Learning how to trade is increasingly popular as a way of making money. If you have not read our article on the overview of investments and trading, you might wish to look at that first to get the context of today’s discussion.
Today, we are going to look at the benefits and risks of investing versus trading.
At the core of trading/ investing, people earn through this term called profit. Let’s first look at the principle of making a profit
Essentially, you want to buy low and sell high so that
Profit = sell price x volume – sell charges – (buy price x volume + buy charges)
The Benefits of Investing
When we have cash, we can either save, invest or spend it. Investing allows us to potentially make a profit by the formula above, or alternatively by getting dividends from the investment products that we buy.
Think of investing as a cousin to savings – it’s more fickle, and less predictable, but over time, history has shown that it typically grows and starts paying off.
Investing is an alternative to savings that has more risk, but also certainly higher returns over time
The Risk of Investing
Since it’s a marketplace however that relies on matching, it’s a dance between two people. If you choose to buy something that people don’t want, you will be stuck with it. Hopefully it performs well and earns you a profit, otherwise the money you spent buying it is wasted. The ‘investment’ then becomes an ‘expenditure’.
How To Trade: The Benefits
In a physical marketplace, you are expected to pay for your purchase immediately either through cash or using a credit card. The investment marketplace is similar – cash trading is now becoming attractive as brokerages offers cheaper charges if you pay upfront. Alternatively you have up to 3 days to make payments for what you bought.
Recall that traders do not want to hold the product for long. They just want to buy and sell, so that they can earn the profit quickly. This means that as long as they buy and sell within 3 days, they actually do not need to have the cash to afford the purchase. Yet, they will still be able to earn a profit.
One key benefit of trading is the ability to earn much profits with low capital.
Also, since traders buy and sell, their flow allows the volume they trade to quickly add up. The brokerages can now earn more on their volume traded. The traders will thus get cheaper charges on each transaction.
How To Trade: The Risks
In trading, because of that 3 day gap, some traders even sell before they buy if they think that prices are going to drop. This is called “Short-selling” as you are selling something you don’t have.
With the typical buy and sell, if prices go down, traders can choose to hold and wait for prices to pick up. However, with short-selling, traders do not have this choice. They risk losing money as they have to buy the product to cover what they sold. After all, you can’t sell what you don’t have!
Another risk traders have is that of margin trading. Brokerages encourage trading as that drives up transaction volume. With margin trading, your $1 can buy you $100 in value of investment. This also means that any losses are immediately multiplied 100 times when it’s time to pay.
Now that you have this knowledge in mind, how would you tweak your trading/ investment plan of action?