Passive and Active Trading
Passive trading is a trading technique that intends to increase earnings by decreasing the amount of money spent on buying and selling financial instruments. At the center of passive trading stands a buy-and-hold strategy in which traders don’t trade in and out of different assets very often.
The goal is to match, not beat, the performance of the financial instruments. One of the most common methods of passive trading is indices trading, a popular passive trading technique in which traders buy a representative benchmark, like the UK 100 index, and hold it for a long time. The indices’ main advantage is that they automatically change their holdings. Thus, traders don’t have to re-balance their portfolios themselves.
Core advantages of passive trading
Simplicity: Passive trading tries to increase the market’s performance by creating well-diversified portfolios of different assets. If done individually, this portfolio would need substantial research and time and have a greater risk.
Lower fees: Because no portfolio managers pick shares, management fees are significantly less costly, and operating costs are lower.
Tax-efficient: The buy-and-hold strategy results in lower capital earnings taxes because long-term trades are taxed at a lower rate because the taxes don’t apply to unrealized profits.
Diversification: Passive trading with indices is a simple way to achieve diversification.
Key disadvantages of passive trading
Market risk: Since indices funds measure the market performance, passive trading is highly affected by volatile markets, especially during bear markets.
Lack of flexibility: Profits do not exceed nor beat the market as the index funds are created to measure the market performance closely.
Stuck with the assets: Despite how well or bad the assets in the index do, passive traders are stuck with them.