Is Trading the Same as Investing?
Investing vs. Trading
The capital markets are full of players with very different objectives. Essentially, there are two main types of market participants, investors and traders. While they all share that they want to earn money, these two groups differ significantly in their approach, especially in the time horizon that underlies their investment decisions.
Investors make long-term investment decisions with time horizons of years or decades. For them, therefore, long-term orientation and development are firmly in the foreground when selecting potential investment objects. A widespread method related to this is so-called value investing. The term was coined to a large extent by the investor and economist Benjamin Graham (1894 to 1976), who is considered the father of fundamental securities analysis.
As the latter indicates, value investing examines the fundamental factors that significantly influence a company's long-term success. Another critical feature of value investing is its anti-cyclical approach. Value investors will only invest if they consider it favourable in terms of expectations of future returns. Value investors pay particular attention to the balance sheet structure and earnings analysis, for example. Fundamental indicators such as the price/earnings ratio (P/E ratio) or the dividend yield serve as a guide to whether an investment is cheap or expensive.
On the other hand, traders prefer a short- to the medium-term investment horizon. For example, the average holding period is a few seconds or minutes (scalping) in the most extreme forms of day trading. Medium-term-oriented traders hold their positions for several days, up to several weeks or months (position trading). The shorter the investment horizon, the less relevant is usually the fundamental situation of the company or the underlying asset, which can also be a currency or a commodity.
Traders are, therefore, often guided by technical analysis. They often use price charts or indicators as supplementary means but also short-term news that moves the price. At this point, it is only possible to go into some existing trading strategies. However, we would like to give you a general overview of the different types of trading strategies:
Trend following - Trend following systems belong to the cyclically focused trading approaches and are very technically oriented. Usually, price charts are used to identify trends. So-called momentum strategies are among the most popular strategies of this type. The art of these strategies is to determine the right moment to exit.
Trend reversal or anti cyclical trading - As the name suggests, market participants in this approach try to find the perfect moment for a trend reversal to participate in the expected upward movement. The challenge with this strategy is to buy when most other market participants are selling out of fear. A piece of good knowledge about the fundamental situation and the relative value is crucial for this strategy. Chart analysis is often used for support.
- Event-based trading - This refers to strategies that profit from price movements triggered by a specific event. Triggers can be events such as interest rate decisions by central banks, company reports, economic data, etc. The basic assumption is usually that the event results in a substantial price movement. The implementation is often done using derivatives and other leveraged products.
Arbitrage - is a general term for several strategies, mainly used by institutional investors, not least because the capital required is usually enormous and the technical requirements are a barrier. The profits are typically minimal in relation to the investment, but on the other hand, they mainly offer a very low risk of loss. The most popular type of arbitrage is to use fully automated trading systems to identify and exploit price differences in an underlying asset on different stock exchanges within milliseconds.
Market neutral strategies - Market neutral strategies are bi-directional trading approaches in which investors benefit from rising and falling prices. This can be done in a variety of ways. Popular trading approaches are equity or commodity long/short strategies in this context. One tries to profitably trade the spread (price difference) of two highly correlated underlying stocks by buying one position and selling the other. For example, different market-neutral strategies can be found in options trading.
Automated trading - Computer-controlled and fully automated trading algorithms are becoming increasingly popular in the age of information technology and are also being used more and more frequently by small investors. Those with the appropriate trading software and are connected to a broker that supports fully automated order entry can choose from a variety of freely available trading algorithms that they find most profitable. The great advantage of automated trading is that it takes less time and eliminates human emotions like fear or greed as risk factors.
Social Trading/Investing - This relatively new type of investment strategy aims to follow in the footsteps of those who have already proven that they can make steady profits in the stock market. With the invested capital, every investment decision of the trader is followed, and in the case of profits, a commission is due. For very uncertain or inexperienced traders, this can be a way to invest profitably without taking unmanageable risks.
A crucial factor in trading is one’s mindset and the ability to control emotions to prevent them from influencing investment decisions. Euphoria and overconfidence, as well as fear and uncertainty, can significantly impact the success of trading. Therefore, creating your own rules and principles as a guideline to have a clear strategy is essential. One of the most critical things in this regard is the explicit limitation of losses and solid money management. Position sizes should always be aligned with one's account size.
How do you protect yourself against losses?
There are different methods to protect yourself against losses. As already mentioned, one of them is to limit losses, for example, by using stop-loss orders. This means a sell order is placed when the price falls below a certain level. If the market falls slowly and massively, this method can generally limit the loss quite sharply.
Another loss limitation can be hedging one’s stock positions with a counter-position. The hedging instrument can be short CFDs or put options, for example. This approach can benefit those who do not want to sell their shares. For example, the owner of a large number of shares with voting rights, who can use them to influence the company's decisions significantly, will not decide to sell his share position due to short-term turbulence. The same may apply to those who receive a significant part of their income from dividends. In addition, the sale of all shares is associated with high costs, especially compared to a single hedging position, which is usually cheaper than selling all shares.
Also suitable as a means of choice is a short sale, in which one borrows a share and sells it on the market to repurchase it at a lower price. The methods mentioned can be used to profit from falling share prices. It is essential to know that positions speculating on falling prices include financing costs in the form of borrowing fees. In addition, positions on falling prices are subject to the unlimited risk of loss. It is, therefore, important to adjust the size of the position to the position you want to hedge.