Financial markets can be segmented into the
following:
- capital markets (bonds, money, stocks) refers to the
raising of capital
- derivatives markets (futures, FOREX, warrants) refers
to the transfer of risk
- currency markets (foreign exchange)
refers to international trade in currencies
A primary market refers to the issuance of securities.
Public companies, government bodies and institutions can obtain
capital through the sale of new stocks or bond issue. The process of
selling new stock is referred to as an Initial Public Offering (IPO)
similarly the selling of bonds is referred to as
underwriting.
Once new issues have been placed on into the market
they become part of a secondary market. This is where traders can
then buy and sell the shares, bonds, futures or foreign exchange.
Simply put, a secondary market is open to price speculation and is a
place where traders can profit from price fluctuations.
There are many different financial products that can
be traded, such include; shares, warrants, FOREX, contacts for
difference, futures, and foreign exchange. All financial products act
differently and need to be considered with their own merit. One of the major differences
between products is the level of leverage. Ordinary shares have the
simplest structure where a loss or win is directly related to the
share price. However when dealing with futures and foreign exchange
leverage can be available up to 400:1 and even more.
Share can be described as owning a part of a company.
Needless to say it is commonly a very small part of that company.
There are different classes of shares beginning with Fully Paid
Ordinary Shares (FPO), Contributing Shares and Preference
Shares.
FOREX are a derivative product that can be place over
shares, futures and other financial instruments. An option gives the
purchaser the right but not the obligation to take the underlying
product at a future date and an exercise
price.
A CFD is a derivative product that allows the
purchaser of the contract to gain from an underlying price movement
of a share. The reason that traders may choose to use such a product
is for it ability to leverage. This margin allows traders to control
share with a margin of 20% for share in the ASX top
300.
A futures contract is a product that allows a
commodity of a standardized quality to be bought or sold at set
price at a future date. Traditionally futures are placed on
commodities like precious metals and agricultural goods this allows
the purchaser to hedge against price fluctuation so a profits can be
locked at todays price. Now futures can be placed on no tangible
assets like a stock index and interest rates and foreign
currency.
The futures contract and especially the index futures
will be discussed in detail in Module
1.
Foreign Exchange trading works on the premises of the
simultaneous buying of one currency and the selling of the other. It
is not traded through an exchange like the ASX or NYSE however
through large banks which is referred to as over the counter (OTC).
Foreign Exchange will be discussed further in Module
2.
Trading and investing needs to viewed as two separate
topics and should not be deemed the same. Investing takes a long
term approach to profiting, commonly with a fundamental
characteristic to make an evaluation. News releases, market
environment and economic conditions may influence investors
decisions of when to buy and sell a particular instrument. Not with
standing separate tax implications an investor may also make only a
few trading decisions during a year.
Trading offers an individual the ability to create an
alternate income from the markets. Typically trading is viewed as
short term profiting from the markets keeping trades from a few
minutes to a few weeks. A trader certainly considers fundamental
factors however makes trading decisions solely on technical reasons.
This means understanding patterns and indicators helps a trader
follow a system to support a reason to enter or exit a
trade.
Mechanical trading offers traders a clear defined set
of rules. This helps the trader choose when to enter and exit a
trade. These rules are back tested over historical data to see if
the rules produce profit. With a short term view, markets function
in a habitual manner this suggests that if a set of rules produce
profit in the past that they are likely to continue producing profit
in the future. These set of rules are created by the trader and,
with the uses of a computer are programmed to scan and alert when a
trade is available.
Similarly, discretionary trading uses a set of rules
to enter and exit a trade based on market patterns and indicators.
However it does not involve programming complex algorithms into a
computer and does not delay the trade execution. It leaves the final
decision up to the trader, needless to say, if a system gives you a
signal you should always take it (assuming it has been back
tested).
A Day trader is defined as an individual taking one to
several trades and closing out in one day. A day trader typically
closes out all positions before the end of the trading day.
Trading should always be treated as a business. This
means keeping accurate records of trades, profit, losses and
expenses (commissions).
Trading has separate taxation implications to
investing. You should sort out a tax accountant to verify these
details.
When dealing in financial products there will always
be a level of risk involved. Some of the risks can be defined in the
following.
- Market Risk refers to the overall market conditions
and factor that can influence loss through market movement. Such
include; political, economic and legation.
- Global Risk international conditions can also have
an influence on markets. These can cause a local market to change
especially if there is a strong connection to that local
economy.
- Sector Risk Sectors related to an industry can be
affected when that supply of demand for the product produced by
the industry change. For example the mining sector can suffer when
a major buyer cancels contracts.
- Specific Risk Risk of loss involved with a specific
share due to specific company reasons is referred to as specific
risk.
- Timing Risk The choice of when to enter and exit a
trade can be highlighted as timing risk. If a trade is left too
long to enter one could be buying at the top and not make enough
profit. Again one could exit a trade too early and miss potential
profit.
- Trading Risk Trading risk refers to the risk taken
on each trade. A decision need to be made on how much one is
prepared to loose if a trade moves against them.
Understanding the risks involved combined with a
tested trading system starts a trader the correct path to becoming a
successful trader. When these are not used to in a systematic
fashion a trader can become emotional when making decisions.
Trading can be extremely stressful this is why a clear
set of rules to enter and exit the market is necessary. Also,
referred to as trading style, the instrument and timeframe needs to
be selected to reflect the personality of the
trader.
The most common mistake that a new trader makes is
selecting an inappropriate style, not understanding the potential
for loss and applying incorrect amount of capital to a trading
float. These combinations of factors lead to an emotional journey
for the novice and subsequently lead to
losses.
This topic is discussed further in Module 5 -
Psychology
