Very simply, financial trading is the buying and selling of financial instruments. These instruments can take many forms, but some of the main categories are:
- Shares – small units of ownership in a company, such as Apple, Google, HSBC
- Indices – the value of a group of companies, represented as a single number, eg the FTSE 100, S&P 500, Nikkei 225
- Forex – global currencies, including the pound, dollar, euro
- Commodities – physical assets, raw materials and agricultural products, for example gold, oil, corn
People and companies often trade financial instruments because they need the assets for themselves or their business. For example, you may be travelling from Europe to the USA and want to convert euros to dollars. To do this you would participate in the forex market.
Or, a laptop manufacturer might need a large shipment of aluminium to build components for its computers. When buying the metal, the firm would be participating in the commodity market.
However, most of the time financial traders don’t need the assets at all. They are simply looking to make a profit from movements in the price, for example by buying low, then selling high.
Just like any other form of market, financial markets are where buyers and sellers come to trade. They are often physical locations where traders meet to exchange a certain type of asset, eg:
- Shares at the London Stock Exchange (LSE)
- Commodities at the Chicago Mercantile Exchange (CME)
But they can also be electronic systems, such as:
- The NASDAQ stock exchange
- The forex market (essentially a network of large banks and currency providers)
We’ll look at the different types of market in more detail later in this course.
Financial markets enable traders to exchange assets quickly and easily, because all buyers and sellers are in the same place – sometimes literally, sometimes electronically, sometimes both.
They also tend to have very strict rules and regulations, which helps to reduce fraud and illegal activity. For example, if you wanted to purchase some cotton on a regulated commodity exchange, you could buy it without needing to inspect it, safe in the knowledge it had been through a number of quality checks beforehand.
Did you know?
Despite the number and variety of different financial markets, when people refer to ‘the market’ they’re usually talking about the value of stocks and shares.
If the market has ‘gone up’ then on average shares are performing well. This is because share trading is the most widely known and understood methods of participating in the financial markets.
Lesson summary
- Financial trading is the buying and selling of financial instruments.
- There are many types of financial asset, including shares, indices, forex and commodities.
- Most of the time financial traders don’t want or need the assets – they trade to make a profit.
- Financial markets are where buyers and sellers come to trade
- The markets are regulated to reduce fraud, keep transaction costs low and improve efficiency.
Imagine that one day you decided to put all your savings under the mattress for safekeeping. If you then forgot all about that money, and left it alone for a year, it wouldn’t have grown. There would be exactly the same amount of money as you put there in the first place.
In fact, in real terms, it would probably be worth less than when you put it there, because the cost of living is likely to have risen in the interim.
Now, imagine you had instead used that money to buy financial assets such as shares or commodities. Instead of lying dormant, your money would have a much greater potential for growth as the value of those shares or commodities could go up. Though, of course, there’s always the risk they could drop in value as well.
Trading the financial markets is all about balancing that risk with the potential reward, and picking assets likely to move in your favour. As we’ll see, if you do this sensibly and intelligently, the rewards could be much greater than simply letting your money sit in a bank account (or under the mattress).
What we’ve described above is called ‘investing’, essentially a long-term form of financial trading which involves buying and holding financial assets over a number of months or years.
In fact, it’s quite likely that you’re already investing in the financial markets in some capacity – possibly only passively. If you have a pension plan, for example, then you’re investing the money you’re earning now with the expectation it’ll grow and be worth more when you retire.
Pension firms generally invest this money for you in return for a management fee. In most cases however, you can have a say in which financial instruments you put your money into. And as the chart below shows, a few simple decisions now could have a dramatic effect in the future.
Looking at the chart, you can see that £100 saved in cash in 1986 would be worth just £38 in 2014 due to inflation. If you’d invested that £100 in the UK stock market you could have received a return of around £1120.
But long-term investing isn’t the only way of participating in the financial markets, there’s also active trading, sometimes known as speculation.
While investors generally focus on the long-term value of assets and attempt to build a portfolio that will perform well in the future, active traders tend to focus on short-term market movements, with some participants placing hundreds of trades per day.
Whether you choose to focus on the long game, making only a few trades per year, or whether you believe that every tiny movement in price represents an opportunity, is entirely down to you, your personality, and how much time you can devote to trading.
