Active traders can employ one or many of the aforementioned strategies. However, before deciding on engaging in these strategies, the risks and costs associated with each should be considered.
There’s a reason active trading strategies were once only employed by professional traders. Not only does having an in-house brokerage house reduce the costs associated with high-frequency trading, but it also ensures better trade execution. Lower commissions and better execution are two elements that improve the profit potential of the strategies.
Significant hardware and software purchases are typically required to successfully implement these strategies. In addition to real-time market data, these costs make active trading somewhat prohibitive for the individual trader, although not altogether unachievable.
This is why passive and indexed strategies, that take a buy-and-hold stance, offer lower fees and trading costs, as well as lower taxable events in the event of selling a profitable position. Still, passive strategies cannot beat the market since they hold the broad market index. Active traders seek ‘alpha’, in hopes that trading profits will exceed costs and make for a successful long-term strategy.
Scalping is one of the quickest strategies employed by active traders. Essentially, it entails identifying and exploiting bid-ask spreads that are a little wider or narrower than normal due to temporary imbalances in supply and demand.
A scalper does not attempt to exploit large moves or transact high volumes. Rather, they seek to capitalize on small moves that occur frequently, with measured transaction volumes. Since the level of profit per trade is small, scalpers look for relatively liquid markets to increase the frequency of their trades. Unlike swing traders, scalpers prefer quiet markets that aren’t prone to sudden price movements.
When a trend breaks, swing traders typically get in the game. At the end of a trend, there is usually some price volatility as the new trend tries to establish itself. Swing traders buy or sell as that price volatility sets in. Swing trades are usually held for more than a day but for a shorter time than trend trades. Swing traders often create a set of trading rules based on technical or fundamental analysis.
These trading rules or algorithms are designed to identify when to buy and sell a security. While a swing-trading algorithm does not have to be exact and predict the peak or valley of a price move, it does need a market that moves in one direction or another. A range-bound or sideways market is a risk for swing traders.
Some actually consider position trading to be a buy-and-hold strategy and not active trading. However, position trading, when done by an advanced trader, can be a form of active trading. Position trading uses longer term charts – anywhere from daily to monthly – in combination with other methods to determine the trend of the current market direction. This type of trade may last for several days to several weeks and sometimes longer, depending on the trend.
Trend traders look for successive higher highs or lower highs to determine the trend of a security. By jumping on and riding the “wave,” trend traders aim to benefit from both the up and downside of market movements. Trend traders look to determine the direction of the market, but they do not try to forecast any price levels. Typically, trend traders jump on the trend after it has established itself, and when the trend breaks, they usually exit the position. This means that in periods of high market volatility, trend trading is more difficult and its positions are generally reduced.
Day trading is perhaps the most well-known active trading style. It’s often considered a pseudonym for active trading itself. Day trading, as its name implies, is the method of buying and selling securities within the same day. Positions are closed out within the same day they are taken, and no position is held overnight. Traditionally, day trading is done by professional traders, such as specialists or market makers. However, electronic trading has opened up this practice to novice traders.
Active investors race to buy low and sell high, but that’s easier said than done. A better strategy, experts say, is to make new investments at regular intervals, a process known as dollar-cost averaging.
Successful investing is less about timing the market than giving a broad portfolio of investments the time it needs to grow. Unlike the frenzied image you may have of stock market trading, slow and steady typically wins the investing race.
If you want to buy stocks, try to keep these to 10% or less of your total investment portfolio. Again, actively managed stock market strategies that seek to beat the market regularly underperform passive strategies.
If you throw all of your money into one or a few companies, you’re banking on success that could quickly be halted by a single regulatory problem, new competitor or public relations disaster. If you still have a strong interest in actively trading with a portion of your portfolio, some stockbrokers offer educational tools and simulators that allow you to practice trading before you dive in.
Ideally, you want to create a balanced portfolio while keeping costs down. Most investors lean on mutual funds, index funds and exchange-traded funds to do that. Rather than betting on any one company stock, these funds pool multiple stocks together, balancing out the inevitable losers and winners.
And these funds are built on passive management strategies. Passive investing seeks only to match wider market gains, as opposed to active investing that tries to outperform the market by frequently buying and selling stocks. And while having an expert pick and choose stocks for you may sound appealing, in the five years leading up to Dec. 31, 2019, 80% of large-cap funds underperformed the S&P 500. In other words, if you’d invested in a low-cost index fund that closely tracks the S&P 500, there’s a good chance you would have seen better returns than in the average mutual fund.
Passive investing also brings fewer of the fees that can erode long-term investment growth. In 2019, the average passively managed fund had an asset-weighted expense ratio of 0.13%, compared with 0.66% with actively managed funds. This cost difference has sparked a growing array of robo-advisors that automate portfolio management, which allows these companies to charge much lower fees than actively managed accounts.
One big drawback of traditional and Roth IRAs: There can be penalties and tax ramifications if you withdraw funds before the age of 59 ½. Roth IRAs are more forgiving on early withdrawals — you can pull out contributions at any time, but you may be penalized or taxed if you pull out investment earnings early.
But that restriction might be OK because there’s a key rule of thumb to keep in mind with any stock market strategy: Don’t invest cash you’ll need within five years. Patience pays when investing — you need to give your assets time to weather the market’s ups and downs.
“A key rule of thumb to keep in mind with any stock market strategy: Don’t invest cash you’ll need within five years.”
If 59 ½ feels too far away, a taxable brokerage account won’t penalize early withdrawals, but it also won’t offer the tax advantages of an IRA or employer-sponsored account (most brokers offer both taxable and tax-advantaged accounts).
Opening a taxable brokerage account may be the next step if you’re already maxing out a 401(k) and an IRA, and you have idle cash sitting in your bank account. However, the following strategies can be applied to both retirement and brokerage accounts.