Most people know that trading involves some sort of exchange of stock. In fact, traders trade securities. Securities are either equity—which provides ownership rights to holders. Debt—essentially loans repaid with periodic payments. Or hybrids—which combine aspects of debt and equity.
This is what differentiates it from investing. Typical investing only deals with equity. The other big difference is the length of time over which they take place.
Professional traders typically work in an investment bank, but this analysis also applies to amateur trading which can take place from your desk at home.
What is the difference between investing and trading?
Investing is allocating money or other resources to generate income or a profit from the investment. This can mean many things, including purchasing stocks on the market, purchasing real estate to generate rent income (or to sell it later at a profit), and starting a business. There are many ways to invest, and doing so generally implies a desire for long-term gains.
Trading, on the other hand, requires active participation in the market. Traders must profit in the long-term to continue doing so, but the action occurs in the short-term. While the most well-known form of trading is buying and selling securities, there are many others and many different ways to do each of them. Some other common trading forms include options trading, futures and commodities trading, forex and currencies trading, and fund trading.
Although investing can involve activities outside the financial market, trading is generally kept within it. Because of the short-term nature of trading, one of the most important factors to consider that you do not need to consider as much with long-term investing is volatility.
What is volatility?
Volatility is a measure of an asset’s price swings around the mean price, or the “dispersion” of returns. In general, volatile assets are riskier and more unpredictable than less volatile assets due to the greater, more frequent price changes. Therefore, volatility is continuously a factor for traders to consider. When making short-term trades, understanding volatility is essential to assessing risk and the potential for success in the market. Volatility is particularly important in options trading, as it is a critical determinant in the prices of options contracts.
Even further, traders pay attention to market indicators to determine entry and exit points for trades. These indicators include volatility indexes such as the CBOE Volatility Index (VIX), the average true range (ATR), and Bollinger Bands. The VIX is one of the most necessary gauges of market volatility. It reflects the implied or expected volatility at any time during the trading day. It includes data from many S&P 500 Index options, which means traders use it to assess the market volatility for larger institutions over the coming days. Unlike the VIX, the ATR is an indicator for many other market components besides stocks in the S&P 500. It shows a 14-day
exponential moving average and tends to indicate when there are periods of eventful or uneventful trading.
Because of the variety of different trades that traders make, they must pay attention to each of the different indices. The market volatility at any time can show potential future market trends and affect the types of trades they make at a given time.
Another fundamental aspect of trading is technical analysis. The most basic aspect of technical analysis is analyzing historical market data such as price and volume on specific stocks and commodities. In doing so, traders rely on the idea that the market price reflects all of the
information that could affect the market. Using charts and indicators, past market data can be used to predict future behavior. They can predict future price changes to a certain degree and show entry and exit points for traders at certain price points. To determine these entry and exit points, traders rely on chart patterns to identify areas of support and resistance. The base for the analysis depends on applying mathematical formulas to prices and volumes.
Fundamental analysis is the other main way traders determine future market movements. They believe that the market often overlooks value. To find undervalued companies, traders using fundamental analysis pay close attention to a company’s financial statements, mission, and operations within the business.
In comparison to technical analysis, fundamental analysis generally deals with trades held for an extended period. This has to do with the fact that fundamental trading looks for value within the current business, rather than the stock price. The stock price can be volatile, and short-term trades with technical analysis are more frequent because they can take advantage of the volatility more effectively. The aspects of a business do not change as frequently, so fundamental analysts have to wait for their determined value to be realized in the price.
Types of Traders
Knowing the basics of what goes into trading is one thing, but it is also essential to know what types of traders there are, especially if you want to become one. For this purpose, we will focus on equity trading. The different types of equity traders are scalpers, momentum traders, technical traders, fundamental traders, and swing traders.
Scalpers make up to hundreds of trades every day to make small profits from each transaction. They generally deal with the bid-ask spread.
Momentum traders look for stocks that are currently increasing in price rapidly. The traders hope to use the momentum of the stock and the high volume associated with that movement to make a profit and sell quickly when they realize their desired return.
Technical traders use technical analysis to look for signals that indicate a buy or sell point.
Fundamental traders use fundamental analysis to analyze the company itself and the financial data associated with it.
Swing traders are fundamental traders who hold their positions for several days or longer hoping that a change in some aspect of the company will create a price movement in their favor.
Trading is, of course, a risky activity for anyone to engage in. It requires experience and in-depth knowledge of the financial markets. Even with experience, technical and fundamental analysis has the potential to fail at any instance, and those who rely on it are not guaranteed profits.
This article was written by Marshall Dolan Henshaw, student at Cornell and aspiring financial services professional.
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