Demystifying Stock Trading Risks, Part 2: Interest Rates

Demystifying Stock Trading Risks, Part 2: Interest Rates

What other potential problems do day traders and long-term investors face? 

In our previous blog post we talked about the potential financial risks with publicly traded stocks. Companies are never immune from mismanagement, low traction and poor market response so as a trader, you should be ready to react quickly to potential problems when you purchase certain stocks. 

We also discussed the role that media plays in swaying investors to over-invest in certain stocks through speculation and “stock tips”.

Are stock tips dangerous?

Stock tips can be, to an extent, dangerous. While there is nothing wrong with reading about the stock market and potentially profitable stocks, it’s dangerous to over-invest in a stock simply because everyone believes that it’s on a “mile high” run and you’re going to make a lot of money from it.

Remember: the stock market is subjected to cyclical economic processes and forces and nothing is ever certain.

The only way that you would be able to safeguard your “fast trades” and long-term investments is by knowing the risks and working around and through them so you will be able to achieve your primary goal which is to make money from buying and selling stocks.

This is the main goal of our current series: to add to your current knowledge of the potential pitfalls of stock trading so you will be able to make more informed trading decisions in the coming weeks or months.

One other major stock trading risk that you should be aware of is fluctuations in interest rates. 

How do interest rates affect investors?

If you’re buying securities and bonds for long-term and low-risk investments, it’s imperative that you monitor the interest rates of the bank that is handling the securities and the interest rates set forth by the Federal Reserve.

Many people don’t know this but long-term investments can be hit hard by sudden changes in interest rates. Some people ignore these changes, thinking that a one or two point reduction in interest rates won’t have any lasting impact on their investments.

However, if you are not engaged in “fast trading” for instant profits and you’re reliant on the interest rates of long-term investment securities, interest rates become the lifeblood of your investments.

How does this work?

For example, if you purchased bonds for $15,000 at six percent interest and the Federal Reserve suddenly announces an increase of nine percent interest, you will lose three percent interest in that particular stock.

You will lose money because everyone who purchases bonds after the announcement of the change in interest rate will be enjoying the new nine percent interest.

One of the logical ways to take advantage of the new interest rate in this scenario is to somehow unload or sell your current stocks at a desirable price and reinvest in the same stocks so your long-term interest rate will rise to nine percent.

This is a rinse and repeat process; if the Federal Reserve of the bank handling the securities you’ve purchased increases the interest rate again, you would have to reinvest to benefit from the change.

What’s the catch?

It seems so simple when you think about it, but there’s more to it than what meets the eye.

Let’s say that Trader A is in the market to liquidate his Company B bonds because the interest rates have increased. Trader A’s bonds (which he purchased for $9,000) have an annual 7% interest. The current interest rate is 10%.

The problem with this scenario is that when interest rates for particular bonds increase, any bonds purchased prior to the increase suddenly lose their trading value.

No one would buy “old bonds” at the current market price, so Trader A would have to contend with some losses just to take advantage of the new interest rate.

Other traders would only be interested in purchasing Trader A’s “old bonds” if they stand to earn an equivalent profit based on the current interest rate of 10% (not the old interest rate of 7%).

The main lesson to be learned from all of this is that you should never invest in the stock market if you cannot absorb big and small losses.

Losses are a part of life when you’re trading. The adage “you win some, you lose some” couldn’t be more correct when you’re talking about investing in the stock market. So before investing any of your money, make sure that you have extra funds and be sure to prepare yourself for unforeseeable losses.

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