs that it has hit a high point. These signs are generally observed by means of technical analysis tools, which we discuss below. The more the trader strives to buy and sell at the extremes, the more aggressive (and risky) their strategy.

Maximizing returns or outperforming the market isn’t just about reaping profits, it’s also about avoiding losses. In other words, the trader will keep an eye out for any signs that the security is about to take a surprising turn in an undesirable direction. When these signs occur, the trader knows that it is time to exit the investment and seek profits elsewhere.

A long-term trader, on the other hand, stays invested in the security if there remains confidence in its prospective value, even though it may be experiencing a downward shift—the buy-and-hold investor must tolerate some losses that the trader believes are possible to avoid.

Use Technical Analysis

You need particular analytical techniques and tools to determine when a trend starts and when it will likely come to an end. Technical analysis specializes in interpreting price trends and identifying the best time to buy and sell a security with the use of charts. Unlike fundamental analysis, technical analysis sees price as an all-important factor that tells the direction a security will take in the short term.

Here are three principles of technical analysis:

• For the most part, the current price of a stock already reflects the forces influencing it—such as political, economic, and social changes—as well as people’s perception of these events.
• Prices tend to move in trends.
• History repeats itself.

From these three principles emerges a complicated discipline that designs special indicators to help the trader determine what will happen in the future. Indicators are ways in which price data is processed (usually by means of a calculation) in order to clarify price patterns, which become apparent when the results of the indicator’s calculation are plotted on a chart.

Displayed together with plotted historical prices, these indicators can help the trader discern trend lines and analyze them, reading signals emitted by the indicator in order to choose entry into or exit from the trade. Some examples of the many different types of indicators are moving averages, relative strength, and oscillators.

Fundamental analysis can be used to trade, but most traders are well-trained and experienced in the techniques of charting and technical analysis. It is a blend of science and art that requires patience and dedication. Because timing is of the utmost importance in active trading, efficiency in technical analysis is a great determiner of success.

Note

While technical analysis utilizes charts and price data for short-term trading, fundamental analysis, which focuses on a company’s financials, is used for long-term investing.

Leveraged Trading

The short-term approach of investing offers opportunities to realize capital gains not only by means of trend analysis but also through short-term investing devices that amplify potential gains given the amount invested. One of these techniques is leveraging, which is often implemented by something called margin.

Margin is simply the use of borrowed money to make a trade. Say you had $5,000 to invest: you could, instead of simply investing this amount, open a margin account and receive an additional, say, $5,000 to invest.

This would give you a total of $10,000 with which to make a trade. So, if you invested in a stock that returned 25%, your $10,000 investment turns into $12,500.

Now, when you pay back the original $5,000, you’d be left with $7,500 (we’ll assume interest charges are zero), giving you a $2,500 profit or a return of 50%. Had you invested only $5,000, your profit would’ve been only $1,250. In other words, margin doubled your return.

However, as the upside potential is exacerbated, so is the downside risk. If the above investment instead experienced a 25% decline, you would have suffered a loss of 50%, and if the investment experienced a 50% decline, you would’ve lost 100%.

You may have already guessed that, with leverage, a trader can lose more than the initial investment. As such, it is a trading tool that should be used only by experienced traders who are skilled at the art of timing entry into and exit from investments.

Also, since the margin is borrowed money, the less time you take to pay it back, the less interest you pay on it. If you take a long time to try to reap profits from a trade, the cost of margin can eat into your overall return.

The Risks of Active Trading

Active trading offers the enticing potential of above-average returns, but like almost anything else that’s enticing, it cannot be achieved successfully without costs and risks.

The shorter time frame to which traders devote themselves offers vast potential, but since the market can move fast, the trader must know how to read it and then react.

Without skill in discerning signals and timing entries and exits, the trader may not only miss opportunities but also suffer the blow of rapid losses—especially if, as we explained above, the trader is riding on high leverage. Thus, learning to trade is both time-consuming and expensive. Any person thinking of becoming an active trader should take this into account.

Also, the higher frequency of transactions of active trading doesn’t come for free: brokerage commissions are placed on every trade. Since these commissions are an expense, they eat into the trader’s return.

Because every trade costs money, a trader must be confident in making decisions: to achieve profits, the return of a trade must be well above the commission. If a trader is not sure of what to do and ends up trading more frequently because of blunders, the brokerage costs will add up on top of any losses.

