The key to understanding financial markets
Financial markets are the engine of modern-day capitalism. The financial market's meaning can be different for different people and institutions. For investment funds, pension funds, and hedge funds, markets are the main place to make long-term investments. For retail and institutional speculators, markets are a way to make money short term. Governments, Banks, and corporations use the Forex market to exchange currencies. The list of participants is endless.
If you ask an economist, why is making money difficult, he or she will reply that the main reason is competition. Many people are competing with each other to increase their wealth. This is even more prevailing in the financial markets. Yes, some people gamble with their money making random investment decisions, but the main goal of speculators and investors is to make money. The nature of international financial markets is digital, fast, and massive. Which means that you need to be one step ahead of the crowd to make money. Getting financial knowledge and developing the ability to make investments on your own can help you grow your wealth. However, keep in mind that the financial markets are not for everybody. Investing is hard and requires hours of learning, trading, making mistakes, learning from them, and adapting.
What are the examples of financial markets?
There are 5 versions of financial markets:
- Stocks (company shares)
- Bonds (lending money to the government)
- Commodities (oil, gas, gold, silver)
- Derivatives (hedge funds)
- Forex (currencies)
As you can see, there are many types of financial markets, but it’s not something to be scared of. Usually, when a person is starting to trade, they choose only one financial market to focus on. But, that doesn’t mean people can’t trade on all of them. The nature of international markets is that anybody can participate in them, the internet and digitization of financial markets have made participation easier. Which in turn is great for the markets as liquidity is higher than before. For example, if a trader from India wants to invest in American companies, they will have to find a broker that allows such trades
What does each financial market do?
Every type of market has its characteristics. Each market has different pros and cons for investors.
- Stocks
- Allows companies to sell parts of their income and gather funds for new projects.
- Forex
- Allows the economy to grow based on currency value.
- Bonds
- Allows governments to fund new projects by offering better payouts in the future.
- Derivatives
- Helps companies to optimize the risk exposure and lets people speculate.
- Commodities
- Regulates the prices of raw materials, which are then used to manufacture goods.
Nature and role of financial markets
The list above shows what advantages financial market trading brings to the economy in general. However, the advantage to the trader him/herself still needs to be defined.
In this paragraph, we will take a look at what traders as individuals gain from financial markets and how they influence their nature. Let's take a look at financial markets examples and learn how they work.
Stocks – Stocks are issued by companies to get funding and expand. Private companies go public in IPOs. IPOs help small companies to become global. The nature and role of the stock market are to determine the value of a particular company. If the company has few shares available for sale, but the price is very low, that’s usually a signal that the company isn’t doing too well. This is in most cases followed up by price increases or new projects to somehow increase the share price. Stock markets are centralized, which means that for trading certain company shares, you need to be investing during an active trading session. Each exchange has its trading hours. It's important to note that there are physical stocks and stocks as CFDs. Physical stocks are a preferred choice of long-term investors. For short-term profits, speculators trade stocks as CFDs. CFD stands for Contract For Difference, which makes short selling possible. Speculators can benefit from shorting stock CFDs.
Forex – Forex is the largest and the most liquid market in the world. Currency trading is decentralized, which means that when one exchange closes, you can still trade Forex in another one. Forex markets are open 24/5. However, it's worth mentioning that Tokyo and Sydney trading hours are not as active as London and New York. Both retail and institutional Forex traders are providing liquidity for banks, governments and other participants. How is Forex trading benefiting you as a non-Forex trader? Every time you go to a vacation in Rome and exchange local currency to Euro, you can thank the Forex market for low spreads.
