Many people, especially those approaching the financial markets for the first time, are confused about the difference between trading and investing. While both traders and investors seek to make money from the financial markets, the similarities basically end there. This article will explore the differences between trading vs investing.
Trading is different from investing in that investors will hold stocks for the long-term (many years) in hopes that their investment in the stock will appreciate in value. Traders, on the other hand, seek to profit from the short-term fluctuations of a stock, and their trades can last from a few seconds to a few weeks. Because of this difference in the amount of time that traders and investors will hold their positions, the two groups also use different tools to evaluate market opportunities.
Because investors aim to hold an investment for many years, they are looking to invest in solid companies and use fundamental analysis to look for investment opportunities. Fundamental analysis attempts to predict the future value of a company (and thus, the stock) by focusing on factors like:
1. The growth rate of the company (how fast the company is growing)
2. The earnings of the company (how much profit the company earns)
3. The price/earnings ratio of the company (how expensive the company is compared to its earnings)
4. The company’s dividend history (how large the company’s dividend payouts are)
5. Future industry trends (how the company will be affected by changes in its industry)
While this is just a sampling of factors that investors might focus on, fundamental analysis is concerned with the health and growth of the underlying company.
Traders, however, as a result of their shorter timeframe, don’t typically use fundamental analysis as investors do. If a day trader will enter and exit a trade within the hour, why should he care what the company he’s trading will be worth ten years from now? Instead of being concerned with the health and growth of the underlying company, traders instead focus their attention on the behavior of the stock itself.
To analyze the behavior of stocks, traders place their trades based on factors like:
1. The price action of the stock (how the price of the stock has behaved in the past)
2. The order flow of the stock (to see if there are any large buyers or sellers of the stock)
3. Technical levels (how the price of the stock behaves at key levels of support and resistance)
4. Price trend (the general trend of the stock’s price)
The Ability To Short Sell
Another difference between trading and investing stems from the ability to short sell a stock. As investors typically aim to find growing companies that will appreciate in value, they generally only look to purchase stocks. Because of this, investors will mostly do well when the overall market goes up (bull market) and will suffer when the market goes down (bear market).
Traders, however, typically have the ability to both purchase and short sell stocks, allowing them to profit both when the price of a stock decreases as well as when it increases. For example, when the stock markets collapsed in 2008, many traders thrived due to the historic volatility (and their ability to short sell stocks) while many investors got hit hard.
While both traders and investors have to pay transaction costs (broker commissions), traders are much more affected by transaction costs than investors because they make many more trades than an investor does. As a day trader, I place anywhere from dozens to hundreds of trades per day, and I must pay transaction costs on each trade I make. Investors, on the other hand, may place only a few trades per year. While the total transaction costs will be higher for a trader than an investor, it’s certainly still possible for a skilled trader to make money after transaction costs (or else people wouldn’t be doing it!).
Which Is Riskier?
Unfortunately, there’s no easy answer to the question of whether trading or investing is riskier. In the past, trading was seen as the risky approach while investing was the safe and steady way to manage your portfolio. With the recent volatility and uncertainty in the stock markets, though, many have come to doubt that conventional wisdom. As famous trader Jesse Livermore put it so long ago: “From my point of view, the investors are the big gamblers. They make a bet, stay with it, and if all goes wrong, they lose it all.”
Because of the higher turnover in the positions of a trader versus an investor, a trader will have more opportunities to quickly compound his money than an investor. This is a double-edged sword, however, as a losing trader also will compound his losses quickly as well.
Both traders and investors seek to make money from the stock market, but do so in different ways. Investors hope to participate in the growth of the economy by investing in solid companies that will appreciate in value. They look to analyze the underlying company’s future prospects to find attractive investments.
Traders, though, are concerned more with the short-term behavior of stocks and seek to profit from their price fluctuations. They look to analyze the price action, trend, and order flow of a stock to identify profitable trading opportunities.
Only you can determine whether trading or investing is right for your financial situation. Whichever direction you choose to take with your portfolio, be sure to educate yourself and to never lose sight of your financial goals.
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