Typically when people think of Wall Street and the Stock Market, they think of investing. They think of Warren Buffett, Mutual Funds, or the Global Financial Crisis. However, what most people realize is that there’s two sides to the coin.
The other side of the coin is trading. You might have heard about it, but odds are you haven’t. If you have heard about trading, odds are that an investor told you about what it is, and probably gave you a very, very biased overview of it.
Well, here’s a review of what trading is, by a trader, along with how trading is different from investing.
Trading… What Is It?
Timeframes have a lot to do with trading and investing. There’s more to it than just timeframes (as we’ll get into shortly), but timeframes are a large chunk of it.
Trading is essentially buying and selling of assets/derivatives/securities within a 6-12 month time horizon. Mainly, when you hear about trading, you hear about “Day Trading”. Day Trading is when you open a new position, and close it out your position by the end of the same trading day. However, Day Trading is only form of trading.
At it’s core, trading can be defined as actively managing your own portfolio/money.
Most proficient traders use derivatives (like Options and Futures) to trade fluctuations in the market and amplify their gains in the process.
Trading Is Different From Investing
Yes, it’s true. Trading is very different from investing. Which is better? Well that really depends on your goals. Investing has more of a set-it-and-forget-it mentality, where you find companies that you think are worthy of investing in, and… invest in them. You buy the stock, and don’t touch it until you die (more or less).
More often than not, when someone invests in a company, index, bond, commodity, or whatever else, the investor will hold that position for multiple years.
Trading has more of a controlled-ADHD type of mentality. Traders are product indifferent. They don’t care if it’s a good or bad company. A trader is just looking for volatility, so that they can trade the prices back and forth. You’ll here some traders say, “If it moves, I’ll trade it”.
Derivatives And Leverage
One of the biggest differences amongst traders and investors is the use of derivatives and leverage. Derivatives include Options, Futures, Forwards, Swaps, and Swaptions. We’ll keep the discussion to Options and Futures, since those are the two most widely used derivatives.
Derivatives get their name because the valued of the derivative is “derived” from the underlying value of the asset that they are based on. That might seem like a mouthful. Here’s a brief example.
Ignoring Implied Volatility, a Stock Option’s value is derived off of the underlying Stock’s value. As the value of the Stock moves, the price of the Option will move too.
Most derivatives involve the use of leverage. Leverage is akin to borrowing money to have more buying power. Here’s an article on leverage, or you can just watch this video below.
Your average investor tends to shy away from the use of derivatives and leverage, because they tend to have longer timeframes where anything can happen. As the video above points out, there’s nothing wrong with leverage. Leverage is what allows you to make money at a faster rate. It’s how traders can make big money, by taking small chunks out of the market. Too much leverage though will wipe you out.
Fundamental And Technical Analysis, Along With Tape Reading
Trading and investing involve different forms of analysis. Traders will mainly utilize Technical Analysis and Tape Reading (also known as Order Flow Analysis) to make decisions on whether or not to buy, sell, hold, or do nothing.
Many professional traders will also have a view on the fundamentals of the underlying that they are trading. However, these professionals are able to draw the line and not let their longer-term views overshadow their short-term decisions.
What ultimately matters is price, and most good traders realize that.
Fundamental Analysis is what is mainly taught in school. It can be quite difficult to teach things like Technical Analysis, and nearly impossible to teach Tape Reading.
This is because trading is both an art and a science. The science of trading is knowing all the mechanical stuff, the terms, the tangible ideas. The art is Tape Reading.
In the same way that most influential artists and musicians spend years and years honing their crafts, so do traders proficient in Tape Reading. You wouldn’t expect to be on par with Mozart or The Beatles when you first learn to play an instrument, nor should you expect to be on the level of Paul Tudor Jones when you first start trading.
That said, it’s definitely possible.
As was alluded to earlier, there are more timeframes to trading than just Day Traders. Here’s a list, with a description of each:
Scalpers resemble the floor traders of old, prior to computerized trading. These traders are looking for very small price fluctuations throughout the day. They might scalp a few ticks here, a few ticks there. Scalpers typically don’t even use charts to trade, and tend to make their trading decisions purely of off the order flow and tape.
Position Day Traders
Position Day Traders look for potential turning points and reversal areas during the day in which they can establish a position for the day’s move. Both Position Day Traders and Scalpers will go home “flat”, but Position Day Traders differ from Scalpers in that they may only make 1-3 trades a day. These traders are looking for the larger intraday swing, and don’t mind sitting in a position the entire day if need be.
