Active trading is the act of buying and selling securities based on short-term movements to profit from the price movements on a short-term stock chart. The mentality associated with an active trading strategy differs from the long-term, buy-and-hold strategy found among passive or indexed investors. Active traders believe that short-term movements and capturing the market trend are where the profits are made.
There are various methods used to accomplish an active trading strategy, each with appropriate market environments and risks inherent in the strategy. Here are four of the most common active trading strategies and the built-in costs of each strategy.
- Active trading is a strategy that involves 'beating the market' through identifying and timing profitable trades, often for short holding periods.
- Within active trading, there are several general strategies that can be employed.
- Day trading, position trading, swing trading, and scalping are four popular active trading methodologies.
4 Common Active Trading Strategies
1. Day Trading
Day trading is perhaps the most well-known active trading style. It's often considered a pseudonym for active trading itself. Day trading, as its name implies, is the method of buying and selling securities within the same day. Positions are closed out within the same day they are taken, and no position is held overnight. Traditionally, day trading is done by professional traders, such as specialists or market makers. However, electronic trading has opened up this practice to novice traders.
2. Position Trading
Some actually consider position trading to be a buy-and-hold strategy and not active trading. However, position trading, when done by an advanced trader, can be a form of active trading. Position trading uses longer term charts – anywhere from daily to monthly – in combination with other methods to determine the trend of the current market direction. This type of trade may last for several days to several weeks and sometimes longer, depending on the trend.
Trend traders look for successive higher highs or lower highs to determine the trend of a security. By jumping on and riding the "wave," trend traders aim to benefit from both the up and downside of market movements. Trend traders look to determine the direction of the market, but they do not try to forecast any price levels. Typically, trend traders jump on the trend after it has established itself, and when the trend breaks, they usually exit the position. This means that in periods of high market volatility, trend trading is more difficult and its positions are generally reduced.
3. Swing Trading
When a trend breaks, swing traders typically get in the game. At the end of a trend, there is usually some price volatility as the new trend tries to establish itself. Swing traders buy or sell as that price volatility sets in. Swing trades are usually held for more than a day but for a shorter time than trend trades. Swing traders often create a set of trading rules based on technical or fundamental analysis.
These trading rules or algorithms are designed to identify when to buy and sell a security. While a swing-trading algorithm does not have to be exact and predict the peak or valley of a price move, it does need a market that moves in one direction or another. A range-bound or sideways market is a risk for swing traders.
Scalping is one of the quickest strategies employed by active traders. Essentially, it entails identifying and exploiting bid-ask spreads that are a little wider or narrower than normal due to temporary imbalances in supply and demand.
A scalper does not attempt to exploit large moves or transact high volumes. Rather, they seek to capitalize on small moves that occur frequently, with measured transaction volumes. Since the level of profit per trade is small, scalpers look for relatively liquid markets to increase the frequency of their trades. Unlike swing traders, scalpers prefer quiet markets that aren't prone to sudden price movements.
Costs Inherent With Trading Strategies
There's a reason active trading strategies were once only employed by professional traders. Not only does having an in-house brokerage house reduce the costs associated with high-frequency trading, but it also ensures better trade execution. Lower commissions and better execution are two elements that improve the profit potential of the strategies.
Significant hardware and software purchases are typically required to successfully implement these strategies. In addition to real-time market data, these costs make active trading somewhat prohibitive for the individual trader, although not altogether unachievable.
This is why passive and indexed strategies, that take a buy-and-hold stance, offer lower fees and trading costs, as well as lower taxable events in the event of selling a profitable position. Still, passive strategies cannot beat the market since they hold the broad market index. Active traders seek 'alpha', in hopes that trading profits will exceed costs and make for a successful long-term strategy.
The Bottom Line
Active traders can employ one or many of the aforementioned strategies. However, before deciding on engaging in these strategies, the risks and costs associated with each should be considered.