The stock market is an exciting system that can help you build wealth over time, and it can become a lucrative career for some. Stories about people who made it big as active traders coupled with images of beautiful people, yachts, cars, and homes flood the internet and magazine ads.
But everything you hear about active trading is coupled with a stark warning surrounding risk.
What exactly is active trading, what are the risks, and what rings of fire would you need to jump through to use trading to land that yacht, car, and mansion?
What Is Active Trading?
Active trading is the process of exploiting short-term volatility in highly liquid markets in an attempt to make profits quickly. Unlike long-term investing, active traders look to buy in and sell out of positions frequently, with a goal of making a profit between the price they pay and the price for which they sell.
Traders find opportunities in the market in two ways:
- Screeners. Traders use forex, cryptocurrency, or stock screeners to find the assets that are making the biggest moves with the highest trading volumes.
- Social Media. Social traders use social media to find the stocks the investing community is buzzing about.
Once opportunities are spotted, traders use technical analysis to find entry and exit points.
Assets Active Traders Focus On
Traders look for assets that come with two key features:
- Liquidity. Traders buy and sell large volumes of stock and other assets quickly. So, the assets must be highly liquid, meaning there are plenty of them available to be purchased and sold at a fast pace.
- Volatility. Volatility refers to the fluctuations in an asset’s price. Traders look for high-volatility assets — those that experience wide swings in value over a short period of time.
Because these two factors are crucially important when trading, traders tend to stick in specific markets where liquidity and volatility are high, such as stocks, forex, and cryptocurrencies like Bitcoin.
Traders generally avoid mutual funds and exchange-traded funds (ETFs) because their inherent diversification limits their volatility.
Trading Risk Management
Trading comes with significant risks that should be considered. When making a trade, you’re trying to predict the future in a highly volatile situation. Even the most experienced traders with the best tools get it wrong sometimes.
The key is taking steps to manage risk.
One of the most important risk management strategies to consider is using stop-loss orders. This order type sets a ceiling on losses. When the asset falls to a predetermined price, the stop-loss becomes a market order to exit the position. This way, when things do go bad, the pain isn’t too much to bear.
Beginners often find a strategy and put it to the test in the real world. Unfortunately, not all strategies will work well. Experts use trading simulators to test new strategies in a real-world environment using digital cash and alleviate the risk of real losses. You should do the same to limit your risks.
Active Trading Strategies
Active trading is a term that encompasses a wide range of different strategies for short-term profits in the market. Each strategy listed below has its pros and cons, but also a long history of generating profits for traders.
The term “day trading” says it all. A day trader never holds an asset for longer than one trading session. Day traders enter and exit positions during market hours — hoping to make profits each day — and generally cash out before the end of each trading session. This type of trading can be mixed with a wide range of trading strategies to determine entry and exit points.
Liquidating before the market closes each day protects the trader from after-hours and premarket losses. News is often released during after-hours and premarket trading sessions, during which the whales of the market can make big moves that lead to substantial changes in stock prices. Day traders avoid this risk entirely by closing their positions by the end of the trading session.
Scalping is one of the fastest-paced methods of trading. The strategy isn’t focused on making big gains with each trade. Instead, scalpers attempt to make several trades, each with a very small profit. Over the course of the trading session, those small profits have the potential to add up to significant returns.
Although scalping is a tried-and-true method of generating profits as a trader, it’s crucial for a scalper to have a strict exit strategy and use stop-loss orders. One loss that’s allowed to get too far out of hand has the potential to wipe out the gains from several profitable trades in no time flat.
Swing trading is a longer-term form of trading during which positions are held for anywhere from a few trading sessions to a few months. The goal of swing trading is to profit from anticipated price movements in the short- to mid-term.
Swing traders use tools found in both an investor’s and a trader’s toolbox. While technical analysis is used to determine trend direction and entry and exit points, swing traders also use fundamental analysis to determine why the price is likely to head in one direction or another and how significant that move might be.
Active Trading vs. Active Investing (Position Trading)
Active investing is often considered a form of trading; in many cases it’s called position trading. However, trading and investing are two completely different beasts in the stock market. The key differences between them are in their time frames and methods of analyzing opportunities.
Unlike short-term traders, an active investor follows a long-term investment strategy. These are investors who look for high-growth or value stocks with the potential to outperform market benchmarks like the S&P 500, Nasdaq, and Dow Jones Industrial Average.
Active investors use fundamental analysis to identify stocks on a strong growth trajectory (growth investing) or those that are undervalued compared to their peers (value investing). As investors, position traders aren’t concerned with short-term price fluctuations, focusing on the long-term benefits of owning the asset.
By contrast, active trading is a fast-paced vehicle for accessing market profits, focused on the short term and midterm.