Swing Traders are not Day Traders or Scalpers. Swing Traders will look to hold a position anywhere from a few days to a few weeks, in order to capture the larger move at play. They like to find the larger trend and will take a position home overnight, sometimes over the weekend even if their trade is profitable.
They might scalp around their core position throughout the day, but most don’t. Interestingly, Swing Trading can sometimes be easier than Day Trading. Here’s an article on how Swing Trading can sometimes be easier than Day Trading.
The bigger the money, the longer the timeframe. Position Traders look to establish trades over a 6-12 month time horizon. More often than not, your bigger Hedge Funds will be in this category, as they will have too much size to be doing much intraday scalping.
There’s really no right or wrong timeframe, no matter what anyone tells you. What’s important is that you match the timeframe to your personality. It’s important to trade the timeframe that you feel most comfortable with.
Advantages of Trading
Contrary to what your pompous Finance professor, and other inexperienced people will tell you, there are advantages to active trading. The only caveat is that you have to be serious about actively managing your own money. As we just laid out in our discussion of the various timeframes, you need to know the timeframe that suits you and play to that.
This is one of the biggest advantages to active trading. You will always have a beat on the market, because you’ll be looking at it everyday (more or less). The market is like a big flow chart of capital, with money being moved in and out of different assets into cash, or stocks, commodities, bonds, etc. It’s symphony like, with each asset playing a part in the global economies. Even if you aren’t the best at Fundamental or Technical Analysis, you can still see the correlation between various asset classes.
Empowerment (It’s True)
Active trading is like selling your house For Sale By Owner (FSBO). You don’t need no stinkin’ suit with a fancy title (I kid. Some of you absolutely do).
The amount of empowerment you feel when you know the world of Options and Futures, or how capital is flowing in the current economy is truly empowering. As I said earlier, they don’t teach you a lot of this stuff in school, mainly because most professors go from high school, to bachelors, to masters, to teaching (are you with me?).
Disadvantages of Trading
Yes, trading is great. Knowing what you’re doing is great. But there are some big downfalls to active trading which, if you aren’t aware of, will most likely crush you.
Transaction Costs And Overtrading
Transaction costs in and of themself are a part of the game that you’re playing. You will pay transaction costs even if you’re an investor who make 1 trade every 2 years, or rebalances their portfolio every quarter.
There’s a common piece of wisdom in the trading community that you should let your winners run and cut your losers quickly. Well, the reality is that not every trade is going to be a winner right off the bat. Sometimes a trade is going to move back and forth through your entry point for 45-minutes before moving in your direction.
If you cut these trades too quickly, too many times, you’ll be following the common wisdom. However, you’ll incur frequent, tiny losers that will add up to huge losses. You will also be paying commissions for every trade that you do, which will add to your costs.
Easy To Overleverage
This is extremely easy to do, and lethal. People say that fear and greed is what drives the market, and I’d agree with that. It is easy to succumb to the desire to use too much leverage when trading. The line of logic is that the more leverage you use, the more you’ll make. That’s true, but you don’t win 100% of the time. You will have losers.
The point is to make more than you lose. There is a point of no return when trading, upon which if you lose too much you cannot come back. This is called your risk of ruin.
Trust me, do not overleverage. Do not do that to yourself. Do not do it. Do not do it.
Easy To Screw Up
Overleverage yourself and over trade, you’re bound to screw up. What is the point of trading and investing? Oh, that’s right! It’s to make money. It’s hard to go wrong with investing in blue chip stocks/assets. However, if you succumb to the disadvantages we laid out here, it’s easy to screw up when trading. However, with risk comes reward.
You Can Simultaneously Be An Investor And A Trader
This would be called scalping around your core positions. There’s many ways to do this, and it can be a great way to make consistent income on your longer term investments, without necessarily closing out of your positions.
Most investors will utilize a variation of Option Strategies and Futures to hedge their positions, and make money in the process. It can be a great way to reduce risk and basis. I’ll do an article on core positions in the future.
Just keep in mind that trading and investing aren’t rigid things like so many would have you believe. It’s an art and a science. Academia and the news tend to forget the art behind it.
Don’t be afraid to be creative, but also know your risk.