Types of trading
The different styles of trading are typically classified by their time-frame. Traders in different time frames tend to have different market philosophies. The long-term investors tend to believe more in an efficient market while the more short-term trader tends to believe the market is beatable. The different groups also tend to have different research methods. The longer the holding period the more an investor relies on fundamental analysis. The shorter the holding period then the more the trader will rely on technical analysis.
A note to the people looking how to trade: although this page describes and compares different trading styles, the purpose of this page is strictly to educate novices. When choosing which time frame to trade you can't simply pick the one you like. You have to pick the one that suits you emotionally.
Day traders get in and out of positions during the day and never hold a position overnight. Most day traders buy and sell stocks looking to take advantage of intraday trends which may last anywhere from 30 seconds to a few hours. There are also a subset of day traders called "scalpers" who attempt to trade both sides of a market at the same time in order to profit from the bid/ask spread.
- Pros: No overnight risk. Ability to use higher leverage due to no overnight risk. Smoother equity curve. Much less analysis needed. Regular work hours. Ability to use 4X margin instead of 2X. May be given broker freebies like comped fees, free technology, and lower commission rates due to high number of trades.
- Cons: Need to be available during the market hours. Higher total commissions paid. Possible higher technology costs in the form of hardware costs (monitors) or software trading tools. $25,000 minimum equity needed if your account gets labeled with "day trader status". Higher administrative requirements of detailing trades on taxes.
- Criteria: Day traders mostly use technical analysis to dictate their trades. In my opinion they - more than any other group - tend to use the "softer" technical analysis techniques like momentum instead of mathematical indicators that require less interpretation. In that sense, day traders are the modern equivalent of ticker tape readers as many of them trade strictly based on price action. For the most part day traders tend to ignore fundamentals but I think the best day traders also understand fundamentals very well because it allows them to better predict intra-day trends.
- Needs: Strong emotional control. Day traders also need better technology than the average trader. They need streaming real-time quotes, time & sales, quick order entry, and real-time open order status so they can monitor their executions. Many day traders also prefer to have Level II quotes and streaming charts. There are also new "custom" tools marketed by online brokerages to try to make it sound like they are offering something not available anywhere else on the market. I don't think these in-house tools add much value. To me, they are marketing tools for the broker more than trading tools for you. You may also need a multiple-monitor set-up.
- Brokers: Serious day traders tend to trade through day trading brokers. These are otherwise known as "software brokers" or "platform-based brokers" because the trading software day traders use is a very important aspect of their trading. Some of the less-serious day traders trade through low-cost popular internet brokers like Ameritrade and E*Trade because these brokers do offer good enough basic technology to day traders.
Swing traders typically take advantage of movements in stocks on a time frame around two days to two weeks.
- Pros: High potential for profits compared to position traders and long-term traders because they attempt to capture all of the short-term swings that stocks have to offer.
- Cons: Potential for unfavorable risk/reward ratio as they are looking for 5-10% gains (sometimes 20%) while exposing themselves to the occasional 30-40% overnight drops. High amount of research needed (both fundamental and technical) as they have the highest turnover of any non-day traders.
- Criteria: Swing traders are stereotyped as people who completely ignore fundamentals and trade purely off chart patterns. Although I do agree that the amount of fundamental input done by the typical swing trader is less than it should be, I still believe this reputation is unfair. The best traders are traders that blend fundamentals and technicals and I think the most successful swing traders do this.
- Needs: A half-hour or an hour to do research before the market open is recommended to take advantage of big gaps down on stocks at the open. They need to monitor the market during the day. They need decent technology like steaming quotes and time & sales. Some swing traders may prefer to have Level II and other advanced tools but I don't think these are needed for swing traders.
- Brokers: Swing traders tend to trade through the low-cost popular internet brokers like Ameritrade, E*Trade, and Scottrade because they don't need the cutting edge technology of the day trading firms. And given their high number of trades, using a traditional broker and paying 10 time what Ameritrade charges is out of the question.
Position traders will tend to hold trades for around two to nine months. They are similar to swing traders except that they hold onto their positions longer and are willing to hold through temporary declines. Position traders are basically swing traders that are trading on a weekly chart instead of daily. Although they are not really considered short-term traders, they are also not considered long-term traders. Like short-term traders, position traders many times rely on both technicals as fundamentals.
- Pros: Ability to get sizable returns (30% to 200%) if they pick the right stocks while not having to hold onto stocks for years. By trading the intermediate term trends they have the ability to make big profits while also staying nimble enough to get out of trades when they are wrong and quickly move on. This way their returns don't stay stagnant for long-term periods. Some dividend income.
- Cons: Unlike swing trading, your returns will be dependent on a few key trades for the whole year. Therefore, there is potential for disappointing returns if you pick a couple of bad stocks.
- Criteria: Position traders typically mix fundamentals and technicals. They tend to know the companies they buy very well so they do tend to favor fundamental analysis a little more. The technical analysis they use will tend to be broader in scope, like support/resistance and overbought/oversold, as opposed to some of the more mathematical indicators sometimes used.
- Needs: Position traders have few needs. Technology-wise they don't need much as they are not entering orders often or watching the market during the day. Research-wise they do a fair amount of research but they don't need to make sure they check the market every day like swing traders looking for good setups.
- Brokers: Similar to swing traders, most position traders tend to trade through the popular internet brokers like Ameritrade, E*Trade, and Scottrade because of the low commissions.
Long-term traders tend to hold a position in a stock for a year or more.
- Pros: No need to monitor the market. Much less research time needed as the number of investments over time is low. Potentially lower tax rate on long-term capital gains. Dividend income. Societal approval.
- Cons: Large potential for disappointing returns as a few key stocks will dictate your return. Maximum return will tend to be generally close to the market. There is potential to beat the market by 10 or 20 points but annual returns of 50% to 100% or more tend to be impossible. There is also a large amount of time needed to execute enough trades and accumulate enough evidence of results in order to judge whether your investment techniques are valid or not. Long-term traders have the biggest "denial rate" out of any trader class. This is because when they have a bad year or two they just write it off to bad luck whereas a day trader who makes no money over the course of a whole year is faced with the objective reality that he failed.
- Needs: Patience. Good business analytical skills.
- Philosophy: Long-term investors tend to believe you can't time the market. They also tend to believe technical analysis doesn't work so they almost always use only fundamental analysis.
- Brokers: Longer-term traders tend to trade through traditional brokers like Fidelity, Charles Schwab, and Merrill Lynch. In recent years though, some of the more self-directed investors have tended to move to the lower-cost environments of online trading through their same traditional brokers where they get a decent drop in commissions while still having access to a traditional investment institution.