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This chapter is from the book

The Nature of Trading

Trading is essentially a game. Like other games, it requires both skill and intelligence. Over the short run, luck plays a role in determining trading performance. However, over the long run, luck washes out and trading skill determines performance. What makes trading so challenging is that although the objective of the game is constant (to make money), the “rules” of the game may change over time as the reaction of other market participants to the same event may differ over time.

Active financial markets are dominated by traders and trading activity. Trading impacts the behavior of financial market (or speculative) prices. Understanding how traders make decisions is important for all market participants.

One important implication of having financial markets dominated by traders and trading activity should be kept in mind: Market prices can deviate from intrinsic value over significant periods of time. These deviations can create investment opportunities for value investors or long-term traders.

How does trading differ from investing? Trading and investing have many characteristics in common. Both involve the assumption of risk. Both are profit oriented. Although many trades are held for short periods of time, the trading horizon need not be shorter than the investment horizon. Nor do the two activities need differ in terms of what is traded or the risk assumed.

Trading differs from investing in the following way: Most investment decisions are based on how the market price of a security differs from its intrinsic value. Thus, the rule is to buy when the market price is less than the intrinsic value or sell when the market price exceeds the intrinsic value. This rule contains the implicit belief that the market price of a security will converge eventually to its intrinsic value.

In contrast, with the exception of arbitrage transactions, traders are not concerned with the relationship between price and intrinsic value per se. Rather, traders are concerned with the likely change in price over their trading horizon regardless of intrinsic value.

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