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Introduction to financial instruments: what you can trade
The financial markets offer a variety of instruments that you can trade. Most traders have heard about forex, stocks and mutual funds, because typically they are the most straight-forward financial instruments that anybody can understand. But the market is not limited only to those and, with a bit of research, you will discover that there are multiple other instruments available, some of which may suit you better than the main ones.
What is a financial instrument?
To put it simply, all assets that you can trade on a market are financial instruments. They can be either real or virtual documents that have a monetary value. To determine which type of financial instrument is suited for your trading style, you must take into consideration some factors:
- Liquidity: this represents how hard or easy it is to trade a certain financial instrument. A high level of liquidity means there is a much bigger chance for you to trade a certain instrument at any moment. One such example is forex.
- Volatility: it refers to how much a market fluctuates in a certain period of time. For example, a market that rises and falls more than one percent over a continuous period of time is called a volatile market. High volatility benefits most to experienced traders who can take advantage of it and generate more profit.
- Transaction costs: this represents the payments (commissions and spreads) that traders give to banks and brokers for their role in the market. An instrument with a low transaction cost typically represents a steadier way to generate returns on a trade.
- Flow of information: the main thing all trading markets have in common is that the prices of their financial instruments depend tremendously on the news. In order to establish a profitable trading career, you need to be up to date with the news, which means that a market with a heavy flow of information should be preferred.
Every financial instrument typically belongs to one of the five main categories: forex, bonds, commodities, equities and indices, all of which are influenced in some way or another by the above factors.
The forex market represents the largest trading market in the world, which is why it has become so popular and comes with some of the best financial instruments that can be traded. The market’s daily average volume is larger than $4 trillion, making it a highly volatile market.
The foreign exchange market mostly deals with the trading of currency pairs, such as EUR/USD, GBP/USD or USD/JPY. Because currencies are a relatively stable financial instrument, the forex market represents one of the best places to establish your career as a trader.
Besides high levels of volatility, as the market is open 24 hours a day, 5 days a week, meaning you can find someone to trade with at nearly any moment, it also offers high liquidity, especially for major currency pairs.
Bonds are divided into Exchange Traded Funds (ETFs), and Government Treasuries. ETFs cover a larger portfolio of financial instruments, including stocks, currencies, commodities and real estate. When buying an ETF, a trader buys a specific number of shares to a certain portfolio. Some traders do decide to trade ETFs on margins. ETFs are preferred by some traders, as they do offer great diversification and a lower risk rate.
Government treasuries are competing with forex as one of the best financial instruments to be traded. The reason behind this is that they do provide a lower risk exposure, making them suited for those who are looking for safety in the trading world. They come with the highest guarantee of return out of all financial instruments, which is why most traders hold some in their portfolio.
Another way to trade stocks is through CFDs (Contract for Differences). This advanced trading method has started to gain popularity, increasing the demand for stock CFD brokers, especially in Europe.
Commodities are liquid assets that can be traded in the financial market. They typically include assets such as gold, silver or crude oil. Commodities provide, for many traders, a way to diversify their portfolio, as they get to experience something other than stock equities. They are typically categorized into five main groups: agricultural, livestock and meat, energy, industrial metals and precious metals.
There are multiple ways for traders to buy or sell commodities, such as exchanges or futures contracts. Prices are mainly driven by forces or supply, meaning that, if one type of commodity has a lower supply, it will result in higher prices, especially if the demand is high as well.
Professional traders invest mostly in precious metals and crude oil, especially as a mean to deal with high inflation or currency devaluation.
Equities are another form of trading, where one can choose to trade individual stocks. Stocks are a mean for individuals to hold partial ownership of a certain company, depending on the number of shares they acquire.
The popularity of stocks is driven by the fact that they come with quite high levels of liquidity. Equities have a tendency to vary in volatility almost daily, making it possible for experienced traders to profit from even the most minor price changes.
While one can buy stocks for most existing companies, the most desired ones are those of important companies. The number one aspect that affects stock prices is the company’s earnings, which is a sign for that company’s financial stability in the future.
Indices are another financial instrument for stock trading, where instead of trading individual stocks, traders focus on a certain portion of the stock market. Indices consist of a list of stocks form companies in a certain sector of the market, typically based on their market cap.
The S&P 500 represents one of the most important financial instruments in this category, as it lists stocks from up to 500 companies. Another preferred index is the Dow Jones Industrial Average, listing stocks from the 30 of the biggest companies in the US.
Again, high volatility and liquidity are what attract traders towards stock indices. In fact, the index represents one fourth of the entire stock market in the United States.
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