One of the questions that I get asked all the time is, "What’s the difference between investing in the stock market and trading the stock market?"
Sometimes people just assume that they are two different terms that essentially describe the same thing. But even though there is some overlap between the two, investors and traders use different sets of tools, different methodologies, and are diametrically opposed in terms of their view of the stock market.
Tools of the Trade
Traditionally, an investor will use fundamental data to evaluate the stocks that they might buy. This can include micro data like price to earnings ratios, profit margins, and dividend rates, as well as macro data such as interest rates and overall economic health indicators.
Traders on the other hand use technical analysis, which can be micro or macro as well. Micro technical analysis focuses solely on indicators derived from the price and volume data for the specific stock that is being analyzed. Popular indicators include moving averages, relative strength index, and the moving average convergence divergence or MACD. Macro technical analysis looks at the overall market using data such as the number of news highs/lows or percentage of stocks trading above/below their 200-day moving average.
Defining the Method
An investor's goal is to identify stocks that have a future value that is not currently reflected in their share price. Buying these stocks based upon their fundamental analysis, they hope that the market will eventually begin to recognize a hidden value or underestimated growth rate which will translate to higher prices.
Because of this, the exact price that an investor buys a stock at is not as important as its potential price increase.
Traders don't care about the underlying company, its product, or any other fundamental factors. They only want to see movement -- driven by short-term buying and selling -- in the stock they are interested in.
Traders aim for exact entry and exit prices -- often down to the penny -- in order to extract as much profit as they can for the least move possible. Traders are also more willing to short a stock than an investor.
Taking the Time
But perhaps the biggest, and most important, difference between an investor and a trader is their perception of the value of time.
When an investor buys a stock, generally they have no set time frame in which they expect the underlying share price to rise. They may wait a number of months or years, until the fundamental data tells them that a stock is fully valued, before they sell it.
Traders on the other hand are hyper-focused on time frames. In the case of a day trader, they expect price to move in their favor very fast, and if it doesn't, they will quickly move on to another candidate. Swing traders will hold their positions longer -- from a few days to a few weeks -- but if any of their technical indicators show that a stock is no longer a good trade candidate, they will close their position out immediately.
And this illustrates the crucial difference between investors and traders. Investors feel that time is their friend and will eventually prove their fundamental analysis correct, while traders feel that time is their enemy, and don't want to waste it on a stock that is not immediately and consistently moving in their favor.
Photo Credit: Michael H/Digital Vision/Getty Images