Prior to answering this key question, let us clarify the difference between a trader and an investor:
From a top-down perspective, there are many elements where both do the same: Participating in the financial markets with assets like stocks, commodities, currencies, treasuries and their derivatives: Futures and options. However, there are behavior differences, where the action of the one is very different to the other: The investor usually takes a longer-term perspective and mostly only makes money when an asset bought, increases in market value. A trader focuses on participating in the short-term price moves of assets and mostly uses methods and trading instruments, which allow making money when prices move up or down.
Successful traders and investors manage the following challenges:
Challenge-1: Finding assets with a future perspective price move.
Challenge-2: Applying a method of protecting profits.
Challenge-3: Managing risk.
Given the circumstances that some assets have price developments: With-, separate from, or against the markets, makes Finding Assets with a price move potential a key challenge. When those are found, the second challenge is to define how far their price move will reach to realize profits or find forms of protection prior to a potential reversal price move.
In general, there are two basic methods to identify trade- or investment potentials:
Fundamental Analysis: Where you equate financial and other business factors of an observed asset to decide for its future perspective. This is the arena of smart people working for the big investment firms, constantly analyzing the world's markets and finding assets to invest in. As a private investor; however, if we try to replicate the same; we are facing a hard time in keeping up with the information base and point of view of institutional investors. Their managers have contact to the world leaders of business and politics and use pre-information constantly to their benefit.
Technical Analysis: If applied right, a sound chart analysis helps you to spot and follow the action of institutional money moves with a trading system which equates the happening in price, volume and volatility for identifying asset in supply or demand, for you to trade along with the referring price moves.
Given the magnitude of more than 40,000 investment instruments in the US-markets only, you might want to find a service, helping you to identify assets with institutional attention, fundamentally or technically.
The equation to consider is: Protecting Profits = Making Profits. A common saying is: "You trade with the trend until it comes to an end". However, there are two fundamentally different ways of making and keeping profits:
Way-1: You find a systematic to trail a critical price level along with the price move of an asset and when the price direction reverses to this level, you either exit your trade or you apply a method of profit protection against a potential counter price move.
Way-2: You define positive trade exit price levels by equating the minimum and maximum expected price move from trade entry. When those critical price levels are reached, you either exit or you apply a form of protection to assure that the gains you made cannot disappear from your account.
Check the graphics below for examples:
Trail Your Stop (Way-1)
Approximate Min and Max Price Expansion (Way-2)
Managing risk builds the foundation for successful trading or investing. Only when you are able to prevent major draw downs in your trading/investing account, you will be suited for staying long-term in the trading/investing business. If the foundation of your trading system/plan is not standing on solid ground, your temple of success will quickly fall: Always be aware that there is no risk-free trade and the higher you put your return expectation, the higher the risk will be to accept a trade or investment. At the end of the day, a million dollars is a million dollars; however, if you are able to build up a trading plan, where you keep a constant low risk, while producing constant returns from multiple trades, you are better on than aiming for a onetime high return with an associated high risk:
Imagine a trader with a $20,000 account, if he aims for a onetime return $10,000 and an associated risk of $10,000. When he fails, 50% of the account holdings are gone and the trader needs a 100% return on the remaining capital to just breakeven. Instead, if he is striving for a $1,000 return/trade with an associated risk of $1,000, he has a much higher probability to being long-term successful, as long as he constantly finds and trades assets with high-probability trade setups.
The key question arises: How to define an appropriate risk in relation to the considered return?
Our recommendation is to consider two risk levels:
The minimum risk is the one you need to accept to allow for a price move in the desired direction, considering the natural price distribution of the asset to trade: Finding this price level prevents that you will be stopped out even so the price moves in your desired direction. If you continuously experience being stopped out and afterwards you see the price taking off, your risk tolerance was too narrow. Best is when a computer programs measure the statistical volatility of an asset at the time to trade, giving you a clear-cut approximation, where to put the stop- or trade adjustment level. Aside from this, you can surely pick a major support or resistance level where the price haltered in the past, at which your base hypothesis of the directional price move will no more have validation when it is surpassed.
In addition to the minimum risk, you need to decide for a maximum risk to allow for accepting a trade, with the implication: When the maximum risk level is touched, a trade adjustment is necessary, which can be released or enforced, depending on the continuation of the price development. If your experience from the past was: Small gains, small gains and big losses, your risk tolerance was too wide and you face the danger to drain your account by either having no trade adjustment or stop level or an inappropriately wide risk tolerance, which is not in relation to the potential reward of the trade you entered. For any trader, if the relation from the maximum risk to the expected return is not in your favor, just do not accept the trade. Price levels, where the prices remained for a longer period in the past, can be used to define maximum risk levels. However, you can also help yourself finding those levels by letting your computer build the associated volume-price-relations, so you can see on the chart where the critical price levels are.
Prepare for your trading success by installing the elements of asset selection, profit protection and risk management. The knowledge how to apply those instruments to your benefits is not widely accessible, however with the help of this article, you can check and balance where you stand today and how you can create your trading future by gaining the necessary knowledge and obtaining the referring instruments, helping you to develop yourself into the trader or investor you want to be.