Finally, because securities are being entered and exited so often, the active trader will have to pay taxes on any capital gains realized every year. This could differ from a more passive investor who holds investments for numerous years and does not pay capital gains tax on a yearly basis. Capital gains tax expense must also be factored in when an active trader is calculating the overall return.

What Does Outperforming the Market Mean?

Outperforming the market means an investment has returned more than its benchmark. For example, if a stock portfolio is benchmarked to the S&P 500, and the S&P 500 returns 15% for the year but the investor’s portfolio returns 25%, they have outperformed the market by 10%. Outperforming the market is the goal of many investors, investment funds, and other market participants, often utilizing unique strategies to do so. However, it is quite hard to consistently outperform the market.

What Is Active Trading vs. Passive Trading?

Passive trading uses a buy-and-hold strategy where an investor buys an asset and holds it for a long period, waiting for it to appreciate and profit from the gains. Passive trading is usually achieved through index funds or exchange-traded funds (ETFs), involves little effort, and is generally low cost. Active trading, on the other hand, seeks to profit from short-term price movements in the market by constantly buying and selling securities. This strategy requires a lot of effort, constant monitoring, high risk, and higher costs.

What Is Dollar-Cost Averaging?

Dollar-cost averaging (DCA) is an investment strategy of regularly investing a fixed amount of money in a security regardless of its price at the time. For example, if you are investing in Apple and utilizing dollar-cost averaging, you could decide to buy five shares of Apple stock every month, regardless of the price. So in month one, you buy five shares when the price is $220, in month two, the price has dropped to $210, but you still buy five more shares, and in month three, the price has gone up to $215, and you buy five more shares.

The goal is to spread out market volatility by averaging the cost of the investments. Because it is difficult to time the market or stock prices, dollar-cost averaging removes that issue by removing the risk of poorly timed purchases.

The Bottom Line

As you gain more education and experience as an investor, you may become curious about the different ways to reach returns. It is important to be willing to learn about different strategies and approaches, but it is equally important to know what suits your personality, skills, and risk tolerance.

You may have guessed that active trading is best suited to those who are committed to taking control of their portfolio and pursuing their goals quickly and aggressively. All of this requires a willingness to not only take risks but also keep up skills and efficiency.

Reviewed by Samantha Silberstein

Stocks should provide a greater return than safer investments like Treasury bonds, at least in theory. The difference in return is referred to as the equity risk premium and it’s what you can expect from the overall stock market above a risk-free return in bonds.

There’s a vigorous debate among experts about the methods used to calculate the equity premium and the resulting answers.

Key Takeaways

• The equity risk premium is the extra return investors should get from stocks versus bonds in exchange for taking on the greater risk inherent in stocks.
• This return compensates investors for taking on the higher risk of equity investing.
• Equity risk premium can be calculated in four ways.
• Experts disagree about which method is the best and they have some good arguments.

Why Does the Equity Risk Premium Matter?

The equity risk premium helps to set portfolio return expectations and determine asset allocation. A higher premium implies that you would invest a greater share of your portfolio into stocks.

The capital asset pricing model also relates a stock’s expected return to the equity premium. A stock that’s riskier than the broader market as measured by its beta should offer returns that are even higher than the equity premium.

Greater Expectations

We expect better returns from stocks compared to bonds due to the three primary risks:

1. Dividends can fluctuate, unlike predictable bond coupon payments.
2. Bondholders have a prior claim while holders of common stock have a residual claim when it comes to corporate earnings.
3. Stock returns tend to be more volatile although this is less true when the holding period is longer.

History validates the theory. U.S. stocks have outperformed Treasuries over any such interval in the past 200-plus years if you’re willing to consider holding periods of at least 10 or 15 years.

History is one thing but what we really want to know is tomorrow’s equity premium. How much extra return should we expect the stock market to give us going forward?

Important

Academic studies tend to arrive at lower estimations of equity risk premiums in the neighborhood of 2% to 3% or even less while money managers often arrive at higher estimations of premiums.

Getting at the Premium

These are the four ways to estimate the future equity risk premium.

Opinion surveys naturally produce optimistic estimates as do extrapolations of market returns but extrapolation is a dangerous business. It depends on the time horizon selected and we can’t know that history will repeat itself. As Professor William Goetzmann of Yale has cautioned, “History, after all, is a series of accidents; the existence of the time series since 1926 might itself be an accident.”

