TRADING OR INVESTING: WHAT’S THE DIFFERENCE?

The terms investing and trading are often used interchangeably when it comes to markets. But the two are actually very different — and you really should know the difference.

Whenever you open a position, you should know whether you are trading or investing so that you know why you are opening a position and how, when, or why you will exit the position.

The basic differences

When you are trading, you are focused primarily on price. If you are making an investment, you are concerned with both price and value.

Value and price may seem the same, but there is a difference: price is what you pay, value is what you get.

In the short term, price movements are the result of changes in supply and demand for an asset. Over the long term, prices change because the value of the asset changes.

Trading usually has a far shorter time horizon because, while supply and demand can change quickly, value seldom changes quickly. A trade can last anywhere from a few seconds to a few months, or in some cases a little longer. Trading is more speculative as traders speculate on changes in supply and demand.

Investing, on the other hand, is reliant on the value of an asset changing. This can occur due to the way a company or economy is managed, growth in the size of a market, or any number of other factors.

What affects supply and demand?

In the short term, the price of an asset is driven entirely by supply and demand. When supply and demand are balanced, the price will move very little – usually trading in a range or consolidating. When demand exceeds supply, prices rise until equilibrium is reached. The opposite occurs when supply exceeds demand.

Sentiment is the primary driver of supply and demand. This can refer to overall market sentiment, sector-specific sentiment, or sentiment around an individual asset.

News can cause rapid changes in sentiment. This can take the form of political, economic, or company-specific news.

Volatility also changes the supply and demand dynamics. When market volatility rises, demand for risky assets falls while demand for safe-haven assets increases.

Support and resistance levels are used by many traders to indicate where demand will increase (support) or where supply will increase (resistance). This reinforces these levels and traders are prone to sell at resistance and buy at support. However, when these levels are broken, traders liquidate their positions causing the opposite to occur.

Other factors that can change the supply and demand dynamics include changes in the constituents of an index and regulatory changes.

What determines value?

Currencies and commodities are usually viewed as trading instruments, though they may occasionally have a place in an investment portfolio. Equities and bonds can be traded or invested in.

Currency investments can be made based on two factors: value and interest rates. If you hold a currency, you will earn interest. If the interest rate increases, you will earn more interest. The value of a currency will also appreciate if the size of an economy increases while the money supply stays constant. Generally, cash is not a good investment, unless a currency appreciates substantially against other currencies, or other asset classes lose value.

Bonds also pay interest, and their value changes when interest rates change. If you buy a bond and interest rates fall, you will make a capital gain and earn interest on the bond. If interest rates fall, you will still earn interest, but the value of the bond will fall.

Commodities gain value when demand increases faster than production can be increased. This can happen when rapid economic growth occurs, and producers can’t increase production quickly enough.

Equities are the asset class most widely held for investment purposes, apart from perhaps real estate. You would invest in listed shares for the same reasons you might invest in an unlisted company. A good equity investment will pay dividends and the value of its assets will appreciate over time.

Value investors look for companies trading at prices that are below their intrinsic value to give them a margin of safety. Growth investors look for companies that will grow their profits which will lead to the company’s value appreciating over time.

Trading vs investing: which is better?

Both trading and investing serve a purpose. Trading can generate returns faster but carries more risk. It’s a good idea to continually invest for the long term, and trade to generate short term profits. Some trading profits can then be moved to your investment portfolio to continually reduce your overall risk.

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