Entering the world of financial markets can be a daunting experience. At first, the more you learn the more questions you have. Often you find yourself knowing enough to realize you know very little, but don’t worry; nobody becomes a trader over night. In order to dispel some of the rumors surrounding trading and put some of your concerns at ease, we’ve compiled a list of the 9 most frequently asked questions about trading. We cover some of the basic concepts pertaining to personal finance, getting started trading, sustainability, expectations, and even some of the more technical stuff.
Yes. Well… maybe.
The main reason why most people start trading, or managing their funds actively, is to earn money. However, most people do so in order to supplement their existing income, and a select few are able to trade professionally. Let’s examine what you would need in order to make trading, and actively managing your funds, your day job and primary source of income.
Let’s start with the basics: the benchmark. There is absolutely no point in trading by yourself if you are unable to outperform the benchmark. The benchmark serves as a baseline for comparison for investors and traders, and is what traders mean when they say “beat the market”. The most commonly used benchmark for trading is Standard and Poor’s 500 Index, or the ETF that tracks it; the SPDR S&P 500 ETF Trust. Investing in the ETF will give you the same return (profit / loss) as investing in the index. If you can’t earn more actively than you would passively, then you’re wasting your time.
Over the last 15 years the S&P 500 averaged an annual return of 9.5%. This means, that on average, the market returns 0.79% per month. Seems reasonable. Now, let’s assume that to replace your job you would need to make a pre-tax income of $60,000 per year. That means that you would need to have $631,578 in your investment account, to earn $5,000 monthly from a 0.79% return. This assumes you don’t reinvest part of your income back into your trading account. Let’s go further to assume that you are capable of realizing a 45% annual return. You would still need $133,332 to earn a comparable income.
However, the real question is whether you can do it consistently. If you’re taking big risks in the quest or big returns it will be difficult to control your downside in the long-run. Trading for a living demands dedication and discipline, and an extensive understanding of financial markets. The reason why many veterans of Wall Street are respected and trusted to handle large amounts of money isn’t always because they deliver stellar returns, but because their experience has taught them how to stay cool under pressure.
What’s most realistic is working, building a trading account with small, regular contributions, which you then trade in order to supplement your income. Think twice about quitting your day job to become a day trader.
No! Trading is not gambling, but it can be used to the same degree.
You are the only person that is able to decide whether you treat the financial markets as a game of chance, gambling away your money, or if you approach trading with a distinct methodology and plan.
When you trade it can be very easy to cross the line from responsible decision making to gambling. In fact, one of the first things that prop and floor traders are taught is how to recognize changes in behavior that is indicative of gambling. One such heuristic is myopic loss aversion, very common with inexperience traders. Myopic loss aversion is the tendency to assume greater risk when you don’t have to witness the outcome. If you find yourself placing a trade and avoiding examining your positions, you have probably bitten off more than you can chew.
If you’re worried that you’re treating the stock market like a roulette table – get out immediately. Make sure your evaluate your mistakes, and go over your due diligence. An understanding of your own propensity towards risk is just as important – if not more – as a good understanding of the financial markets. You’re the only one that can turn a profession into a game of chance.
It depends on what your goals are. If you’re learning it’s perfectly acceptable to trade with a smaller amount of money, but as you gain more experience it’s important for it to be worth your while.
A major limitation of trading with less money is that it changes your consideration of risk. Losing $1000 in the market feels a lot different than losing $10,000. On the other hand, trading a large amount of money with little experience is a recipe for disaster.
Paper trading is a fantastic option, especially in learning how to navigate charts, search for symbols, and and execute the trades. However, many traders consider that it contributes to investor overconfidence, because they naturally assume greater risks when no real money is at stake.
Eventually, it becomes important to trade with enough capital that it’s worth it. For some people making an extra $50 a month is enough, while others might see it as a waste of time. If you’re starting off with a limited amount of capital, focus on growing your account size through strategy, rather than redeeming your gains. By reinvesting in your account you will be effectively compounding your gains, and increasing your future return size. You can start building a diversified portfolio with less than $10.
Not consistently, and not predictably.
The problem with technical analysis is that it falls victim to confirmation and hindsight bias. It is, firstly, easy to examine a stock’s price action in retrospect and identify patterns, and secondly, it’s very easy to find elements that fit your narrative. Technical analysis was no pioneered out of purely mathematical pursuits, but began as an anecdotal study by analysts that referred to themselves as “chartists” – for their fascination with charts. Believe it or not even in the 1600s, when the East India Company traded it’s own stock over-the-counter, there were chartists that would meticulously plot prices in order to find patterns. Notably, they were working with a lot less data and it was easy to infer correlation even in the absence of causation.
