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Oct 20

Active Trading vs. Passive Investing

The typical dividend growth investor, myself included, follows a buy and hold style where the day to day fluctuations of an individual stock are essentially ignored and the focus is instead directed on the receipt and reinvestment of dividends coupled with long term asset growth.  This strategy is also often referred to as passive investing, since there really isn’t much effort involved on a day to day basis.

Active trading contrasts passive investing in that the trader is solely focused on short term movements of the stock price and isn’t particularly interested in dividends or long term valuations.  It is much more exciting than passive investing, with the notion of making a quick score luring in many investors into this method.

passive v active trading

How Active Trading Works

An active trader, or day trader, purchases an investment at a price he or she thinks is on the low end of a typical fluctuation range for that particular stock.  They determine a desired sale price and would typically create automated instructions for the security to be liquidated upon reaching the desired sale price. To be successful you need to know the top penny stocks to watch, period.

Below is a chart showing how Apple’s stock price fluctuated this past Friday.  For a typical buy and hold investor, it was actually a pretty good day – up $2.95 or 0.6%.  For an active trader who played his cards right, it could have been a really good day.

Say this active trader had $10,000 and had the foresight to set up an automatic purchase prior to markets opening to buy 20 shares at $492.  Around 10am, the stock price slid down to $492 and the purchase was made.  When he got back from his coffee break and saw that the purchase was complete, he set up an automated sale price of $498.

After a nice long Friday lunch he got back to his computer around 2pm and sees that the price is nearing his sale target – watching with anticipation it hits his magic $498 number around 2:30 and he celebrates as he just raked in a cool $100 ($6 profit on 20 shares minus two trading fees of $10 each).

How Much Can Active Trading Make?

How much a person makes using an active trading technique depends on many factors such as initial investment, commission costs, market fluctuations, knowing the ultimate stock alerts, and to some degree, luck.  The better information a person has on a particular company, the better are his chances of making wise decisions.

Highly sophisticated active traders can utilize leverage to make money off of someone else’s money, but there are always additional risks when taking this approach.

Challenges of Active Trading

The two biggest challenges that active investors have is to know what target buy-in and sale prices should be used on a given day for a given security.

To help them identify both the buy-in point and the desired sale price they can use historical charts, beta values, market news, cycles and insight, moving day averages and so on; however, there is never a guarantee that the decision they make is correct or even realistic.

Risks of Active Trading

As with any investment there are always risks, but with active trading there are additional risks as well.  For example, if your buy in point is too high and the stock price continues to drop after you make a purchase you will be down.  When this happens, a typical individual investor might become scared and set a sale price lower than he wanted, maybe even selling at a loss just to get out.

The excitement with active trading amplifies the emotional response people experience with investing and there is a point where it starts to mirror gambling.

Summary – Active vs Passive Investing:

The table below shows some advantages and disadvantages of the two approaches.  Obviously, since I place myself into the dividend growth camp I am somewhat biased, but regardless I truly believe the buy and hold approach is much better in the long run and much more enjoyable of a ride too.

Have you ever considered or tried active trading?

 

Active Trading
Passive Investing
Requires significant effort and attention from the investor Requires minimal effort and time from the investor
Higher Level of Risk Lower Level of Risk
Potential for Quick Gains Potential for Long Term Gains
No Dividends Dividends
Stressful Minimal to No Stress
Capital Gains Tax Only pay Capital Gains When (or if) You Sell
High Trading Fee Cost Minimal Trading Fees
Significant Accounting Effort Minimal Accounting Effort
No Special Tax Credits Dividend Tax Credits