Last Updated on 21 September, 2020 by Therobusttrader
If you are conversant with the stock market, you must have been aware of how widely stock prices can fluctuate and how badly they can fall, especially in a bear market. But in spite of all the adverse movements, can a stock go negative?
The price of a stock can fall to extremely low levels and is capable of falling to zero if the issuing company goes bankrupt, but it can never get to a negative value. However, this does not mean that you cannot lose more than you invested — depending on what you do in the market, you may find yourself owing your broker.
Obviously, you would like to know how the value of a stock can get to zero and why you can lose more than the amount you invested. Keep reading to learn more!
What Happens When a Company Goes Bankrupt?
When a company goes bankrupt, it is very likely that the stock price will fall to its lowest levels because investors will see the stock as being worthless. A company can file for any of two types of bankruptcy — Chapter 7 and Chapter 11 bankruptcy.
If a company files for a Chapter 7 bankruptcy, it ceases to operate, and its stock stops trading on the exchange. Its non-exempt assets are sold to compensate the stakeholders — creditors, bondholders, preferred stockholders, and common stockholders — in that order. Thus, there is a real possibility that a common stockholder may not get anything.
For instance, if the proceeds from the assets are not enough to compensate the creditors and preferred stockholders, common stockholders will not receive any payment for their stocks. So, they end up losing all their investment.
In the case of a Chapter 11 bankruptcy, the company’s stock may continue to trade on the exchange, but the declaration of bankruptcy will force the price of the stock down, as investors scramble to dump the stock. In some situations, when a company reorganizes as a Chapter 11 filing, common shares may be canceled, and the common shareholders will not get anything out of their investment.
So, the difference between a Chapter 11 and Chapter 7 bankruptcy is that in the former, shares of the company can still be traded — at the investors’ risk anyway — while in the latter, all business activities in the company are terminated and its assets sold.
What Stocks Are Most Likely to Become Worthless?
Because of what stocks stand for and how the stock market works, every stock is a risky investment. Still, some stocks are more risky than others. The following stocks are more likely to become worthless than others:
Penny stocks are stocks that are trading at very low prices. In the past, the $1 mark was used to classify a stock as a penny stock, but recently, the Security and Exchange Commission (SEC) classifies any stock that is trading below $5 as a penny stock.
Stocks in this category mostly trade on the OTC markets, such as the OTC Bulletin Board (OTCBB) and the Pink OTC Markets Inc., and they are usually very volatile. The companies that issue penny stocks often have little to no profit, and often are subjected to scams of varying types. Therefore, penny stocks are more likely very to go down to zero or near-zero levels.
Companies With Poor Business Models
Even stocks that are not classified as penny stocks can still fall to near-zero levels if the business model of the issuing company does not make sense and the company goes bankrupt. This is why it is very important to study a company and understand what it does before investing in it.
For example, before the Lehman Brothers went broke, they were investing heavily in worthless mortgage-based derivatives.
Situations Where You Can Lose More Than You Invested
Even though the value of a stock can never go below zero, it is possible to lose more than what you invested in the stock market and end up with a debt. This can happen when a stock is declining in value, as well as when it is appreciating in value. Let’s take a look at the two possible situations when this can happen.
1. When You’re Trading on Margin
Trading on margin means borrowing money from your broker to complement your own money when buying a stock. In this case, your trade is leveraged. Depending on the percentage of the trade that is from your money, the leverage can be up to 1:2. You can trade on margin only if you are operating a margins account, as against a cash account.
When you are trading with a borrowed money, any loss you make is multiplied by the leverage. Thus, if you borrowed 50% of the money you used to buy a stock — which is a 2X leverage — and the stock falls lower than half of the price you bought it, you have lost more than your own money, and you now owe your broker. While there are regulations to guard against this, and some brokers implement certain policies to prevent such an occurrence, it can still happen if the broker’s system fails.
2. When You’re Going Short
Another situation where you can lose more than you invested is if you take a short position in a stock and it suddenly goes up by more than 100%. This is why shorting a stock is very risky even when the company is not doing well financially.
How to Protect Your Money
As a stock investor, you should always have a way of protecting your investment. Fortunately, there are many ways to do that, and these are some of them:
1. Using stop losses
A stop loss order is an order that protects your trade from an adverse price movement. It limits the amount of money you can lose in a trade. There are different types of stops you can use to protect your trade: such as hard stops and trailing stops.
A hard stop is fixed at a specific price level such that if the stock price falls to that level, it triggers a sell order. Trailing stops, on the other hand, move with the stock price whenever it is progressing, but when the price is falling, it stays at the highest level it got to.
2. Making Use of Put Options
Using a put option strategy is an effective way of protecting your investment in stocks. What you do is to buy a put option for the stocks you are invested in. So even if the stock price falls significantly lower, you can still sell your stock at the strike price before expiration, thereby protecting your investment from huge losses. This type of options strategy is known as protective put options.
3. Stock Diversification
One good way to protect yourself in the stock market is to diversify your stock portfolio. Buying an individual stock or a few stocks from the same industry is inherently risky, but having a diversified stock portfolio reduces the risk. When looking to diversify your portfolio, these are your options:
Building a diversified stock portfolio: This involves buying several stocks from different industry sectors to make sure that they are non-correlating, but it can be capital intensive.
Buying an ETF: An easier way to get a diversified portfolio is to buy an ETF that has a lot of non-correlating stocks in its basket. An example is an index ETF that mirrors the S&P 500 Index.
Investing in an index fund: Another option is to invest in an index fund that tracks a broad market index, such as the S&P 500 Index.
4. Diversifying Into Other Non-Correlating Assets
While a well-diversified stock portfolio can protect you from unsystematic risk, it may not protect you from systematic risk. So, it may even be better to add other assets that do not correlate with stocks, such as government and municipal bonds, commodities, and real estate, to your investment portfolio.
The price of a stock can fall to extremely low levels and is capable of falling to zero if the issuing company goes bankrupt, but it can never get to a negative value. However, this does not mean that you cannot lose more than your initial capital — if you trade on margin, you may lose more than you invested.
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