One widely accepted historical accident concerns the abnormally low long-term returns to bondholders that started right after World War II. Low bond returns subsequently increased the observed equity premium. Bond returns were low in part because bond buyers in the 1940s and 1950s misunderstood government monetary policy and didn’t anticipate inflation.

Building a Supply-Side Model

The most popular approach is to build a supply-side model. It has three steps:

1. Estimate the expected total return on stocks.
2. Estimate the expected risk-free return on bonds.
3. Find the difference: expected return on stocks minus risk-free return equals the equity risk premium.

We’re looking at expected returns that are long-term, real, compound, and pre-tax. “Long-term” means somewhere in the neighborhood of 10 years. Short horizons raise questions about market timing. It’s understood that markets will be overvalued or undervalued in the short run.

“Real” means net of inflation. “Compound” means we ignore the ancient question of whether forecasted returns ought to be calculated as arithmetic or geometric, time-weighted averages.

Taxes Make a Difference

It’s convenient to refer to pre-tax returns but individual investors should care about after-tax returns. Taxes make a difference.

Let’s say the risk-free rate is 3% and the expected equity premium is 4%. We therefore expect equity returns of 7%. Now say we earn the risk-free rate entirely in bond coupons taxed at an income tax rate of 35%. Equities may be deferred entirely into a capital gains rate of 15% (no dividends). The after-tax picture makes equities look even better in this case.

Step One: Estimate the Expected Total Return on Stocks

Dividend-based approach

The two leading supply-side approaches start with either dividends or earnings.

The dividend-based approach says that returns are a function of dividends and their future growth. Consider an example with a single stock that’s priced at $100 today and pays a constant 3% dividend yield calculated as dividend per share divided by stock price but for which we also expect the dividend in dollar terms to grow at 5% per year.

You can see that the stock price must go up 5% per year, too, if we grow the dividend at 5% per year and insist on a constant dividend yield. The key assumption is that the stock price is fixed as a multiple of the dividend.

It’s equivalent in terms of P/E ratios to assuming that 5% earnings growth and a fixed P/E multiple must push the stock price up 5% per year. Our 3% dividend yield naturally gives us a 3% return at the end of five years or $19.14 if the dividends are reinvested. The growth in dividends has pushed the stock price to $127.63 which gives us an additional 5% return. We get a total return of 8%.

That’s the idea behind the dividend-based approach: The dividend yield plus the expected growth in dividends equals the expected total return. It’s a re-working of the Gordon Growth Model that says that the fair price of a stock (P) is a function of the dividend per share (D), growth in the dividend (g) and the required or expected rate of return (k).

Earnings-based approach

Another approach looks at the price-to-earnings (P/E) ratio and its reciprocal, the earnings yield which is earnings per share divided by stock price. The idea is that the market’s expected long-run real return is equal to the current earnings yield. This theory says that the expected return is equal to the earnings yield of 4% (1 ÷ 25 = 4%) if the P/E ratio for the S&P 500 was almost 25 at the end of the year. If that seems low, remember it’s a real return. Add a rate of inflation to get a nominal return.

Here’s the math that gets you the earnings-based approach.

The dividend-based approach explicitly adds a growth factor but growth is implicit in the earnings model. It assumes that the P/E multiple already impounds future growth. The model assumes the earnings are profitably reinvested at 4% if a company has a 4% earnings yield but doesn’t pay dividends.

Even experts disagree. Some “rev up” the earnings model on the idea that companies can use high-priced equity to make progressively more profitable investments at higher P/E multiples. Others prefer the dividend approach for the opposite reason. They show that the retained earnings they often opt to reinvest result in only subpar returns as companies grow. The retained earnings should have instead been distributed as dividends.

Handle With Care

The equity premium refers to a long-term estimate for the entire market of publicly traded stocks. Several studies have cautioned that we should expect a fairly conservative premium in the future.

Academic studies are almost certain to produce low equity risk premiums for two reasons regardless of when they’re conducted. They assume that the market is correctly valued. The dividend yield and the earnings yield have reciprocal valuation multiples in both the dividend-based approach and the earnings-based approach.

Both models assume that the valuation multiples of the price-to-dividend and P/E ratios are correct in the present and won’t change going forward. It’s notoriously difficult to predict an expansion or contraction of the market’s valuation multiple.

The earnings model might forecast 4% based on a P/E ratio of 25 and earnings may grow at 4% but if the P/E multiple expands to 30 in the next year then the total market return will be 25%. Multiple expansion alone contributes 20% (30/25 -1 = +20%).

