The Fundamentals of Trading

There are a lot of similarities between what we call investing and what we call trading, and all instances of placing trades to take positions in financial securities is technically trading. We do have the distinction between these two ways of doing it to distinguish trades which are expected to be held for a long period of time with those which are expected to be of a shorter duration.

There is another distinction though between investing and trading which generally applies, and it’s that trading tends to be more strategic than investing, even though it’s true that investing does often follow distinct strategies.

The Fundamentals of TradingOften, the main strategy with investing is to look to capitalize on the tendency for assets to accumulate in value over time, especially in the very long term. Stock markets do move in various cycles, with one of them being the long term, where both bull and bear markets may persist for a couple of decades or more.

The thinking here is that if you just hold these investments over the very long term, for 20 or 30 years or more, based upon past performance, the odds are good that you will realize a decent return. Stocks average about 10% per year return over the very long term, so if you don’t bother to time these moves, and hold that long, you do stand a good chance to capture similar returns if you hold them long enough.

The main problem with this strategy is that it does require you to hold the stocks and not seek to time them, and therefore forego the ability to evaluate your positions based upon current performance or future expectations.

One could certainly look to time their entries with even a long-term approach, and although this would make a lot of sense, as you wouldn’t want to be entering during a bear market for instance, this option isn’t even offered. This would be like a car salesman telling you to come back at another time when the deals may be better, but these people are paid to sell cars and that’s what they do.

It’s better to pretend that no market can be timed, because it then becomes a lot easier to sell investments, when it’s always a good time to buy their investments, whether it actually is or not. Poor entries can really impact long term results, where one can be well behind and have to make up a lot of ground just to break even.

The distribution of these results varies widely, where markets can be mired in long term declines where they can lose half their value, or rocket up and increase several fold over a period of just a few years.

While investments certainly can take advantage of market timing, their management is heavily weighted toward the passive side, where active intervention is usually only used in times of turmoil, and often not very effectively, with moves being more inspired by fear or panic than calm and sensible deliberation.

With Trading, Timing is Everything

Trading, on the other hand, seeks to actively and strategically time the trading of financial securities, with the view of entering and exiting positions based upon the rolling probabilities of its performance.

Investing treats these probabilities as fairly constant, where when you enter into a trade you may be looking at its probable return based upon past performances. This view will tend to be held throughout the investment where activity during the investment is virtually ignored, as it is seen to be outside the scope of the strategy.

If there is an expectation of poor performance, meaning that the value of one’s investments are declining and are expected to continue to decline for a while, one would just ignore these events, where one seeks to keep their eyes on the horizon and not the road so to speak, driving through storms rather than pulling over and waiting them out, or looking to take advantage of them.

There is a lot of interest in keeping people doing that in the investment industry, because if investments were managed that way more, this would produce much more volatility, and especially produce longer and more severe bear markets. This is seen by a great many as undesirable, even though there isn’t a good reason for this other than those who would continue to stay the long term course being subject to even more risk.

Trading, on the other hand, does seek to time markets, and that’s essentially what trading is, taking an active approach to trade management and looking to take a more dynamic view of the probabilities involved.

Trading also involves strategies that look to stay in trades only when the probabilities are favorable, and not look to ride out storms of an unacceptable magnitude. During bear markets, traders will look to either step aside, or even better, to change horses and take advantage of declining prices by betting the other way so to speak.

Where a market may rise and fall, leaving those who held the position throughout flat, traders will look to time the move up and take advantage of the momentum involved, and when the bears start to take over, the trader may either go flat or even look to join the bears and look to capture the downward momentum as well.

Not all traders look to capitalize on both up and down momentum, and there is a long bias that is often present with traders as well as investors, especially those who mostly trade stocks. Some of this is due to the fact that shorting stocks isn’t always quite as easy as buying them, in addition to things like rules limiting shorting at times, even though this all usually isn’t a problem with actively traded stocks. Traders of other assets like indexes, commodities, and forex can enter and exit both long and short positions with the same ease, and these traders aren’t really biased either way fundamentally.

