Types of trading instruments
The majority of novice traders, who for the first time face financial markets, have a poor understanding of the mechanism of pricing of trading instruments, which negatively affects their profitability. As a result, trading operations on a particular instrument turns into a kind of casino in order to guess the direction of the trend and earn a few tens or hundreds of dollars on the directional movement of prices. The place of weighted decisions, which should be at the heart of any trader’s trading activity, is occupied by spontaneous trading operations, based on emotions, which inevitably leads to financial collapse of a beginner.
By definition, a trading instrument is an asset that can be the subject of a trade transaction, such as a currency pair, security, physical goods, derivatives, etc. In fact, a trading instrument is a means of transferring something of value from buyer to seller.
The most common trading instrument for online trading in Russia in the last decade is currency pairs. Trading in currency pairs is offered by the overwhelming majority of brokers providing their services on the territory of the Russian Federation, and is carried out on the international currency market Forex. In fact, all transactions in the Forex market involve the simultaneous acquisition of one currency and the sale of another, but a currency pair is considered an independent instrument that can be sold or bought. If a trader buys a currency pair, he buys the base currency (the first one in the currency pair) and sells the quote currency (the second one in the currency pair), if he sells – then vice versa. Purchase price (direct quotation of the currency pair) reflects the necessary amount of the quote currency to purchase the base currency. For example, if the EUR/USD currency pair is traded at the rate of 1.5, and the trader acquires this pair, it means that he receives 1 euro (EUR) for every 1.5 U.S. dollars (USD).
All currency pairs are divided into subcategories according to their liquidity. The most liquid currency pairs are the so-called “dollar pairs”, i.e., pairs containing the U.S. dollar, such as EUR/USD, USD/JPY, GBP/USD, etc. High liquidity of these financial instruments causes high volatility, which is necessary for private traders to make profit. These highly liquid instruments are referred to the group of so-called “majorities”, or major currency pairs.
Another large group is the cross-rates, i.e. currency pairs that do not contain the U.S. dollar. Quotations of such currency pairs are determined through the third currency (the U.S. dollar), that is, through the ratio of two currency pairs containing the U.S. dollar. For the sake of clarity, I’ll give you an example of the EUR/JPY cross rate:
EUR/JPY = EUR/USD * USD/JPY
Suppose the current EUR/USD quote is 1.3600 and the current USD/JPY quote is 100.00. The EUR/JPY quote in this case will be 1.3600*100.00=136.00. Similarly, the cross-rates of other currency pairs that do not contain the U.S. dollar are calculated.
As a rule, the need to use cross-rates arises for currencies, the volume of direct trade operations between which is quite low compared to the volume of dollar currency pairs. The volume of direct transactions of EUR to JPY (and vice versa) is much lower than the volume of major currency pairs EUR / USD / JPY, so EUR / JPY relate to crosses.
Trading on the foreign exchange market is over-the-counter, so currency operations of traders are not regulated by the state supervisory authorities, which significantly increases the risk of fraudulent actions by brokers against traders in the event of a conflict of interest. A conflict of interest arises when a broker performs internal clearing of traders’ operations without entering the interbank market. In this case, he acts as a counterpart, that is, if the trader wants to buy a currency pair, the broker is forced to sell it to him in case there is no counter order from another trader. As a result, the broker earns not on the spread, but at the expense of the trader’s losses, which can cause a shift in quotes and other unfair schemes against the open positions of the trader.
Preferred trading instruments are stock exchange instruments, such as stocks. Trading operations with shares are carried out in the securities market, the actual place of their exchange between sellers and buyers is the stock exchange. Exchanges are regulated by national supervisory authorities, for example, exchanges in the UK are regulated by the FSA (Financial Services Authority), in the USA by the Securities and Exchange Commission (SEC), and in Russia by the Bank of Russia. The main advantage of the stock market in comparison with over-the-counter markets is the possibility of legislative challenge of unfair actions of market participants, i.e. legal protection of the trader from fraudulent actions by brokers, insiders, etc.
Another, certainly not less significant advantage is the greater predictability of price movements. This is due to the fact that the share price is formed by a much smaller number of market participants, in addition to taking into account the indicators of a particular company, whose shares are operated by the trader, that is, the share price is formed by a more understandable algorithm with a more or less understandable final number of influencing variables. While the value of currencies can be affected by anything from central bank activity to political or natural disasters, a company’s share price is affected by far less and usually a fairly specific number of factors.
However, trading in stocks requires a more thorough professional preparation, because the first place is given to fundamental analysis, and technical analysis is used only to make profit in the short term in a speculative manner. Equity transactions are longer term because the leverage provided by brokers in the stock market is tens of times less than the leverage of foreign exchange brokers. Thus, a trader should have a sufficiently large equity capital to receive any significant average annual profit, but the risks of large losses are much lower compared to the risks in Forex.