The second reason low equity premiums tend to characterize academic estimates is that the total market growth is limited over the long term. You’ll recall that we have a factor for dividend growth in the dividend-based approach. Academic studies assume that dividend growth for the overall market can’t exceed the total economy’s growth over the long term.

If the economy measured by gross domestic product (GDP) or national income grows at 4% then studies assume that markets can’t collectively outpace this growth rate. A real equity premium of 4% or 5% is pretty much impossible to exceed if you begin with an assumption that the market’s current valuation is approximately correct and set the economy’s growth as a limit on long-term dividend growth or earnings or earnings per share growth.

What Is Beta When Measuring Stocks?

Beta is a measurement of a stock’s volatility compared to the market as a whole. It uses historical price data and the basis line is one: This number represents the overall stock market. Anything higher than one indicates volatility. Anything lower indicates less volatility.

How Does the Income Tax Rate Compare to the Capital Gains Tax Rate?

Capital gains tax rates are typically lower than ordinary tax rates, at least for those with moderate earned income. Ordinary income tax rates range from 10% to 37% in 2025 but the 37% bracket applies only to those with significant income: more than $626,350 for single filers or $751,600 for married taxpayers who file joint returns.

Capital gains tax rates are 0%, 15%, or 20% depending on the extent of the taxpayer’s income. Rates of 25% or 28% can apply for certain assets such as qualified small business stock and collectibles.

What Is Gross Domestic Product?

Gross domestic product (GDP) is a measurement of the health of the U.S. economy. It’s a percentage figure that’s based on the value of goods and services produced in the country and it’s compared to the GDP for a previous year or quarter. States and counties also measure GDP.

The Bottom Line

Now that we’ve explored the risk premium models and their challenges, it’s time to look at them with actual data. The first step is to find a reasonable range of expected equity returns. Step two is to deduct a risk-free rate of return and step three is to try to arrive at a reasonable equity risk premium.

Reviewed by JeFreda R. Brown

The balance of payments is a double-entry accounting system that’s based on corresponding debits and credits. Its purpose is to record payments and receipts from the residents of one country with residents of all other countries.

It’s important to distinguish between the balance of payments and the current account. The terms “trade deficit” and “trade surplus” are almost always referenced to the current account when they’re used in the media. The current account is just one part of the overall balance of payments which also contains the capital account and the financial account.

Key Takeaways

• The balance of payments is based on corresponding debits and credits.
• A deficit in the balance of payments adjusts an excess supply of money between the occurrence and the recording of a transaction.
• A unilateral transfer causes a balance of payments deficit when U.S. residents send money as foreign aid to another country and don’t receive anything in return.
• It’s impossible to indefinitely sustain a deficit in the balance of payments but temporary imbalances do occur because of accounting difficulties.

When the Balance of Payments Runs a Deficit

It’s impossible to sustain a deficit in the balance of payments, at least in theory. Temporary imbalances do occur in practice because of accounting difficulties, however.

Payments and receipts are necessarily equal in double-entry accounting. The balance of payments must therefore always be theoretically equal as well. All current account transactions, normally thought of as international trade, are canceled out by capital and financial account transactions.

Important

A deficit in the balance of payments is a mechanism that adjusts an excess supply of money between the occurrence and the recording of a transaction.

An Example

Consider a scenario wherein Americans purchase $100 million in cars from German automakers but Germans don’t purchase anything from American businesses. Most Americans don’t regularly hold euros so the vast majority of those purchases are made in dollars.

The Germans aren’t using those dollars to purchase U.S. goods in this scenario so they have no choice but to hold deposits in U.S. banks or make other dollar-based investments in the U.S. The current account shows a deficit with Germany of $100 million. That’s balanced out by a surplus in the capital and financial accounts where $100 million in payments are made from the Germans to individuals, businesses, and banks in the U.S.

What Causes Deficits in Balance of Payments?

A “unilateral transfer” is the most obvious cause of a balance of payments deficit. U.S. residents who send money in the form of foreign aid to another country don’t receive anything in return economically speaking. Few economists would suggest that balance of payment deficits resulting from foreign aid are a “bad thing.”

No accounting system is perfect, however. Most accounting rules are arbitrary and subject to timing irregularities. It becomes tricky to account for changes in value in the foreign exchange market. These transactions are normally broken out and treated separately on one side of the balance of payments equation.

