What is Trading?
Most people are familiar with the term “trading”. However, it is useful to look at the word “trading” and define it in a way that suits our purpose for trading the Forex market. This is what we will do in this article.
Trading involves the transfer of the ownership of goods or services, from one person or entity to another, in exchange for money, goods or services. A network that allows trading is called a market.
That definition seems precise, simple and clear from a technical standpoint. From this definition, we can say that anything we exchange for money is a form of trading. The term “trading” simply means exchanging one item for another.
When we are talking about trading in the financial markets it’s essentially the same thing as when you exchange your money to buy a pair of shoes from the local shoe store. You walk into the store, look around at all the lovely shoes, pick out the pair that you like, try them on, and if you like them enough you make a purchase of those shoes with your money.
Trading in the Forex market is the exact same process. You open up your trading platform, find a trade you think will make you money, and then you place the trade in exchange for some of the money in your trading account. Job done, you are now a trader in the financial markets.
If you buy a currency pair and the value of that pair is higher when you sell it, then you make money. If the value goes down at the time you sell then you lose money. This is trading in its most simplistic form. You buy something for one price and sell it for another price. The idea is that you hopefully make money when you close your trade.
Then there is the flip side of the coin. In the Forex market, you can also sell a currency pair first at one price and then buy it back at another price. This process is called short selling and it allows you to make money when the price of an asset, such as a currency pair, goes down. The idea is that when you buy the currency pair back you want the price to be lower than the original price that you sold at.
Some people really over-complicate what short selling is. Many traders misinterpret this concept to their detriment and become very confused by the idea. For now, just know that you can make money if the price goes up and you can make money if the price goes down. Short selling simply gives you the ability to make money when prices go down because you sell it first and buy it back second. It is the same as buying and then selling except you simply sell first and buy second.
It is worth mentioning that prices tend to go down faster than they go up so understanding short selling can generate trading profits faster over time.
The Difference between Investing and Trading
Investing and trading are typically perceived to be two very different methods of approaching the financial markets. However, the commonality between them is that each method is attempting to make money on price movements in the various financial markets.
Whether investing and trading are two entirely different approaches to executing transactions in the financial markets really depends on who you ask. There are a lot of people that define each term slightly differently. There are similarities and differences between both but the common thought on what differentiates the two is the time horizon involved to make a profit.
Traditionally, the goal of investing is to build wealth over a longer period of time. Typically, this is done through buying and holding a portfolio of stocks, mutual funds, index funds, bonds, real estate or other investment vehicles. Savvy investors will attempt to make more profits by compounding or reinvesting any profits and dividends into more of the assets that they deem appropriate for their portfolio. They might also like to buy more of their assets when they decline in value because doing this will lower their cost basis and reap more profits if and when the prices go back up again.
Investments are often held for a period of years, or even decades, taking advantage of interest, capital appreciation, dividends, and stock splits that may happen during the longer holding period. While all markets do inevitably fluctuate up and down, investors tend to "ride out" the downtrends with the expectation that prices will rebound over time and any losses will eventually be recovered. Sometimes these downturns in the markets are viewed as good buying opportunities to add more shares at better prices.
Some portfolios of stock have the purpose of buying dividend-paying stocks and then reinvesting those dividends back into the same stocks. The idea here is that every quarter you are paid a dividend for each share that you own, then you reinvest that money into buying more of the same stocks at the prevailing market price. Over time you wind up with more and more shares and also bigger and bigger dividend payouts. This is a very long-term but extremely professional way to compound wealth.
Investors are typically concerned with market fundamentals, such as price/earnings ratios, company management team forecasts, and the outcome of a certain country’s economy. This is called paying attention to the fundamentals over the long term.
Trading is typically viewed as a much more active style of buying and selling assets when compared to investing. The main goal of trading is to outperform the traditional buy-and-hold investment model that investors tend to use. While investors may be extremely happy earning 5-10% per year, traders might seek to gain at least that much on a monthly basis. The percentage gain a trader will aim for on a monthly basis will really be a product of how much time they have to devote to trading, the amount of risk they take, and their overall level of skill.
The goal of trading is to get in and out of the market at a much more rapid pace when compared to investing. There are many different time frames that a trader might look to hold a position but the general amount of time could be from seconds, minutes, hours or even several days.
Sometimes people will try and classify traders by the amount of time that they spend in the market. For example:
- Traders that are looking to be in a trade for seconds to a couple minutes are called scalpers
- Traders that look to hold from minutes to hours are called day traders
- Traders that hold for one day to a couple of weeks are generally referred to as swing traders.
The idea behind trading is that you attempt to get in on a wave of positive momentum, as in the case of going long or buying, and then look to sidestep the times in the market when conditions are not favourable to your trading edge. Trading more frequently requires you to be in tune with the market far more than investing because even small news events can have a huge impact on your trading performance. This is especially true and magnified if you are using leverage in your positions.
Traders in the know will also be concerned with the fundamentals. Fundamentals are very important to investors and to traders alike.
Anyway you try to spin it, trading is geared more toward generating income while investing is geared more toward generating long-term wealth in a sustainable fashion.