We look at this topic in detail in the ‘Planning and risk management’ course, but for now it’s important to note that there are many different ways to trade, and many different types of trader. And whatever your interests, skills or priorities, there’s always a form of trading that will suit you.
One of the main differences between traders is the type of asset that they trade, and that’s what we’re going to start looking at in the next lesson…
Summary
Financial trading provides the potential for your money to grow, but there’s always the risk you can lose money as well.
Investing focuses on the long-term value of assets.
Active trading focuses on shorter-term movements in price.
If you’ve ever gone on holiday and exchanged say, pounds for euros, then you’ve participated in the forex market. Simply put:
Forex is how individuals and businesses convert one currency to another.
Forex, also known as foreign exchange, FX or the currency market, is the largest financial market in the world. On average over $5 trillion worth of transactions take place every day. That’s around 100 times more than the New York Stock Exchange (NYSE) – the world’s biggest stock exchange.
As well as being traded by individuals and businesses, forex is also important for financial institutions, central banks, and governments. It facilitates international trade and investment by allowing companies that earn money in one currency to pay for goods and services in another.
There are a huge number of market participants looking to trade forex at any particular time, from individual speculators wanting to turn a quick profit, to central banks trying to control the amount of currency in circulation.
However, by far the most significant players in the forex market are the major international banks. Between them, Citigroup, Deutsche Bank, Barclays, JPMorgan and UBS account for around 50% of global forex trade.
Individuals and businesses participate in the forex market for two main reasons:
Speculation
The vast majority of forex transactions are made simply to make money. This means the person or institution making the trade has no plans to take delivery of the currency, they are just looking to turn a profit on movements in the market.
With major financial institutions always looking to profit from small changes in forex prices, many large trades can occur throughout the day. This activity means currency rates are some of the most consistently volatile financial markets in the world – which in turn provides more opportunity for speculators to make money.
Purchasing goods or services in another currency
Every time a transaction is made between two entities in different regions, a foreign exchange transaction needs to take place to pay for the goods or services exchanged. Transactions such as this happen globally, every second of every day.
Despite the number of transactions, the amount of currency traded is often very small compared to trades made by large speculators. Therefore commercial trading tends not to have such a big effect on short-term market rates.
Unlike share trading, forex is an over-the-counter (OTC) market. This means that currencies are exchanged directly between two parties rather than through an exchange.
The forex market is run electronically via a global network of banks – it has no central location, and trades can take place anywhere via a forex broker of your choice. This also means that you can trade forex at any time, so long as it’s during trading hours in any one of the four major forex trading centres (London, New York, Sydney and Tokyo).
Forex trading hours: April-October (UK time)
In practice, that means you can trade most forex pairs from around 21:00 or 22:00 (UK time) on Sunday to 21:00 or 22:00 (UK time) on Friday, every week. The exact times can vary due to daylight saving time changes in the UK, USA and Australia.
Forex prices are always quoted in pairs such as AUD/EUR, which stands for the Australian dollar versus the euro. This is because if you want to purchase Australian dollars you need to buy them with another currency, like euros.
When trading forex you are simultaneously BUYING one currency while SELLING another.
Each currency in a pair is known by a three letter currency code. In general the first two letters stand for the country/region, and the last letter represents the currency. So taking USD/JPY as an example:
USD stands for the US dollar, while JPY represents the Japanese yen.
Summary
- Forex is how individuals and businesses convert one currency to another
- The main players in the market are major international banks
- Speculation accounts for the vast majority of transactions
- It’s an over-the-counter (OTC) market, where trades take place directly between two parties rather than through an exchange
- Forex is traded in pairs – you are simultaneously buying one currency while selling another.
- The first currency in every pair is the base or primary currency. The second is the quote or counter currency.
When you hear people speak about trading or investing, most likely they’ll be talking about share trading. It’s one of the most popular – and most traditional – ways to trade the financial markets. Particularly among individual investors.
As we saw in the previous lesson, if you’ve got a pension plan, the chances are you’re already investing in shares in some capacity. But what are shares? And how do they work?
A share is a unit of ownership in a company.
So, if a particular company is worth £10,000 and has issued 2000 shares, each share would be worth £5 (10,000 ÷ 2000).