The success of a trader depends on how well one can time their positions, their trades, seeking to enter and remain in positions that have a positive expectation, and exit when this positive expectation over the chosen time frame wanes.

Assessing The Probabilities of Success

It’s one thing to aspire to timing trades properly according to the changing probabilities of it succeeding and continuing to succeed, but it can be another thing to come up with a plan that is accurate enough to be workable.

This is not as challenging as many may think though, because all you need to do is achieve results that are better than random. One could trade purely randomly, allowing a random number generator to decide what trades to enter and when to exit, and have a neutral expectation over time less trading costs.

Trading costs these days are pretty minimal, especially compared to the old days when you had to use a full service broker with huge commissions, high enough to be even prohibitive to shorter term trading. One can still trade too often though and a lot of traders do, but when handled properly trading costs, including spreads, brokerage fees, and slippage, can be kept to enough of a minimum as to not overly impact results.

There is only one real reason why one’s expectation in regard to the trades themselves would be negative over time, and that’s poor trading itself. Just as skilled trading can produce a positive expectation, poor trading can produce a negative one.

The idea here is to conduct one’s trades in accordance with the probabilities, and this means that one’s ability to properly assess these probabilities is going to be central to that, and if one does a poor job at this then one’s results can really suffer.

A good example of this would be someone caught in a trading range, where they sell at the bottom, the price moves up, they buy it back, it goes back down, they sell again. The price may not have moved but the trader may have experienced a succession of losses due to nothing else but bad timing.

This is just one example of how a trader may mess up, and all involve poor timing, where one is out of a trade when they should be in and vice versa. Many traders allow emotions to shape their decisions too much, and even a little here is too much, similar to investors panicking when their portfolios get hammered and selling at the bottom, and then fail to re-enter until the rebound is well underway.

Staying Within Yourself When Trading

The more one is prone to mistakes, the more careful one should proceed in trading. The more trades one places, and the shorter the time frames involved, the more potential there is for these mistakes, in addition to the more potential for success.

There is a lot involved in becoming a successful trader, even being able to break even after trading costs are deducted, and newer traders generally have no idea of the challenge that faces them, perhaps thinking it will be so easy and then realizing later that it is not anywhere as simple as they may have thought.

As a general rule, the less frequently you trade, the less potential there is for mistakes, and the more you trade, the greater this potential is. The real challenge isn’t so much coming up with trading ideas that work, it’s avoiding ones that do not.

That’s the first order of business in learning to trade actually, to cut down one’s mistakes, and there is a big difference between making a good decision that didn’t work out and making a bad one that didn’t. Good decisions will lead to good results over time, and bad ones will lead to bad results.

On the other hand, one must often learn through one’s mistakes, and more frequent trading will at least provide that opportunity, as a training ground. Perhaps the worst thing that can happen to a trader is a very long initiation period, lasting many years, where so few trades are placed each year that one does not have the opportunity to learn fast enough and eventually give up.

The goal in trading is to ride the waves of momentum, much like a surfer would, but surfing takes skill and the only real way to learn to surf is to get out there and try. You do want to make sure that you don’t risk too much while learning though, and start out with small waves and work your way up as you improve.

This is exactly what traders need to do as well, to be eager to try and get lots of experience, make a lot of mistakes, and look to learn from them, all without subjecting themselves to too much risk. The expectations need to be not that one is going to rack up big gains right out of the gate, but that one is going to struggle, and therefore one should not be risking anything very substantial until one has proven that one can manage things well enough.

Trading can be a very exciting endeavor that can provide both a lot of enjoyment and financial success, but it is a real profession, and all professions require that one master it sufficiently prior to expecting to be able to do well at it. Should one have the right attitude and approach though, the odds of succeeding get much better.

Andrew Liu


Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.

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