Beginner’s Guide to Different Financial Instruments You can Trade

Financial Instruments for Trading

The financial market brings together millions of people around the world to trade a wide array of financial instruments. Being the largest market, there are various securities or instruments that one can trade and take advantage of price movements to squeeze in a substantial amount of profit.

Financial instruments are classified into five broad categories:  Indices, Equities, Commodities, Bonds, and Forex. Given the vast array of financial instruments, there are many factors that one ought to consider before trading any of the above.

Factors To Consider In Selecting Financial Instruments

  • Liquidity: This refers to the ease of buying and selling a financial instrument at any given time.  Instruments with high levels of liquidity tend to be easy to trade as one can enter and exit a position with ease.
  • Volatility: Volatility refers to the ability of financial security to rise and fall sharply. That said volatility is a two-edged sword that can be a blessing and a curse at the same time. High volatility tends to work to the advantage of traders who know what they are doing as it allows them to generate profits multiple times. However, a small mistake in times of high volatility, losses tend to accrue much faster.
  • Low Transactions costs: A financial instrument with low transaction costs is ideal as it allows one to generate optimum returns on any given trade.  Brokers charge different trading fees for different financial instruments.
  • Availability of Information: Free flow of information is necessary if one is to have a profitable trading career trading given security. News affects prices from time to time this one should only trade an instrument whose news or information is readily available.

Top Five Financial Instruments

Forex

Foreign exchange market being the largest market in the world also comes with some of the best financial instruments that one can trade on a daily basis. The market accounts for more than $4 trillion in average daily volume.

Foreign exchange is the art of trading currencies by merely taking advantage of changes in currency pair prices. Some of the commonly traded Forex instruments include currency pairs of the biggest economies in the world. Such instruments include n EUR/USD, GBP/USD, USD/JPY, and USD/CHF among others.

Read: What is Forex Trading ?

Forex instruments are some of the best to trade in part because of their relative stability. The fact that these instruments are available round the clock also makes them ideal to trade at any given the time of day regardless of jurisdiction. Forex brokers also tend to provide a significant amount of leverage that makes it easy for traders to place a trade that in normal circumstance their capital would not be able to handle.

Forex instruments are also ideal for short-term day trading, as they tend to offer high liquidity. Besides, they come with high levels of volatility that makes it easy for traders to take advantage of short-term price swings.

However, traders should always avoid exotic currency pairs as they lack the much-needed liquidity. Brokers also tend to charge huge amounts of spread on such currency pairs, something that makes it hard to generate optimum returns on small price movements.

Stock Indices

Stock indices highlight the performance of a broader stock market or a portion of the market. Such indices list stocks of companies from a given sector or based on their market cap. Prices of selected stocks usually are weighted as a way of making it easy for investors to compare returns of specific investments.

A stock index could represent the performance country’s economy or the entire world’s stock market.  S&P 500 is one of the best financial instruments under the stock indices category. The index lists stocks of some fees into consideration the stock of the largest companies in the U.S

FTSE 100 Index

Read: What is the FTSE 100?

The S&P 500 is a diverse financial instrument as it includes stocks of up to 500 companies. For that reason, the performance of the index acts as a good indicator of the movement in the broader U.S stock market.

In contrast, the Dow Jones Industrial Average another highly traded index consists of stocks of 30 of the largest companies in the U.S. The index is a price-weighted index. What this means is that larger companies account for more in the calculation of the index ratings.

The fact that the index accounts for about a quarter of the value of the entire U.S stock market makes it an ideal financial instrument. High levels of liquidity, as well as volatility, means one can trade it with ease.

The Wilshire 5,000 is another popular stock index that includes stock up to 5,000 companies listed in the U.S. The index is extremely diverse given the number of stock prices taken into consideration when computing its ratings.

Other High profile stock indices worth trading as financial instruments include the DAX, whichlist stocks of the biggest stocks in Germany, Japanese Nikkei 225 as well as Britain’s FTSE 100.

Equities

In addition to stock indices, individual equities are other exceptional financial instruments. Instead of gaining greater exposure through indices, one can opt to trade individual stocks of companies. Stock trading allows one to enjoy ownership of a company depending on the number of shares one buys.

Stocks are popular financial instruments in part because they come with high levels of liquidity. Trading volumes, as well as volatility, tend to vary on a daily basis allowing traders to take advantage of slightest price movements.

Growth Stocks Guide

Read: Guide to Investing in Growth Stocks

Stocks of some of the biggest companies are some of the best for day trading given the high levels of liquidity and volatility they come with. Such stocks include Apple, Microsoft, Amazon, and Google Qualcomm Intel, etc.

When trading equities, it is essential to take note of the things that affect stock prices. Top on the list are earnings that come out after every three months. Earnings affect share price as they act as an indicator for the financial health of a company as well as its long prospects. A stock price could essentially rise on investors looking at data and extrapolating it to indicate the company’s value will rise with time.

Analyst’s stock ratings also do affect share price in one way or another. Analysts do carry out an in-depth analysis of companies and consequently, provide recommendations of how traders should trade them — such reports most of the time trigger price swings.