The problem with technical analysis, especially in the form of drawing SAR (support and resistance) lines on a chart, is in it’s discovery. As soon as a pattern would be deemed predictable – everyone would act on it. There are still some arguments for technical analysis that point to it’s validity.
Technical analysis is so popular that many claim that it has to work to an extent. The market, and economics in general, is a social science – it only works because we make it work. It quickly turns into a paradox; if everyone believes in mean reversion strategies (such at the RSI), and enough people act on them to the point that it justifies the price action – does that mean technical analysis works, or does it mean that it only worked in that instance?
Principles of behavioral finance also resonate through technical analysis. Humans have a close affinity towards round numbers and pretty integers. This lends to price-action forming horizontal consolidation regions at price thresholds like 100 USD. For instance, travelers are more sensitive to exchange rates (think of EUR-USD @ 1.11, 1.12, 1.13), and therefore, as retail market participants lend themselves to predictability that contributes the resistance areas found in currency rates.
Realistically, gaining a good understanding of technical analysis is useful for becoming more comfortable in interpreting charts, and learning to recognize phenomena such as the post-announcement drift. However, technical analysis as part of a decision making process is not as effective.
Investing and trading are similar practices, stemming from the same idea; the expectation of an increase in value of an asset and the realization of a benefit, however the use of the two words has changed greatly as markets evolved. In the context of the stock market, investing now refers to buying stocks with the intention of holding them for an extended period of time. The investment horizon may be years, but is generally not smaller than a month. Trading is the opposite. Trading refers to investing in positions with the intention of realizing the return on a shorter investment horizon. In reality the only discerning factor between the two is transaction frequency.
Despite this small difference, it is the root of a mammoth debate within the finance community.
On one side, some investors believe that passive investing is the most superior form of achieving returns. It comes from an assumption of long-term growth, and inability to time the market effectively. This view is also supported by countless academics that believe that in the long-run nobody is able to beat the market, especially when activity fees are accounted for.
To traders, the arguments for passive investing can be upsetting. After all, with so many people around the world involved in active fund management, it’s hard to believe that their jobs are effectively meaningless in the long-run. Traders argue that they are able to outperform the market consistently, and that passive-investing will not work when the market enters a long-term decline. After all, even J. M. Keynes said “in the long-run we’re all dead”.
It is impossible to determine which investing style is better or worse. It will ultimately come down to your own perception and – frankly – ego. However, the distinction between investing and trading is clear.
It can be tempting to run in head first, diving into the deep end of the pool – however it may yield undesirable results. Before you even make your first trade it’s important for you to understand yourself, and your relationship with risk. Consider your financial well-being, and determine whether you intend to pursue an aggressive or a passive investing/trading strategy, and the amount of capital that you intend to dedicate to your account. Once you’ve determined your goals, you will be able to build a strategy that will aim to realize those expectations.
The number one thing to remember in the market is to always have a plan, and to stick to the plan. One of the most helpful things to do is to keep a trading journal that outlines and documents your decision making process. There isn’t a “one size fits all” strategy, every trading plan will vary based on risk tolerance. Regardless of whether you place a trade based off intuition, technical analysis, or value investing principles, you should record and reflect on a number of factors.
Start with the idea, write down the date and time, and extensively outline the idea that you’ve had. Then conduct a bit of research, and write down any observations that relate to your ideas. Next, write down your expectations for the trade and your expected holding time. Whether you close the position in a profit or a loss, it’s important for you to revisit the journal and reflect on whether you were right or wrong. Let’s consider a short, fictional, example:
Stock XYZ Healthcare Corp. is trading at $20.5, it's down $7 from it's high after posting uninspiring earnings. You review the financial performance and quarterly guidance, and see that they are developing a new drug and will announce in a couple months the results of the clinical trial. If the results are good, you consider, the stock price should skyrocket. You write all of this down, and buy $100 worth of the stock. A couple months later the stock rises well past your expectations, and you close your position. You've realized your return, but your job isn't over yet. You now have to go back and confirm why did the stock increased in the way that it did. Was it your prudent analysis, or was it an external factor that you didn't consider? Whatever the reason, write it down, and consider whether this factor may be at play in your other positions.
