Trading or Investing [or both]

When getting started in the market, it’s important to define your strategy of how you will be deploying your capital.

Will you be trading or investing?

There’s a lot of overlap between the two terms.

The generally accepted description of a trader is someone who buys and sells at relatively short time intervals depending on what is happening to the stock or option at that particular time.

An investor would be someone who takes a long term position in a stock — buy and hold — regardless of interim price fluctuations.

For example, a trader might buy AAPL at $325 and sell it at $332 on the same day for a quick profit of $7, before watching the stock move back to $330. By selling at $332 the trader has avoided the $2 drop. An investor will buy at $332 and hold, because he believes in the long term fundamentals of the company and expects it to go much higher in the future. So even if the stock drops in the interim, he will hold until the fundamentals underlying his thesis change.

Now let’s say that over the next few months AAPL stock rises to $450. The investor will be holding on to a $125 gain (which is actually what has happened to AAPL as I write this). The journey to $450 was not a straight line up. There were pullbacks along the way. But those pullbacks do not effect an investor. In fact, they might actually be viewed as buying opportunities.

The trader in this same scenario certainly has the potential to make much more than the investor, since he can avoid the pullbacks by selling before them and then buy the stock back at lower levels to capture more upside. The trader can also short the stock on the way down to capture more gains. In other words, while the investor made $125 (from 325 to 450), the trader could have potentially made a whole lot more, depending on the size of the pullbacks.

Based on what I’ve said, trading AAPL would appear to be a much better deal than investing in it. But here’s the catch: to achieve this kind of trading success you need to be able to time the market. You need to be able to sell right before the stock pulls back and then buy in again before it goes back up.

Very few traders can successfully time the market.

What ends up happening is traders end up taking profits too early and then missing out on extended gains. Or they end up selling when the stock dips, only to watch the stock bounce and rocket back up and away before they get the chance or the guts to buy back in.

The trader who bought AAPL at $325 and sold it at $332 when he saw it start to pull back felt really good at ringing up his 7 point gain as the stock dropped back to $325. But then he woke up the next morning to find the stock gapping up by 10 point on some good news. Or maybe he just took his eyes off the monitor for a couple of hours and missed the run up.

So now the stock is at $335 (2 points above where he sold it the previous day), and the trader is deciding whether to get back in at this level or wait until the stock pulls back to buy it at a cheaper price. Let’s say he waits for a bit of a pullback — but it never comes. Instead the stock shoots higher over the next couple of days to $355. At this point he must again decide whether to wait for a pullback, which everyone is saying has got to happen — because nothing goes in a straight line — or to buy in 33 points higher than the price he sold the stock a few days earlier. The investor, who sat tight through the pullbacks, ended up with a nice gain and without the stress and frustration related to constantly watching the screen and tracking every price movement.

Should you trade or invest?

There’s no right or wrong answer. It depends on your goals, timeframe, stress level, time and capital availability.

And it doesn’t have to be fully one or the other. You can do a combination of trading and investing. For example, you can have some core stock holdings that you treat as investments, and then deploy additional capital to either trade around those stock positions or other stocks or options.

Timeframe

There are also different timeframes within which you can trade.

Day Traders buy and sell within a single day, trying to capture intraday moves. If you do decide to day trade, you’ll need at least $25,000 in your brokerage account, according to US securities laws.

Beyond that requirement, the amount of capital shouldn’t determine whether you choose to trade or invest. You can buy and hold with practically any amount, or trade — especially if you use options contracts. For example, if you invested $10,000 in Amazon shares in 1997 ($18/share), your stake would be worth around $12 million today. If only….

Swing traders can hold stocks for anywhere from a day to a few months, depending on stocks technical signals.

There are also differences in investor timeframes.

Some investors have year long time frames while some, like Warren Buffet, might have a timeframe measured in decades.

And there’s no rule that says that you can shorten your timeframe and sell a stock whose fundamentals or technicals have materially changed or broken down.

There’s no glory in going down with a sinking ship (unless you’re the captain?). Even Warren Buffet sells stocks (in a big way), like he recently did when he totally liquidated his positions in the airlines.

How much time can you invest?

Professional traders and investors spend all of their work time on their portfolios. Most outsiders will probably only need to spend a few hours a week, although you can easily spend an hour or 2 a day looking at charts, reading reports and watching CNBC (I love Fast Money). It depends on how actively you want to trade your positions.

If your plan is to day trade, then you should be prepared to spend your work day in front of your monitor looking for opportunities and placing trades. If you can do that for only a couple of hours a day and reach your financial goal, then go for it. The amount of time you’ll spend trading is a personal choice.

Stress Management

The move actively you trade, the higher your stress level will be. If you want to day trade, you need to be able to handle the stress of watching minute by minute price fluctuations.

When the price is going against you it can be gut wrenching. Some people can thrive on that thrill — like riding a roller coaster unbuckled. I personally hate roller coasters, in amusement parks and on my trading screen. So I’ve chosen to extend my trading horizon beyond the intraday charts, although I will still occasionally place a quick trade if I see the opportunity.

There is a level of stress in any type of trading or investing, no matter how long term the timeframe. But the longer your timeframe, the less acute that stress will be. So you might have stressful times, but not on a daily basis.

Tax Considerations

When you sell a security for a gain, the tax man gets to claim his share. But there is no tax on unrealized gains — you can defer paying taxes on your gains as long as you hold onto the stock. Depending on your personal tax situation, selling or holding a stock could have a material effect on the tax you’ll owe, so you need to take this into account when deciding whether to trade or hold. Check the IRS site or your brokerage site for more info on taxes.

Bottom Line

The answer to the question of whether to trade or invest is…well, it depends on you — your goals, time and temperament. But why choose when you can do a bit of both? 🙂