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Trading And Investing

Traders tend to believe that because they are entering and exiting from the market many times every day, if they do the opposite by keeping their position for weeks or months, they would betray their true trader nature.

Dealing with financial markets on a daily basis gives a trader enough knowledge to invest, at least decently, in the stock market.

I know many successful day traders who miss a lot of long-term opportunities because they think that buying a stock and keeping it for one year is implicitly saying that they would not be able to do better by trading this stock actively.

Ages ago, a friend of mine, a part-time trader, reported the following bad news to me.

He made a lot of money investing on General Motor.

The bad news consisted of the fact that he used to trade unsuccessfully with that specific stock, so he gave up trying. He bought it, kept in his portfolio for one year, and made a good return.

He felt that his account, now showing him a nice good return, wanted to tell him that he was not a good trader, and that by doing the opposite, he did well.

Most of the time, a wound in our self-esteem cannot be balanced with a financial win.

Trading is investment on a shorter time frame, and investment is a trading on a longer time frame.

It sounds like the financial version of a Tao Te Ching quote.

When someone is already a good trader, he probably already has the attitude to be a good investor. He can finally use some of the knowledge that he has acquired during his activity, but never used before.

The necessity of looking at financial data, or Central Bank speech, are opportunities to get a financial perspective on the world, which can be used when doing asset allocation.

Investment and trading, although requiring similar skills, as I have just said, must be used to achieve completely different goals.

If you are actively and successfully speculating on dax futures, your trading activity must be seen as your own business, and in order to run it, you need to allocate some resources. That should be money you can really afford to lose without harming your financial situation.

If you are doing well and you are not spending more money than you earn, you’ll have some savings in the bank. This is the money you might need someday, in case things go wrong.

Savings should not be traded because they cannot be part of your business activity. This is for the same reason that if you open a company, you are not paying your company debt with your own money.

It is very obvious that putting your wealth at risk by speculating on the financial derivatives is dangerous.

You’d be surprised that most newbies who fall into the get-rich-quick schemes start by trading their savings, until they inevitably blow them .

As an example, we can look at a seasoned dax futures trader who has survived at least 15 years, never trades his savings, and even when he blew his trading account, he did not transform his savings account into a trading one to keep doing his activity.

When he burst his account, he usually waited some time before starting again with a fresh mind and a brand-new dedicated trading account. That is why he has survived.

He lived in the two extremes of risk:

dax futures and cash, high-leverage and high-risk and zero leverage and risk.

This approach, although very raw, is not necessarily a bad one. But by allocating cash to different assets with a long-term view, the result would be better.

If someone, not just a trader, got enough time to live, investing in the stock market has more potential than any other asset.

This is not just because stocks go up or because there are no 20-year periods where the S&P 500 does not have positive return, but it comes from an intrinsic characteristic of financial market volatility.

A return of a stock’s is defined as:

Volatility indicates how much the quantity above deviates from the mean, which is usually measured as the standard deviation of the returns.

It is a quantity that cannot be measured—only estimated. And understanding why it is like that really goes beyond the scope of this article, but for now, just understand that when estimating how much returns are deviating from the mean, it will be dependent on how much past data you are considering, as if the last year was exceptionally volatile, you could have a high value, but If we consider the past the years, volatility could be lower. That is why there is not an exact formula that can tell us what volatility is.

If you try to collect daily returns of most of American stocks, you’ll notice that, if plotted on a histogram, you’ll see something similar to a gaussian bell.

The bell you are seeing now, under which all the data are lying, can be approximated with a probability density function of a normal distribution, with a mean equal to the mean of the returns of the observed stock and standard deviation equal to the result you got from applying the std () function in Excel to the return column.

We can use this function to model the returns, and we can also use other known properties of this function to show, quite rigorously, why a trader should not keep his money in cash.

I am now pretending that you got so passionate that if you were doing something while reading this article, you couldn’t wait to go back home to open your laptop and play with Excel.

The way a stock moves can be modelled using an auto regressive process AR(1).

This can be simulated easily in Excel. When I teach that at the university, it takes no more than 15 minutes and is really simple.

The volatility, measured as standard deviation returns, scales with . This is to say that, if the yearly volatility is 10 % and the current simulated stock price is 100$, in one year the chance of seeing the price between 90$ and 100$ are68%.

In three years the stock won’t be three times more volatile, just  times more volatile.

Volatility, as time passes, becomes less relevant. In easier words, if a stock portfolio has a risk of 10%,being in position for ten years won’t grow the risk proportionally with the time you hold that stock for, but it will be much less.

The stock portfolio will grow exponentially with time; therefore, the more time you can be in position, the better.

If a stock portfolio grows 10%, and the starting value is 100$, after one year, it will be 110$. However, after ten years, by reinvesting all the profits, it will be worth 260$.

If someone wanted to complain that I am not being rigorous, they would be right (but he is also a mean person). However, saying that returns are normally distributed, and that the stock itself moves similarly to an AR(1) process, is not a bad approximation. And for the purpose of this article, even using extremely complex models like the jump diffusion processes, the finally investment decision about whether stock or cash is preferable would be the same.

We have shown with no more than high school math that unless the properties of the financial market change completely in the future, traders or anyone else who has some savings had better invest in stocks rather than lower risk assets, because in the  long term ,volatility of stock markets becomes less relevant.

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