Can stocks go negative?
Can stocks go negative? Contrary to what guru-investors on social media may steer you to believe, stocks can go negative – and you can end up owing your own money out of pocket in a worst case scenario. This is especially common when you get into more complex investment strategies like stock shorting or margin trading. Today, we’ll cover everything you need to know about how stocks can go negative – and how you can protect yourself when stock trading.
Stocks have been increasing in popularity for a while, but interest in stock market trading has skyrocketed ever since the Gamestop debacle. People saw their friends earn a full time income in just a few months of stock trading. Common people with no background in finance became rich essentially overnight. It was something that made people curious.
However, many soon realized that stocks can be a little more complicated than they appear. That is why it is important to be educated when dealing with stocks. Questions like can stock go negative, what stocks usually become worthless, and more will be answered in this article. Let’s start with the main question at hand today – can your stocks go negative?
Can Stocks Go Negative?
Can stocks go negative? Yes – and while it’s rare, it does happen. Usually, a stock price will not reach $0 altogether – but it’s not impossible. And as an investor, this could spell disaster. Picture this: you invested $1,000 into the stock market. You purchase 100 shares of company XYZ at a stock price of $10. But news comes out that company XYZ goes bankrupt, and actually owes money. The stock price would plummet, and in a worst case scenario, you could watch your investment of $1,000 turn into $0.
This sounds scary – and it is. But, there are steps you can take to protect your investment portfolio from going negative value. Things like stop losses, maintaining a diversified portfolio, and consistently following company news will prevent you from losing your entire investment. We’ll cover all this and more throughout today’s article. First, let’s take a look at a related question we get: how can stocks go negative in the first place? How does this happen?
How Can Stocks Go Negative?
So, how can stocks go negative? What makes a stock’s price reach $0?
Sometimes companies can go bankrupt. When that happens there is usually one outcome. Typically, stock prices will become the lowest price they’ve ever been. They can fall to near-zero or zero levels. This happens because investors will see the stock as worthless. There are two forms of bankruptcy that a company can file for. There are two types of bankruptcy: Chapter 7 bankruptcy and Chapter 11 bankruptcy.
Chapter 7 Bankruptcy
Chapter 7 bankruptcy means a company will cease to operate and stocks will stop trading on the exchange. Any non-exempt assets are sold to pay off the stakeholders. Stakeholders are creditors, bondholders, and stockholders (prioritized in that order.) That means that when it is all said and done, stockholders could not get anything in return. Which would mean a loss in the investment.
Chapter 11 Bankruptcy
If it is a Chapter 11 bankruptcy, then it is a bit different. Unlike a Chapter 7 filing, the company will still be able to have its stock traded on the exchange. However, the declaration of bankruptcy will cause the price of the stock to decrease since investors will be in a hurry to get rid of their stock. In some instances, a company’s reorganization as a Chapter 11 can cause common shares to be canceled. When this cancellation occurs, shareholders could receive nothing from their investment.
To summarize, the difference between a Chapter 7 and Chapter 11 bankruptcy is that in the former, all business activity in the company is ended and the assets are sold. In the latter, the company still has shares that can be traded, but at the risk of the investors.
Are There Stocks That are More Likely to Go Negative? If so, What are They?
When building your stock portfolio, you constantly hear of the importance of diversifying. This can lead to you purchasing a wide variety of company’s stock. But, there are certain types of stocks that should be avoided altogether. These stocks are more likely to become worthless. This is due to how the stock market works. Every stock still has risk, but some way more than others. Some of the stocks that will likely become worthless are:
Penny stocks are ones that trade at very low prices. Originally, any stocks that were $1 were defined as penny stocks. Since then, the Security and Exchange Commission (SEC) classifies any stock under $5 as penny stocks.
It is these types of stocks that trade on an OTC market. Examples of these markets include the Pink OTC Markets Inc., or the OTC Bulletin Board (OTCBB). These markets are typically extremely volatile. This is due to the fact that the companies that give out penny stocks usually have little to no profit. Penny stocks are also commonly involved in a variety of scams at varying degrees. That’s why they have a higher chance of going down to near-zero or zero levels.
