Traders or Investors?
This is a basic but a confusing aspect. Most of the people use these words conversely without realizing the important differences among the two, though both these concepts differ on a vast scale. Traders are an integral part of the markets, as without the active participation of traders, markets cannot function efficiently. Traders participate in the same market as investors, but their roles, objectives, strategies and method of approaching financial markets differ. Traders are also market participants who purchase shares in a company based on the market rather than the company's fundamentals.
Traders are the ones who trade on a shorter time horizon, often looking for price fluctuations in a stock and making profit from it rather than investing a security for the long-term like investors. Traders make their predictions and take hints from price patterns, supply and demand, and market emotion. Major traders include investment banks, market makers, arbitrage funds, and proprietary traders and firms. Ultimately, it is the traders who create liquidity for investors and always become the second party in investor’s trades. Whether it is market-making or fading, traders make a necessary part of the marketplace.
Factors Considered by Traders in order to Make Decisions
Traders take their cues from their analysis of different terms.
Traders analyse the price history and predict future price movements, which is known as technical analysis.
Supply and Demand
Traders keep themselves well informed on the movements of their trades to track where the money is moving and why.
One factor that cannot be avoided is the market situation. Traders trade relying on the fear of investors through techniques like fading, where they bet against the crowd after a large move takes place.
Market makers (one of the largest types of traders) are actually hired by their clients to provide liquidity through rapid trading.
What are the Key Roles that a Trader plays in the Market?
A trader in his day to day life plays critical roles in the smooth functioning of the market. Traders buy and sell financial instruments with the aim of making a profit. They can choose between cash instruments such as shares, forex or bonds, or derivatives such as futures or options. With cash instruments, the aim is to buy an asset at a low price and sell it at a higher price. Traders are in the market to earn profits from short term to medium term trades.
Let’s discuss the five key roles of a trader
Infusing Liquidity by Trading in High Volumes
Traders help the other buyers and sellers by making the high trading volume transactions possible. This happens because, traders are in the market to earn short term to long term profits. Traders deal in high volumes frequently to make profits out of the short term or medium term price differences. At higher levels, these traders can be sellers and the same traders can be buyers at lower levels. This two-way approach of traders makes the market liquid for the rest of the buyers and sellers, and increases the volumes in the market and ensures that your transactions get executed with minimum risk.
Help in interpreting decision points
In any trading day, there are a number of triggers or situations that influence the market price. There could be changes in RBI policy, quarterly results coming out, and even company-specific announcements, corporate actions. This makes it difficult for an investor to sit and evaluate these factors on an individual basis. So, by trading in and out of the markets by relying on the news flows and market flows, the traders are instrumental in distributing information about a stock. This becomes a very critical input point for the other traders and investors in the market.
Traders help to keep the trading spreads in control
Traders help the market overcome the problem of wide bid-ask spreads in control. Any spread where the difference can cause a loss to the seller/buyer, the traders benefit you. If the traders find the spreads too wide, then traders participate in intermediate spreads encouraging buyers and sellers to settle at a profitable level. In the process the trader also makes a spread but also reduces the overall risk in the market by tightening the bid-ask spreads on the stock.
Traders remove inefficiencies in the market
Traders actually help the market to get away with the inefficiencies. Many traders have computerized trading systems set to monitor fluctuations in similar financial instruments. Any inefficient pricing is usually acted upon immediately, and the opportunity is eliminated.
For Instance, If a stock is quoting at a spread-gap of 1% between the BSE and the NSE. Any smart trader will spot this arbitrage opportunity and buy the same stock in the exchange where it is priced lower and sell in the exchange where it is priced higher. This also happens in case of stocks where the cash/futures arbitrage spread is too wide. For example if the stock of Reliance Industries Ltd. is quoting at Rs.900 and the future is quoting at Rs.918, then it translates into an arbitrage spread of 2% per month. Traders and arbitrageurs will immediately buy RIL in the spot market and sell it in the futures market till the time the spread comes down to more realistic levels.
Traders can prevent acute market crashes
Many people are afraid of the stock market crashes because it results in closure of positions and massive losses. Normally, speculators and short sellers are blamed for market crashes but ironically these short sellers can actually prevent the market from crashing sharply. Here is how! When traders are negative on the market, they will sell the stock or the future short. While it puts pressure on the market, it is not a free fall as the delivery positions are not liquidated. Secondly, when short sellers sell the stock at higher levels, they also come to buy back the stock at lower levels. This short covering helps in stabilizing the market limiting your losses in the process. However, in the absence of short sell traders, markets can go into a free fall with larger implications for investor wealth.
Without traders, investors would have no liquidity to buy and sell in the market. Without investors, traders would have no basis from which to buy and sell. Combined, the two groups form the financial markets as we know them today.