Trading Strategies Overview

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

In the financial markets, the average stock is held for 22 seconds - a far cry from the investment strategy of 'buy and hold.' This is due to computerized trading and short-term trading, some strategies of which we'll discuss in this lesson.

Trading Strategies versus Investment Strategies

Historically, the financial markets were run by investors. Professionals would invest in a stock and hold that stock for a long time, based on an analysis that suggested it was a good investment that would build wealth.

While investing is still a significant part of the activity in the financial markets, trading has now become the source of most of the activity in the stock market. Typically, traders don't want to hold a stock for longer than 2-3 weeks and very often, the time a trader holds a stock may be measured in seconds.

Overview of Trading

There are thousands of books about trading strategies. But, that doesn't mean there are thousands of different strategies. Each of these is most often a variation of a more basic strategy.

Make no mistake - trading is a very difficult way for a retail trader to make money. A retail trader is an individual trading on their own from home with no affiliation to a hedge fund, a financial trading company focused on trading, or an investment bank, a financial company focused on investing their capital to grow wealth. But, just because a trader doesn't have all the tools the large investment banks and hedge funds have doesn't mean there aren't basic strategies that can be used.

Basic Trading Strategies

Four basic trading strategies are using margin, buying long, selling short, and pair trading. Each of these can be used anytime a trader feels there is an opportunity, which is hopefully identified through accurate and complete analyses.

Margin

The first strategy is using margin. A margin trading account allows a trader to use more than the money they have invested in the market. Depending on the broker through which they have a trading account, a trader may receive anywhere from 5 to 25 times leverage on the cash they have invested.

That means if a trader invests $20,000 into their account, they can actually trade with anywhere from $100,000 - $500,000! As good as that sounds, it's worth noting that the broker is only going to allow the trader to lose the $20,000 they invested. Twenty-thousand dollars is just 4% of $500,000, so if a trader makes one bad trade it may wipe out their account. But, because trading is based on buying a lot of shares of stock and trying to capture small short-term gains, traders generally need a margin account to be able to buy the volume of stock necessary to make a profit.

Buying Long

The second basic trading strategy (and the one most people think of when they think of trading in the stock market) is trading long, or buying low and selling high. A trader, unlike an investor, may only be looking for a .10 move in the stock price. If I trader bought 1,000 shares of the stock that moved .10 within an hour, they would have made $100 in that hour.

Selling Short

The third strategy is the opposite of trading long and is called selling short. Selling short is when brokers allow traders to sell the stock before they own it, and then buy it when the price is lower. The mechanics of this trade are complex, and involve the trader 'borrowing' the shares from the broker and then paying the broker back the same number of shares later.

When selling short, if the shares the trader uses to pay back the broker are bought at a lower price than the shares they borrowed to sell, they make a profit. So, if a stock is at $21.56 and drops to $21.31, a trader could 'borrow' 1,000 shares at $21.56 - costing them $21,560 and then pay back those shares with the cheaper $21.31 shares, costing them $21,310. That .25 drop made the trader $250.

Pair Trading

The fourth strategy is called pair trading and is becoming more popular because it is a market neutral strategy. That means that whether the market goes up or down, the trade itself shouldn't be impacted. Pair trading involves trying to make a profit on the price difference between two stocks.

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