Stocks from a Company with a Bad Business Model
Stocks besides penny stocks can still fall to near-zero levels. This can happen when the business model of the company that is giving out the stocks does not work out and the company files for bankruptcy. A mismanaged company is a terrible way to lose money. That is why it is not only important to research the stock market, but the company of the stock as well. You should do this research before deciding to invest.
When Can You Lose More Than What You Put Into The Stock Market?
Most of the time when you invest in the stock market, you are only risking your initial investment. Think back to the first section where we answered the question: can stocks go negative value? In that instance, you lost $1,000. However, there may be instances where you can owe money beyond your initial investment. And this can be crippling for your stock portfolio – and your personal finance in general.
While actual stock prices can never fall below zero, you can still lose money beyond what you invested. You could fall into debt if this happens. There are two situations that could cause you to lose more than what you put into the stock market.
Situation #1: You Trade on Margin
Margin trading means you borrowed money from your broker in order to match your own when you buy a stock. This means you have a leveraged trade. The leverage on your trade can be up to a 1:2 ratio, depending on the percentage that is from your own money. There are two account types you can trade with. You can either trade with a margin account or a cash account. You are only able to trade on margin if it’s from a margin account.
Trading with borrowed money means that any loss is multiplied by the leverage. In numbers, this means if you borrowed 25% of the money you used to buy a stock, which is 1x leverage, then you lost more than the amount of money you put in if the stock price falls lower than a quarter of the price that you bought it at. You would end up owing the broker. There are usually rules in place to protect individuals from this happening (under the financial industry regulatory authority), but it is still a possibility.
Situation #2. You Go Short at the Wrong Time
Short selling is a great way to capitalize on opportunities despite poor market conditions. However, you take on a substantial amount of market risk with this strategy. Here’s how:
A bad trade call can cause you to owe money. If you opt for a short position with your stock but it then increases by over 100%, then you will owe money on the increase in stock price. That is why you need to be cautious with your stocks and understand the value of a stock before taking positions.
What Can You Do to be Proactive As an Investor?
If you are dealing with stocks, you always want to have a plan. You not only want to have an investment plan but a plan to protect your investments as well. There are numerous ways that you can protect your investments but some of the common ones are:
1. Use a Stop Loss
You can limit the amount of money you lose in a trade with a stop loss. These are orders that are designed to protect your trade from any negative price movement. There are a variety of stops that you can use for trade protection. Some of the common stops are hard stops and trailing stops.
If you opt for a hard stop then you will determine a price level that will trigger a sell order if the value of the stock price falls to that level. A trailing stop moves with the stock price whenever it increases. However, when the price begins to fall, it will stay at the highest level that it went to. Both of these stops are good methods to protect your trade in order to ensure you don’t lose as much money as you could.
2. Use Non-Correlating Assets to Diversify Your Portfolio
When you have a well-diversified stock portfolio, you can be protected from unsystematic risk. However, what will protect you from systematic risk? That is when non-correlating assets should be considered. You want to find assets that have no correlation to your stocks like real estate, bonds, commodities, etc. When these assets are added to your investment portfolio, you are improving your protection against systematic risk.
Can Stocks Go Negative? Final Thoughts
So, can your stocks go negative value? You know now that technically, stocks will not fall below $0 – but they can drop to $0. However, you can still lose money beyond your initial investment in the stock market – this can happen in a few different situations. When you trade on a margin account, you’re borrowing money – and it has to be paid back eventually, no matter the outcome. This can also happen with short selling – you expect a company stock price to fall, and yet it skyrockets.
The value of a stock can fall to zero or near-zero levels. However, the stock price itself can not fall below zero. You do run the risk of having to owe more money than what you put in. If you trade on margin or short sell incorrectly then that is a very real risk that you can deal with. Take your time to research stock prices when deciding how you want to trade. Trade protections can help save you from losing too much money.