As the share price fluctuates, so does the value of the company. Investors who buy shares in a company are hoping it will grow in value, enabling them to sell the shares at a higher price.
To raise money
By allowing investors to buy part of the company, the management are able to raise capital to put back into the business. For example, they may need extra cash to expand into other territories, or launch a new line of products.
If the funds are used wisely and the company becomes more profitable as a result, the value of the share price – and therefore the business – should rise.
This means the company and its shareholders are heavily reliant on each other. The company needs shareholders to raise funds, and the shareholders hope the company will use their investment to grow the business – so they can make a profit.
Share prices can stay fairly stable for months, or move rapidly. The amount a share fluctuates is known as its volatility.
Whether a share price moves up or down is based fundamentally on the laws of supply and demand. Essentially, if more people want to buy a share than sell it, the price will rise because the share is more sought-after (the ‘demand’ outstrips the ‘supply’). Conversely, if supply is greater than demand then the price will fall.
How levels of supply and demand move prices
Supply and demand can be influenced by many factors, but the main two are:
Earnings
These are the profits a business makes. If the earnings are better than expected, the share price generally rises. If the earnings disappoint, the share price is likely to fall. Companies tend to release earnings announcements for a specific time period, usually a quarter, half or full year. The firm’s share price can be particularly volatile immediately before and after the announcement, especially if the figures are significantly better or worse than anticipated.
You can use an economic calendar to see when certain companies are releasing earnings results.
Sentiment
This is perhaps the most complex and important factor in a share price. Share prices tend to react strongly to expectations of the company’s future performance. These expectations are built on any number of factors, such as upcoming industry legislation, public faith in the company’s management team, or the general health of the economy.
Summary
- A share is a unit of ownership in a company
- Companies offer shares to raise money, usually to invest back in the business
- Share prices are influenced by: supply and demand, earnings figures and market sentiment
Most major shares are traded on the stock market. This is a general term for a global network of specific exchanges where shares are bought and sold.
For example, the majority of UK shares are traded on the London Stock Exchange (LSE), while most US shares can be found on the New York Stock Exchange (NYSE) or NASDAQ.
These exchanges are highly-regulated marketplaces where buyers and sellers come together to negotiate the transaction of shares. Only certain qualified individuals are allowed to trade physically on the exchange itself, so investors generally need a stockbroker to act as a middleman.
You may have already heard of stock indices such as the FTSE 100, the Dow Jones or the Nikkei 225. Numbers often quoted on the news, or in the business section of the newspaper, usually alongside a value saying how much they’ve moved up or down.
But what are they? And what do they represent?
A stock index is a measurement of value of a certain section of the stock market.
This ‘certain section of the stock market’ can be:
An exchange (like the Tokyo Stock Exchange or NASDAQ)
A region (such as Europe or Asia)
Or a sector (energy, electronics, property, etc)
The FTSE 100 for example, is a number representing the largest 100 companies traded on the London Stock Exchange.
If, on average, the share price of these companies goes up, then the FTSE 100 will rise with them. And if the share prices fall, it will drop.
Stock indices give traders and investors an indication of how an exchange, region or sector is performing.
The ASX 200 for example, tracks the performance of 200 of the largest companies in Australia. If the ASX 200 starts to rise, then on average these companies are performing well. A rising ASX 200 tells investors that, generally, the state of the Australian stock market is improving.
And if the Australian stock market is on the up, then more often than not, the entire Aussie economy tends to be doing well. So, movements in the price of major stock indices can often give traders an indication as to the health of an entire country.
That’s important information when planning your next trade.
Most major indices are either calculated using a capitalisation-weighted or a price-weighted system.
Capitalisation-weighted system
Used by the majority of stock indices, this system takes the size of each company into account when calculating the value of the index as a whole. So, the more a particular company is worth, the more its share price will affect the index.
You can tell how much a particular company is worth by multiplying its share price by the number of shares issued. This is called its market capitalisation.
The FTSE 100 is calculated using this method. So if, for example, BP is valued at twice the size of Barclays – any change to BP’s share price will have twice as large an effect on the FTSE 100 as a similar change for Barclays.
Other indices using this system include the S&P 500, NASDAQ-100, Hang Seng, CAC 40, IBEX 35 and ASX 200.
