Many people consider stock trading and stock investing to be the same thing, but they are not. They occur in the same manner, and similar research may be used when determining what to buy, but the intent of trading and investing varies greatly. Both investors and traders operate with the intention of generating returns, but the expectations of how those returns will be realized vary greatly.

In this chapter, you’ll learn about the differences between trading and investing, and we’ll explore the fascinating life of a day trader. We’ll look at some of the rewards and risks associated with trading, including speculating, which, as far as we are concerned, is never a good idea.

At the end of the chapter, you should be geared up to learn how to become a stock market investor. Trading has its place, and some people have done very well by it. For the great majority of people, however, investing is the smarter route.

Investing is a long-term process based on the study of fundamentals such as a company’s earnings, sales, debt, and industry outlook. Fundamentals are what investors look at to determine the outlook for a company and how its stock will perform in the future, and you’ll be learning much about them in later chapters. The study of fundamentals regarding a company is called fundamental analysis.

An investor, at least a smart investor, makes an informed decision to purchase the stock of a particular company, and, because he’s done his homework, he can be fairly confident that, over time, his investment will increase and he’ll realize some returns. That means he doesn’t get overly excited if the value of his stock increases or decreases, and he doesn’t feel the need to micromanage his portfolio. He doesn’t lie awake at night wondering if he can make up tomorrow what he lost today, or if he might lose tomorrow what he earned today.

Trading, on the other hand, is a quick succession of buying and selling of stock, based not so much on fundamentals as on what the market is doing at any given time. A trader has an immediate, or at least a short-term, goal of appreciation of capital. That means that stock must be watched closely, so that it can be acquired or sold to meet that goal. It’s sometimes said that a day trader concentrates on the view as to the next price movement of a stock. He or she certainly isn’t looking at the overall market, or even at the particulars of an individual company.

You’ll read more about income taxes in Chapter 22, but you should know that short-term trading has its disadvantages. Under the wash-sale rule, an investor can’t deduct a loss on his tax return if he buys the stock back within 30 days.

While investors tend to rely on fundamental analysis, most traders lean more toward the use of technical analysis, which is a method of evaluating stocks by looking at statistics based on market activity such as volume or pricing. Technical analysis involves the use of charts and other tools to spot patterns, which are considered predictors of future activity.

Traders who buy and sell securities within a single day are called day traders. Some people work at day trading as a profession, while others are amateur day traders who trade with their own funds or on behalf of someone else.

Day traders have been the subject of a lot of controversy, and often are painted as greedy and reckless speculators looking to get rich quick. While that description might apply to some, day trading is a legitimate business, and some people do it very well and have made lots of money in it. Many others have not done as well. So, who are these day traders, and how do they operate?

Being a successful trader, as you can imagine, requires a lot of study, and a sound understanding of market trends and the events that cause stock prices to move up and down. Most day traders are well educated and have significant resources, both of which are necessary qualities for success. Day traders also must have steady nerves and great focus, as they have to act quickly as opportunities arise. Day traders share the goal of buying low and selling high with other investors; it’s just that they do so in minutes or hours instead of months or years.

Among professional day traders, some work on their own and some work for financial institutions. Those who work for financial institutions, called institutional day traders, have access to lots of fancy analytical and trading software, support teams to help with research or news analysis, trading tools, and lots of money.

Those who work on their own often don’t have the advantage of state-of-the-art equipment, but they do have access to a very large number of Internet resources, such as day trading platforms and sources for news that could affect the market. Most day traders employ direct access trading systems, which use trading software and high-speed computer links to stock exchanges. Direct access trading systems allow day traders to execute trades almost instantaneously, with confirmations immediately displayed on their screens.

Successful day traders make money by making numerous trades throughout the day. That allows them to maximize profits through volume trading. Day traders might make 30 trades or more during one day, generally selling everything before the end of the day to avoid overnight price fluctuations.

Initially, day traders buy part of a position, some shares, and then if a stock continues or begins to move higher, they add a little more to the position. If a stock moves up a certain percentage or dollar amount, the shares are sold. Shares are sold immediately if the shares go down. A small loss can turn into a large loss quickly, so day traders sell quickly to keep losses at a minimum.

