The key to understanding financial markets
Financial markets are the engine of modern day capitalism. Financial market 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 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 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 require hours of learning, trading, making mistakes, learning from them and adapting.
What are the examples of financial markets?
There are the 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 digitalization of financial markets has 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 own 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 of 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 its 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 good. 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 own 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 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. Commodity market is highly influenced by demand and supply. For instance, in the times of war and political instability, demand and therefore the price of oil increases. Global warming damaged food production and commodities such as wheat go up in value. Traders that are aiming to invest in commodities, need to study 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 price, you should be keeping an eye on energy rices. 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 – 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, put an emphasis on 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 business to effective ones and get rewarded for it. Big business 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 business 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 that are not following market developments closely, investing in such markets might become costly. The best way to protect your investments is to stay informed.