Industry news can at times have a domino effect consequently affect the price of individual stocks. It is thus essential to analyze industry news from time to time when it comes to trading equities as financial instruments.

Commodities

Liquid commodities such as crude oil, gold, and silver also provide a way for people to trade the financial markets. Commodities as financial instruments provide a way of diversifying away from equities or stock indices.

One can buy and sell various types of commodities through futures contracts on exchanges. Such financial instruments are classified into five main categories, agricultural commodities livestock and meat commodities, energy, precious metals, and industrial metals.

Under the metals category, the most traded financial instrument is gold, silver, Platinum, and Copper. Under Energy, crude oil remains the most traded followed by natural gas and gasoline. Livestock and meat category attracts most of its demand on live cattle feeder as well as pork bellies and lean hogs. In the agricultural sector, the most popular financial instruments are corn, soybeans, wheat, rice, cocoa, and coffee. In the U.S, the most popular exchange for trading commodities is run by the CME Group.

Investing in Gold

Read: Investing in Gold

In the Commodities market, forces of supply and demand drive prices. In this case, a lower supply on a given commodity would most of the time result in higher prices, especially on high demand. Gold is the most traded financial instrument in the commodity sector as traders view it reliable and dependable as a way of conveying value.

Professional traders also turn to precious metals to hedge against high inflation or during periods of currency devaluation.  Crude is another popular financial instrument as changes to oil outputs from wells around the world affect prices, allowing traders to take advantage of price changes.

Grains and other agricultural produces tend to be extremely volatile and perfect for trading during summer. Population growth as well as limited agricultural supply most of the time provide opportunities as they trigger price swings.

Exchange Traded Funds and Government Treasuries

Summing up the top five traded financial instruments are Exchange Traded Funds, and Government Treasuries also known as Bonds.  ETFs are investment funds that seek to track the performance of given sector indices, commodities or bonds.

Exchange Traded Funds to cover a broad range of assets ranging from stocks, bonds, currencies as well as real estate and commodities. Whenever a trader buys an ETF, he or she is buying shares to a portfolio that is trying to replicate the performance of a given underlying asset.

What is an ETF?

Read: What is an ETF?

Instead of trading equities or Indices, some traders do buy ETFs as they make a trade like stocks. ETFs can be bought’ and sold on margin, as their price fluctuates throughout a trading session. Also, they do provide greater diversification, and reduced risk is given that they only track the performance of underlying indices.

SPDR S&P 500 (ARCA: SPY), S&P 500 VIX Short-Term Futures ETN (ARCA: VXX) Russell 2000 Index Fund (ARCA: IWM), and PowerShares QQQ Trust (NASDAQ: QQQ) are some of the biggest and most traded ETFs.

Government treasuries are some of the best financial instruments given the safety net they come with when it comes to risk exposure.  No other financial instrument comes with a guarantee when it comes to returns as treasuries also known as bonds do. It is for this reason that they have continued to stand the test of times as some of the best investment tools for income-focused investors.

Treasury securities are divided into three T-bills, which take the shortest time to mature between 4 to 52 weeks. T-Notes are the middle-range government bonds as they take a minimum of 2 years to mature and maximum of 10 years.  T-Bonds, on the other hand, are for long-term investors as they take up to 30 years to mature.

Which Financial Instruments to Trade?

The ideal financial instrument to trade depends on some factors. For starters, the number of resources that one has will dictate to a great extent the type of instrument they can trade. For instance, investing in government bonds, will most of the time require one to have a significant amount of money compared to Forex markets where leverage is always on offer.

When it comes to day trading, some financial instruments tend to be volatile and liquid at different times of the day or week. For starters, currency pairs pegged to the dollar will most of the time be volatile and liquid during the New York trading session.

The Forex market is turning out to be the go-to destination for most people looking to launch investment careers in the financial markets.  The market boasts of a daily turnover of more than $4 trillion making it the most liquid market, ideal for opening and closing trades with ease to take advantage of small price movements.

The low capital requirement is another reason why people are trading forex instruments, in numbers, compared to other securities.  With as little as between $100 and $1000, one can be able to open an account and day trade a wide array of forex instruments.

Conclusion

The financial markets play host to a wide array of instruments that one can trade. However, that does not mean that every alternative would be good for each. Having a clear understanding of a given financial instrument as well as the factors likely to affect its price is a sure way of launching a profitable investment career.

One should never pick financial instrument until they have gained sufficient knowledge of the things that can affect it. Picking a financial security just because it is widely traded and not carrying out thorough research first is a sure way of losing money in the financial markets.

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Ruchi holds a first degree in Accountancy and Post Graduate Diploma in Business Administration (First Class) from the International School and Business and Media in India. Proficient in financial databases like ThomsonOne, CapitalIQ, Factiva, and has also worked on Bloomberg and Datastream. She has previously worked as Assistant Manager at Genpact India, providing content in support of credit risk assessment of existing and potential clients of GE.


ruchi@moneycheck.com

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