What are investors doing that traders should do too? Despite the vastly different strategies that these two groups employ, there are a handful of hints that a trader could successfully take from the typical long-term investor - after all, both groups are just looking to buy low and sell high. In this article, we'll take a look at earnings, market hype, buy-and-hold strategies and diversification - if you think these principles can't be used by traders, think again! Read on to find out how a few tips from investors can help you make better trades.
Tutorial: How To Assess Market Strength
Earnings Still Mean Everything
If sound trading strategy can be boiled down to just one key idea, it's this: You want to move before the rest of the market does. Sounds too simple, doesn't it? However, no matter what technique a trader is using, all he or she is really trying to do is find current opportunities that nobody else has found yet. Later, when others realize the same value, their buying efforts will push stocks higher or lower, as the case may be. There are certainly many techniques to find those opportunities, but they're all ultimately designed to beat the crowd. (For further reading, see Day Trading Strategies For Beginners and Day Trading: An Introduction.)
The goal for traders is to deduce what investors are likely to do to a stock over a particular time frame - usually a short time frame. Now ask yourself, what single piece of data is most scrutinized by the investing crowd? The answer: earnings. The only compelling reason anybody would want to own shares in a company for the long haul is that the company has at least the potential earnings of similar investment options. If a company can't provide adequate compensation for the risk that investors must take on, investors have no real reason to continue holding that stock. If a company can provide risk-commensurate returns, investors will be scrambling for its stock. The problem is that investors can't do all this buying and selling in a very orderly fashion. In fact, the market can get downright disorderly when investors get too emotional about earnings (future or present). When the investing public makes a mistake and provides the trader with an opportunity to take advantage of the likely correction, this is the so-called "sweet spot" for traders.
As a trader, keeping tabs on earnings could provide an edge when it comes to being able to answer two key questions about a company: First, is the company profitable, and what kind of earnings growth are they achieving? Second, and perhaps most important, what kind of response will any earnings news create? It pays to find out whether the company has a history of over-promising and under-delivering as well as how investors typically behave before, during and after earnings news. Also keep in mind that individual stocks have 'groupies' that create reasonably predictable movement patterns around earnings. (Form more information, check out Earnings Forecasts: A Primer and Everything You Need To Know About Earnings.)
Hype Can Defy The Odds
As any trader will tell you, trading is a game of odds, not a game of logic. That's why most traders use some sort of data-oriented or charting software. These programs help traders weigh the odds that a particular event will actually happen. In fact, the more mechanical the trading system, the more effective it usually is.
However, there is a flaw in the methodology. The odds that a trader seeks to define are largely based on history. For instance, a chart-watching technician is looking for particular historical patterns that have repeatedly led to the same result. When that same pattern is seen again in the future, the trader will act on the assumption that the same result will yet again be achieved. This gives the trader an idea of his or her odds for success on a given trade.
The flaw in the trading strategy becomes evident when things go awry. Take the year 1999, for instance. In that particular year, most traders were seeing all sorts of overbought chart patterns - a condition that indicates stocks have moved too high too quickly and are likely to pull back. Despite these signals, stocks didn't pull back until early 2000. Had a trader acted on those bearish signals, he or she would have been well into the red that year.
How can a methodology that works so well in most cases end up working so poorly in others? In many cases, hype and hysteria can overcome odds and tendencies and the historical patterns used to calculate the odds don't account for the kind of madness and euphoria we saw in 1999. In other words, trading software assumes that all trading environments are always the same when, in many cases, they're not. (For more insight, see The Madness Of Crowds and How Investors Often Cause The Market's Problems.)
As a trader, you absolutely must be able to recognize when a particular trading system is ineffective because of an abnormal trading environment. This is tough to do, as it bucks the discipline that most traders have worked hard to develop. However, this skill will save you - and your account balance - a lot of pain.
Buy and Hold - Not Just for Investors Anymore
The term "buy and hold" has become largely interchangeable with long-term investing, but this doesn't mean that it's something a trader should be unwilling to do.
Traders don't just try to get in and out of trades as quickly as possible because they're trying to fit the mold - the issue is one of efficiency. Although everyone knows the market moves, we tend to forget that it moves in short bursts, rather than with a lot of daily consistency. Long-term investors are OK with this; they just want to stay invested so they can benefit from the points when stocks do move. Traders, on the other hand, are simply looking to avoid being in a stagnant stock or index. They prefer to find hot spots or stocks, making the most of time that would otherwise be wasted.
However, as a trader, it's easy to get into the habit of rapid entries and exits, even when you shouldn't. Take the run-up in crude oil prices between late 2001 and early 2006, for instance. Crude futures went from under $20 per barrel to over $70, for a gain of more than 250%. And if you had the full leverage that futures can provide, you would have done even better. Would a trader love to have an annualized gain of that magnitude? You bet! And it could have been achieved with only a handful of contract rollover transactions. However, trading oil futures in the short term (two weeks to three months) proved to be rather difficult over that four-year period. As choppy and erratic as oil prices were, most traders weren't able to reap the full benefit of the major move in oil prices. The most profitable oil futures choice, after commissions, may have been a buy-and-hold approach. It was, after all, a much more efficient trend than usual, and that's all traders are really looking for. (For more insight, read Ten Tips For The Successful Long-Term Investor.)
Larry William's said it best in his book "Long Term Secrets To Short-Term Trading" (1999). He points out that "the longer you can hold a trade, the more money you'll make." That's about the most effective way it can be said.
Diversification Is Always Prudent
Finally, traders should take a cue from the diversity investors seek, at least in a sense. A traditional investing strategy typically has a diversification component to it, primarily designed to limit volatility and provide more chances at holding a winner. Usually this involves spreading a portfolio out among all the major sectors, and sometimes dividing a portfolio up between different market capitalizations and countries. The idea, though, is simple - don't put all your eggs in one basket. (For further reading, see Introduction To Diversification and Achieving Optimal Asset Allocation.)
Traders tend to be at the other end of the spectrum, solely focusing on just one market, or just a small set of securities. That, however, is still too much reliance on one kind of opportunity. For example, in a slow or sideways market, an index futures day trader may not have enough movement in any direction to even cover commissions. Or, in the same kind of involatile market, an option trader may find that time decay is far greater than the net gains of his or her slow-moving option trades. And even for stock swing traders, who focus on a particular group of names (like technology stocks), an individual equity really needs other stocks in the same sector or industry to move in the same direction. Otherwise, those trades make little to no progress.
In other words, any style, market, or strategy has a limited useful lifespan. While it's true that everything is cyclical and that hot markets that turn cold will eventually turn hot again, a one-trick pony may find that he or she is not getting enough viable opportunities over the course of a year to make it worth the effort. Most good traders have a couple of different ways to make monetary progress.
The Bottom Line
Nobody owns the corner on how to beat the market, but investors do understand several concepts that help reach that goal. Traders can use those same concepts too, and significantly improve their returns without significantly changing their approach.
For related reading, check out What Can Investors Learn From Traders?
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