What is a Trader?

A trader is an individual who engages in the buying and selling of financial assets in any financial market, either for himself or on behalf of another person or institution. The main difference between a trader and an investor is the duration for which the person holds the asset. Investors tend to have a longer-term time horizon, while traders tend to hold assets for shorter periods of time to capitalize on short-term trends.

Key Takeaways

  • Traders are individuals who engage in the short-term buying and selling of an equity for themselves or an institution.
  • Among the drawbacks of trading are the capital gains taxes applicable to trades and the costs of paying multiple commission rates to brokers.

Understanding Traders

A trader can work for a financial institution, in which case he trades with the company's money and credit, and is paid a combination of salary and bonus. Alternatively, a trader can work for himself, which means he is trading with his own money and credit but keeps all of the profit for himself.

Among the disadvantages of short-term trading are commission costs and paying away the bid/offer spread. Because traders frequently engage in short-term trading strategies to chase after profit, they can rack up large commission fees. However, an increasing number of highly competitive discount brokerages has made this cost less of an issue, while electronic trading platforms have tightened spreads in the foreign exchange market. There is also disadvantageous tax treatment of short-term capital gains in the United States.

Trader Operations: Institution vs. Own Account

Many large financial institutions have trading rooms where traders buy and sell a wide range of products on behalf of the company. Each trader is given a limit as to how large of a position he can take, the position's maximum maturity and how much of a mark-to-market loss he can have before a position must be closed out. The company has the underlying risk and keeps most of the profit; the trader receives a salary and bonuses. Most people who trade on their own account work from home or in a small office, and utilize a discount broker and electronic trading platforms. Their limits are dependent on their own cash and credit, but they keep all profits.

Discount Brokers: An Important Resource for Traders

Discount brokerage firms charge significantly lower commissions per transaction but provide little or no financial advice. Individuals cannot trade directly on a stock or commodity exchange on their own account, so using a discount broker is a cost-effective way to gain access to the markets. Many discount brokers offer margin accounts, which allow traders to borrow money from the broker to buy stock. This increases the size of the positions they can take but also increases the potential loss.

Electronic Foreign Exchange Trading Platforms

Foreign exchange trading platforms match currency buyers and sellers in the spot, forward and options markets. They sharply increase the amount of price information available to individual traders, and thus narrow price spreads and reduce commissions.

Short-Term Capital Gains Tax

A disadvantage of short-term trading profits is that they are usually taxed at the trader's ordinary income tax rate. Long-term capital gains are taxed at 20% but require the underlying instrument be held for a minimum of one year. Under current laws, there is no technical definition of traders for taxes.

While there is a Trader Tax Status (TTS), election for this status is based on presented facts and circumstances of an individual. Some of the facts that the IRS considers while evaluating traders tax status are holding period of securities, number of trades conducted, and frequency and dollar amount of trades.

There are workarounds for traders to reduce their tax liabilities from short term trades. For example, they can write off expenses utilized in their trading setup, much like a freelancer or small business owner. If they selected Section 475(f), traders can value their entire trades for a particular year and claim deductions for the losses they incurred.