The flow of money between central banks and treasuries, including gold, is particularly sensitive to exchange rate fluctuations. This often results in short-term deficits or surpluses from excess payments or receipts. The transactions that are recorded in the current and financial accounts might not balance out because of irregularities with the capital account.

What Is a Double-Entry Accounting System?

Double-entry accounting requires that an opposite entry must be made to an account for every entry made to another account. These entries are typically debits and credits. Double-entry accounting is a means of balancing accounts and it presents a clear view of a company’s financial health.

Can the Balance of Payments Apply to Just One Country?

No. The balance of payments requires the movement of money from one country to the rest of the world. The transfers include initial transactions in international trade of goods and services but not stocks that can be subject to numerous transactions.

How Often Do Exchange Rates Fluctuate?

Foreign exchange pricing moves by the second because it’s based on supply and demand in the global market and the market operates 24 hours a day five days a week. Banks and other financial institutions typically only post rates once per day, however.

The Bottom Line

A balance of payments deficit is a means by which an excess supply of money is adjusted between the time it’s incurred and when it’s recorded. It isn’t necessarily good or good in the short term. It does mean that there’s more importation than exportation occurring until the value of money adjusts, however, and it can have ominous implications for the long term.

You may not have been “born in a small town,” as the John Mellencamp song goes, but living in one might be perfect for your retirement. Thanks to small-town perks like lower costs of living, affordable housing opportunities, low crime rates, and access to recreational and local activities, these towns across America may help you save money in retirement.

Key Takeaways

• Small towns often offer a lower cost of living than urban areas.
• Retirees may find part-time employment opportunities in small towns.
• Transportation and amenities can be more accessible and affordable in small towns.
• Small towns provide a strong sense of community and cultural engagement.
• Potential drawbacks include limited access to specialized health care and entertainment.

Lower Cost of Living, on Average

When you retire, if you are living on a fixed income, you have to consider your living expenses carefully, and small towns may be less expensive, from housing to taxes to entertainment. 

Take the small town of Henderson, Kentucky, one of the friendliest places to live, according to Southern Living magazine. If you live in Henderson County, where the town of Henderson is located, your monthly cost of living, including nearly all your expenses—health care, housing, groceries, taxes, utilities, and other necessities—is $3,172 per month on average. Similar expenses in Nashville, Tenn. will cost you $4,247 per month on average. 

If you want to buy a home when you retire, many small towns, especially in rural areas, will likely cost you less. For example, if you like New England, the median price of a home listed for sale in Boston is $949,000. If you purchased a home in the charming town of Rutland, Vermont, the median listing price is only $420,000. If you plan to rent, consider that you pay less in a small town, too, although the rental stock may be smaller. 

In addition, if you sell your home (provided it has equity) in a higher-cost area, you may make enough to buy a home outright or with a smaller mortgage in a small town. 

Small towns in rural areas provide shopping opportunities at small farms and from local growers. You could even start a vegetable garden or fruit orchard—all of which could save you money. However, your grocery bill may be higher in a rural area than a suburban one, due in part to fewer places to shop and increased transportation costs.  

Note

Rural areas may face higher utility bills, but it may be easier to utilize things like solar panels, which could help keep costs down, in a small town versus a large city. 

Transportation and Accessibility

Transportation can cost more if you depend on a car, but many small towns have walkable main streets with grocery stores, pharmacies, and other shops, making them more accessible (and safer) than urban packed streets and heavy traffic. Check out small towns with railway access, like the ones dotted along the river in the Hudson Valley of New York or built alongside the T-line in Boston. Many trains offer discount tickets for older adults so they can afford to visit for leisure or health care reasons. 

Social and Cultural Aspects

Small towns can offer a plethora of public events, social clubs, cultural entertainment, and access to recreation. Retirees can join boards and attend programming at local schools and libraries, participate in the local senior center, and join local committees. 

Many vibrant (and slightly larger) small towns are home to colleges and universities that provide a wealth of opportunities, from free lectures to cultural events for retirees. It may be easier to join recreational classes or clubs without getting on a waiting list. 

Health Care and Essential Services

When looking at small towns, always evaluate their access to health care and other services, including ambulatory care (many small towns only have a volunteer EMS team, for example). Doctors and health care workers may also have a more personal relationship with their patients in a smaller town. If you need extensive services, note how far away (and how accessible) the nearest large medical center is from your town. 

