What is the difference between investing and trading? Whole volumes have been written on the subtleties. Although some educators teach that trading is a type of investing, we need to make a different distinction today. Investing, for purposes of illustration, is the practice of allocating funds in a buy-and-hold market move, generally with a market order, where small differences in price are inconsequential to the portfolio objective, which is seen as long term. Trading is about the mechanics of bringing a buyer and seller together and making money during and because of the transaction itself. By definition, executing a stock trade is an "instant-in-time" sort of transaction, whereas investing time horizons can be years. (To learn more, see Buy-And-Hold Investing Vs. Market Timing.)

TUTORIAL: Behavioral Finance

Effect of Time Horizon on Significance of Price Movements
The small differences in price, which are inconsequential to the investor, are at the heart of trading (in addition to a transaction fee volume if you are a professional). If we buy a security one day for $30 and sell it a week later for $31 or $29, the dollar difference is small compared to buying Microsoft at $21 during the company initial public offering (IPO) in 1986 and holding it until 2001 when it was equivalent to $10,000. Even less significant, are the minute-by-minute "streaming quote" differences of a "tick."

However, if you make trillions of trades and profit a little on every one, these small differences add up. The "market's inefficiencies" are based on an unspoken agreement between investors and traders because of this difference in where profit comes from. In the outlook of an investor, profits don't come from a zillion pennies. For a trader, taking a risk over decades is more dangerous than trying to profit no matter which way the market is heading.

Setting and Taking
"Traders set the price, investors get the price," is another important way to distinguish the two activities; however, there is trouble on the horizon. The "gentleman's agreement" where the "average investor" makes a market order purchase to buy and hold, breaks down when the average investor decides she or he wants to make a short-swing profit. Suddenly, the differences in objectives make an "uneasy truce" between the two sides' outright competition. The side with a thousand shrewd traders, with banks of computers calculating spreads and setting the price, is most likely to win.

There is a sad recent phenomenon not always spoken about candidly, or sometimes even joked about by professionals: the "amateur trader" has become a significant new profit opportunity for professional traders. If we trade often, we're incurring significant transaction costs and playing a game we can't win, if we remain unconcerned or unaware of which side of the bid/ask spread we're "harmonizing" with, or who is on the other side of the trade. In other words, we can't be a price-taker and ever profit from trading, especially playing against large institutional traders who can't lose, because they can set the price.

In economics, there is a technical term called a "price-taker." This means that you can make a buying or selling decision and your output is assumed not to affect the price. (Actually, MR=delta TR/delta q =(p*delta Q)/delta q=p, or MR is inelastic with respect to output so the price graph is horizontal, but we don't need to go into all of that). In practical terms, if someone has a monopoly, their own actions can set the price they charge, because, if you control supply, demand has to take the price you charge.

Pretend you're doing the opposite: you decide to sell water. You are selling a product that is available from a zillion other places and for which consumers can see prices everywhere, from their water bill to the supermarket. If you decide to set the price of a gallon of your water at $10, you will likely sell zero, because as a commodity, even differentiated water from icebergs might sell for $1.20 instead of 95 cents a gallon in a health food store. The feeling that you can't really set your own price or control your own margins is what a price-taker feels like to an individual in an efficient market, or to a company with very small market share amongst a pack of other suppliers.

So, how can traders dictate prices and you become a price-taker, when markets are supposed to be efficient? Shouldn't they be takers too? Technically, yes, but there is another side to the trade when it happens at an instant in time: for every trader who wants to "buy low/sell high," there has to be another trader with disparate information on the other side of the trade, who the first trader thinks is "buying high" (by definition). The second trader thinks they're also "buy low/sell high" but both cannot be right at the moment of the trade. If the second trader turns around and tries to sell quickly, they're facing into no-win odds, because they are bringing the wrong tools to the game.

Are Markets Efficient?
These discrepancies happen because markets and information are not always efficient. Professional traders have access to information and use techniques not well understood by average investors. The most important example on this topic is the trade objective/type interface. When you sign in to your online broker and the little pull-down menu lets you select market or limit order, the average investor, time and again, chooses market. That means, "hey, I want this stock, go grab it for me at as close to what its trading at right now."

