Thursday, December 03, 2009

Trading > Investing

There's a simple equation you should memorize:

Trading > Investing

Why is trading better than investing? I'm glad you asked, otherwise this post would have been pretty short and boring.

What do investors do? Investors invest money into an instrument (primarily stocks and bonds) and after a certain amount of time they cash out and accept whatever their investment has grown (or shrunk) to. 401k's, IRA's and so forth are classic investment vehicles. They only profit when the price of the instrument rises and they rarely if ever will cash out of their positions before the date they are needed (such as retirement, funding an education, etc.).

What do traders do? Traders do the same thing, but their time-frame is much shorter and their expected payouts are much smaller. When things start going badly, traders get out and don't weather the storm like an investor would. Time-frames may be seconds, they may be months. Rarely will traders hold positions for very extended amounts of time, especially if you're a futures trader as in most cases the contract you are trading will expire within months.

Simply put, investors are only concerned with the destination while traders are only concerned with the ride. Traders profit when instruments go up and when they go down, depending on their position. Investors only benefit when prices go up.

Take a look at this chart, which I've annotated to illustrate how a trader versus an investor would handle the situation.

 (Click to enlarge)

This chart is for the S&P 500 futures continuous contract. While this example only covers a few months, this chart could span a few years; the point is long vs. short-term time-frames. Both the trader and investor enter on the same day (9/3/09) and while the trader and investor exit on the same day (11/23) the trader reverses their position when the price begins to turn downward and vice versa when price turns upward again which gives them a net of 5 trades from start to finish.

Granted, this is a perfect scenario as I have the trader bailing near the peaks and valleys of each wave but it shows clearly the difference between a trader and an investor and there's no reason a trader could not pick off those peaks and valleys. The trader makes almost 200% more than the investor in the same amount of time simply by trading rather than investing. Oh, and this is only picking off the major peaks and valleys. If we speed up the chart and pick off the smaller peaks and valleys contained within I'm guessing the profit is probably 500% more and if you speed it up to the time frames that I trade you're probably looking at 1000% or more profit with near perfect execution (not quite there yet. HA!).

The lesson here is this: Trading will ALWAYS be more effective and profitable than investing simply because it takes advantage of reversals in price and at a minimum keeps your money out of the game as price retreats and potentially makes you even more if you happen to go short when prices retreat. If you start at A, why only worry about Z? Traders want to make decisions at every letter of the alphabet and as a result they will be far more prosperous than investors.

There are, of course, drawbacks and catches with trading. Most notably, trading takes time and effort. Depending on your time-frame you could be looking at a full-time profession like mine or at the very least a few hours of research each week to decide what to do with various trades. Trading also increases your transaction costs. For me, each trade costs on average $5 per contract per round-turn (going in and getting out). Therefore, on most days I'm looking at transaction fees of about $50 which translates to around $12,500 a year. Crazy, huh? For a relatively active investor/trader in stocks, lets say that each trade will cost $10 and you execute 20 stock trades a month so you're looking at $200/month in fees or $2,400 a year. There's also tax implications with trading as each time you trade and net a profit Uncle Sam will hold his hand out for his share. But, in the end, the benefits/profits WAY outweigh the costs of trading versus investing.

Should you trade? Absolutely!! Would I recommend trading like I do on an intraday basis, holding for seconds or minutes at a time? No way. But, if you have the ability to self-manage a 401k or dabble in stocks as an investment vehicle you owe it to yourself to look into various longer and shorter-term trading strategies. Don't listen to the people that say that trading is difficult and costly due to transaction fees and such. These are the people who are lazy or are investors and have made mistakes investing and watched their portfolios dwindle to nothing as they try and weather the storm while the traders pulled their boat out of the ocean long ago. I don't mean to sound callous but I don't have much sympathy for people that had a choice in what to do with their investments, saw the storm coming and decided to sit around and wait it out rather than pull it all out and seek shelter. It's irresponsible and shows a complete lack of pro-activity on their part and it's not like trading would require a ton of time. What's an hour or 2 every week to keep up with your investments? A small price to pay to ensure that your hard earned money doesn't end up going down the drain...

I'll get off my horse now, but take a look at various investment sites or ask me about some trading strategies on a longer scale (say, holding weeks or months at a time) as I want you to be far more profitable as a trader than you'll ever be as an investor.

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