You will need to consider the cost of health care overall because Medicare usually only covers doctor visits, hospital stays, and bloodwork and labs. In a small town, your options for other care may be limited to a few offices, which may or may not be affordable. Your primary care physician should be able to coordinate care easily for you, including with specialists in the area. Ask the local doctor’s office about community health and recreational programs for older adults. 

Lifestyle and Quality of Life

Living surrounded by natural beauty can benefit everyone. In fact, according to research, spending 120 minutes a week in nature may improve your mental and physical health. Small towns can offer access to outdoor spaces, fresh air, and recreation; even simply gardening or bird watching can be beneficial to your quality of life. Many small towns offer a slower pace, often less crime, and opportunities to de-stress. 

Financial Implications of Moving for Retirement

It costs, on average, $4,890 to move 1,000 miles or more depending on your location and a few other factors, but it can be positive for your bottom line. If you save more on the cost of living after a move, you keep more savings for travel, leisure, and family. If your everyday expenses and cost of living go down, your retirement dollars will stretch further and last longer. 

Another advantage of a small town is that finding part-time work in local shops or schools may be easier, as the applicant pool is smaller and the community is closely knit. 

Potential Drawbacks

Retiring to a small town has its drawbacks. Limited access to some health care services or insufficient access to regular specialist visits may make it impossible. You may need more opportunities for arts and cultural events. If you don’t join groups or become actively involved in your community, you may risk feeling isolated in a small town versus a large city because just walking outdoors puts you in proximity to people. 

The Bottom Line

The cost of living varies widely across the United States, so you may have to do some due diligence to find the perfect small town that fits your budget and lifestyle. The money you save moving to a small town may allow you to spend your retirement on what’s important to you. 

Retiring to a small town can improve your mental and physical health. It can provide a sense of community, fresh air, and access to nature, plus a lower cost of living, where you can stretch your retirement savings. Identify health care services and medical facilities, and if the town doesn’t have them, please make sure you have easy access to ones nearby before committing to move.

Reviewed by Akhilesh Ganti

Traders and market makers have used pivot points to determine critical support and/or resistance levels for many years. Pivots are also very popular in the forex market and they can be an extremely useful tool for range-bound traders to identify points of entry. They can also help trend traders and breakout traders spot the key levels that must be broken for a move to qualify as a breakout.

It’s key to understand how pivot points are calculated, how they can be applied to the FX market, and how they can be combined with other indicators to develop other trading strategies.

Key Takeaways

• Traders have been using pivot points for years to determine critical support and resistance levels.
• The previous period’s high, low, and closing prices for a security are used to calculate the pivot point.
• Calculating two support and resistance levels is common practice but it’s not unusual to calculate a third support and resistance level as well.
• Breaks tend to occur around the time of one of the market openings.

Calculating Pivot Points

A pivot point is a point of rotation. The prices used to calculate the pivot point are the previous period’s high, low, and closing prices for a security.

These prices are usually taken from a stock’s daily charts but the pivot point can also be calculated using information from hourly charts. Most traders prefer to take the pivots as well as the support and resistance levels off of the daily charts and then apply those to the intraday charts such as hourly, every 30 minutes, or every 15 minutes. It tends to reduce its accuracy and significance if a pivot point is calculated using price information from a shorter timeframe.

The textbook calculation for a pivot point works like this:

Central Pivot Point (P) = (High + Low + Close) / 3

Support and resistance levels are then calculated off of this pivot point. They’re outlined in these formulas:

• First level support and resistance:

First Resistance (R1) = (2*P) – Low

First Support (S1) = (2*P) – High

• The second level of support and resistance:

Second Resistance (R2) = P + (R1-S1)

Second Support (S2) = P – (R1- S1)

Calculating two support and resistance levels is common practice but it’s not unusual to derive a third support and resistance level as well. Third-level support and resistances are a bit too esoteric to be useful for trading strategies, however. 

Important

It’s also possible to delve deeper into pivot point analysis. Some traders go beyond the traditional support and resistance levels and also track the mid-point between each of those levels.

Applying Pivot Points to the FX Market

The pivot point is generally seen as the primary support or resistance level. This is a 30-minute chart of the currency pair GBP/USD with pivot levels calculated using the daily high, low, and close prices.

Significance of FX Market Opens in Pivot Points

There are three market opens in the FX market: the U.S. open which occurs at approximately 8:00 am EST or the European open which occurs at 3:00 am EST, and the Asian open which occurs at 7:00 pm EST.

