The Difference between Stock Trading and Investing
Trading differs from investing. Here's why it matters.
Back in the late 1990's, the stock market was almost like a casino. Many stocks, particularly those involving the internet, were swinging wildly in price on any given day. Thanks to the internet, people could trade stocks almost instantly, making dozens of trades and executions in a single day. This phenomenon was known as "day trading", and people asked each other if they "played the market", which only perpetuated the feeling that the market had become a casino. Of course, the stock market bubble burst shortly thereafter, and many people lost a lot of money.
"Trading" is no longer a dirty word in the stock market, but it is very different from "investing". The latter term is used when someone chooses a company they truly want to invest their money in. They intend to buy stock, which represents a tiny piece of a company, and hold it for a long time. In effect, they become part owner of that company. Over time, they hope the stock price will appreciate and their little piece will be worth more than it was when they first purchased the stock.
"Trading" can mean many things, but it primarily refers to taking short-term positions in a stock, either long or short, that has nothing to do with a company's intrinsic value. A stock trader believes he understands how a stock price may move in a given pattern based on various factors. By buying a stock when an expected pattern begins to form, the trader hopes to take advantage of it and make some quick money. This can also be done by shorting a stock -- selling shares with the expectation the price will fall, then buying the shares back at the lower price, thereby profiting from the fall. For example, sometimes a stock moves in anticipation of its underlying company's upcoming earnings announcement. Sometimes a stock may trade in a specific range. By buying at the low end of the range and selling near towards the high end of the range, profits may be realized.
Technical Analysis in Trading
Many traders subscribe to something called Technical Analysis. Here, a stock's chart over a certain period of time will have many different indicators associated with it -- such as the momentum of price in relation to volume, or the velocity at which a stock falls when it falls below a certain price. Traders who are educated in Technical Analysis attempt to take advantage of this information to create profitable trades.
The Risks of Trading
There is a lot of danger in just trading. Just because a stock appears to behave according to a certain pattern does not mean it will always do so. Even if a trader buys a stock at what is perceived to be a bottom price in its trading range, the company could announce some unexpected bad news and the stock price could crash further.
Trading also makes one more susceptible to emotion. It's hard enough to stay the course when invested long-term. But sudden and volatile moves in a stock can make a trader do something irrational that costs him dearly.
Finally, there is the matter of cost. Trading can cost the trader a lot of money in commissions if he does it too often, and the brokerage he is with charges a lot per trade. If one is going to trade, it's best to be with an online discount brokerage, which has the cheapest fees. For example, Firstrade stock trading is only $6.95 per trade.
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How to decide
Choose a handful of stocks to follow
The best thing you can do if you want to trade stocks is to become a student of a handful of stocks that you have followed regularly for several years. If you understand the company, you'll understand why the stock moves on any given day. Then you can look for patterns and take advantage of them.
I recommend: Choose companies in a sector you know from personal experience.
Don't pressure yourself
This isn't a casino. You aren't trying to hit the jackpot. A bunch of singles will pay better than a home run and dozens of strikeouts.
I recommend: Don't trade unless you have a definite strategy.
Useful Trading Advice
- Have a planned entry and exit point. Stick to them. It eliminates emotional decisions.
- Use stop-losses. By setting a stop-loss on a stock you've purchased, it will prevent you from losing your shirt if the stock unexpectedly crashes.