A more cost-effective alternative to expensive equity transactions is the so-called “CFDs” or Contract For Difference, which in recent years have become a very popular trading tool offered. CFD brokers are increasingly offering this financial instrument to their clients. A CFD trader tries to guess the direction of the price trend of the underlying asset of the contract and to earn on the price difference between the current and future moments of time. In fact, the trader avoids expensive administrative and other expenses associated with the acquisition of shares, but in this case he also loses all possible benefits available to the actual owners of shares (dividends, voting rights, etc.).
The main advantage of CFDs is the ability to use leverage, so the trader needs much less equity to trade. On the other hand, CFD is an over-the-counter instrument with possible problems for a trader. More detailed description of CFDs can be found in the article “CFDs or real stocks”.
Exchange-traded trading instruments also include debt instruments, in particular bonds. Bond trading on foreign exchanges is quite common, which is not the case in the Russian market. In spite of the weak promotion among the general population of the Russian Federation as compared to the stock or currency markets, the bond market is very attractive for private investment. The reason for the low popularity of this trading instrument is the lack of information on the Russian-language Internet and the need for a fairly large start-up capital (compared to Forex or CFD) – from 50,000-100,000 thousand rubles. Yes, the value of the bond is only 1000 rubles, but the operation with just one bond will cause losses to the trader, because the profit obtained in this case will not even cover the brokerage fees. Bond trading in Russia is carried out on the MICEX exchange, so to access this trading instrument it is necessary to open an account with a broker who has access to this exchange.
Other exchange instruments available to Russian traders and traded on MICEX are Russian Depositary Receipts (RDRs), foreign depositary receipts and UIF units.
A depositary receipt
A depositary receipt is a certificate issued in the form of a security granting the right to hold a certain number of shares in a foreign company. The currency of the Russian depositary receipt is the Russian rouble. The currency of foreign receipts is the currency of the country in which the receipt is issued. The most well-known and popular depositary receipts are the American Depositary Receipt (ADR) and the Global Depositary Receipt (GDR), which are traded mainly in European markets. The use of depositary receipts allows reducing the amount of commissions associated with the acquisition of foreign securities.
UIF units (unit investment funds) take the third place by the volume of trade operations on MICEX after shares and bonds. UIF is a structure without formation of a legal entity, the property of which is under trust management of the fund. UIF unit – a registered security certifying the investor’s right to receive a certain amount of the fund’s funds based on its current value. The main advantages of this investment instrument are its accessibility for private investors (5-10 thousand rubles is enough for the purchase of shares), high profitability, reaching 50-60% per annum, and strict regulation by the state. The main drawback is the higher investment risks compared to the risks of fixed-income securities and other investment instruments with state guarantees.
The above mentioned trading instruments belong to the group of main instruments (except for depositary receipts, they occupy a separate niche in the classification). There is another large group of trading instruments – derivatives, or derivative trading instruments. By definition, a derivative is a security whose value depends on the value of one or more assets. The most commonly used underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates and market indices.
Typical derivatives are futures, forward contracts, options and swaps. Although the main purpose of derivatives is to hedge risks (e.g. currency), traders actively use them for trading speculation.
A futures contract is a derivative financial instrument used by parties (seller and buyer) to fix a certain value of an underlying asset at a certain future date (delivery date). The quantity and quality of the underlying asset is specified by the parties in the contract specification at the time the contract is concluded. A futures contract is executed at the end of its validity (delivery period), as a result, the seller of the futures contract either delivers the underlying asset to the buyer or pays the difference between the price fixed in the contract and the current market price of the underlying asset. Thus, when buying a futures contract at a certain price, the trader stakes on the growth of the value of the underlying asset during a certain period of time. If at the moment of contract execution the value of the underlying asset exceeds the value of the futures, the trader earns profit, and vice versa. Transactions with futures contracts are carried out on the stock exchange.
Forward contracts differ from futures in that they are not standardized and are an over-the-counter trading instrument. As a result of the forward contract, only the actual delivery of goods is performed, i.e. speculative operations with forwards are not possible. Forwards are usually used by enterprises to hedge the risk of price fluctuations in the production of goods.
Options are derivative financial instruments that allow a seller (buyer) to sell (purchase) a particular commodity at a predetermined price within a certain period of time. The most popular companies offering trading in this trading instrument are binary options brokers. Variants of options, examples of their use, their advantages and disadvantages are given in the article “Binary options. Features, advantages and disadvantages.
The most preferable trading instrument for beginner traders with sufficient capital (from 50-100 thousand rubles) are shares. The process of becoming a professional trader takes a long time, during which a potential speculator should study all the features of financial markets and the necessary tools, including fundamental and technical analysis, principles of capital management, risk hedging, etc. Thus, the main task of the beginning trader is not to get profit, but to survive on the market. Currency market, CFDs and other instruments promoted by brokers carry increased risks due to the use of large leverage, which leaves virtually no chance for beginners in the financial market.