The trading range for the session usually occurs between the pivot point and the first support and resistance levels because a multitude of traders play this range. You can see in the areas circled in this chart of the currency pair USD/JPY that prices initially stayed within the pivot point and the first resistance level with the pivot acting as support. Prices moved lower and stayed predominantly within the pivot and the first support zone when the pivot was broken.

One of the key points to understand when you’re trading pivot points in the FX market is that breaks tend to occur around one of the market openings due to the immediate influx of traders entering the market at the same time. These traders go into the office, take a look at how prices traded overnight and what data was released, and then adjust their portfolios accordingly.

Prices may remain confined for hours between the pivot level and either the support or resistance level during the quieter periods. These typically occur between the U.S. close at 4:00 pm EDT and the Asian open at 7:00 pm EDT and sometimes even throughout the Asian session which is the quietest. This provides the perfect environment for range-bound traders.

Two Strategies Using Pivot Points

Many strategies can be developed using the pivot level as a base but the accuracy of using pivot lines increases when Japanese candlestick formations can also be identified. You could sell short in anticipation of the price going back to trading back below the pivot point if prices traded below the central pivot (P) for most of the session and then rose above the pivot. This would simultaneously create a reversal formation such as a shooting star, Doji, or hanging man.

An example is shown in this 30-minute USD/CHF chart. USD/CHF had remained range-bound between the first support zone and the pivot level for most of the Asian trading session. Traders began taking USD/CHF higher to break above the central pivot when bulls lost control as the second candle became a Doji formation and Europe joined the market.

Prices then began to reverse back below the central pivot to spend the next six hours between the central pivot and the first support zone. Traders watching for this formation could have sold USD/CHF in the candle right after the doji formation to take advantage of at least 80 pips of profit between the pivot point and the first level of support.

Another strategy employed by traders is to look for prices to obey the pivot level, therefore validating the level as a solid support or resistance zone. You’re looking for the price to break the pivot level, reverse, and then trend back toward the pivot level in this type of strategy.

It’s an indication that the pivot level isn’t very strong if the price proceeds to drive through the pivot point. It’s therefore less useful as a trading signal. The pivot level is more significant and suggests that the move lower is an actual break, however, if prices hesitate around that level or “validate” it. It indicates that there may be a continuation move.

This 15-minute GBP/CHF chart is an example of prices “obeying” the pivot line. Prices were first confined within the mid-point and pivot level for the most part. GBP/CHF rallied and broke above the pivot level at the European open at 2:00 am EDT. Prices then retraced back to the pivot level, held it, and proceeded to rally once again.

The level was tested once again right before the U.S. market opened at 7:00 am EDT. Traders should have placed a buy order for GBP/CHF at this point because the pivot level had already proved to be a significant support level. GBP/CHF bounced off the level and rallied once again for traders who employed that strategy.

What Is Range Trading?

Range trading begins with identifying entry and exit points within a market that consistently trades between two lines of resistance and support. You’re looking for flat lines in range trading. Lines that move up and down indicate a trending market. “Range” means that the market is moving in a strong, single direction.

Where Can I Find a Stock’s Daily Charts?

TradingTools offers numerous charts and Yahoo! Finance is also a comprehensive resource.

What Are the Japanese Candlestick Formations?

Candlesticks are used to identify price movements. Numerous Japanese candlestick charts are available including several variations of the Doji chart as well as bullish and bearish patterns. The basic concept was developed by a Japanese rice trader, Munehisa Homma, in the late 1700s. Steve Nison, an American technical analyst, brought the concept to the U.S. centuries later.

The Bottom Line

Traders and market makers have been using pivot points for years to determine critical support and/or resistance levels. Pivots can be especially popular in the FX market because many currency pairs tend to fluctuate between these levels. Range-bound traders will enter a buy order near identified levels of support and a sell order when the asset nears the upper resistance.

Pivot points also enable trend and breakout traders to spot key levels that have to be broken for a move to qualify as a breakout. These technical indicators can be very useful when the market opens.

An excellent way for individual investors to become more attuned to market movements and make more educated transaction decisions comes from having an awareness of where these potential turning points are located. Pivot points can also be incorporated into many trading strategies given their ease of calculation. The flexibility and relative simplicity of pivot points make them a useful addition to your trading toolbox.

