What is Passive Trading?
Passive trading is a term you’ll often hear associated with a buy-and-hold strategy. While the time horizon isn’t nearly as long as indexed investors, passive traders will hold for as long as an opportunity takes to manifest. Often, passivity is synonymous with patience. That said, passive traders will take profits as soon as they materialize and need to have a clear exit strategy.
Most passive traders automate their trades. They open the position, set a stop-loss, set a target price and leave the rest up to the market. While they might monitor and reevaluate their trade levels based on patterns and context, actual trade activity remains minimal. They’re looking to realize their thesis and take profits above what a day trader might expect to see.
Passive Traders vs. Buy-And-Hold Investors
The biggest difference between passive traders and buy-and-hold investors is time. Buy-and-hold investors often wait years and years before they take profits. Passive traders tend to trade inside of a year, but can have positions open for 18 months or more if the pattern formation is long-tail.
There’s another fundamental difference between the two. Buy-and-hold investors look to pace or slightly outpace major indices. Passive traders look for larger gains based on a specific pattern in the security’s chart. In this way, passive trading is a good intermediary between day trading and long-term investing. Day traders fear time. Investors rely on it and passive traders leverage it.
Minimize Losses by Leveraging Time
Day traders fear time in the market and seek to capitalize on small shifts in price. Buy-and-hold investors will stay in a position for years at a time, with the expectation that markets generally go up. Passive traders exist somewhere in-between. They profit from trends in the market, yet don’t stay in positions long enough to see major reversals. Here’s an example:
Matthew sees the formation of a butterfly pattern on the stock chart for XYZ Company. He opens a position accordingly and expects to wait roughly five months for the pattern to complete. He sets a target price and stop-loss and waits for the pattern to culminate.
This time period is more risk than an active day trader or swing trader wants to take on. Yet, it’s a much shorter time horizon than a buy-and-hold investor prefers. Passive traders live in the middle. They leverage the time it takes for a pattern to fully culminate and are willing to wait for it to break out to take profits.
The biggest consideration is the system a passive trader uses. Because they’re not actively engaged in trades daily, passive investors need confidence in their system. This means strong technical analysis and rigid adherence to rules.
The Benefits of Passive Trading
Passive traders tend to avoid the fees that active traders incur. They’re not subject to the $25,000 minimums of the pattern day trading rule. They also avoid triggering frequent taxable events. In fact, if a position bridges taxable years, passive traders can defer the tax burden.
For passive traders, time acts as a hedge against volatility. A security’s price may fluctuate, but passive traders see it in the form of a developing pattern. So long as their analysis of the pattern is accurate, fluctuations are nothing but noise—noise they can wait out. And, because they’re not tied to a position for years and years like buy-and-hold investors, passive traders aren’t illiquid.
There’s also potential for larger returns. Passive investors are willing to wait for market-beaters over several months. In doing so, they accumulate stronger gains than day traders and regain liquidity to invest in similar positions quicker than buy-and-hold investors.
Passive Investing Drawbacks
Liquidity can be an issue for some passive investors since they’re at the mercy of a pattern. Expecting returns in three months and waiting five months for a pattern to reach fruition can cause problems for traders.
Similarly, the longer you’re in the market, the more potential for macro interference. A pattern might fall apart two months in on news of executive misconduct or something similar. Passive traders are subject to taking a loss when the pattern unravels. Larger market downturns or sector disruptions compound this.
Less of a drawback and more a barrier to entry, technical analysis skills are a must-have. Without the ability to distinguish patterns and understand their governing factors, passive traders risk gambling. Passive trading only works when you have the confidence to predict normal behavior in the context of technical variables.
The Bottom Line on Passive Trading
Passive trading moves at a slower pace than day trading or even swing trading. It’s a great mode of investing for those who are patient enough to develop a thesis and monitor their position. Like all types of trading, a passive approach takes discipline. Passive traders need an exit plan and principles that govern their decision to exit a position. Sound technical knowledge is a benefit, and the ability to read a chart is paramount.
Passive trading is growing in popularity. And it’s a great way to build wealth in your life. Sign up for the Liberty Through Wealth e-letter below to further advance your knowledge of passive investing.
Passive traders typically believe that the market is too volatile to predict intraday movements. Likewise, they believe there are market-beating opportunities over shorter time horizons than an annualized return. It’s a true middle-ground between active day trading and passive buy-and-hold investing.