Sunday, June 14, 2009

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Is Long Term Trading Better than Short Term Trading?

I am sure this question must have occurred to many traders whether they are new to trading stocks or not. I cannot really say long term trading is better than short term trading or vice versa. Because there are times when both are good and there are times when only either of them is better. But nevertheless to maximize the returns from your stock trading you need to definitely learn which one is better at which timeframe.

is long term trading better than short term trading? , S&P 500 historical chart from 1950Image Source

The three basic things that happen with these two types of trading are the three types of market behavior. Stock markets can move strongly in a particular trend whether up or down. Other times they also make moves much similar to swinging. These swings form range trading patterns but they can range from months, years to decades as well. History very well proves this pattern. But it can be noted that the range trading pattern is what markets spend most of their time while the biggest movements happen in a relatively short and concentrated period of time whether up or down.

Only depending on the type of stock market movement can we determine which type of trading is best to do. A trader who bets only on one type will not be able to succeed consistently. And remember that it is the consistency of the right bets that makes a successful stock trader.

Strong Trends or Current Trends

There are times in the stock market that are most noted in history. For example, as per the current economy scenario the stock market slides of the last year are now noted in history to be the sharpest ever falls. These become popular because they do not happen every now and then. That is not consecutively for a significant period of time to move the market swiftly in a particular direction.

These times are associated with the powerful economic development or economic depression. Either way they make the market move suddenly and continuously in the same trend. The trend can be either up or down and depending on that they will be bull markets or bear markets. But you should note that these strong trends happen only for a short period of time even in a bull or bear market period.

When such trends occur, it does not matter which type of trading you choose. Both long term and short term trading offer equal potential for returns. I cannot really judge which is the best in these times because I found enough evidence to get the highest returns from stocks held for sufficiently long time for many months or trading stocks on short term that are making swift moves one after another in only a week’s period of time.

For example, there are stocks that gave as much return as 1800% within a year during strong trend. During the same time, if we try to accumulate the gains when made with short term trading of stocks that move one after another, there were enough opportunities to make similar gains. Though I could not take advantage of this myself, I had learned that it can be taken. Not many traders find this fact.

Also notable is the compounding effect of short term trades that make their returns comparable to one long term trade’s returns. Trading in strong trends is like rowing boat along the direction of current. It is very easy to do!

Trend Reversal Periods or Uncertain Trends

I think there is no need to give an example for this type of situation. This is because the last year’s market movements were a perfect example for this. When the markets started reversing their major trend in the last year from bullish to bearish, they did not do that overnight. There was a lot of time for uncertainty which made many traders make big losses well before the market made its biggest crashes in the September-October months.

It is true that markets made overnight falls like they did during January 22nd and 23rd. But the days after that they did make violent moves in the opposite direction. There was plenty of opportunity during that time but only with the right approach.

The right approach during these times is to do short term trading. You cannot make a long term bet because there is no certainty of the trend for more than a week or a month. But you may think that there is a risk with short term trading. As I explained earlier about the difference in risks between investing and trading, similar pattern holds here too.

The short term risk is obvious and makes you to be alert. The long term risk being non-obvious at the moment, can make you go broke in the end with a wrong bet. Especially it goes wrong during uncertain period. If you are still doubtful about this, go check your trading journals and observe the reasons for the mistakes during these periods of stock markets.

Most of the Time or Normal Period

I couldn’t get the right term for this timeframe where the markets spend most of their time. It in fact consists of periods where small bull and bear markets come and go. It also consists of times when stock markets move in a range but in a relatively longer period of time. Overall if the stock market average returns are calculated, they will turn out to be a big zero or even negative for a short term trader.

This is how stocks move most of the time. If you use traditional principles of investing without active involvement you will end up losing money after adjusting for inflation.

You might have heard that stock market returns beat any fixed income investments over the long term. Let me tell you that it is not true. It is actually dependent on the time frame chosen for this calculation. When the markets are considered during their strongest trending periods, their returns or losses outrun any other type of investments. But when these are considered during their normal periods, they underperform any other type of investment. They can even end up in loss.

But during these times both short term and long term trading can give returns. But that depends only on the specific stocks traded. If you diversify and then do short or long term it does not matter, the returns will get cancelled. You should go with only stock specific approach. And note the fact that you have to do this for more time your trading life. But more over the best returns come from long term trading during this period.

Actually I need to give a paradigm about long term trading. It does not have to do with the decades of period that you hold a stock. It has to do with the stock specific behavior which is identifiable unlike in a powerful bull market.

In a powerful bull market trend, almost every dumb stock makes noise. But during that time everything can give profits. During normal market periods, there will be only few stocks that make their consistent movements almost like spirals moving upwards or downwards. These stocks make their movements not just for a short time like a week or a month but continuously repeat the trend for many months or over a year.

The advantage for long term trading during these periods is that it is easy to identify such stocks. Just go and look for stocks listed in the 52 week highs or all time highs section of market statistics. Historically many stocks have made their golden periods in a relatively short period of time but still long enough for long term trading.

Long Term Trading is Not Long Term Investing!

Don’t confuse this with long term investing. People go for long term investing essentially to capture the benefit of long term trading but at a reduced effort on their part. By betting during the whole period of the stock movement, they are certain to catch that golden period as well.

But the stock market is not about betting with certainty. You should be able to handle uncertainty by learning stock specific patterns to deserve higher and consistent returns. If you go with long term investing, all you will get is a big return but without another chance before a trend reversal. If you rather go with long term trading, though you will get slightly lesser return, you will have the time saved for next long term trade. It is anyway easy to identify those next good bets. You will gain more here because of the compounding effect. What is good when compounding is missing from your finance?

One important thing that should be noted here is that long term trading cannot be applicable to institutional investors. It is because of their size of funds involved. Though they buy or sell stocks over a long period of time, they can only do long term investments without making losses to their portfolios. This is one area where an individual investor has an edge over institutional investors.

Another thing I should mention is that there is a genuine long term investing that gives high returns not because you are capturing a stock’s long period but because the sector or industry or the company itself performed well for that long period of time. For example, the infrastructure boom in the current Indian markets. But still these returns do not come anywhere close to long term trades of individual investors. But they are big enough for those with rich money that cannot be traded easily in the market!

There is Nothing Like Long Term Trading Better than Short Term Trading…

Now you know what is the best type of trading you should do in a given period of time. There is nothing like “long term trading is better than short term trading”. Of both, I liked the long term trading for the long lasting good feeling it creates, huge returns from compounding effect and at the same time not requiring as much effort as the short term trading. But the time should be suitable for that. Identify the market movement trends and take the right approach in your stock trading.

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