Investors are generally defined as those who buy assets and hold them until they appreciate, selling them at a later date for a capital gain. Traders typically buy and sell more frequently, making smaller and more frequent profits.
Although their strategies may differ, there are a number of lessons that traders could learn from the successful long-term investor.
The goal of a trader is to predict a price movement before the market does. Then, when the rest of the market catches up, buying or selling will push asset values in your favour.
Consequently, the goal for traders is to determine how investors are likely to react to different events in the short-term. As the most important piece of data for stock investors is company earnings – for an investor to invest in the stock of a company, it should have the potential earnings of similar investments. If a company can’t provide adequate compensation to the risk its investors take on, those investors have no motivation to continue holding a stock.
Stock traders who keep up-to-date on earnings will know both whether a company is profitable and its earnings growth, as well as the response any earnings news will create. If a trader can monitor how investors typically behave before, during and after earnings announcements, he can reasonably predict price movements surrounding those announcements, particularly if a company has a history of over-promising and under-delivering.
Lesson 2 – sentiment can defy the odds
From the 17th century Dutch tulip mania to the more recent dot-com and US housing bubbles, history has provided traders with ample evidence that trading is not logical.
Most successful traders use some technical analysis in their trading system, with chart patterns helping traders weigh the odds on whether a particular event will occur. However, these odds are based on historical patterns repeating themselves and, although these are often successful, when euphoria or hysteria grips the markets, these patterns often break down.
For example, if we look at the monthly US Tech 100 chart in 1999, the index remained at overbought levels for the entire year, only falling in April 2000. Traders who had been banking on a quick reversal would have made significant losses.
Similarly, the monthly gold chart over the past few years has shown gold consistently topping overbought levels, remaining overbought from November 2005 to September 2006, for most of August 2007 to July 2008 and from September 2010 until the time of writing, excluding a break in early 2011. Despite nearly constant overbought readings for the past year, with current global economic turmoil investors aren’t likely to abandon this safe haven any time soon.
Consequently, traders must recognise when technical trading systems are ineffective due to unusual trading environments.
Lesson 3 – Buy and hold
Although buying and holding assets is associated with long-term investing, it doesn’t mean that this is a strategy that traders should avoid.
Traders typically get in and out of trades as quickly as possible, recognising that markets move in short bursts, rather than consistently. Long-term investors accept this and understand that stocks usually trend over time, and that they will benefit from the gradual movement. In contrast, traders usually avoid being in static markets.
However, this means that traders can fall into the habit of rapidly opening and closing positions, even when they shouldn’t. If a price movement shows signs of continuing, traders could make larger profits by staying in the one trade, rather than switching to benefit from volatility.
One way to let profits run is to use a trailing stop, as this essentially takes the burden of choosing when to close a trade off the trader. A trailing stop closes a trade automatically, much like a traditional stop loss. However, a trailing stop is set a certain level from your starting price, and then follows the market when it moves in your favour. This means that, even if the market changes direction and triggers your loss, you will still keep the profits up to the new level of the trailing stop. Please note, however, that the types of stop loss orders available to you will vary depending on your trading provider, and possibly on the market you trade.
Lesson 4 – Diversify
As investors hold assets long term, they search for diversity to compensate for when some markets or sectors underperform, and that diversity often results in more consistent profits over time as it reduces the overall volatility of their portfolios.
As traders don’t hold positions for as long (usually ranging anywhere between minutes and weeks), they typically focus on a single market. However, this results in a reliance of one type of opportunity, which can result in losses when that opportunity doesn’t present itself. For example, in stable markets, an options trader might find that the time decay on his options trade is greater than his net gains. Similarly, in a sideways market a trader trading stock index derivatives might find that there isn’t enough movement to cover his commissions.
Although markets move in cycles, a trader focusing on one style, strategy or asset may not get enough viable opportunities to make it worth the effort. The most successful traders have a number of methods through which they can turn a profit.
Although trading and investing are both ways in which people can profit, and the method you choose will depend on a number of factors, including your lifestyle, temperament and objectives. By keeping some key investment concepts in mind, those who choose the trading route can improve their returns without significantly changing their approach.
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