Experience in the market is just a collection of price observations, and remembering what makes prices tick. Keeping a documented account of your thoughts, ideas, and results is the trick to making the most of your time in the market.
Not yet. This is one of the most common questions that we’ve heard asked in the past decade, and it’s not as simple as it seems. Computers are capable of crunching numbers and executing tasks a lot faster than we are, and they’re able to perform optimally – meaning to execute the function that will yield the most desirable outcome. However, a computer or algorithm that hosts a strategy is not able to infer beyond the variables that is is provided with, and those strategies are made by humans.
With the introduction of artificial intelligence (AI) into the framework the strategy is able to change on it’s own – which does provide an edge, while still being limited to the confines of it’s own programmatic and logical DNA. Perhaps in the distant future AI will be able to make discretionary-like choices on a complex systematic level to the point where traders and strategists will be eliminated from the industry, but that’s not happening anytime soon.
The two biggest uses for systematic decision making in trading come from relative-arbitrage, spotting price discrepancies across multiple instruments, and execution, when a fund wants to enter or exit a large position without moving the market.
Believe it or not, it is still commonplace for traders to call each other during the trading day to negotiate the buying and selling of large orders. Additionally, most strategy-generating algorithms are still interpreted by a person before execution.
Not perfectly. It’s easy to get away from this question by saying that nothing is perfectly random, however, usually this question beckons whether the stock market lends itself to predictability. The goal of almost every stock market participant is to find some sort of deterministic behavior that would provide an edge in predicting price action. Even at Morpher we try to find patterns in the stock market, such as testing pre-market predictability.
The debate of stock market randomness dates back to the early 20th century, where mathematicians like Benoit Mandelbrot were trying to answer this very question. It bred discussions of market efficiency, popularized by Eugene Fama with the Efficient Market Hypothesis. Fama suggested that in the most efficient form of the market, prices move unpredictably because everyone has perfect access to information. Since nobody knows when new information comes out, this makes prices move randomly. This is not the case in the real world.
The reality of stock market is that it might as well be considered random. There are statistical properties that lend the market to certain weak forms of predictability. Unfortunately, any profound predictability seldom lasts long, as the market interprets it, reacts to it, and causes it to no longer be valid.
Choosing when to buy and when to sell as stock is difficult, and there is no universally accepted method that will guarantee positive results. Even professionals struggle in identifying the best buying and selling opportunities.
One of the most common ways to trade is by the fundamentals of a company, by trying to find companies that are undervalued. This is a slower way of trading that relies on the interpretation of the quarterly issued company financial reports. By analyzing a company’s financials one is able to determine the profitability, and financial health of a company. One of the simplest metrics that analysts examine is the P/E ratio.
At any given time there is a number of company shares that are circulating the market – these are known as outstanding shares. We take the quarterly profit of the company, and we divide it by the number of outstanding shares, giving us the Earnings per Share (EPS) metric. It tells you how much of the total earnings you can attribute to one share. Then you take the current market price of the stock, and divide it by the EPS – giving you the Price-Earnings (P/E) ratio. The P/E ratio is important because it contextualizes how much investors are willing to pay for the current level of earnings.
Stocks rarely trade for their fair value (how much they’re really worth), because they have expectations factored into the price. Here’s the tricky bit; companies within the same sector (or scope of activities) normally have very similar or close P/E ratios (not price!). For example; semi-conductor manufacturers Nvidia Corp (NVDA) and Advanced Micro Devices Inc. (AMD), are very similar companies, and they trade at a P/E ratio between 36 and 40. Intel Corp. (INTC) operates in the same sector, but hasn’t had the best fundamental performance, and trades at a P/E ratio of 12. If your own market expectations and analysis points to a stellar future performance, you might consider buying the stock, because it’s undervalued when compared to AMD and NVDA. Or you could consider the performance of Intel and determine that AMD and NVDA are incredibly overvalued, and cannot sustain that type of valuation for long, and you may choose to short the two companies.
When it comes to the start market, remember to diversify your holdings, but retain exposure to a niche market that will give you an edge. There are thousands of different ways to pick stocks, so make sure to extensively research which method suits your goals the best.
Disclaimer: All investments involve risk, and the past performance of a security, industry, sector, market, financial product, trading strategy, or individual’s trading does not guarantee future results or returns. Investors are fully responsible for any investment decisions they make. Such decisions should be based solely on an evaluation of their financial circumstances, investment objectives, risk tolerance, and liquidity needs. This post does not constitute investment advice.