You know that the stock market provides an opportunity to make money, but you aren’t quite sure how investors know when to buy and sell. Or maybe you’ve heard some terms like “noise trader” or “arbitrage trader” and you want to know more about them. Either way, an exploration of a few of the many types of trading strategies will provide some insight into the terminology and strategies used by various investors as they seek to build wealth by investing in the stock market. Understanding these strategies can help you find one that best matches your personality.
Fundamental trading is a method by which a trader focuses on company-specific events to determine which stock to buy and when to buy it. To put this in perspective, consider a hypothetical trip to a shopping mall. In the mall, a fundamental analyst would go to each store, study the product that was being sold, and then decide whether to buy it or not.
While trading on fundamentals can be viewed from both short-term and long-term perspectives, fundamental analysis is often more closely associated with the buy-and-hold strategy of investing than it is with short-term trading. That noted, the definition of “short term” is an important consideration.
While some trading strategies are based on split-second decisions and others are based on trends or factors that play out over the course of a day, the fundamentals may not change for months or even years. At the shorter end of the spectrum, for example, the release of a firm’s quarterly financial statement can provide insight into whether or not the firm is improving its financial health or position in the marketplace. Changes (or lack of changes) can serve as signals to trade. Of course, a press release announcing bad news could change the fundamentals in an instant.
Fundamental trading has a real appeal to many investors because it is based on logic and facts. Of course, unearthing and interpreting those facts is a time consuming, research-intensive effort. Another challenge comes in the form of the financial markets themselves, which do not always behave in logical ways (especially in the short term) despite reams of data suggesting that they should.
Noise trading refers to a style of investing in which decisions to buy and sell are made without the use of fundamental data specific to the company that issued the securities that are being bought or sold. Noise traders generally make short-term trades in an effort to profit from various economic trends.
While technical analysis of statistics generated by market activity, such as past prices and volume provides some insight into patterns that can suggest future market activity and direction, noise traders often have poor timing and over-react to both good and bad news.
While that description may not sound very flattering, in reality, most people are considered to be noise traders, as very few actually make investment decisions solely using fundamental analysis. To put this style in perspective, let’s revisit our earlier analogy about a trip to the mall. Unlike the fundamental analyst, a technical analyst would sit on a bench in the mall and watch people go into the stores. Disregarding the intrinsic value of the products in the store, the technical analyst’s decision would be based on the patterns or activity of people going into each store. Technical analysis, like other strategies that involve data analysis, can be time consuming and may require quick reactions to take advantage of perceived opportunities.
Sentiment traders seek to identify and participate in trends. They do not attempt to outguess the market by finding great securities; instead, they attempt to identify securities that are moving with the momentum of the market.
Sentiment traders combine aspects of both fundamental and technical analysis in an effort to identify and participate in market movements. There are a variety of sentiment trading approaches, including swing traders that seek to catch momentous price movements while avoiding idle times and contrarian traders that try to use indicators of excessive positive or negative sentiment as indications of a potential reversal in sentiment.
Trading costs, market volatility and difficulty in accurately predicting market sentiment are some of the key challenges facing sentiment traders. While professional traders have more experience, leverage, information and lower commissions, their trading strategies are restricted by the specific securities they are trading. For this reason, large financial institutions and professional traders may choose to trade currencies or other financial instruments rather than stocks.
Success in this endeavor often requires early mornings studying trends and identifying potential securities for purchase or sale. Again, analysis of this nature can be time consuming and trading strategies may require quick timing.
Market timers try to guess which direction (up or down) a security will move in order to profit from that movement. They generally look to technical indicators or economic data in order to predict the direction of the movement. Some investors, especially academics, do not believe that it is possible to accurately predict the direction of market movements. Others, particularly those engaged in short-term trading, take the exact opposite stance.
The long-term track record of market timers suggests that achieving success is a challenge. Most investors will find that they are not able to dedicate enough time to this endeavor to achieve a reliable level of success. For these investors, long-term strategies are often more satisfying and lucrative.
Of course, day traders would argue that market timing could be a profitable strategy, such as when trading technology shares in a bull market. Investors who purchased and flipped real estate during a market boom would also argue the market timing could be profitable. Just keep in mind that it’s not always easy to tell when to get out of the market, as investors that got burned in the tech wreck crash and real estate bust can attest. While short-term profits are certainly possible, over the long term, there is little evidence to suggest that this strategy has merit.
Arbitrage traders simultaneously purchase and sell assets in an effort to profit from price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. This type of trading is often associated with hedge funds, and it can be a fairly easy way to make money when it works. For example, if a security trades on multiple exchanges and is less expensive on one exchange, it can be bought on the first exchange at the lower prices and sold on the other exchange at the higher price.
It sounds simple enough, but given the advancement in technology, it has become extremely difficult to profit from mispricing in the market. Many traders have computerized trading systems set to monitor fluctuations in similar financial instruments. Any inefficient pricing setups are usually acted upon quickly and the opportunity is often eliminated in a matter of seconds.
So maybe none of these trading strategies seem to be a good fit for your personality? There are a host of other strategies to consider, and with just a little research you may be able to find a strategy that is a perfect fit for you. Or perhaps proximity to your investment goals rather than company-specific factors or market indicators is the primary factor driving your buy/sell decisions. That’s okay. Some people engage in trading in an effort to achieve their goals. Others just buy, hold and wait for time to pass and asset values to rise. Either way, knowing your personal style and strategy will help give you the peace of mind and fortitude to remain comfortable with your chosen path when market volatility or hot trends make headlines and cause investors to question their investment decisions.
P.S. Subscribe to this blog for a timely information on the basic of stock market investing.