Day trading is not for the faint of heart. While the Internet is loaded with success stories from defenders of the practice, it’s also got tons of tales of woe, like the schoolteacher who became so addicted to day trading that he eventually lost his job because he couldn’t stop trading during classes, or the young man who one day realized he owed more than a quarter of a million dollars in taxes—money he didn’t have.

Speaking of taxes, a problem with day trading is that, as you read in Chapter 4, gains on investments held for less than a year are taxed at the same rate as your regular income tax rate. So in day trading, big gains result in big tax bills, and that’s been the downfall of some traders, like the young man mentioned previously, who didn’t reserve enough of the gains to pay them.

While best left to the pros, an increasing number of amateurs are testing their hand in day trading, sometimes to the detriment of their careers and relationships. The U.S. Securities and Exchange Commission warns that “day trading is extremely risky and can result in substantial financial losses in a very short period of time,” and advises people who are trading or considering day trading to read its publication, “Day Trading: Your Dollars at Risk.” If you’re thinking about trying your hand at day trading, you can check it out at www.sec.gov/investor/pubs/daytips.

Even if trading is profitable, it tends to be more expensive than holding stock for a period of time. An investor incurs expense through brokerage fees both when he buys and sells shares of stock. Even at deep discount brokerage charges of $7.95 or $8.95 per trade, these charges add up if you trade often.

We would never advise anyone to begin day trading, and particularly not someone at your current level of investing knowledge. Consider that legendary investors like Warren Buffet are proponents of intentional, long-term investing, not day trading.

Speculation occurs when someone chooses stock based on the expectation that its value will increase rapidly and can be sold at a higher price than for what it was purchased. Speculation is not based on knowledge of fundamentals or underlying value or the industry futures or any of the factors that investors consider before buying stock. It’s a guessing game, and it’s risky.

So, you ask, doesn’t everybody buy stock with the expectation that its value will increase and they can sell it at a higher price? Well, yes. Certainly, that’s the point of investing money. You want to select a stock that, because of its inherent value, will increase in value and result in returns. Speculation, however, doesn’t pay much attention to the inherent value of a stock; its concern is only that the stock will increase in value as other speculators buy it and force up the price.

Some consider speculation to be just a form of gambling, and in some ways it is. But in other ways it’s different, because speculators (at least the smart ones) buy what they buy based on information. Of course, there are speculators who buy based on a tip overheard at a cocktail party, but many speculators are financially savvy and their speculation is based on informed decisions, just not the sort of informed decisions that investors use as a basis for buying and selling stock.

If you feel the need to trade speculative stocks, allocate a very small portion of your portfolio to this very risky activity—no more than 1 or 2 percent. And if you lose that money, don’t take any additional from your current portfolio. Save up more money before you begin again.

Speculation occurs at all levels and in all areas of finance. People speculate with stocks, bonds, currencies, real estate, collectibles, and other entities. Speculation is a controversial topic among economists, some of whom claim it’s valuable to financial markets, and others who say it increases volatility and can wreak havoc if it goes unchecked. One thing is for certain: speculation is not investing, and it shouldn’t be used as a substitute for informed purchasing of long-term investments.

You read a little bit about short-term and long-term investing in Chapter 4, so you know that, for our purposes, a short-term investment is one you keep for less than three years, and a long-term investment is one you keep for more than three years.

Stock market investing is generally a long-term endeavor. History tells us, without a doubt, that the stock market is a good place to park your money if you plan to keep it there for a long time. Positive years in the market far outweigh negative ones, and if you’re willing to ride out the negative years you will be successful.

Short-term investments sometimes are necessary because you’ll need the money in a short period of time. The stock market, however, is not a good choice for investing for the short term.

The market has its highs and lows, but as a whole, there are more up years than down years, as shown in the following table. Investors who are willing to ride out difficult periods most likely will realize a return over time and will benefit from long-term investing.

