Trading vs Investing: The Ways to Participate in the Market

Living in a luxurious house, taking a family vacation to an exotic location, and enjoying a peaceful retired life are dreams we see with our eyes both closed and open. And we would all agree that resources to fulfil these dreams are rather limited. A single source of income, say from your salary or business, may not be enough. However, additional income from investing in stocks can be a means to make extra money that can take us many steps closer to our dreams.
But remember, Rome was not built in a day, so it’s important to understand the rules of the game before investing in stock markets.

Investing vs Trading

The stock market offers both investment and trading opportunities.

• Investment offers capital gains or growth and dividends or incomes
• Trading offers quick profits upon buying and selling of shares within a short period

So what is the difference between trading and investing? The key differentiator here is the element of time.

While the objective of a trader is to make quick profits and deploy them into another trade, the objective of an investor is wealth creation over a longer period to achieve long-term financial goals. Trading is a short-term method fraught with risks, while investing, being long-term, runs lower risks. One can choose to be a trader or an investor depending upon their orientation.

The stock market offers a wide variety of financial instruments or products for you to choose from:

• Shares
• Bonds
• Exchange-traded funds (ETFs)
• Mutual funds
• Derivatives

Investing for the long haul

Spending time in stock market:

Time is the essence of long-term progress. Value is created over time, and therefore, the concept of ‘time in the market’ is not misplaced. This is because markets can be volatile in the short term and long-term investments exhibit lower volatility. To digest short-term blips in the market requires patience and conviction.

Historical market data suggests that the bounce after a blip is often sharp. The benchmark Nifty dropped from an all-time high of 12,430 in January 2020 to a low of 7,511 - a drop of almost 40 per cent in March 2020 - when the Covid-19 pandemic struck. However, the recovery since then has been remarkable.

The market recovered from a low of 7,511 and made an all-time high of 18,604, a recovery of 1.5 times from the lows of the pandemic. A long-term investor with an appetite to hold on to his investments would be a happy man today.

However, if one tends to invest at top of the cycle, say in December 2007 or September 2021, one may have to wait a few years before seeing positive returns on one’s investments. Therefore, the ability to have minimum horizons of at least three to five years is important when entering the investment game. 

Diversification:

Diversification helps in mitigating volatility. Investing in a single stock can have an adverse effect during a volatile event. It may take a very long time to recover, even if the stock is held for a long time. If one is not adept in choosing multiple stocks and building a portfolio, they can invest in ETFs or mutual funds.

Long-term goals:

Long-term goals imply beginning your investment early. Early setting of goals assures a smooth journey of growth.

Tools for investing:

Fundamental analysis or expert advice are the tools for long-term investments.  One can also use technical analysis tools on higher timeframes, like monthly charts, for long-term investment. Some investors combine both fundamental and technical tools for an edge.

Treading the trading path

Trading involves identifying short-term opportunities for profits. Although it is risky as a trade can go against you, it is the most prolific way of making money. And, it’s not easy. One big advantage of trading over investing is that in trading one can play both the long (bullish) and short (bearish) side of the markets. Therefore, those who work very hard at the trading game and keep sharpening their skills may have chances of making money in most types of markets. The challenge, though, is that it requires tremendous emotional discipline, which is difficult to master for most people. This is also why only a small fraction of traders make money over time.

Some traders invest a portion of their yearly profits into other assets or stocks and build their long-term investment portfolio from trading gains. Obviously, this requires a much higher skillset than pure trading or investing, and can be successfully done by only a few.

The process involves forming opinions and entering a trade quickly and for a short time. The risk is very high as volatility is high in the short period. A trader usually has his target and stop-loss figured out before the trade. Stop-loss is a way of reducing loss when the trade goes against the trader. The time horizon of trading can be a few minutes to a few days or weeks.  Another key aspect for a trader is the bet or position size, i.e., what percentage of one’s capital is being risked on a single trade.

Types of trading

Day trading means taking a position for the day and closing it at the end of the day regardless of profit or loss made. Day traders employ many strategies and techniques to identify opportunities. They use tools like technical analysis to define their entry, exits and stop-losses.

Swing trading involves taking positions for one or more days. This involves identifying market swings. Stocks or indices that move within a range of channels are chosen and it requires the trader to be an expert with charts and price actions.

Scalping is a trading method where traders enter into several trades and exit with small profits. The idea is to make quick profits within a very short time, ranging from seconds to minutes. A lot of concentration and nimbleness is required for scalping.

News traders are traders who either take up positions based on their perception ahead of scheduled announcements or take positions from unscheduled breaking news. Markets are full of rumours or grapevines; traders interpret these to quickly enter and exit a trade as the news impact fades with time.

Derivatives trading

Derivatives are financial products that derive their value from their underlying equity securities. Index derivatives derive their value from the respective index while stock derivatives derive their value from the respective stock. Options and futures are by far the most common equity derivatives. The two main purposes of derivatives are hedging against risk and speculation. It is an instrument of risk transfer without the need to trade the underlying instrument.

A good example of derivative from our day-to-day life - curd is a derivative of milk.

Following are the types of derivatives:

Forward contracts are agreements between two parties who come together to buy or sell an underlying asset on a future date at a fixed price. The terms of contract are mutually agreed upon. Forward contracts are subject to high counterparty risks.

Future contracts are similar to forward contracts. However, here the contracts are standardised and routed through an exchange.

Options contracts are contracts that provide the option holder with the right but not the obligation to buy or sell an underlying asset on a specified date at a specified strike price. Options are of two types - call option and put option.

A call option is bought when a trader believes the market will go up in future. A put option is bought if a trader believes the market will come down in the future. A buyer of a call option or a put option pays a premium for buying the option.

We’ll learn more about this as we move ahead.

Points to remember

• Whatever your approach, the key is to stay committed
• Enjoy the process and be involved wholeheartedly
• Plan your approach, know your risks and don’t put all eggs in one basket