Wednesday, December 5, 2012

Creating a trading system II - Trading versus investing

There is an inherent distinction between traders and investors. Depending on how you think, you may be suited for one versus the other.

An investor likes to think there is an inherent value for an instrument (stock, index, future) and any price below it is cheap and any price above is expensive. The actual value could be determined in a variety of ways.

For example, the simplest way of looking at a stock investment is to look at it as an alternative to buying bonds. Assuming that you could have a stop at 10% below your entry price, a stock that gives a dividend yield of 10% is worth at least breakeven. There are not many stocks that give such a good yield unless they are so cheap due to recent devaluation that owning them is high risk.

In a bull market, a stock expected to perform with the market, i.e. at 7 to 11% annual gain is possibly worth breakeven if it gives a 3% yield with a 10% stop.

When price falls below the current price, the yield and the expected gains increase, and the stock is said to be value for money. Similarly, when the stock makes a large price gain, the expected remainder of the gain and the dividend yield decrease and therefore its expensive.

In reality, no one pays attention to this very common sense way of investing. Most investors buy or sell based on recent strength or weakness or financial advisors or media. Part of the reason is that the best performing stocks often do not pay dividends, but rather reinvest their cash into developing their business.

To account for this situation, there are a variety of fundamental data that investors use to determine value based on PE, earnings growth, revenue to debt ratio, price to sales and so on. The problem with this is that these values are totally disregarded in a strong bull or bear market.

In any case, investment is primarily about determining fair value based on earnings, dividend, growth potential, etc. and buying below and selling above.

A value price may be $10 and there is no sense buying above $10. An investor may want a minimum return of 10% and therefore will only buy at $9 or better. He is likely to sell at $11 since it represents greater than market expectation of gain. He will continue to buy near $9 and sell near $11.

Traders on the other hand, do not think in terms of value but in terms of demand and supply. Fundamentals are but one factor in demand and supply but there are many others such as irrational exuberance and news.

While some traders have successfully married the concept of value in trading using market profile, most traders are better off trading pure demand and supply and disregard all notions of value. Institutional value fluctuations usually do not happen at the minute levels and frequency of day trading. For traders, price is about demand and supply and this is translated to concepts such as support and resistance, trends, legs, etc. In other words, traders trade patterns, investors trade prices.

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