What’s the difference between trading and investing? Investors have money which they invest; traders have very little capital but borrow in order to invest.
How can this be? The answer is easy. Traders borrow using the security of the securities they are going to buy! How does it work? Well suppose you think Marks & Spencer shares are going to rise in value. You buy them, then immediately pass them to a bank which in return provides cash. You then use this cash to pay for the securities you have just bought! This is called repo (short for ‘sale and repurchase’) and is exactly like secured lending. Everyone is happy. The lender has security in shares to cover the loan, and you have been able to borrow to speculate on shares rising.
But traders are not always bullish. Sometimes they want to bet on shares going down, In this case, the reverse transaction takes place. You sell shares you don’t own – called selling short. You immediately borrow the shares from another institution and hand them the money you’ve received from the share sale. When the price has – you hope – fallen, you buy back the shares at a lower price and close out your position.
Another way of speculating when you don’t have much capital is to use derivatives. These are synthetic securities which can be traded in the same way as shares, but where you only have to pay an initial deposit (margin) which is as little as 1% of the underlying value. If the price goes the way you have bet, then you need put no more money in, just take the profit when you sell the shares. But if the price goes against you, you have to top up the account to cover the losses on a day to day basis. But in general, derivatives allow you to leverage up by factors of 50 or more.
In recent years, hedge funds, who are investors in that they manage a pool of money, saw the profits that could be made through leverage and began to behave like traders. All went well until the credit crunch. But when things go wrong, leveraged traders can be wiped out very easily. The hedge funds run by Madoff used derivatives to enhance return supposedly without taking on too much risk. Yet anyone in the business knew that there is no holy grail. You can make fat profits in the good times only if you take on risk – and that means there is always the chance of going bust.