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Basics of Financial Trading

Posted on Posted in Trading

In finance, trade is typically an exchange of a financial security (share, bond, etc.) with cash. (To understand more around how financial securities are created by discounting cash-flows, please read more on securitisation at the following link www.kunalonfintech.com/securitisation-1-o-1/) Trading financial securities has been a genuine profession for at least a few centuries.

Broadly , trading can be classified into:

 

Speculation

One may buy a security in speculation that in future its prices will go up and then the person can make money by selling it at a higher price. Most of the trading in the financial markets is driven by speculators. This can be further classified into 2 categories,

– Fundamental

You may chose to buy or sell a financial security if you know that fundamentally its price will go up or down in the future. For example, you may buy the shares of a telecom company in an emerging country where the use of telecoms is expected to grow rapidly. The analysis maybe based on some technical indicators (fancy term for mathematical calculations)

– Non-Fundamental

In this kind of speculative trading, the trader may buy a financial security for a shorter duration when it’s cheaper and sell it when its value goes higher. Irrespective of the fundamental valuation change of the financial security. (Example illustration below)

 

 

But timing is also very important. You may end up buying and selling at wrong times as illustrated below and end up losing money.

 

 

Arbitrage

In arbitrage trading, you try to generate profits by selling a financial security in one place and buying it (or a similar financial security) at another place where its price maybe lower.

 

Hedging

You may want to hedge your position in the market by buying or selling a financial security. For example, if you are an airline company, you may chose to hedge your exposure to oil price rise (as you will need oil to fuel the airplanes for the future flights) by buying an oil future contract.

 

When you are trading in the financial markets, there are several factors that play an important role in your profits and losses, including,

– access to information: having the information around certain markets, companies, financial securities is important in making trading decisions

– speed of information and trading access: whoever gets access to the information and ability to trade faster can make more profits if the trading decisions are right

– experience: with experience you improve your judgement calls and make better trading decisions.

– discipline: its paramount to be disciplined in your trading and do not let emotions interfere with your trading decisions. For example, if you buy a financial security and you are sure you will sell it at x% profit or y% loss, you must try and follow that plan.

– psychology: trading is like playing poker with millions of people. financial markets are not easy to predict and are not always rational either. Same piece of news and information may lead some traders to make a buying decision, and some others to make a selling decision of the same financial security. Hence, its important to consider what’s rational, as well as what others may be thinking, while trading a financial security. It’s easier said than done.  

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