Are you a trader or an investor?

By Kim Iskyan

To most people, investing – the long, slow process of letting compound interest work its magic – is boring. It’s the tortoise, while the hare hops away.

But the fast-paced action of trading – even (or especially) for people who only know it from the movies – is like riding a motorbike on an icy canal while holding a box of nitro glycerine. It’s excitement on steroids with some real financial danger in the mix.

Of course, any kind of asset, whether it’s stocks, ETFs, bonds or commodities, can be held as a long-term investment or traded for short-term profit. The major difference is how long you hold it.

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 – only hold positions for fractions of a second.

But all types of traders have one main objective – to make short-term gains on an investment.

The different types of trading strategies

Momentum traders look for assets that are making a major move up or down and have a large number of shares trading hands. They hope the momentum will continue, and they hold the asset until the price reaches a pre-set level – which can take minutes or days.

Technical traders look for patterns or trends in stock, bond, index or currency charts. They make trades based on what those 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 look at various charts and indicators before the markets open in the morning. Then they 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 months.

Fundamental investors base their buy and sell decisions on an asset’s fundamentals – like earnings, profits and debt levels and valuations.

Usually a change in company fundamentals can take time to affect a stock price (although a surprise change in fundamentals – like an earnings disappointment – can have an immediate effect on the share price). So “fundamental trader” is a bit of a misnomer – people who look to fundamentals to guide their investment decisions usually have more of an investing mentality.

Trading isn’t for everybody

Being a short-term, active trader can be a lot of work and it can be stressful. Sure, waking up in the morning, making $1,000 by noon and taking the rest of the day off sounds great. But you could just as easily lose $1,000 by noon if you’re on the wrong side of a trade.

Successful traders have three things in common: They stick with one short-term trading strategy (like momentum, technical or fundamental)… they take a disciplined approach (more on this in a moment)… 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.

Here’s a closer look at each…

1. Stop losses. A stop loss 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, you’d set your stop loss price at 25 percent below the price you paid for the stock. So, if you paid $20 per share, your stop loss level would be $15 ($20 – 25%).

As the share price moves higher, you might want to use a trailing stop to make sure you don’t lose more than 25 percent based on the new higher price. 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.

2. Position sizes. Many would-be traders put a lot of time into researching whatstock to buy. But they hardly give any thought to how manyshares 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 need to know your stop loss level.

Let’s say you’re buying the $20 stock above and you set $17 as your stop loss level.

Now, consider how much of a paper loss (that is, how much it’s gone down on paper, before you actually sell the position) you can handle. With a $100,000 portfolio, you may feel that a $2,000 loss would make you nervous… that’s your comfort threshold.

So you’d divide $2,000 by your $3 per share loss ($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 of any number of permutations):

(Maximum $ Risk)/ (Current Stock Price – Stop Price) = Position Size

3. 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. Many 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. Instead, you want to 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 of your portfolio you do want to trade with, make sure you spread your exposure around to a few different sectors. That way, if one sector falls, your entire trading portfolio won’t be blown up.

 

Kim Iskyan
Kim Iskyan is the publisher of Stansberry Churchouse Research, an independent investment research company based in Singapore and Hong Kong that delivers investment insight on Asia and around the world. Kim has nearly 25 years of experience as a stock analyst, hedge fund manager, political risk consultant, and financial commentator in more than half a dozen emerging and frontier markets. He's been quoted in the Economist, The New York Times, the Wall Street Journal, Barron's, and Bloomberg, and has appeared on Fox Business News, China Central Television, and Bloomberg TV, and has written commentary for the Wall Street Journal, Slate.com, Salon, TheStreet.com, breakingviews.com, and other publications. For more of his insights, Click here to sign up to receive the Asia Wealth Investment Daily in your inbox every day, for free.

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