Q:But what is the difference between investors and speculators?A: Before you start investing it is important to identify whether you want to be an investor or speculator.
Characteristics to each:
Speculator: active buying and selling, short-term cfd trades, uses technical analysis to trade, contracts for difference account, spread betting…etc, focused more on capital gains from share price appreciation over a shorter limited period of time.
Investor: usually uses fundamental analysis i.e. checks the firm’s cash flows, yields value ratios, prefers ‘value’ stocks, usually stays invested for the medium to long term and is focused more on income from dividends.
Trouble is, when you talk about trading or investing, you have to be clear about your perspective on time. It’s simply no use talking about a day to a day trader, they are concerned with minutes, usually 1, 5 and 10. Likewise, it’s no use talking to an value investor about daytrading because he’s thinking in terms of years. And there is not just a superficial difference between trading and investing; a number of ordinary shares may for instance be unsuitable for holding on a long term basis due to their high volatility; such stocks may need constant attention and a long-term investor who is unable to keep checking his account everyday may be at a disadvantage to a trader who is able to access such information instantly. If you trade on different timeframes it is important not to confuse the timescales and effectively become a daytrader while trading on weekly charts!
Longer-term investors are typically passive investors who lack the time or inclination to follow the market and will only trade infrequently so as to minimise dealing expenses. They typically build their share portfolios around a handful of key stocks that do not require constant monitoring and although they might do some housekeeping, their strategy is largely based on holding stocks for the long haul. This is also the preferred route for income investors. Long term investors view their investment as a stake in a company’s future cashflows, which returns can then be injected back in the company to make it grow further or returned to them as a valuable dividend payment. For the investor, the idea of weathering the ups and downs of being in the market is all part and parcel of the business. Long term investors will tend to have a preference for companies with high barriers of entry, have well-known brands, pricing power and competent management; all of which help to make a firm highly profitable with a stable revenue stream. Investing (i.e. putting your money to work over longer periods of time) also implies diversification, which means spreading your investments over a number of different asset classes so as to maximise gains while minimising potential losses.
Traders fall, in the main, into two sub-categories; the ‘occasional’ or ‘active’ trader. For the trader, the objective is to try and capture smaller moves of the market and then exit. This style of trading can be quite time consuming as one has to constantly follow the markets. Timing remains an all-important component of survival for traders who will try to take advantage of market volatility and try to identify chart turning points. A trader will usually go for share price momentum while studying stock market newsflow with valuation being less important as long as the stock is moving in the correct direction.
Note: Remember though that investing is still trading as you are still buying and selling and thus you still need to know what you’re doing.
Both trading styles carry risks. Buy and hold is a real tricky one for me – buying and holding has been proven to be very painful for anyone holding in the last two years and the speed of change makes long term stock holding tricky. There is simply no way of looking 5-10 years ahead in any stock and having the faintest idea as to what conditions will be like then. Charts and stuff is not so important if you aim to hold for the long term but right now buy and hold is more like buy and hope! In this economic climate it is best to assess market conditions and then adjust your portfolio as needed i.e. I believe that in these market conditions trading your long-term portfolio may be a superior strategy. At some point it will be right to hold again but as things stand it’s very tricky knowing whether the market is going to rise or fall. On the other hand if you are constantly getting in and out of positions, commissions can quickly add up and eat into your profits over long periods of times.
Day trading is sometimes compared to poker in that it is simply a zero-sum game; if there are four people sitting around a table playing poker, by the end of the day, two people will have won and two will have lost but no new money is created. This is quite similar to speculators who are in the stock market for short term plays – a business could not hope to sustainably make a 5% gain over a few days and as a result speculators are betting against each other. So on the one hand a speculator can take advantage of short-term pricing discrepancies but on the other hand if the speculator doesn’t have a trading system with an edge what he may gain in one short-term bet may be offset by a losing trade and he still has two commissions to pay each time.
P.S. The techniques to use depend on your experience, investment time horizon, degree of risk you are willing to accept/retain, whether you have sufficient time throughout the day to manage intraday positions and of course on whether you are in for the long haul or only wish to trade shorter-timeframes. This doesn’t mean that investing is better than short-term speculation or vice-versa. George Soros, Warren Buffett, and Richard Dennis are all examples of professional traders who trade over different timeframes but each is successful in his area. George Soros, for instance established the Quantum Fund for the explicit purpose of taking advantage of short-term and opportunistic foreign exchange moves while Warren Buffett is widely known as a value investor. Richard Dennis uses commodity options as a way to trade his way to major moolah. And you can always reach a compromise where you invest part of your capital in long-term positions while using the rest to trade on a short-term basis.
Q:Why is trading sometimes said to be a zero-sum game?A: Trading the markets is a zero sum game (pdf file) on the grounds that traders simply exchange risk between each other. If you don’t take into account dividends (positive value) and commissions and fees (negative values) you are left with nothing but the raw capital gain (or loss). The total capital gain for winning traders, from the movement of a stock price, will always be equal to the capital loss of the losing traders. Thus, the stock market (and other financial and commodity markets) are zero sum games.
To elaborate further, here’s an example:
Trader A buys 100 shares of XYZ stock for $20 per share from trader B (who sells at the same price and volume, obviously).
XYZ moves up $10 and trader A sells his 1000 shares to trader C for $30. Trader A has now made $10 per share and trader B has lost $10 per share so far.
If trader B sold shares he bought at $10, he has made a profit of $10, but lost an opportunity for profit by getting out too early (an opportunity cost). If, however, trader B sold short at $20 (i.e. he never owned the stock in the first place) he has made a real loss of $10.
It is this combination of Profit on one side and Opportunity Cost and Real Cost on the other side of the equation which makes trading a zero sum game.
Sum Profits = Sum (Opportunity Costs) + Sum (Real Costs)
This is made more complicated by the constant exchanges between different traders at different prices and volumes – in effect creating a domino effect.
In the example, if the market price of XYZ moves down to $27 from $30 and Trader C sells his 100 shares (he bought at $30) to trader B:
Trader A has made $10 per share
Trader B has lost $7 per share
Trader C has lost $3 per share
Trader A has profited from the losses of both Trader B and C – zero sum.
Of course this has to be taken in context as it depends on a multitude of factors. If you only look at the price movement which is caused by the counterparty transactions/trades, then the market is entirely zero sum – you can only win what someone (or group of people) has lost and vice-versa. However, if you start including things such as dividends (positive) and costs such as commissions, exchange fees, etc (negative) then the situation becomes more complex. The market gets injected to and reduced billions of times a day and sometimes with complete randomness over certain time frames. A top trader will exploit this by finding an edge. And it’s more complicated than “stock markets go up traditionally, so always be long”.