Introduction to Trading the Financial Markets – Part 2
We mentioned short selling several times in our first article so let’s further discuss the two ways we can trade a financial instrument.
Selling Short: The term ‘selling-short’ or ‘short-selling’ often confuses many new traders. Short selling allows traders to benefit from a fall in the market value of an instrument.
But how can we sell an asset we do not own?
Your broker can borrow it.
Buying Long: In traders’ jargon when we want to buy an instrument it is called ‘going long’. Going long is a concept all new traders should be familiar with. We’ve all heard the phrase ‘buy low & sell high’. That is exactly what we are doing. By buying or going long we want that instrument to rise in value. So if we buy 1 share for $5 and we sell it for $6 we have made a profit of $1 – simple.
The easiest way to explain is with an example:
So say Apple stock is currently trading at $500 per share and we believe that the price of Apple stock is likely to decline in the future to say $400 per share. We would like to profit from this fall in value and are willing to short sell 1 share so we can make $100 on this trade if it falls to this level.
Say John owns one share of Apple and is happy to hold on to this share as he is a long-term investor or he believes it will rise in value. We approach John and ask him can we borrow his one share and we will give it back to him at a later date. He agrees.
We instantly sell the share we have taken from John at the current market price of $500. Sure enough, we were right and the price of Apple fell the next week to $400 per share. Now we can buy back the one share of Apple we sold for $500 for the new price of $400. We can give John back his share and we can keep the $100 profit we made.
Now you may be thinking that is a complicated process for a beginner trader. But as we are trading CFDs and futures contracts it is made as simple as possible. We do not have to find someone on the other side of the transaction (i.e. John) to lend us his share. Our broker will arrange that for us hassle-free and all we have to do is click on the SELL button if we believe the instrument will fall in value and alternatively click the BUY button if we believe it will rise in value.
The Trading Platform
Since the rise of the internet the financial markets have become much more accessible for individual, retail traders. We can now use online brokers (such as AVA Trade) to open and close trades in these financial instruments using a trading platform provided by our broker.
Brokers have evolved to offer platforms for tablets and apps for smart phones so we can always have access to our trading account wherever we have an internet connection.
Our trading platform will consist of all the live prices of the various instruments we can trade, their relevant charts which show their price movements over time and the ability to buy or sell an instrument with the click of a button. We can also choose the size of the position we would like to buy or sell and set price levels where our positions will automatically open or close.
Most brokers will allow us to open a demo or practice trading account before we open a real account. A demo account should have most of the same functions and features as a live account and most importantly have the correct live prices. Becoming familiar with the trading platform is essential so we are comfortable trading on it with a live account.
Cost of Trading – The Spread
The cost of placing a trade with our broker is called the spread. Our broker receives a spread for providing us with the services of their trading platform, software and access to the market. All instruments will quote two slightly different prices depending on whether we are buying or selling the instrument. When we want to sell an instrument we are offered one price and when we want to buy we are offered another slightly higher price.
This difference between the buy and sell price is the spread. The spread is usually quite a small difference but the cost to us will depend on the size of our position. Larger positions will mean a larger monetary amount. We will discuss spreads again in greater detail but for now all we need to know is that this is the cost of placing a trade.
Due to the high level of leverage offered on various financial instruments, we do not need a large amount of capital to start trading. Most brokers allow us to open a trading account with as little as $/ €/ £ 100 although most traders will start with a few thousand so they can cope with the volatility in certain markets.
Leverage essentially means that our broker lends us the money to trade larger positions and we only have to put down a small portion of the investment as collateral known as the margin requirement. Leverage allows us to open larger positions by using a relatively small amount of capital (or margin). This means we can make much bigger gains but also bigger losses.
So for example $100 can give us the buying power of $20,000 on an instrument if the leverage offered in 200:1. Various instruments have different levels of leverage depending on the liquidity of the market.
Leverage is an important concept of trading which we will discuss in greater detail in a later article.
Where to start?
To be a successful trader, either on a full-time or part-time basis, it is important that we put the time and effort into educating ourselves.
Continue reading the beginner articles so you understand the basics, watch the beginner video content to understand some beginner technical and fundamental concepts and start practising on your demo trading account.
Understanding how to read charts is essential and having a good grasp of what economic, political and social factors move the instruments we are trading is equally important. These two elements are what are known as technical and fundamental analysis and are both covered in much greater depth in our beginner video section.
So get learning and good luck with your trading.