Price-weighted system
This method is based on the actual share price of the companies in the index, rather than their overall size.
The higher the share price, the more influence that company has on the value of the index. For example, a stock trading at $100 would have five times more clout than one trading at just $20.
The only two major indices that use this system are the Dow Jones Industrial Average and Nikkei 225.
Since indices are effectively just numbers, you can’t buy or sell them directly. There’s no asset to own and nothing to exchange. Therefore, to trade on the price of an index, you need to choose a product that mirrors its performance. There are several that do this:
Index fund
A specialised investment fund that attempts to replicate the movements of a particular stock index. You can invest in index funds through a fund manager.
Exchange-traded fund (ETF)
A distinct type of index fund that can be traded like a stock on an exchange. Just like stocks, the price of ETFs can change throughout the trading day as they are bought and sold. Currently the largest ETF in the world is the SPDR S&P 500 which, unsurprisingly, tracks the S&P 500.
Derivatives
Financial products that derive their price from the performance of an underlying instrument. For example: futures, options, binaries, spread bets or contracts for difference (CFDs).
Summary
- Capitalisation-weighted indices are calculated based on the size of their component companies.
- Price-weighted indices are based on share prices.
- Stock indices are just numbers so you cannot trade them directly. You need to use funds or derivatives.
Commodities are physical assets. Unlike shares, indices or currencies they are raw materials mined, farmed or extracted from the earth. Some examples include:
To be officially tradable, a commodity must be entirely interchangeable with another commodity of the same type, no matter where it was produced, mined or farmed.
For example, to a commodity trader, gold is gold. It doesn’t matter where it was extracted. An ounce of gold mined in Australia is worth exactly the same amount as an ounce of gold mined in China, the USA or Tanzania.
The same can be said of other commodities such as natural gas, cotton and copper, so long as they meet certain minimum quality or purity standards.
Economists call this being fungible and it means large quantities of commodities can be traded relatively quickly and easily on an exchange. This is because every trader can be confident they are buying/selling equivalent assets without needing to inspect them, or find out where or how they were produced.
Commodities are often placed into two groups:
Soft commodities
These are agricultural commodities, farmed rather than mined or extracted. Softs tend to be very volatile in the short term, as they’re susceptible to seasonal growing cycles, weather and spoilage which can suddenly and dramatically affect prices.
Hard commodities
These are generally mined from the ground, or taken from other natural resources. Hard commodities are typically easier to handle and transport than softs, and are more easily integrated into the industrial process.
You may also see commodities classified according to their ecological sector:
- Energy (oil and gas)
- Metal (gold, silver, copper, lead, etc)
- Agriculture (wheat, coffee, livestock, etc)
There are two main ways to trade commodities:
The spot market
The spot market is where financial assets are sold for cash and exchanged right there and then. So, if you need immediate delivery of a commodity, you’d head to the spot market.
For example, say you ran a business that built industrial pipes. You recently got an order for a large amount of copper piping, but there’s none left in the warehouse. You need the copper immediately, so your best bet is to go to the spot market and buy some.
Similarly, if you owned a mining company and had some copper you wanted to get off your hands straight away, you’d try and sell it on the spot market.
Due to the large quantities of commodities traded – and global nature of these trades – set standards are used by the spot market so traders can buy and sell commodities quickly without the need for a visual inspection.
The futures market
The futures market is a place where buyers and sellers agree to exchange a specific quantity of an asset at a fixed date in the future, at a price agreed today.
The assets in question are not physically traded on the exchange, so the participants buy and sell futures contracts instead. This enables traders to speculate on the price of commodities without having to own them at any point, because the contracts can be sold or closed before the actual delivery date.
Which is particularly useful if, for example, you want to trade on the price of cattle, but don’t want several herds of live cows delivered to your door in a few months’ time…
While futures contracts are often used by individuals and companies looking to exchange physical commodities at a later date, they are predominantly used for speculation and hedging.
It’s also worth noting that the price of futures contracts tends to be different from buying or selling an identical amount of that same commodity on the spot market. That’s because the seller needs to take into account future risks and charges, such as the cost to hold the commodity and then transport it to the buyer. Hence futures contracts are valued using forward prices, rather than spot prices.
There are four main types of commodity futures trader.