With only seven of the years between 1975 and 2010 resulting in losses in the annual returns of the Standard & Poor’s (S&P) 500, it’s easy to see that long-term investing, although sometimes nerve-wracking, is a sound strategy.

You’ll notice that this section is about short-term trading, as opposed to short-term investing in the stock market. As you’ve just read, short-term investing and the stock market are not compatible, and you should consider other investment vehicles, such as a money market fund, short-term bond, or certificate of deposit if you’re looking for a short-term investment. The stock market is not a place to be if you are going to need the funds within a short time frame. That’s because if you’re looking at a short-term investment, it probably means that you have a target date for when you’ll need the money you’re investing. There’s just no way to accurately predict where the market will be at your target date and, therefore, no way to assure your investment will be there for you. As tempting as it might be to think you can jump into the market and trade your way to big returns, it’s not realistic, particularly at the level of investing knowledge you currently find yourself.

Chances are that you’ve heard or read about someone who’s made a killing from short-term trading. Again, though, it’s a risky business. If you do decide to jump into short-term trading, consider the following advice.

Technical analysis, which most short-term traders rely upon, includes looking at moving averages, which are the average price of a stock over time. Moving averages are used to measure the general trend of a certain stock, and they’re normally measured over 10, 20, 30, 50, 100, and 200 days. Stocks that stay above the average would be considered healthy, while those that fall below would not.

The price movement of the stock relative to its moving average is often used as a buy/ sell indicator. If a stock price crosses a moving average line from above, it’s considered a bad sign and an indicator to get rid of the stock. A rising stock price that crosses a moving average line from below, however, is a good sign, and a signal to buy.

Technical analysis also relies on relative strength indicators (RSIs), which compare the amount of recent gains to recent losses in order to figure out whether a stock is either overbought or oversold. The RSI ranges from 0 to 100. A stock is considered to be overbought when it reaches the 70 level. This is an indication that the stock may be selling for more than it’s worth and a signal for a trader to sell it. A stock that reaches 30 on the RSI chart is considered to be oversold and a candidate for becoming undervalued. Traders look for oversold stock.

Traders also use technical analysis to recognize market trends, which are simply either upward or downward drifts of the market. As you read in Chapter 2, a downward market trend is called a bear market, and an upward trend a bull market. Traders buy more stock in a bull market than in a bear market.

If you’re going to trade on a short-term basis, it’s important to control your risk to the greatest extent possible. One step in doing that is to employ stop orders and limit orders, which you’ll learn more about in Chapter 16. Basically, you decide at what price point you will buy or sell a stock and place a brokerage order indicating that. That way, if the price of your stock drops below a certain level, it will automatically be sold, limiting your loss. If it increases, you’ll realize a profit by selling the stock.

If you look at stock market performance over the past 50 or 60 years, you would notice that most of the gains have occurred between November and April, and the period between May and October tends to be flat. Certainly there have been exceptions, and this doesn’t mean that you should limit your investments to the months between November and April, but it’s something to keep in mind if you’re looking at short-term trading.

Conventional Wall Street wisdom advises investors to “sell in May and go away,” suggesting that it’s a good idea to sell your stock in May and sit out the market until fall comes around. A big proponent of this axiom is Jeffrey A. Hirsch, the editor of the Stock Trader’s Almanac, a yearly report of stock market data, statistics, and trends collected from over the past 100-plus years. Hirsch claims that data collected between 1950 and 2008 indicate that the Dow Jones Industrial Average gained an average of 7.3 percent for the November-through-April periods of those years, and only 0.4 percent during the May-through-October periods. This phenomenon is attributed to the theory that vacation season begins in May and investors are more interested in hitting the beach than trading stock. Reduced trading tends to pull down or hold down markets, and the prices of securities fall.

Successful short-term traders generally are knowledgeable and experienced, with a thorough understanding of how the market works. There is a lot more involved with short-term trading than what you’ve read here, and if you’re thinking about getting involved in it, you’ll need to learn much more about it if you hope to be successful.

The Least You Need to Know