In any actively traded market, for any financial asset, the market is always in a state of flux, where bids and offers and trades executed are constantly changing. The changing dynamic with the forces of supply and demand for the instrument will cause its price to move up and down as the competing forces exert their influence over time.
We may have a certain outlook for the trend of these changes in price, over a certain time frame that we are focused on, and this outlook may be based upon either fundamental or technical considerations or both.
Trading or investing is always based upon expected changes in price, where we essentially place bets on the price of something moving in one direction or another. What we call investing is just another form of trading, albeit one that has longer term time horizons and expectations.
If you buy something and you expect that it will be worth significantly more 30 years from now, you are placing a bet on the price going up over this time. Regardless of how good or bad this bet ends up being, we know that along the way, the instrument will experience constant fluctuations in price as it heads toward our goal, or not.
Apart from positions of a very short duration, measured in seconds, trades do not go straight up or down and experience fluctuations both ways over time. If the overall trend is in our favor during the trade, and we execute it properly, and the gain is significant enough to overcome trading costs and slippage, we may profit from it, otherwise we will not.
This is the goal of all trading and investing, to place and execute successful bets on financial instruments, such that we may experience a desirable return on our investment, meaning that our bets have been profitable enough that we are happy that we have placed them versus doing something else with our money.
Shorter Time Frames Have More Potential
There are several major factors that go into what time frame a trader may end up choosing, and what time frame a trader should choose, and one of these is how opportunity cost affects these decisions.
When we choose one time frame over others, for instance trading with 4 hour bars over daily bars or 15 minute bars, provided that we have the skill to trade all of these time frames effectively, we need to measure the opportunity cost of each in looking to compare them.
When we do so, we can’t just use competing returns, as the other main element in trading, risk management, factors into things as well. Providing one’s trading system has a reasonable expectation of success, as a general rule, the longer the time frame, the more difficult it is to manage risk.
All things being equal, we should prefer shorter time frames over longer ones, although all things are seldom equal, and profit potential in particular plays a central role as well. However, profit potential can usually be managed better with shorter time frames, provided one is successful in managing one’s trades.
As a general rule, provided one is trading proficiently, with a positive expectation in other words as well as effective execution of the plan, shorter time frames provide advantages over longer ones in both categories, profit maximization and risk management.
This does not mean that everyone should be trading very short term time frames, and there are a number of reasons why one may not want to choose this type of trading. There are two big ones, which are practical considerations, and the lack of sufficient skill, experience, or disposition.
Different instruments may also be more predictable and therefore tradable in one time frame rather than another. While the skills involved in trading do transfer well to any instrument in any time frame, from very short term scalping to long term investing, with just about any asset, there are differences here that astute traders need to look to adapt to.
How Risk Reduces With Shorter Time Frames
There is a view among those with little to no understanding of trading that the longer the time frame used, the lower the risk, and the shorter the time frame, the greater the risk. This is not only a false belief but should be counterintuitive.
This view is held and sold by those who sell longer term investments, and they seem to do all they can to discourage their clients from trading themselves, especially trading shorter term, the antithesis of the investments they push.
They cite the legions of traders who have tried this and screwed things up, and that part is certainly fact, but this is not the reason why so many new traders struggle so much. The real reason for this is that these traders are either not using a plan with a positive expectation, or are using one but not following it, and we see a lot of both in the market.
The more you trade, the more exposed your strategic weaknesses are, as more active trading serves to accelerate the process. It can accelerate profit by improving efficiency if one’s trading is proficient, but it can also accelerate losses by providing for more opportunities for mistakes.
Shorter term trading, by definition, at least if one trades sensibly, reduces the risk of one’s trades because the shorter time frame means quicker exits if the position moves against you. The 0.5 to 1% that good traders risk on their trades would be considered a meaningless blip with long term trades for instance, where even being behind by 20% or more may not get you out of the trade depending on the strategy.
There’s no question that shorter term trading provides opportunities to manage risk better than longer term trading, and this is not an all things being equal situation, as this is always the case. Of course, if one does not practice sound risk management, for instance if one accepts larger losses than is appropriate for expected returns, this is another matter.
Since the goal of trading is to seek an optimal balance of risk and return, the higher the potential return of the trade, the more risk that will be involved. If you are seeking to get a 100% return on a trade over time, it just wouldn’t make sense to give it 1% of room, as these goals would be badly misaligned.
On the other hand, if you are seeking a 1% return but are prepared to lose much more on the trade, you aren’t managing risk properly, as you would need to predict these trades correctly almost every time to make a profit trading like this once trading costs were deducted.
Still though, when your prediction goes against you, the more room you wish or need to give the trade before you exit, the higher the risk of the trade, and this is a matter of just simple mathematics.
Shorter Term Trading and Trading Frequency
In spite of shorter term trades risking less, one may still end up losing a significant amount if the quality of one’s trades or the quality of their execution is poor. This is exactly what happens with many traders, they don’t have a good plan or can’t bring themselves to execute it properly, and the losses may pile up.
It is quite common to see traders deliver results much poorer than random, simply from these mistakes compounding.
Another mistake many traders make is choosing larger trading sizes than is appropriate for their situation, as a result of overconfidence or just seeking higher profit levels than they should.
Trading more frequently also involves higher trading costs, as a percentage of your bottom line. Without a sufficient expectation, these trading costs can result in going from the positive to the negative or from the negative to the more negative.
The impact of trading costs is cited as a major criticism of short term trading, even though this can be very well managed with a sound trading plan. If the plan is not sound, these costs can indeed worsen things.
Trading costs do need to be accounted for in one’s decision about the average lengths of one’s trades, where the profit potential needs to be sufficient net of the costs. There’s also efficiency considerations here, where the added costs of more frequent trading needs to be sufficiently offset by the added efficiency that more frequent trading can provide.
For example, if a trade is entered on one time frame that ends up going your way for a time and then giving back all the profit, resulting in a break even trade, the added trading costs of exiting it earlier and re-entering in the other direction may be much more than the added costs of an extra trade.
The problem that traders tend to run into with over trading is where they would have been better off either staying in the position or closing it sooner and not re-entering, where multiple trades not only involve greater trading costs but can produce poorer results as well, being out of the position when it was favorable to stay in for instance.
More frequent trading is like a double edged sword where capturing moves is concerned, as it can produce results that are much more efficient than just holding the asset, or they may produce much less efficiency, depending on how well one times one’s entries and exits.
Higher frequency trading is much like driving a sports car instead of a big truck. The sports car is a lot faster and a lot more maneuverable, but if under the care of a driver who isn’t skilled enough, it is easier to crash.
This is not to say that those who lack sufficient skills to manage higher frequency and shorter time frame trades should avoid this type of trading, and if anything, the opposite is true. One’s education can be much more accelerated with higher frequency trading, and the shortest time frames like one minute or even 30 second bars can provide less skilled traders with an abundance of experience, where you can execute more trades in a single day than a position trader would in a year.
The key though is to manage your money so that you can very comfortably handle even the worst that might happen with this, which means either simulated trading or trading with very small sizes.
Those who are looking to achieve more or even much more efficiency than investing provides may want to consider shorter term trading, although trading intraday requires one be present during these trades, and more casual traders don’t have the time for this.
Swing trading, with 4 hour bars for instance, can provide one with the ability to trade pretty efficiently, perhaps not as much as good full time traders can, but considerably more so than the investors, in a way that is both more efficient and also fits in with the time they have to devote to this.
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.