Trading and investing are sometimes viewed as separate and distinct activities. While there are broad differences, they have much in common. Both seek superior market returns. This means that principles applied in trading can inform investors.
One difference is the timeframes employed by each group. Traders tend to be more active, trading more volume more often. At the highest level of investment endeavour there is great expertise, but the frequent testing of trading theory against the rock of daily profit and loss evaluation means there is a greater body of established principles of trading. Some of these principles are easily transferred to investment practice.
This is not to suggest that there is a single approach that is better than all others in all market conditions. There isn’t. Whether these principles apply to a specific investor depends on that person’s individual circumstances.
The first rule of trading is to stay in the game. A proprietary trader who “blows up” may face unemployment, with significantly reduced prospects of re-employment. The corollary for investors is that capital preservation is highly important. Diversification across and within asset classes is a powerful risk management tool available to investors.
Investors willing to invest in themselves and study derivative instruments have greater choices for portfolio protection. The surge in market volatility means options are now significantly more expensive than before the Covid-19 rout. However futures and CFDs over stocks and the Australia 200 index offer capital preservation opportunities.
Real-time mark-to-market profit and loss measurement means that traders cannot hide from changes in the market environment. They cannot hide a losing position in a stock by ignoring a loss. Traders call this putting a stock in “the bottom drawer”. Flexibility and adaptability are prized trading attributes. One aspect of success in the highly disrupted market environment is recognising the enormous change in conditions.
Acknowledging the changed environment is the first step. Traders then re-formulate their approach, based on the new market imperatives. Investors must do the same. Investment criteria that was formerly highly important may not only not apply - it can be dangerous. A good example is reliance on dividend yields. In a stable market environment with low interest rates, dividend yields played a significant role in stock selection, especially for investors seeking income. The potential for companies to slash dividends due to virus outbreak related earnings drops means dividend yields may now mislead and trap investors.
Another risk management technique used by traders in highly volatile times is to reduce position sizes. Investors looking at buying now can incorporate by spreading their buying over time. Buying one quarter of a desired stock position now, another quarter in a week or a month’s time, and so on, allows more flexibility and an opportunity to buy in more certainty.
This method requires patience and discipline. Again, there is a parallel with traders. Some traders go days, weeks or even months, without making a trade, because there are no opportunities that match their trading plan. Patience and discipline are also investment virtues.
Traders expect to be wrong. None of us know the future, including top traders. This makes it inevitable that some decisions will lead to losses. To make money investors and traders alike must take risk. Good trading, and investing, is not about avoiding loss, but about minimising the damage when losses arise. The right way to do this depends on individual investment circumstances, but planning ahead of time to deal with investments that go wrong leads to better returns over time.
The final tip from the trading world is about emotion, and the dangers it presents to success. Many traders start out with practise trading. They open demonstration accounts, with play money balances. This is a sound way to learn about placing orders and managing positions.
Problems can arise when a trader graduates to trading real money, because when real profits and losses are on line, the emotional effect is much higher. Fear and greed interfere with good decision-making. Investors who focus on the rout induced losses in their portfolio are not helping themselves, and are potentially harming themselves by inducing a depressed or panicky emotional state. Investors are better off accepting the reality of sunk costs, and looking forward.
