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Long-Term Investing Versus Short-Term Trading: Avoiding the Pitfalls
03/24/2010 12:01 am EST
There are several ways to classify traders, but one of the most significant differences is the one between short-term and long-term traders. Traders in both camps may use technical and fundamental analysis, and stop and limit orders, in very similar ways, but with some important differences that can lead to disaster if not properly understood.
At Learning Markets, we hear from traders quite frequently, and lately, as the market has become more volatile, a common issue has been recurring with increasing frequency.
The problem relates to the use of short-term style stops and position sizing in long-term trading opportunities and vice versa.
Transposing short-term methods for risk control and position sizing on a long-term trade inevitably leads to whipsaws and losses. Similarly, applying long-term methods for stops and position sizing against a short-term position leads to an unfavorable risk/reward ratio.
The solution to this problem is to understand how consistent and proportional position sizing applies to different time frames. In the video below, I will detail this issue in two case studies on the GBP/JPY.
Both case study trades were short (bearish) and utilized technical analysis. In both, it was assumed that a stop was set above resistance to protect capital.
Case One: Long Term
As you can see in the image below, the GBP/JPY began consolidating in a rising wedge pattern from March through August of 2008. When the breakout occurred in August, an initial profit target, based on the prior trend, provided a projected upside potential of about 5,500 pips.
Based on the profit target and upside resistance levels, a stop loss could have reasonably been placed almost 1,000 pips above the breakout, near resistance, to protect capital.
The large stop in this case was perfectly reasonable to account for volatility that may occur in the near term as the trend began to re-emerge. If you assume that you had a $10,000 account balance and were willing to risk 5% on any given trade, you would round up and only be trading one mini lot in this case.
Case Two: Short Term
The GBP/JPY recently formed a triple top and subsequently broke down to an initial profit target of 335 pips. A stop above resistance could have been placed at least 100 pips away. Assuming the same kind of portfolio sizing calculation was done in this trade as in the last one, you could have been trading five lots.
As you can see in these two contrasting examples, the analysis was similar, but the position sizing was proportional. Traders applying a 100-pip stop loss in the long-term position would have accumulated large losses as the market remained volatile and "whipped" them out. Similarly, an extremely large stop loss would have essentially left the short-term position uncovered.
The issue is compounded by the fact that a longer-term trader applying a short-term stop loss may have been getting in too heavily. We have found that it is very common for traders taking advantage of a long-term trade to get spooked very early because they are in the trade with too much size.
If any of this sounds familiar to you, take a minute to re-evaluate how you are position sizing, and make sure that your initial targets and stop losses are proportional to the opportunity, rather than transposed from another time frame.
Note: In the video, I will discuss another difference between long- and short-term trading: Costs. Trading in the short term can be fun, but it is expensive. The forex is one of the most expensive markets to trade in the short term, and in this example, the costs associated with the short-term trade could easily have been 1.5% of profits.
In the long-term example, costs were .0009% of profits. That makes a huge difference over many trades and could ultimately make the difference between an annual profit or loss.
Click here to learn more about position sizing in the forex market.
Watch the video now:
By John Jagerson of LearningMarkets.com
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