TYPES OF FINANCIAL INSTRUMENTS
Almost anything with a liquid price, from shares in a new company to soybean meal, from raw aluminium to Patagonian currency (whatever that is!), is probably trade-able somewhere in the world, through some vehicle, on some exchange. With so many types of financial instruments on offer, how do you set about deciding exactly what to trade? Let’s start by taking a look at some of the different types of financial instruments on offer:
Stocks and Shares
The first type of financial instruments is stocks and shares. A large proportion of individual stocks are not ideally suited to short term trading strategies. One or two of the day-trading setups we cover (such as the opening gap) could be played in the very heavy stocks, but with the super-liquid indices sitting there, why bother? Individual stocks really come into their own when used as part of longer-term investment strategies. Such as the Dual MA setup.
Stocks and shares are a method of equity participation. When you buy shares in a company’s capital stock, you attain ownership of a fraction of that business. Typically, you will receive a certificate of this ownership. Shares are the units into which a company’s total stock is divided. There are different classes of shares, each of which has specific rules, privileges, and values.
Unlike shares, which are equity security, the various forms of the bond are debt securities. They are issued by institutions in order to raise equity – often governments who wish to finance current expenditure. Essentially they are a loan contract. The issuer of the bond is a borrower (debtor), and the holder is the lender (creditor). The date at which the loan must be settled (along with any interest) is when the bond is said to ‘mature’. With ‘perpetuity’ or ‘Consol Bonds’ there is no fixed maturity date.
These financial instruments are typically a vehicle for very long term investment (usually between 10 and 30 years). Not something you’re likely to actively trade. However, movements in the bond markets provide important fundamental information when considering directions in the stock markets.
The next type of financial instruments is indices. An index is a group of stocks, and its price is determined by the total price of its stocks. Any change in an index represents the net change in the price of its constituent stocks. The FTSE100, for example, contains one hundred of the UK’s largest stocks. If the price of all of these stocks rises on a given day, so will the FTSE index. If most of the stocks rise but a small group declines, then the value of the index would most likely still rise. One sector alone would have to decline very significantly in order to ‘outweigh’ and drag down the whole index.
Many of the strategies we will cover are intended for trading the indices. In particular the FTSE100, the DOW30 (Dow Jones Industrial Average), and the S&P500 (‘Standard and Poors’). Unlike stocks, which you can physically buy and own, an index doesn’t really exist in any literal sense. An index is just the total price of a group of stocks.
You might expect that the price of a commodity such as lumber or corn would depend on fundamental factors such as the weather or consumer demand. Commodities are real-world items that people need. They are subject to all the changeability of the real world – droughts, plagues, collapsed mines, and political takeovers. You’ll be surprised to learn then, that commodities often trend beautifully, and can be traded according to specific strategies with relative ease. You don’t need to know anything about the state of coffee farming in Kenya to trade coffee! If something is truly capable of moving a market then the first place that this will be reflected is in price, and someone who knows nothing whatsoever about coffee will be able to relate to these movements on a price chart and begin to draw some conclusions.
Nevertheless, this doesn’t stop a lot of people trading commodities from fundamental data alone. Though such speculators are often very well informed, they frequently miss their entries into the markets, providing easy pickings for the disciplined technical trader.
Foreign Exchange (forex) has become a very popular type of financial instruments. The currency or ‘forex’ markets are not something that we will cover in this post beyond a brief introduction here. Why? Forex can be very difficult to trade, especially as a beginner. Learning to trade with consistently profitable results is never a breeze. Why not give yourself a break and steer clear of the difficulties of forex until you have gained some experience in an easier market?
Here are some reasons why forex markets are not a good place for beginners:
All forex pairs (value of one currency against another eg. dollar against yen) are traded with spreads rather than commissions. In the first instance, this is the bid/ask spread, and it is what the banks and institutions pay. They have no ‘brokerage’ fee to pay as forex is an interbank market. This means that the banks are the market makers.
If you want to participate in this market you will have to do so through a broker. The bank would quote a wider spread to the broker, and this will be passed on to you. The broker probably won’t charge you any commission, instead, widen the spread even further to ensure a profit for themself. By the time that you’re quoted the spread, it may have been inflated somewhere in the region of 5 pips. A ‘pip’ is the ‘price interest point’. It is the minimum permissible movement in a currency pair, rather like ‘ticks’ in other markets.
You will need to factor in spreads when you place stops and targets. In case you buy at the top of a five-point spread, to exit this position you must sell at the bottom of the spread, which is already five points away from where you have entered at the top. If you have a stop placed ten points from your entry at the top of the spread then this stop is only actually five points from where the bottom of the spread is. Just a five-point move against you will result in you being stopped out for a ten-point loss. If none of this makes any sense to you yet, then that’s another good reason not to trade forex!
The interbank market is de-centralised (it doesn’t trade anywhere in particular on an exchange). It is not regulated – this means that those with the real muscle in the big investment banks can do pretty much whatever they please. Like determining your stops to create liquidity for their own orders (they can see exactly where they are because the stops are on their order books). De-centralisation also means that there is no authoritative data source and that there is no market internals such as volume to confirm your trading decisions. Why would you choose to trade a market where you don’t have all this valuable information at your fingertips?
For some reason, there is currently a great deal of romance attached to forex trading. Millions of amateurs hand trillions of pounds over to the markets each year. Take a quick glance around the trading forums online and you will see how popular the Forex markets are with amateur traders. As well as, how many traders are frustrated with their inability to turn a profit with this type of financial instruments. Try not to become one of them!