This article was first published by Truewealth Publishing.
“Investing should be like watching paint dry or watching grass grow. If you want excitement… go to Las Vegas.”
This quote from American economist Paul Samuelson sums up the difference between investing and trading – investing is for the patient… trading is for those who want more excitement as they search for profits.
Any kind of investable asset, whether it’s individual stocks, stock index ETFs, bonds, commodities or foreign exchange, can be held as a long-term investment or traded for short-term profit. The major difference has to do with how long you hold on to the asset.
Traders will buy an asset and hold it anywhere from a few seconds to a few weeks. Over the last decade or so, and thanks to the exponential growth in computing power, a growing number of traders – called high-frequency traders – hold positions for only fractions of a second. Some of these traders even make use of algorithms to automate their trades.
All types of traders have one main objective – to make short-term gains on an investment, then sell it and move on to the next idea.
Different types of trading strategies
Some are momentum traders who look for assets that are making a major move up or down and have a large number of shares trading hands, or high trading volume. They hope the momentum will continue, and they hold the asset until the price reaches a pre-set level – which can take minutes or an entire trading day.
Technical traders look for patterns or trends in stock, bond, index or currency charts. They then make trades based on what those same patterns have done in the past. They may not know anything about the asset they’re buying or selling… their decision is only based on what the chart looks like.
The patterns may have names like a “double-bottom,” a “V-reversal,” a “head and shoulders top” or a “rounding bottom.”
Day traders are often technical traders – they may look at various charts and indicators before the markets open in the morning. They’ll then make trades throughout the day to try and profit from how they hope the chart will look later in the day.
Other technical traders will hold an investment for several days or several months. Investors will also use technical research to make long-term investment decisions, but they usually base the decision on long-term charts that show longer-term patterns, not just on what happened the day or month before.
There are also fundamental traders. They base their buy and sell decisions on an asset’s fundamentals – things like earnings, profits and debt levels. The short-term fundamental trader may buy or sell a stock based on what an upcoming company earnings report will say or an anticipated acquisition.
Since a change in company fundamentals can take time to significantly affect a stock price (although a surprise change in fundamentals, like when a company doesn’t make as much money as analysts expected, will have an immediate affect on the share price) fundamental traders often hold a position for several days or weeks.
Trading isn’t for everybody
Being a short-term, active trader can be a lot of work and very stressful. We’ve known quite a few bright people who thought they would do some day trading in the morning, make $1000 by noon and take the rest of the day off. But they soon discover that doing that day after day is not that simple – and you can just as easily lose $1000 by noon if you’re on the wrong side of a trade.
That said, many investors who do make a living as traders – but they know what they’re getting into. And that being a successful trader takes more hard work than luck.
Successful traders have three things in common: they choose one short-term trading strategy (like momentum, technical or fundamental, mentioned above) and stick with it, they take a disciplined approach… and they have nerves of steel.
Three keys to disciplined trading
A disciplined approach to trading involves the right mix of assets and knowing how to set your position size and stop-loss levels.
Many would-be traders put a lot of time into researching what stock to buy. But they hardly give any thought to how many shares they should purchase. Knowing your optimal position size is vital to a well-thought out investment strategy. The amount to buy should be determined, not by how much money you want to make, but how much money you can handle losing.
To help determine your position size, you also need to know your stop-loss levels. A stop-loss, or trailing stop, reflects the most amount of money you’re comfortable losing on an investment. So, if you don’t want to lose more than 25 percent of your position on a stock, you set your stop-loss price at 25 percent below the price you paid for the stock. So, if you paid $20/ share, your stop-loss level would be $15 ($20 – 25%).
As the share price moves higher, and you now don’t want to lose more than 25 percent based on the new higher price, you would establish a trailing stop level. So, if that $20 stock has moved up to $25, your trailing stop level would be 25 percent below that – or $18.75 ($25 – 25%). If the price goes to $30, your trailing stop would be $22.50, and so forth.
Now, you can use your stop-loss target to figure out your position size.
Let’s say you’re buying the $20 stock and you couldn’t handle it if the share price dropped below $17. So, $17 would be your stop-loss level.
Now, consider how much of a paper loss (that is, how much it’s gone down on paper, before you crystallize the loss by selling the position) you can handle. With a $100,000 portfolio, you may feel that a $2000 loss will make you nervous. So, simply divide $2000 by that $3 per share loss you decided you could tolerate ($20 – $17 = $3), and you get your position size. In this case, that would be 667 shares.
Here’s the basic formula (this is just one out of dozens available) and a table to illustrate:
(Maximum $ Risk)/ (Current Stock Price – Stop Price) = Position Size
To Calculate Position Size
|1. Portfolio Value||2. Loss Tolerance||3. Maximum $ Risk (3) = (1) x (2)||4. Current Price||5. Stop Price||6. Position Size
(6) = (3)/ [(4) – (5)]
Asset allocation and risk management
The other part of being a disciplined trader is to know what asset allocation is best for you. Asset allocation refers to the mix of stocks, bonds, cash and other assets in your portfolio. Some say asset allocation is the number one factor affecting investment returns.
For instance, it’s a terrible idea to use all your savings to “play the market” as a trader. The prudent thing to do would be to just use a portion of your overall portfolio to trade – and leave the rest as a mix of good long-term investments, like dividend paying stocks, bonds, cash and some gold.
For the portion you do want to use to trade with, make sure you spread your exposure around a few different sectors. For example, you probably wouldn’t want to just trade energy company shares or make short-term foreign currency trades. Instead, get familiar with a few different sectors so you can make informed trades in any of them. That way, if one sector tanks your entire trading portfolio won’t go down the drain.
And even if it does, because you’ve “diversified your assets” by having the rest of your portfolio in long-term investments, it will be a little less painful.
This article was sponsored by IG. All views expressed in the article are the independent opinion of Truewealth Publishing.