Psychology of investing and trading

“Stock” is the capital raised by a company through allotment of its equity shares to the general public, institutional investors, financial institutions etc. The procedure for allotment is called “Initial Public Offer” in which the company may issue the shares at a fixed price or through book building method. In book building method, the company fixes the floor price and the price band within which the investors need to apply.

Once the company allots its shares to the public, it is listed and traded at the stock exchanges. The purpose of trading is to:

• provide liquidity to a company’s shares;
• widen its shareholder base;
• provide the public an opportunity to enter or exit from the stock;
• raise the company’s public profile;
• attract institutional investors;
• get an assessment of the company by the market.

What is the difference between investing and trading?

It is the holding time of a particular stock. By investing, we mean a stock will be held by the person, say from a few days to few months or years. Trading, on the other hand, is a matter of few seconds to maximum 2 or 3 days.

Classification of investors and traders:

• Long term investors
• Medium term investors or sometimes called “position traders”
• Short term investors or sometimes called “swing traders”
• Intraday traders
• Extreme short term traders

Long term investors:

As the name suggests, these investors buy stocks for holding for a period of at least one year or more. Some people may not have access to live trading. So they prefer to watch stock quotes at the end of the day. Usually high profile executives, people who are active in other professions and have no time to watch market action and some NRI’s fall in this category.

These investors generally read reports by financial magazines, newspapers etc. Some people also seek broker advice. Few experienced people buy stocks based on their ‘value’ i.e. they check the 52 week high, low, P/E ratio, EPS etc. and decide on investing. Some get expert advice from friends, consultants and so on.

Long term investors have no time to analyze the stocks technically. Their knowledge on technical analysis is somewhat limited. As a result, a person may not sell a stock even if he gets, say 4 to 5 times price appreciation. This cannot be called greed. It is just a matter of hope and further expectation. Also, they do not seem to worry much if the stock keeps declining. As far as they are concerned, it is just another form of an asset like gold or real estate.

Medium term investors:

They normally enter the trade when the stock is just about to get a bullish breakout. The stock is held for several weeks to few months. They may get lower amount of profits compared to long term investors but their risk is also somewhat low.

These people act on own research or on broker recommndation or on getting advice from a consultant. They may not watch the market live at all. This type of investing is useful for people who expect moderate returns and also want to reduce the risk to some extent.

Medium term investing is also the best choice for people with busy lives. It can be done with as little as one hour or two a week because the stock is held for much longer periods of time.

Short term investors:

Short term investing, or “swing trading” is the preferred method among investors now a days. It requires the study of technical charts every day. Some simple rules can be followed for the stock selection. However, not all strategies are effective all the time. In this type of trading, there may be periods where the trader may not place orders since already holds many stocks.

Swing trading is not for everyone. It is suited to those traders who have time every evening to study charts, who like daily activity in the market, and who have a moderate sized capital base available to trade stocks. Swing trading is more difficult and takes more time to become proficient at than position trading.

Intra day traders:

These traders initiate and close the trade in a single session. They do not carry positions overnight. The commission for day trading, at least in India is several times low compared to “delivery” taking or buying and holding for sometime. Day trading can be particularly rewarding, if one strictly follows its rules. It is to be always remembered that because the positions cannot be carried forward, there is always a possibility of loss in day trading.

The day traders have few strategies: Some people subscribe to consultants, analysts, etc. and follow the support, resistance and targets given by them. Some others select their favourite high volume stocks and calculate pivot points, supports, resistances and trade. Eitherway, if one is willing to gain or lose half or one percent in a day, it is fine. Normally day traders’ volume is much higher and profit percentage is much lower compared to a delivery based or swing trader.

The day trader needs to watch the market till the trade is complete. It is very essential to use “stop losses” or acceptable losses to minimize the risk. For example, some one may short sell a stock (sell a stock that he does not have in possession) thinking that it may decline. However, if it is bullish in short term and medium term charts, it may bounce back after hitting supports. In this case the trader needs to cover it up immediately by buying from market and closing it. There have been cases in which, by not employing stop loss methods, traders have lost more than 20% by shorting stocks. Once a stock freezes or hits the upper circuit, the short seller may not be able to buy it back. In this case, the short sold stock will go to auction by the exchange. The short seller will be penalized by the stock exchange for not covering up.

Day trading involves considerable risk. The success rate of day trading is also low compared to swing trading. The day traders are usually addicted to stock or compulsive traders, who will trade irrespective of market conditions.

Extreme short term traders:

“BTST” or buy today sell tomorrow and “STBT” or sell today buy tomorrow fall in this category. Usually cash stocks are not traded in this method. Futures and options are traded. The investment needed for futures contract is much higher compared to cash stocks since market lot is between 25 and 14000 depending upon its price. These type of traders also usually subscribe to consultants etc. Some may act on their own intution as well.

Conclusion:

From the above discussion, we can conclude the following:

1. Those who wish to make reasonable profits with some risk can invest in medium term.

2. Those who wish to take more risk for a better return may invest long term.

3. Those who are technically capable of analyzing markets can play short term.

4. Day trading is not a recommended method particularly for beginners since all the principles of short term trading apply to day trading too. The so called pivot point calculations may work once a while, but intra day charts are the best tool available to day trader.

5. Extreme short term may be suitable for futures traders.

It is upto the investor to decide the best strategy depending on his skills, capabilities, availability during market hours, period of holding, risk appetite, profit expected and so on.