If you are new to trading the financial markets your first thought will be “Where do I start?”, many new traders may be overwhelmed when they open their demo trading account for the first time and might try to run before they can walk. Understanding the basics of trading is an essential starting point and in this the two part article we will cover the key characteristics of trading, the various financial instruments we can trade, the concept of going long and going short, trading platforms, starting capital and what it takes to succeed.
What is the Difference Between Investing & Trading?
Investing and trading are two different ways that we can profit from the financial markets. Many people new to the world of finance can be confused over what is the difference between the two. Here we will describe what we mean for each.
The aim of an investor is to gradually build up their net worth by buying and holding a portfolio of stocks, bonds, mutual funds or other investable instruments.
Investments are often held for years or even decades. Investors take advantage of certain perks such as dividend payments, coupon payments and/or interest during this time. When the markets fall in value, many investors will hold on to their investment in the expectation that the price will rebound. Investors are therefore looking at the long-term value of their investment and aren’t too concerned with the day to day volatility in the market.
Investors take physical ownership of the instruments they have purchased. So for example, if an investor buys shares in a company they will physically own a portion of that company and will receive a certificate of ownership. A shareholder can carry certain privileges such as voting rights on certain corporate actions, as well as benefit from dividend payments on the profits..
Trading, on the other hand, is the more frequent buying and selling of financial instruments with the aim of outperforming buy-and-hold investments. There is no ownership of the underlying asset so traders are merely speculating on the price movement.
Traders can therefore profit from falling markets as well as rising ones. A trader can buy an asset just like an investor but traders also have the ability to sell an instrument without owning it. This is known as short selling and is why many people are particularly attracted to trading. It is a key concept to understand and is a major reason why traders can outperform buy-and-hold investors. (We will discuss buying and selling in greater detail later.)
While investors are often satisfied with annual returns of up to 15% depending on the risk element of the investment, some traders seek to make returns that are a multiple of this, as they can benefit from the dips in the market as well as the increases because of the ability to short sell.
The length of time a trader has a position open for can range from seconds to years. This timeframe is entirely up to them and relates to their objectives, account size, risk profile and time they can commit to trading. Trading requires a more hands on approach than investing and regular assessment of market conditions is essential when traders have open positions.
What Can We Trade?
A financial instrument is a tradable asset of any kind i.e. it is an asset we can buy or sell at a monetary value on a financial market.
Examples of financial instruments include currency pairs (i.e. the foreign exchange/FX market), commodities, stock indices and the stock of companies (also known as individual equities). As we do not take ownership of these assets when we are trading we are actually speculating on the price of futures contracts for FX instruments and Contracts for Difference (CFDs) for shares, commodities and stock indices. The price of these contracts is directly related to the price of the underlying instrument. So any movement in price of the physical asset will see a similar move in the price of the contract.
The reason we trade futures contracts and CFDs is mainly due to the ease at which they can be traded and their cost-effective nature. For example if we physically owned a share in a company we may be liable for additional costs such as stamp duty in certain countries. There is no such cost with futures contracts and CFDs (We will discuss the costs associated with them later). CFDs can also be sold short. This is something that other types of instruments are prohibited from doing.
Check out our next beginner article where we will cover the concept of going long and going short, trading platforms, the cost of trading and what it takes to succeed.