What is the difference between trading and investing?

Introduction

CFD trading involves entering and exiting positions quickly, normally on an intraday basis, a characteristic that differentiates it from long-term investing. Many of the principles of successful trading – technical analysis, risk management, position sizing – are used in both trading and investment, but the emphasis is different in the two disciplines. Investors are normally less sensitive to short time price moves, more interested in fundamental analysis, and look to hold their positions for the long term to achieve capital gains.

Asset classes also change, with equities the most popular for investors while traders dominate in the forex and commodities markets. CFDs are not designed with long-term investing in mind, but many of the skills that make a good investor also help with your trading, and given that in some markets, especially equities, investors make up a significant percentage of overall volume, it is vital to understand how they impact the market.

A good place to start is thoroughly understanding how the two strategies differ and how they influence market movements.

Trading versus investing

The average hold time for US equities fell from around five years in 1970 to 10 months in 2020, following a steady downward trajectory throughout the period. There are lots of reasons for this, including the rise of high-speed and algorithmic trading, changing strategies among mutual funds (who still hold US stocks on average for 2.5 years per position, longer than the overall market), far greater overall participation in the market, and new trader types such as hedge funds. Leaving aside any debates on whether or not this is desirable, it is clear that something big has changed in the stock market. In other markets, where reliable data is harder to come by, positions were always traded on a shorter term basis, but likely have also become steadily shorter for the same reasons.

CFDs are a short-term trading tool, ideal for intraday trading or holding positions over a few days, so although CFD positions do not influence average holding times for stocks, since a CFD trader never takes ownership of the underlying asset, they are clearly part of the same trend towards more frequent, shorter term trading horizons. In lots of ways this makes sense; in 1970 copying out trading charts by hand was commonplace, many common technical indicators simply didn’t exist, and in most markets executing a live trade involved at best phone calls and more often brokers waving hand signals in strange jackets. Simply put, markets weren’t technologically advanced enough for many of today’s highly technical, fast-paced strategies to make sense or even be possible. CFD traders are able to use all of these strategies in a convenient way, but to properly understand how markets work we also need a good idea how buy-and-hold strategies work and who uses them.

Investors

The most important investors are large passive investment management companies, who buy and sell stocks to match an index, sometimes themed but normally arranged by market capitalisation and geography. These funds do trade, rebalancing their holdings to reflect changes in the index, but they do so without any view on the price trajectory of the assets traded. It is a controversial topic whether these funds, be they ETFs or passive mutual funds, impact price action in the broader market – it seems likely that they do – but in general the largest indices increase demand for the biggest stocks, with inclusion on a famous index such as the S&P500 or MSCI world index normally seeing increased demand.

The next most important are active mutual funds, which try and actively beat a benchmark by following a trading strategy, usually fundamentally-driven but sometimes including technical factors for market timing. Most active investment funds do not beat the market over the long term, but they contribute to the overall price action of the stock market by cycling into and out of stocks based on fashionable financial metrics, which influence the market in predictable ways.

For example, when value investing was popular in the 1970s and 1980s, large utility stocks and other sectors with low P/E ratios tended to outperform as active investors favoured them, whereas a change in investment philosophy after the 1990s saw them begin to consistently underperform in favour of growth stocks. Whatever their underlying fundamental strategy, equity investors tend to use buy-and-hold strategies, monitor performance at the level of each position, and hold a smaller number of large positions compared to traders.

Traders

Different types of traders are active in global equity markets, including hedge funds, high frequency traders, and retail day traders. These disparate market actors are united by holding positions for short time periods, relying as much or more on technical analysis than fundamental, and for executing trades at a high frequency. The presence of lots of traders in a market requires and encourages lower fees, because high turnover strategies like scalp trading are only viable when fees are low, and their presence improves liquidity for all participants. In terms of market behaviour, equity CFD traders fall into this category, except of course that we have no impact on the overall market because we do not take ownership of the underlying asset.

Markets with lots of active traders tend to have lower spreads, higher volumes, and fewer liquidity issues, because traders use competing strategies and so there is normally someone to take the other side of a trade. Traders consider their performance in terms of a strategy, looking at win rate and risk reward ratio, rather than the performance of individual positions, and compared to a buy-and-hold strategy will hold a greater number of smaller positions.