Disclosure: This article is not intended to provide investment advice. Investing in securities entails varying degrees of risk and can result in partial or total loss of principal. The trading strategies discussed in this article are complex and should not be undertaken by novice investors. Readers seeking to engage in such trading strategies should seek extensive education on the topic.

Now that Google, owned by Alphabet Inc. (GOOG), has unveiled its powerful new Willow quantum chip, cryptocurrency holders face an uncomfortable truth: the technology that makes their digital assets secure today could become their biggest vulnerability tomorrow.

This is because the foundation of modern cryptography—which tokens like bitcoin and ether require to function—are based on mathematical problems that are extremely difficult for traditional computers to solve (like factoring large numbers), but which quantum computers might be able to crack.

Key Takeaways

• In December 2024, Google announced what it said was a major breakthrough in quantum computing.
• This raises some concerns that such quantum chips could break the encryption securing cryptocurrencies.
• Still, crypto proponents say these concerns are overblown, at least for the time being.

The Quantum Threat Explained

A tiny chip the size of a breath mint may have demonstrated that cryptocurrency‘s encryption systems might be living on borrowed time. In December 2024, Google said its new Willow processor achieved what researchers are calling a “mindboggling” breakthrough in quantum computing speed—and it might be only the beginning.

While today’s most powerful computers would need billions of years to crack cryptocurrency encryption, quantum computers operate in a fundamentally different way. The Willow chip harnesses quantum mechanics—where matter can exist in multiple states simultaneously—to perform calculations at almost inconceivable speeds. The chip can solve certain computational problems in under five minutes that would take the world’s best supercomputers about 10 septillion years to complete—a timespan that greatly exceeds the age of the universe.

The problem for holders of crypto? If you think of your crypto wallet’s security like a massive combination lock, regular computers would have to try combinations one at a time. Quantum computers? They can test millions of combinations simultaneously.

That’s why, even though experts say there’s likely a good amount of time left for Bitcoin and other blockchains to build better defenses for themselves, a Deloitte analysis found that about a quarter of Bitcoins now in circulation would be vulnerable to hackers with quantum computing.

Important

If a recent Deloitte analysis is correct, quantum computing could soon make about 25% of Bitcoins vulnerable to hacks, which would involve assets with about $500 billion in value as of late 2024.

Why Your Crypto Isn’t in Danger (Yet)

Even with these advances, your crypto assets are safe for now. Breaking Bitcoin’s encryption would seem to require about 13 million qubits—far beyond Willow’s current 105 qubits, according, at least, to the crypto proponents at CoinDesk. But ending a recent piece with dismissing concerns arising from quantum computing—”Try another day, crypto naysayers”—the site’s article laid out some real dangers.

The article notes that Google’s Willow doesn’t yet have the scale or ability to correct for its errors so it can get around encryption methods used in Bitcoin transactions (RSA, ECC, and AES). But that’s right after this sentence: “Bitcoin uses algorithms like SHA-256 for mining and ECDSA for signatures, which might be vulnerable to quantum decryption.”

This is like saying the cash registers in a store are safe, but thieves could just walk out the front with any of the stuff on the shelves.

Here’s why: Mining and signatures are crucial to how the Bitcoin system functions. Mining is how new Bitcoins are created, and transactions are verified and added to the blockchain. If a quantum computer could crack the SHA-256 algorithm used in mining, it could take over that process, tampering with transaction history or preventing new ones from being confirmed. In addition, if it could tamper with the ECDSA encryption for signatures, an attacker could steal Bitcoins by forging transactions to appear legitimate or impersonate users by taking over Bitcoin wallets.  

How Crypto Systems Might Defend Themselves

The crypto community isn’t sitting idle. Ethereum‘s co-founder Vitalik Buterin hasn’t been as sanguine as others in the crypto world about what quantum computing might be able to pull off.

Since quantum computers excel at finding hidden patterns in current cryptographic signatures, he’s suggested quantum-resistant systems could use completely random, one-time-use keys with no patterns to discover. Buterin said that including this as part of a hard fork—a permanent divergence in a blockchain that creates two separate and incompatible chains—could mitigate the risks from quantum computing.

The Bottom Line

While Google’s Willow chip represents a remarkable leap forward in quantum computing technology, we’re likely still some time away from quantum computers threatening crypto encryption. Nevertheless, the industry is already preparing for a quantum future and the threats it might pose, with some platforms exploring quantum-resistant algorithms.