Commodities – Commodities are raw materials that can be grown or mined. Trading commodities increases liquidity and creates a more risk-free environment for commodity producers. Investors can invest in commodities in various ways. They can purchase physical precious metals, purchase commodities as CFDs, or invest in companies that produce commodities. The commodity market is highly influenced by demand and supply. For instance, in times of war and political instability, demand and therefore the price of oil increases. Global warming damaged food production and commodities such as wheat went up in value. Traders who are aiming to invest in commodities, need to study the global economy. Commodities are strongly tied to the economy as a whole. Even if you are only going to trade currency pairs, learning about commodity markets can help you make more informed decisions. OPEC countries are largely dependent on the revenues made by exporting oil. If you are trading a currency pair that is highly correlated to oil prices, you should be keeping an eye on energy prices. Currencies that are dependent on commodity prices are called commodity pairs.
Through the commodities market, you as a trader will take part in changing prices for electricity, petrol, jewelry, etc.
Bonds – The bond market is considered to be safer than other financial markets. Bonds are issued by governments and large corporations. The low-risk assets are characterized by low returns.
Criticism of modern day financial systems
People that criticize modern financial institutions, emphasized the fact that speculators do not create an actual product. They get rich by taking from other people. However, this might be an exaggeration. Traders are actively involved in price creation, they provide increased liquidity to Banks and other institutions. Speculators move funds from infective businesses to effective ones and get rewarded for it. Big businesses use funds received from financial markets to increase production through automation and create wealth. Money is not real wealth. If you print more money and give it to the world, the world will remain poor. The only thing that will change is inflation. The real wealth is created by the businesses that build products and offer services.
It's worth mentioning that modern financial markets help assets grow in price drastically and drop sharply. Thanks to digitalization, printing money from thin air, and globalization, inflating financial bubbles has become easier. For passive investors who are not following market developments closely, investing in such markets might become costly. The best way to protect your investments is to stay informed.
Demystifying Derivatives: Understanding Complex Financial Instruments
Derivatives are complex financial instruments that require a deep dive to understand correctly. Major financial markets including Forex offer various types of derivatives, making it crucial for traders to understand what these asset types represent. Derivatives are financial contracts whose value is derived from an underlying asset, index, or even rate. Derivatives play a significant role in modern financial markets, as millions of traders are speculating on these assets, often without the need to own underlying securities.
Options and futures
The list of popular derivatives includes futures contracts, options, swaps, forward contracts, interest rate derivatives, and more.
Futures and options are very popular derivative markets, where billions of dollars are traded daily. While not as gigantic as Forex markets, options and futures markets are significant contributors to global financial market share. Options are derivatives that provide the holder with the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price (strike price) within a specific time frame. In essence, traders usually use options to make profits from price movements, and they rarely use options to buy the underlying asset. Unlike options, futures oblige the two parties to buy or sell the asset at a certain date and price.
CFDs demystified
In Forex markets, the most popular forms of derivatives are CFDs or Contracts for Difference. In many cases, Forex brokers typically offer the majority of their trading instruments in different asset classes using CFDs. CFDs allow traders to speculate on the price of an asset without actually owning it. Forex CFDs, in this case, are currency pairs that can be traded without owning the underlying currency pair.
While being criticized and even prohibited in the United States, CFDs can be super beneficial for specific assets like cryptocurrencies. The main reason why it is much more flexible to trade crypto CFDs instead of actual digital currencies is their execution speeds. CFDs are typically lightning-fast and allow traders to instantly speculate and make profits from short-term movements. Cryptos require network confirmation from the blockchain, which makes them much slower when compared to CFDs.
However, there is a dark side to CFDs as well, as they are highly risky assets and traders can experience substantial losses if they are not carefully controlling their risks. CFDs usually come with higher leverage levels that can amplify potential profits manyfold. The same is true for losses, and traders must employ well-implemented risk management strategies to limit losses. The most basic risk management tool that is also very potent in this regard is to always use stop loss in all trading activities.
Binary options explained
One type of derivative is especially dangerous. The binary options are derivatives that allow traders to bet on where the price will be at the predetermined time when compared to the current price of an asset. Traders can buy put and call binary options instead of going long or short, and they come with expiration times and dates. Binary options are usually offered for Forex pairs and are prohibited in many countries because they resemble gambling.