2/14/2024

How is a trading loss converted

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Many brokers have experienced a similar situation at least once: they decide to check their trading account, only to find that their brokerage account balance has plummeted. And a simple but interesting question arises – where did these funds go?

Luckily, money made or lost in stocks doesn’t just disappear. Let’s talk in more detail about the trading mechanism.

Basics of market relations

It is important to understand that whether the market is rising (bull) or falling (bear), supply and demand determine the price of a stock. And it’s the fluctuations in stock prices (and the points at which you buy and sell stocks) that determine whether you make or lose money.

Purchasing a share at a price of $10 and then selling it for $5 results in a loss of $5 per share. But it is a mistake to believe that this amount goes directly to the buyer of the shares.

A similar situation arises when an investor who owns shares records a loss on their sale due to a decrease in price. A buyer who purchases a share at a lower price does not necessarily profit from the original owner’s loss. This is due to the fact that for him the “entry point” is precisely this lower price. Making a profit (unrealized or realized) is possible only when the stock price rises above the “entry point”.

Thus, losses and gains in the stock market are not directly related to other traders. They are determined by the “entry point” and “exit point” of the transaction for each participant.

What happens to money during short sales

There is a category of investors who, acting through a broker, enter into transactions to sell shares at a predictably high price in anticipation of its subsequent fall. This strategy is called “short selling.”

If the stock price declines, the short seller makes a profit by buying back the stock at a lower price and closing the deal. Net profit is calculated with the broker.

It’s important to note that while short sellers benefit from the price decline, they do not “take” money from investors who lose money when they sell the stock. Their operations are independent and, like long stock traders, there is a risk of loss or incorrect forecasts.

In other words, the short sellers’ profits from the price decline are not directly related to the losses to the traders who bought the shares. These are two independent trading scenarios.

What happens next with the money depends on the implicit and explicit value of the shares.

Implicit value

The value of shares can change not only depending on objective factors, but also under the influence of implicit value, which is determined by the subjective perception and analysis of investors. Implicit value is based on revenue and profit forecasts and investor perceptions and expectations.

Changes in implicit value, including those caused by abstract factors such as faith and emotion, lead to corresponding changes in the stock price. A decline in implicit value means a loss of value for shareholders because their asset is now worth less than its original price.

Explicit value

In addition to implicit value, which is subject to fluctuations in perception, money also represents explicit value, which is the concrete value of the company.

Explicit value, also called accounting or book value, is calculated by adding all of a company’s assets and subtracting its liabilities. It represents the amount of money that would remain if a company sold all of its assets at fair market value and paid off all of its liabilities, such as notes and debts.

Explicit value is the basis for a company’s implicit value. Investors’ interpretation of a company’s financial condition and performance is based on explicit value.

The main feature of trading

When engaging in trading, you must take into account that when trading shares on the stock exchange, expectations affect the real value of the company. A narrowing of forecasts regarding a company by investors, analysts and market professionals leads to a decrease in their willingness to pay the previous price for shares. The faith and expectations of investors are thus transformed into real money, but are conditioned by the perception of the company’s ability to create the products or services that people and businesses need.

Thus, the better a company copes with these tasks, the higher its income and investor confidence will be.

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