Producers
These are companies/individuals that produce or extract commodities and enter into a futures contract to offset the risk of future price movements. If, for example, you are a coffee farmer and agree to sell your yield for a specific price on a specific date, you will have a guaranteed income on that date even if coffee prices plummet in the meantime.
Speculators
These are traders looking solely to profit on commodity price movements. They generally have no interest in owning the physical commodity itself.
Hedgers
These are mid- or long-term investors who hold commodities in their portfolio to provide protection against downward movements in other securities. Commodities tend to move in an opposite direction (or at least an unconnected direction) to certain stocks and bonds.In the event of a stock market crash, for example, investors holding commodities may not suffer as badly as those with exclusively share-based portfolios. Gold in particular is seen as a ‘safe haven’ and receives significant investment when equities are unstable.
Brokers
These are firms or individuals who buy and sell commodity contracts on behalf of their clients.
Summary
- Commodities are physical assets that are mined, farmed or extracted from the earth
- They can be soft commodities (agricultural) or hard commodities (energy and metals)
- They are traded on either the spot or futures market
- The spot market is generally for buyers and sellers of the physical commodity, while the futures market tends to be dominated by speculators and hedgers
Commodities are bought and sold on a number of exchanges specialising in a particular type of commodity.
LIFFE
The London International Financial Futures and Options Exchange is the largest trading floor for commodities in Europe
Speciality
Soft commodities: cocoa, wheat, coffee, sugar, corn
New York Mercantile Exchange (NYMEX)
The world’s largest physical commodities futures exchange
Speciality
Energy and metals: crude oil, natural gas, heating oil, RBOB unleaded gas, gold, silver, copper, platinum, palladium
London Metal Exchange
The world’s leading non-ferrous metals market
Speciality
Metals that do not contain iron: aluminium, copper, tin, nickel, zinc, lead, aluminium alloy, cobalt
ICE Futures US
A leading global soft commodities futures and options exchange
Speciality
Soft commodities: sugar, cotton, cocoa, coffee, orange juice
Chicago Board of Trade (CBOT)
The world’s oldest futures and options exchange
Speciality
Grains: corn, soybeans, soybean oil, soybean meal wheat, oats, rough rice
Contract size
Commodity futures are traded in contracts. Each commodity market has a standard size, set by the futures exchange where it trades. As commodities are often bought and sold in large amounts, the contract size also tends to be large.
Let’s take gold as an example. The contract size for gold futures is 100 troy ounces. So if gold is trading at $1100 per troy ounce and you buy just one contract of it, your contract would be worth $110,000 (1100 x 100 ounces).
Small investors generally don’t have access to such large amounts of money, so just like when trading forex, you can often trade commodity futures on leverage. Many exchanges and brokers also offer ‘mini’ contracts, which tend to be between 10% and 50% of the size of a standard contract.
It’s very important to note that both standard and mini contract sizes vary widely depending on the type of commodity – so it’s vital to check the contract size carefully before placing a trade.
As with all trading, the most important factor that affects commodity prices is the balance between supply and demand.
If, for example, there’s a good cotton crop which boosts the amount in circulation – the price of cotton will decrease (assuming that demand remains the same). On the other hand, if clothes manufacturers and other companies using cotton need more of the commodity, but producers don’t have the capacity to match this demand, the price will increase.
Other factors that drive commodity prices include:
The weather
Agricultural commodities are particularly dependent on the weather as it influences the harvest. A poor harvest will result in low supply, causing prices to rise.
Economic and political factors
Events such as war or political unrest can have a big effect on prices. For example, turbulence in the Middle East often causes the price of oil to fluctuate due to uncertainties on the supply side.
The US dollar
Commodities are normally priced in US dollars, so their prices generally move inversely to it. If the price of the dollar falls, it takes more dollars to buy the same amount of commodities – so the price of commodities rises. Conversely, if the dollar goes up then it’s cheaper to buy commodities, all things being equal.
Summary
- Commodities are bought and sold on special exchanges in contracts
- Contract sizes vary depending on the type of commodity traded, but tend to be very large
- However, smaller investors can usually buy and sell commodity futures using leverage
- Commodity prices are often very volatile and are affected by supply and demand, the weather, geopolitical factors and the value of the US dollar.