In January 2021, a struggling video game retailer dominated global headlines. The story of GameStop – which saw thousands of small investors push a struggling stock to soar 1,700 percent – has made many people wonder if they too should take a chance and invest in stocks.
Short-term stock trading is more accessible than ever before, thanks to convenient trading apps like Robinhood and the plethora of investment information online. However, there are significant risks to short-term investing – so before hopping on board the short-term stock bandwagon, it’s important to understand what short-term trading really means and where it could lead to big losses.
Short-Term Trading vs. Long-Term Investing
Short-term trading usually involves buying low-cost stock in a company, letting it sit for a few days or even just a few minutes, and selling before the price can fall. It’s the classic buy low, sell high scenario. Particularly after GameStop, many people are now reading social media forums or other informal investment news sites to learn how to identify stock patterns or find the “next big thing” before everyone else does.
Long-term investing, on the other hand, takes a more hands-off and diversified approach. Rather than investing your money in just stocks and tracking them vigilantly, as a long-term investor you are more likely to put money into a mutual fund or index fund that includes a variety of stocks and is managed by an investment professional. That professional would make limited trades, based on market conditions and the level of risk set out by your selected fund. Some long-term investors may also invest in stocks only but hold a small portion of their investments in just stocks.
Market Volatility: Risk and Reward
Short-term trading and volatile markets go hand-in-hand. When people talk about volatile markets, they’re referring to the likelihood of wide price fluctuations and heavy trading. In other words: your investment could significantly increase in value, but it could equally see a significant loss.
The idea of getting rich fast is enticing, but beware of any investment that seems too good to be true – it probably is. A key risk when investing in a volatile market is the bubble: when lots of people become enthusiastic about the same investment, leading to a rapid rise in its value. Unfortunately, the bubble can pop just as quickly as it grew – and if you don’t get your money in and out at exactly the right time, you might lose everything.
Another key risk of stock trading is investing money you don’t actually have. Margin trading, for example, means using borrowed money to buy securities; which ultimately means you could lose more money than you’ve invested in the first place. Short selling is another potentially risky move, in which you bet on the likelihood that a certain stock will lose value. This exposes investors to potentially unlimited losses if the stock actually does climb to a higher price, as we’ve seen in the recent GameStop stock surge. Investor.gov provides more details on short sales and other investing terms.
What About Taxes?
No doubt about it, short-term stock trading feels exciting – from the research into what companies are on the up-and-up, to the thrill of (hopefully) watching your investment rise. And yet, it’s important to recognize that any potential profits from short-term trading are subject to some not insignificant tax rules.
For tax purposes, an investment profit or “capital gain” is defined as short-term if it’s purchased and sold within one year or less. Short-term capital gains are subject to higher taxes than capital gains from long-term investments, which means that even if you bet right on the stock market and quickly make a profit, your earnings will be taxed up to 37% depending on your tax bracket. Long-term capital gains, on the other hand, are normally taxed 15% or lower for most investors. Tax rules like these are one of the strategic reasons that many people choose to diversify their investments with long-term investment. The IRS website provides details on capital gain tax rules.
The ultimate takeaway is that short-term investing is risky, especially in comparison to a long-term investment plan that’s more diversified and tax-advantaged. Check out official resources online such as www.investor.gov and IRS.gov to find more information about investing and see how to make the best decision for you and your money, today and well into the future.