The investor is focused on that particular stock and isn't as concerned with technicalities like limit orders. The objective is to buy that stock because it is hot, loved, underpriced, based on a tip, etc.; we are target-fixated on the stock and don't care as much about small differences in price, as getting it right away while it is low or before it goes up. Frantic novice day traders think that's how day trading works, but this couldn't be farther from the truth.

A shrewd trader is more likely to take their time, carefully set a price trap and wait for the wildebeest-novice to step in it. Shrewd traders do not want to be price-takers, they want to set the price, so they always use some form of limit order. Never, ever (ever) buy at market for a short swing; market orders are (by definition) putting a little red "kick me" sticker on your back that says I'm a price-taker. It's OK to be a price-taker in an efficient market where our objective is long-term growth, but not in a time horizon where profit comes from setting prices and capitalizing on market inefficiencies.(For more insight, see Working Through The Efficient Market Hypothesis.)

The Bottom Line
Professional traders play with a loaded deck. They make money whether the market goes up or down, on pure transaction volume and their ability to set prices. Understanding limit orders is the first step to success. Like any shrewd buyer, you are saying, "hey, here's my price: take it or leave it" and you are willing to walk away over that price. If you do this and are sitting waiting with a block of other "pros" you are playing their game. To do this, we have to be absolutely detached from wanting a particular stock at any price.

Related Articles
  1. Investing Basics

    Earn More Profit With Less Trading

    Avoiding overtrading can save your money and your sanity. Find out how to slow your turnover and build your profits.
  2. Investing Basics

    The Basics Of The Bid-Ask Spread

    The bid-ask spread is essentially a negotiation in progress. To be successful, traders must be willing to take a stand and walk away in the bid-ask process through limit orders.
  3. Investing Basics

    Long-Term Investing: Hot Or Not?

    Forget the latest craze - you're more likely to succeed with a buy-and-hold strategy.
  4. Entrepreneurship

    The Giants Of Finance: Andrew Carnegie

    Though not as well-remembered as some of his contemporaries, Andrew Carnegie's legacy is strong and moralistic.
  5. Trading Strategies

    10 Tips For The Successful Long-Term Investor

    These guiding principles will help you avoid common folly during the decision-making process.
  6. Active Trading Fundamentals

    The Stop-Loss Order - Make Sure You Use It

    It's a simple but powerful tool to help you implement your stock-investment strategy. Find out how.
  7. Technical Indicators

    Using Pivot Points For Predictions

    Learn one of the most common methods of finding support and resistance levels.
  8. Investing Basics

    Quit Your Job To Trade Stocks

    Changes in technology have turned trading into a career field that’s easy to enter. But staying in it is a different story.
  9. Active Trading Fundamentals

    5 Must Watch Films and Documentaries for Day Traders

    Discover these five must-watch films and documentaries for day traders reviewed with the takeaway lessons that inspire, motivate and entertain.
  10. Trading Strategies

    The Traits All Baller Traders Have In Common

    When it comes to traders, these are the traits that separate the wheat from the chaff.
  1. What are the key differences between pro forma statements and GAAP statements?

    The U.S. generally accepted accounting principles (GAAP) require companies to adhere to uniform reporting standards that ... Read Full Answer >>
  2. Is it better practice to use a stop order or a limit order?

    Both stop orders and limit orders have their advantages and disadvantages; traders need to decide between the two based on ... Read Full Answer >>
  3. How do day traders capture profits from the difference between bid and ask prices?

    Day traders capture profits from the difference between bid and ask prices by scalping stock. Sensing that a stock is going ... Read Full Answer >>
  4. How is buying on margin regulated by the Securities and Exchange Commission (SEC)?

    The Federal Reserve Board and the Financial Industry Regulatory Authority (FINRA) regulate buying on margin to a greater ... Read Full Answer >>
  5. How do the C-suite members work together to make a successful company?

    Corporate managers, typically chosen by a board of directors in large organizations, are ultimately responsible to stakeholders ... Read Full Answer >>
  6. Why is the Vortex Indicator (VI) important for traders and analysts?

    Doug Siepman and Etienne Botes developed the vortex indicator to anticipate reversals in price trends. They believed that ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center