Recently, active investing has come under a bit of scrutiny because data suggests that even most investment professionals fail to beat the market, according to Business Insider. This has led many investors to prefer a more passive investing approach, like a buy-and-hold strategy centered around diversified index funds.
Active Trading vs. Day Trading
Day trading is a form of active trading, but the term active trading encompases a wide variety of trading strategies that could lead investors to hold assets for minutes, days, weeks, or even months. Day trading is a process that involves holding an asset for a maximum of one trading session.
Active Trading Pros & Cons
Trading is an exciting concept. Not only do traders have the potential to make jaw-dropping amounts of money, they work in a fast-paced environment that can be fun in itself. However, there are drawbacks to consider. Here are the pros and cons:
Active Trading Pros
Trading wouldn’t be such a popular topic if there weren’t attractive benefits to it. Here are the most significant perks to becoming a trader:
- The Potential to Make Serious Money. Some traders really do hit it big, going from rags to riches on Wall Street. Although doing so requires significant dedication and a willingness to take risks, you have a real possibility of making a significant income as a trader.
- Excitement. At first, trading in financial markets may seem daunting. However, it’s an exciting, fast-paced process that keeps even the most seasoned traders on their toes.
- Make Your Own Hours. Once you get the hang of trading, it’s possible to earn a living wage from it, giving you the ability to make your own hours. Some traders work 40-hour weeks, and some only work a couple of hours per day. The only limitation to your working hours is the fact that the market is only open weekdays from 9:30am to 4:00pm, although after-hours and premarket sessions offer extensions to these hours.
Active Trading Cons
Although there are plenty of reasons to consider becoming a trader, there are also some pretty serious drawbacks to consider as well:
- Risk. Trading is a risky business. Not only will you be taking a shot at predicting the future, you’ll be doing so with assets that are known for wide price movements. If there’s potential for significant returns on Wall Street, there’s also potential for significant losses.
- Technical Analysis Required. The best traders spend their time combing over charts, looking for technical indicators that suggest where the price of the asset is headed next. The best traders have a detailed understanding of technical analysis and can spot patterns in charts like hawks spot mice in fields. This type of expertise can take years to develop.
- Tax Implications. Trading exposes traders to short-term capital gains taxes on the profits they earn because their investments are held for less than one year. This means traders will pay taxes at their standard income tax rate, rather than enjoying the benefits of a lower long-term capital gains tax rate.
Should You Be an Active Trader?
This is a tough question, and there’s no one-size-fits-all answer. Whether you should become a trader in financial markets depends on multiple factors:
- Your Risk Tolerance. Trading is a risky process that could lead to significant losses if things go wrong. A trader has to live on the wild side, being willing to accept large risks in exchange for the potential to generate big gains.
- Your Ability to Set Emotions Aside. Emotions like fear and greed have the potential to devastate your returns. Traders must be able to check their emotions at the door and strictly adhere to their trading strategy to be successful.
- Your Bank Roll. If you make more than four round-trip trades — opening and closing your position during the same day — in any five-day period, your brokerage will label you as a pattern day trader. Under FINRA guidelines, pattern day traders must maintain a minimum of $25,000 in their trading account at all times.
- Your Willingness to Learn. Trading requires an intricate understanding of technical analysis that may take some time to develop. To become a highly skilled trader, you must have a willingness to learn and a can-do attitude.
How to Start Active Trading
Starting your trading career is a simple process. Use the steps below to get rolling:
- Step #1: Learn. Before you even consider choosing a strategy, you’ll want to learn everything you can about trading. Consider signing up for trading courses and joining chat rooms. Get to know the market and the people in it for your best chances of success.
- Step #2: Choose a Trading Strategy. Strictly adhering to your trading strategy is the name of the game. Research the different strategies that are known for creating the most compelling gains with the least risk, and decide which direction you’d like to go.
- Step #3: Test Your Strategy. Using one of many free trading simulators, test your strategy in a real-world environment with digital cash before putting your hard-earned dollars in the ring.
- Step #4: Open a Brokerage Account. There are several brokers to choose from, each offering access to different assets, different trading tools, and different perks. Each will also determine its own fee schedule and promotions. Compare brokers and open an account with the one you believe provides the best offering.
- Step #5: Start Trading. Once you’ve opened and funded your brokerage account, you’re ready to start trading. Use stock screeners, signal services, and social media to hone in on the types of stocks you’re looking for.
- Step #6: Limit Your Risks. When you start trading, make sure risk management is at the forefront of your strategy. Trading comes with risks, but there are also plenty of ways to limit them. Take advantage of stop-loss orders to limit your downside potential and always do adequate research before making any trades.
The allure of a nice car, house, or boat may have you ready to start trading today. However, before making the decision to become a trader, it’s important to consider the risks and the type of personality you need to have to be successful.
If you decide to give it a shot, do your research and test your strategies before risking a dime in the market.