Markets other than equities

So far, we have focused on the difference between short-term trading and long-term investing in the equity market, with swing trading and scalp trading strategies employed by day traders or funds contrasted to the buy-and-hold strategy favoured by long-term investors. Outside of the stock market, the picture is a little different depending on each asset class.

Bonds

Bonds are income-generating assets, so are most commonly bought by investors as part of a buy-and-hold strategy. Government bonds are often held as hedges against equity market volatility, so a consistent portion of a portfolio is left in long-term bond positions, that will be rolled over at expiry into a new contract. Income-seeking investors use bonds to generate a reliable income, also rolling over or buying bonds on multiple expiry dates as part of a bond ladder strategy. With high-yield or non-investment grade bonds, which experience greater price fluctuations, short-term strategies are more widely used, and leveraged traders may also execute short-term trades on investment grade bonds which normally fluctuate at or above parity. Generally though, bonds are an asset favoured more by investors than traders.

Forex

Trades in the forex market are much more likely to be short-term and technical, and day traders appreciate this market for that reason. Holding long-term positions in forex is possible, but this sort of trading is more normally carried out by corporates or financial institutions with a business requirement to hold certain currencies. There is no concept of long term investing in forex equivalent to the stock market, as moves are smaller and do not have the bias towards growth seen in equities over very long periods. Instead, forex traders use leverage to profit off smaller moves in the market – a practice which also increases the risk of losses – and trade technically, measuring their success over multiple smaller trades.

Forex trading often involves derivatives such as FX futures, forwards or options. Sensitive to changes in time frame, forex requires technical analysis on the right time period. But whether positions are held long or short-term they are considered trading rather than investing, because currencies do not produce an income, nor do they experience significant capital gains when compared to classic investments such as property (in some markets) and equities.

Commodities

With the exception of gold, commodity markets do not really correspond to the trading vs investing split seen in other markets. Instead, the most important division in the commodities market is between hedgers and speculators, with both investors and traders included on the side of speculators. Hedgers are producers or industrial users of a commodity looking to lock in a price for planning purposes, while speculators are interested in capital gains, whether over the short or long term. As with forex, commodities are not an income-yielding asset, so traders tend to hold them for capital gains purposes exclusively, and normally on shorter timeframes than for equities.

Cryptocurrencies

Some people might argue they are investing in cryptocurrencies, but few really believe them: these are firmly speculative assets. Crypto CFDs allow traders to share in both positive and negative price action of these notoriously volatile assets, but must be traded with caution especially when using leverage. Anything involving cryptocurrency price action is very much on the trading side of the investing – trading spectrum, and should be approached accordingly.

Trading with investors

Equity CFD traders are participating in a market where a significant amount of overall volume is driven by longer term investors. This is true regardless of the decrease in average holding times since the 1970s, since even ten months is significantly longer than a CFD day trading position. That means day traders using strategies such as swing trading or scalp trading need an awareness of what’s going on over longer time frames. Finding out this information can be as simple as extending the time frame on a bar chart, to see the prevailing trend behind the shorter market moves. It is often a good idea to bias your trading strategy to favour moves in the direction of the main, slower trend.

For example, if you are swing trading using the RSI, you might want to set the entry point for a long trade at a lower level than its equivalent for a short trade, if the prevailing long-term trend is positive. Long-term trends exist in forex too, with the US Dollar experiencing a general strengthening over the past few decades. On very short-term movements this has little to no effect, but moves taking place over the time frame of weeks or months can influence the smaller subtrends that form over a few days within them. You will need to experiment with different strategies and rules to find out the best way to balance your day trading against the backdrop of investor positions.

Conclusion: which is better?

Trading and investing are similar activities in that they involve buying and selling securities, or derivatives contracts based on them, but very different in terms of intention, strategies used, and the types of market participants involved. Investors operate on longer time scales, are less likely to use leverage, and are biased in favour of bonds and equities.

On the other hand, traders tend to move in and out of positions quicker, often use leverage, and prefer forex and cryptocurrencies – although stocks are popular with both traders and investors. Simply put, which of these two market activities is best will depend on who you are and your objectives: trading crypto CFDs is not an appropriate way to manage your pension portfolio, and property or physical gold are of limited use to day traders.

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