A Guide to Stock Trading Strategies
Broadly speaking, there are two approaches to investing: passive and active. The former entails buying assets and holding them, typically over a period of years, with the goal of building long-term value. This style of investing often makes use of mutual funds, ETFs and indexed assets. By contrast, active investing – sometimes referred to as trading – focuses more on actively trading assets to spot under- or over-valued assets and exploit fluctuations in price. There are several specific strategies one can follow to effectively trade stocks and other securities.
The pair trade is also known as the long/short split or long-short investing. With some assets you take long positions, anticipating an increase. In others, you take short positions, anticipating a decline. You try to find assets related to each other. Pair trading can mitigate risk. If the market as a whole, or the segment you have invested in, declines, your short sales will mitigate your losses. Ideally, however, in the pair trade you will profit off what is called the “spread.” Your long positions will increase in value while your short positions decline, leading to a spread in asset values that maximizes returns.
The golden rule of day trading “never hold a position overnight.” In day trading you purchase and sell assets within the same business day, sometimes within a few hours or even minutes of making the initial trade. The goal is to profit off short-term fluctuations in the market. Instead of waiting for a share to go up by several points, you might wait for it to go up by a single point or a fraction thereof. Day traders generally need to work with large volumes to make money. This is because they need to pay their trading fees and because most trades are relatively small value positions. This is also a relatively risky strategy. While it can pay off handsomely, it can also result in big losses.
Trading the News
This strategy, one of the most common forms of active investing, is based on publicly available information. For example, if the weather looks bad in a coffee-growing region, a trading the news strategy might short Starbucks shares in anticipation of higher coffee prices. News traders strive to act on publicly available information more quickly than the rest of the market or to anticipate an event’s effect that other traders are not anticipating. Arguably every investor is a news trader to one degree or another.
Fundamental Analysis Trading
Fundamental trading is based on an assessment of the underlying company. That assessment is based on metrics like a share’s price-earnings ratio, dividend yield and return on equity. It is important to note that it is a difficult strategy to profit from in the short term. Given that you are working with information available to the entire market profiting off fundamental analysis depends on you seeing something in a company that the market as a whole missed. Passive traders also use fundamental analysis to take their positions. In the case of passive investment they look for companies with long-term potential rather than short- or mid-term growth, but the process is much the same.
Technical Analysis Trading
This type of active investing is based on an assessment of market data of a stock. Technical analysis looks at how shares have performed historically. Specifically, this means how pricing and trading volumes have changed over time. You trade based on trend lines and price movement, metrics that make use of charts and graphs. If the share price has shown volatility that leads you to expect future losses, you might sell. If it has declined below its historic average, you might buy and expect an upward correction. The goal of technical analysis is to predict trends from existing data and then to trade on the basis of those trends.
This trading strategy attempts to make money off the same asset having two different prices in two different places at the same time. Arbitrage, which is extremely short-term, is most common in the foreign exchange markets. For example, say that in New York the British pound was trading against the U.S. dollar at 1 pound to $1.30. At that same moment in London, markets were trading 1 pound for $1.35. In that case you could buy 1 million pounds for $1.3 million in New York then exchange your 1 million pounds for $1.35 million on the London market. You would have made $50,000 in two trades.
Communications technology has made this strategy challenging. Markets around the world are highly interconnected so exploitable price differences rarely last for very long. In our example above, you would not be the only person to notice this. Traders – or their algorithms – would leap on the difference between New York and London prices in a flurry of trading that would align the two markets. In most cases this alignment takes minutes, if not seconds, to resolve. Being consistently successful at arbitrage is extremely difficult.
The Speculation/Investment Split
This is less of a trading strategy than an overall approach to investing. In this plan you organize your portfolio by assets you need and assets you can afford to lose. Money that you need to hold onto, retirement funds for example, gets invested according to a low-risk, passive strategy. Typically you will invest this in something like an index fund or a mutual fund that posts solid returns. Money that you can afford to lose goes into the speculative basket of your portfolio where it buys equities and other higher-risk, higher-reward assets. Typically this is a minority section of your portfolio, anywhere from 10 percent on the low end to 40 percent on the very high end.
The Bottom Line
There are numerous active trading strategies, all of which require much closer attention than passive investment. Some strategies are more challenging – and potentially lucrative – than others. There’s no need to take an either-or approach to these; it’s OK to mix and match. Whichever you pick, do your homework and be disciplined.
Tips for Investing
Consider talking to a financial advisor about which investment strategy is best for you. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
There are other ways to categorize types of trading strategies besides active and passive. Here’s an overview of some of the other ways to think about some investing strategies and goals. Also, if you’re new to investing, check out this helpful investment calculator.
Photo credit: ©iStock.com/dima_sidelnikov, ©iStock.com/400tmax, ©iStock.com/Tuned_In
The post A Guide to Stock Trading Strategies appeared first on SmartAsset Blog.