Learn To Trade – Trading Guide for Beginners
Table of Contents
What is Financial Trading
At its heart, financial trading is no different to any other form of trading: it is about buying and selling in the hope of making a profit. Here’s a rundown of the key concepts, participants and markets involved in financial trading.
What is being traded?
Financial trading involves the buying and selling of financial instruments. These can be cash instruments, like shares, forex or bonds. They can also be derivatives, such as CFDs, futures or options.
Whatever the instrument being traded, the intended outcome is always the same: to make a profit. To do this, you usually buy low and sell high. If you sell an instrument for less than you bought it, you’ll make a loss.
Who is doing the trading?
In financial markets, millions of companies, individuals, institutions and even governments are all trying to profit from buying and selling financial instruments at the same time.
This means that the prices of those instruments tend to constantly be on the move. A market that moves a lot is known as a volatile market. These markets bring more opportunities for profit, but also mean increased risk.
Where does trading take place?
Financial instruments can be bought and sold in one of two ways:
- They can be traded on exchanges, highly organised marketplaces where a particular instrument is bought and sold (like the New York Stock Exchange)
- Or they can be traded over-the-counter, when two parties agree to trade instruments with each other (like when you trade CFDs with a provider)
Risk
Risk is a key concept to all types of financial trading. No matter what instrument is being traded, who’s trading it or where the trade takes place, balancing potential profit against risk is what trading is all about.
BUYING AND SELLING
In every market, there are buyers and sellers – it’s important to understand how their relationship works, and how it influences the markets. When you place a trade, you’re notionally either ‘buying’ or ‘selling’ a financial asset. Buyers – also known as ‘bulls’ – believe an asset’s value is likely to rise. Sellers – or ‘bears’ – generally think its value is set to fall.
HOW DO BUYERS AND SELLERS AFFECT THE MARKETS?
At any given time, one group tends to outweigh the other, and that’s one of the reasons the price of a market fluctuates. When the buyers outweigh the sellers, demand for the market rises. As a result, the price of the asset climbs. When it’s the other way round, supply increases and demand for the asset starts to drop – and the price falls. The way supply and demand affects markets is often referred to as volatility.
GOING LONG AND SHORT
In traditional trading, you generally buy an asset in the expectation its price will rise so you can sell it later for a profit. This is called going long. However it’s considerably more difficult to take advantage of falling prices – also called short selling or going short. With leveraged trading, because you never actually own the underlying asset, betting on the value of an asset falling is just as straightforward as betting on it rising.
Short selling: what is it?
Short-selling is the term for a trade that makes a profit when the market in question falls in price. It goes against one of the key tenets associated with financial trading: buy low and sell high. Instead, a short-seller will try to buy high and sell low.
How does short-selling work?
When you short-sell, you are in effect borrowing the asset you are trading from your broker. For instance, if you believe Rio Tinto shares are going to drop in price you can borrow 100 shares from your broker, then sell them for the current market price. If they then drop in value, you can buy 100 shares at the new, lower price, and return them back to your broker for a profit.
Derivatives like CFDs and spread bets make short selling a lot simpler. Because you never own the asset you are trading, going short with these derivatives is as easy as going long.
Why short-sell?
Making a short trade offers the opportunity to make trades in markets heading downwards as well as upwards. On top of this, it can also be a great way of hedging.
For example, if you hold shares in several stocks featured on the Nikkei 225, then a downward move in that index could negatively impact your portfolio. Go short on the Nikkei 225, and you may be able to lessen the impact if your Japanese shares start dropping in value.
However, these opportunities carry with them a significant risk. When you buy an asset, the maximum risk of your trade is that the asset’s price drops to zero and you lose your investment. When you sell an asset, its price could rise infinitely so there is no cap on your losses. For this reason risk management tools, such as stops, can be useful when short-selling.
What is the Spread?
When you look at most financial markets, you’ll see three prices: the market price, buy price and sell price. The difference between the buy and the sell price is called the spread.
It’s a simple concept, but one that you’ll come across often when trading financial markets – and it could have a significant impact on the profitability of your trades.
Why is the spread important?
Tighter spreads tend to mean lower trading costs, as long as everything else is equal. This is because a tighter spread means that the market price doesn’t have to move as far from your entry price for your trade to become profitable.
Who sets the spread?
When you are trading assets like shares, forex or commodities, the spread is dictated by other participants in the market. If you are trading at market price, the offer is the lowest price at which you can buy, and the bid is the highest price at which you can sell.
When you are trading derivatives like CFDs or spread betting, your provider will often add their own spread on top of the market price. This spread represents the fee you are paying to trade the derivative.
What changes the spread?
Other than pricing, a number of factors can influence the size of the spread.
In general, the more people who are buying and selling a particular market, the tighter its spread. If there are fewer participants, spreads tend to widen.
Volatility, such as that brought about by major news or economic announcements, can cause large market movements that lead to increased spreads. This is to cover the increased risk of volatile markets.