The difference between active and passive trading is like the difference between the actions of one individual versus the actions of a group as a whole; an alternative way of thinking about active trading is like trying to bet on who will win the Super Bowl, while passive trading would be the ability to profit as all the NFL teams collectively made money on ticket and merchandise sales. Each strategy has certain advantages.
Each strategy has certain advantages. In passive investing, a lot of return can be collected after significant time if stock takes a favorable course. But for volatile stocks that are not expected to necessarily rise greatly over months or years to come, short term transactions that exemplify the active investing style can make the most of the market.
A: Active traders
Active traders sometimes border on the fanatic. They read everything on investing, study the stocks, and subscribe to magazines, associations, or newsletters. Their motivation can be to flip stocks and make money fast, or it can be the satisfaction of finding a treasure missed by Wall Street pundits. Whether driven by wealth or ego, this type of investor turns investing into their hobby and even passion.
These investors learn how to read financial statements, market predictions, economic analysis reports, and editorials. They learn the names of the world's best economists, and are familiar with the London and New York Times Newspapers.
An active trader buys and sells stocks with the intention of making money in the short term. Active traders typically don’t hold individual stocks for many months or years, and generally do not focus upon long-term economic trends.
Also, an active trader who seeks to buy and sell the same stock shares during a single day often fits the definition of a “day trader”.
Being labeled as an active trader under the definition of “day trading” is defined by three main characteristics:
- Time frame - Very short ,usually within a trading day.
- Purpose - Active traders attempt to profit from the daily price fluctuation of a particular stock. They rely on technical analysis rather than fundamental analysis for predicting these price fluctuations.
- Volume - Active traders make multiple trades throughout the trading day. In addition, active traders usually scale out of positions, meaning they sell portions of their investment throughout the trading day.
Day traders have the potential to make (or lose) money quickly, but must devote much more time to trading than most long-term investors do.
Active traders prefer stocks that are rising and promise to be a forerunner for future outperformance. They have one focus, accelerating earnings, such as from a company which has tapped into a new product or innovation that promises to hit the market hard. There are many approaches to picking stocks, based on a number of factors including stock price behavior, markets, and earnings growth.
Active traders aren’t involved in trading to earn money from corporate dividends. They also do not usually purchase preferred stock, which offers benefits that are oriented toward people who invest for the long-term.
Compared to other traders, somewhat different tax rules apply to active traders. Pages D-3/4 of the Schedule D instructions provides details on these differences, as well as additional information on how to determine the definition as an investor or trader.
B: Passive traders
This type of stock trader is often interested in investing their money, but they do not want to spend their weekends studying financial statements, markets, and even weather reports. This type of investor laughs at the good luck mantras and charms used by some investors. They are often happy to put their money in the hands of a broker and walk away.
The passive trader creates a plan, researches stocks, invests, and then patiently waits for a return in the future. A passive investor takes a look at the company's value, assets, debt, and financial health. They consider market and competition when estimating the company's opportunity for success. They are not aggressive, or looking for a quick gain.
As long as their losses are not in the high-risk level, they leave their portfolio alone. They follow the 10% rule when estimating acceptable loss. Once a stock falls 10% below what they paid, it is time to sell to the bargain hunters.
Passive trading relies on the fact that over time the market has always gone up. If a trader is not passionately interested in the stock market and they’re investing mainly for retirement, a passive strategy may be the best bet.
Passive trading can deliver a decent return in the long run with a minimum of involvement. Two things are critical to this strategy:
- Choosing stocks that have good potential to increase steadily in value over the term of the investment, and
- Selecting a diversified portfolio, to offset the unforeseen fate of one particular company or market sector. To achieve this they can consider hedging by adding instruments such as bonds, which tend to go up in value when stocks are going down.
Passive investing advantages
The main advantage of this strategy is that, when properly employed, it can bring in a lot of profit, rather than a series of small, short-term profits garnered by the active investing approach. For instance, at a time when the auto industry has been greatly suffering, passive traders may buy a significant amount of shares of a car company that they thinks will rebound, and wait years for the industry to improve, and the company stock to increase by, say, three times. If the trader avoids short-term trades that may mean selling at small increases, more money can be made in the long term if stock steadily climbs.
Although passive traders regard short-term fluctuations in stock prices as minor compared to long-term growth, they still can't just pick a portfolio and forget about it.
Often, passive traders do not even monitor stock. One good reason for this is that checking in regularly could reveal enticing short term values that might cause traders to abandon their strategy and settle for short term gains rather than the expected, more favorable long term gains that may result from successful passive investing. However, even passive traders should re-evaluate the performance of their stocks periodically and respond to long-term market changes.
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