Investing and Trading - Differences and Similarities
We have prepared an educational article for the people who are at the start of the road when it comes to financial decisions. Find out what is the difference between trading and investments in the below article.
As with any industry, when you first enter the world of financial markets, one of the first barriers to entry is the language and terminology that is used. And one of the initial difficulties that you may have is having an understanding of the differences and similarities between investing and trading. Here we are going to explore the distinctions and parallels between these differing approaches to financial markets in some more depth.
Whether Investing or Trading when we enter into the realm of financial markets, we are usually looking to preserve our current capital (money) and to hopefully increase this capital, by means of speculation. Speculation really means taking some risks, as there is no easy way to profit and benefit without having some exposure to losing capital, that is making a loss. Here we are going to look at the five main ways we can classify the investing and trading methods with respect to financial markets, by examination of:
1. Time Frame
2. Risk Exposure
3. Leverage (or gearing)
4. Profit Potential
Investing time frame
Generally speaking, investing is viewed as a speculative process to make profits over a longer time frame, that it is a longer-term activity. But what do we mean by “longer-term? If the economic venture that is being entered into, the speculation is being undertaken over multiple months and longer, it would generally be viewed as an investment, therefore as investing. If you are looking to profit from the ownership of a financial asset for over multiple months, then you are more likely to be investing and the holding period for an investment, that is how long you hold onto the asset could have a far longer time horizon, maybe for many years or even for decades.
Let’s take a look at an example. If we bought Apple stock back in 2017 and held onto the stock until 2020 when we then sold the stock, this would be seen as an investment. The purchase may have been at $100 and the sale at $300, giving a profit of $200 per share that was owned during this time frame (as well as any dividends, which we discuss in the Profit Potential section below)
With investing, there are various approaches that investors may use to decide what to invest in. These methodologies would include; value investing, Dollar Cost Averaging, momentum investing and growth investing.
Trading time frame
Trading is generally viewed as being for a much shorter time frame than investing, although there is no defined cut off point when a trade becomes an investment, as it is not only the time frame that differentiates them, as we will explore further below. However, if the speculative activity is under one month, then we would generally not really regard this as investing, but rather as trading.
Moreover, we can also further define the trading approach depending on the length of time the trader looks to enter any trade for, from their trading approach by time frame.
a) Swing Trading or Position Trading: A trading style that sees traders looking to hold positions over at least multiple days to multiple weeks, is described as Swing or Position Trading. As can be seen in the chart below for the German DAX Index, a Swing or Position trade is looking to take advance of the swings that occur in a market during a short- to -intermediate-term trend.
b) Day trading: A very popular form of short-term trading is day trading, which is quite basically trading that is confined to within a day. A day trader’s strategy is to take a view of just what the market may be doing for any particular day, or possibly a 12-24 hour period. Therefore, it requires looking for very short-term opportunities, with any open positions typically closed (exited) before the end of the trading session, Day traders would usually NOT run open positions overnight. Below we look again at the chart for the DAX Index, with day trade opportunities.
c) Intraday day trading or Scalping: This form of trading looks to profit from extremely short-term price movements, taking multiple trading positions throughout the day. A Scalper or intraday trader may hold positions for maybe just a few minutes, over even for less than a minute, maybe for seconds. These types of traders often look to profit from very quick, volatile market movements. The price movements could be triggered by a macroeconomic event, such as a data release, possibly by a technical analysis event, such as the break of a key support or resistance level, or even by a geopolitical incident
Investing risk exposure
Usually, but not always, when we talk about investing, we are often looking at less exposure to risk. Again, generally speaking, investment is usually made over a longer time frame (as we have discussed above) and is slay in a relatively safe asset, like a government bond or a blue-chip stock. Also, as we will discuss below, investing is usually done without leverage, so the value of the asset would have to go to zero for the investor to lose all of their invested funds.
However, some investments are riskier, such as investing in maybe commodity markets or Foreign Exchange, or possibly in less well-known stocks or into Emerging Markets. So, investing does not always necessarily indicate less risk.
Trading risk exposure
When trading, the exposure is often leveraged (see below), which automatically brings greater risks and possible bigger losses. However, there is also often a view that trading is done in more risky asset classes. This is not necessarily the case though, with many traders participating in well know, large-cap shares, or in Government Bond markets. It is the gearing or leverage that brings greater risk exposure. Some traders do, however, participate in more exotic markets such as Emerging Markets, commodities or Forex, which brings even great risks when leveraged.
Investing and leverage
Generally speaking, when one is an investor and investing, there is no leverage. The leverage is at a multiple of 1, which is not leveraged. If one invests in an asset with no leverage, then it would require that the value of the asset that has been purchased to go to a price or worth of zero for the amount invested to be fully lost. In most instances with investing, the maximum loss is the amount invested and this would only occur if the value of the asset was zero. If the value or price of the asset rises, for example by 10%, then the value of the investment would also rise by the same 10%. Occasionally, investing does include some leverage, but if that is the case, it is usually a very low multiple of leverage.
Trading and leverage
Contrary to investing, positions are very often leveraged when trading. With leverage comes the possibility of higher profits than with a non-leveraged position. However, it must be stressed that with leverages or trading on margin, there is also a potential for larger losses. You can see more about leverage in our article on What is CFD Trading?.
Investing and profit potential
When looking at the returns from an investment, we would hope for capital growth, that is the value of the asset increases as the price goes up, thereby the value of the investment increases to make a profit. In addition to his capital growth, there may also be an expectation of some kind of incomer from owning the asset. This may be a dividend in relation to a stock or share, or a coupon payment from a bond.
Trading and profit potential
When it comes to profiting from trading, the general expectation is increases capital in the short-term, via a leveraged product like a Contract for Difference, which would be unlikely to return any income, as the underlying asset is not actually owned. Broadly speaking, profits from trading in the shorter run are from the capital gains from changes in the price of the market.
When entering into an investment, it is generally seen as a purchase of an asset, therefore, the investor owns the asset. That is to say, the investor buys a stock, or a bond and is long the market, looking to benefit from the price of the asset and market when the price rises to make a profit. It is less likely that an investor would sell an asset that they do not own, which is to be short of the asset and benefit in a fall in the price. Investing is usually, long-only
With trading, however, if a trader expects the market to rise, then they can purchase, buy, go long. This way, as with investing, they benefit as the price rises. However, with trading, it is equally likely that the trader can short the market, that is selling the underlying asset, in turn looking to benefit from a fall in the price.