What investors can learn from traders

Posted: 6 pm ET

Traders are looking for short-term gains when putting money to work, while investors have a longer time horizon. That doesn’t mean that investors can’t learn a few things from traders when investing.

Traders have buy and sell disciplines

Traders pick the spots where they’re willing to enter the market, a profit objective and a level where they will sell out of a position if the trade goes against them.

Long-term investors that have a passively managed portfolio invested in indexed mutual funds or exchange-traded funds (ETFs) are willing to be the market versus trying to beat the market. They may have a buy discipline of dollar-cost-averaging investments over time, or they may create a laddered bond portfolio. Sell disciplines can be a conundrum for the indexed investor.

An investor following an active strategy is trying to earn a return, net of fees, that is higher than the overall market’s net of fees return. An active investor will be more willing to sell out of a losing position and be more likely to have a specific profit target for a position.

Traders use stop loss orders

Because they have a sell discipline in place for when things go wrong, they know the level that they want to the exit the trade and place a stop order to get out at that level.

Investors also can use a trailing stop that follows the stock price higher. A trailing stop can be set either as a percent or a dollar price. If a stock is trading at $50 and the investor puts a 10 percent trailing stop order on the stock, the stock is sold when the price falls 10 percent% or drops to $45. If the stock moves up to $60 per share the stock is sold if it falls by 10 percent to $54.

Trailing stops don’t guarantee that you get out at the stop price. If the stop was set at $5 instead of 10 percent, the stock would be sold when it fell $5 below its high price. An earlier blog post, Trailing stops’ let your winners run, provides more detail on this type of order. Another post, Know your options when placing orders, discusses other order types.

Traders are more willing to sell a position short

Long-only investors don’t sell short a position. With a short sale, the trader sells the position now with the stipulation that they will buy it back later. The trader borrows the shares that he or she shorts and eventually has to return them to the owner. A short seller makes money if the price of the borrowed shares falls, and loses money if the price of the borrowed shares rise.

Traders, by being willing to take either a long or short position, can make money in up markets and down markets, as long as they’re on the right side of the trade. Long-only investors are counting on prices over the long term trending higher to make money in a position and stay away from short sales.

Exchange-traded funds (ETFs) have made it much easier for small investors to leverage positions in currencies, commodities, interest rates and the stock market. While leveraged ETFs can work well for traders, investors should be extremely cautious, since leveraged ETFs aren’t designed to be long-term holdings.

Traders don’t fight the tape

Traders are more likely to consider technical analysis in placing trades, where the investments price historical price movement and volume of trading is thought to signal future price movement.

Long-term investors are more concerned with an investment’s fundamental analysis which is based on microeconomic and macroeconomic considerations driving the firm’s performance and the economy. That said, an investor doesn’t want to fight the tape any more than a trader does and may benefit from understanding what the technicians are saying about an investment before buying the investment.

Don’t try to catch a falling knife was how I put it in last week’s blog post on investment adages.

What guidelines do you follow when you invest?

Follow me on Twitter: @drdonsays

Related posts: