In this section we will take a brief look at some of the markets that you may get involved with. Specifically we'll look at:
- The stock market - investing in shares
- CFD's (Contracts for Difference)
- FOREX (or forex currency pairs)
- Commodities (or Commodity Futures)
The Stock Market
For the purpose of this website we are not really interested in this market, but for the sake of an introduction, let's look at it. When a company has reached a certain size and it wants to raise money, it may list on an Exchange - such as in South Africa the JSE. Ordinary people and corporate companies alike may then invest in the company by purchasing shares - each share giving the owner a really small percentage ownership of the company. The money the company raises in this way it will use for conducting its business and as the business grows the value of the shares will increase, giving the shareholders each an increased value for their investment, proportional to the amount of shares they purchased.
Thus, as Investor, you buy shares and as the value of the shares increase / decrease you either make or loose money. However if the value of the share trades at say R400 per share, then buying 100 shares will cost you (R400 x 100 = R40,000) and if the value of the shares increases to R401, you will make a profit of ((R401 - R400) x 100 = R100)! A hundred rand profit on an investment of R40,000 is not really worth the trouble - but this is not the reason you by shares. Share buying is a long-term investment. You buy and hold the shares, sometimes for years. In time, as the company grows, the share may become R1000 a share and your money likewise will undergo significant growth.
CFD stands for "Contracts for Difference" and has lately become very popular as a trading method. Basically, all participants in this market sign an agreement, through their broker, that they will settle the difference in price (from where they bought and sold) for any instrument in which they are trading. Unlike a share, where you may buy the share and hold it for a long period of time, with the CFD you have to close the transaction. In other words you have to buy AND sell (in a relatively short space of time) in order for the price difference to be determined in order for you to settle the difference in price. And from there the name - you sign a CONTRACT that you will settle the DIFFERENCE.
This method of trading introduces two concepts - the first is leverage and the second is margin - they are both explained on the right.
OK, so through your broker you are able to enter into a contract for difference (a CFD) on almost anything - shares, selected commodities, forex currency pairs, etc. Your broker (Standard Bank trading platform, or Nedbank, ABSA, Old Mutual, or whoever you use) will also give you a certain leverage. Using our leverage we may now buy and sell CFD's and settle the price difference when we closeout the transaction.
NOTE: With shares we were limited to BUYing the shares, holding and selling the shares. We could not sell shares that we did not have. Thus we could only trade the market in one direction - when it goes up. With our CFD we are no longer limited to this - we are not buying and selling shares, we are now buying or selling CONTRACTS. Thus nothing stops us any more from selling a contract and buying it back later. We are now able to trade the market in both directions!! If we think prices are going to drop, we SELL our CFD (to someone else - remember the zero sum game story) and then later just BUY our CFD back. Or vice versa, if we anticipate rising prices, we buy now and sell later. Thus there is no longer any difference (or limitation on us), we may either buy now and sell later, or sell now and buy later - as long as we close the transaction and settle the price difference!
EXAMPLE: We use the same share of R400 per share as in our shares case. With a 200:1 leverage, we are able to buy 100 shares for R200 ((100 shares x R400 per share) / (200:1 leverage) = R200) on a contract for difference. Should the price of the underlying shares increase to R401, we will make R100 profit (but on a R200 investment this is a 50% return on our investment) - not like the R40,000 share guy to whom the R100 was nothing! Should the price drop however to R397 per share, our loss will be R300 ((397 - 400) x 100 shares = -R300), which is more than the R200 we invested. In order to safeguard himself (and for us to be able to cover this loss), the broker will require that we put up a certain margin before allowing us to enter into this transaction. The broker determines the margin amount based on the perceived risk - it might be something like R4000. Thus the broker will only allow us to enter into this transaction if we have at least R4000 in our trading account.
CFD trading can be very profitable, but they are also quite risky, if you get the market movement wrong and you are not quick enough to get out, you may also loose quite a bit quite fast.
Ahh the Forex Currency market.. This is much similar to CFD's. You get countless different forex currency pairs - the GBP/USD, USD/EUR, USD/CHF, CHF/JPY, etc. (USD = United States Dollar, GBP = Great British Pound, EUR = Euro, JPY = Japanes Yen). And you can trade in them through a trading platform. What is a Forex Currency pair? It is the exchange rate between two countries' money units.
You trade in a currency pair by buying (or selling) a certain amount of the one currency. For example with the USD/EUR you are buying $100,000 worth of currency. The currency exchange rate changes typically in the fourth decimal (thus 0.0001 of the exchange rate). With $100,000 worth of currency, such a change is equal to ($100,000 x 0.0001 = $10) profit or loss.
You also trade on leverage - typically 100:1. Thus instead of you requiring $100,000 to buy the currency, you only need $1,000 to purchase $100,000 worth of currency. The $1,000 is also the margin you require to trade (although you broker may require additional margin)
Nowadays you get mini-sized contracts - $10,000 worth of currency - you therefor only require $100 to trade, but your risk likewise is reduced to $1 (R12) per 0.0001 move in the currency price. Through your CFD trading platform you may even be able to trade micro-sized contracts, limiting your exposure to R1 per 0.0001 price movement. Other than these, it works exatly the same as the CFD market.
The foreign currency market - FOREX in short - has been (and continues to be) very extensively marketed and is usually the first type of trading a new trader is exposed to. Unfortunately this is also a death trap to most traders out there - once caught in this web it is very difficult to escape from it. A new trader will start here, he will swear by it and may very well eventually die here without ever tasting the success that is possible through trading - simply because of the many bad habits that this form of trading instill into the aspirant trader right from the start.
Commodities (or Commodity Futures)
Very few (South African) traders ever get here. Once caught in the FOREX trap and later in the CFD trap, they stay trapped in those markets until the day their accounts have been wiped out and they finally give up on the trading dream. Commodities are stuff like Gold, Copper, Silver, Crude Oil, Gasoline, Cattle, Hogs (bacon), Corn, Wheat, Soybeans, Coffee, Cotton, Sugar, Orange Juice, etc. - the typical stuff we use day-to-day in our everyday lives and that are traded through various Exchanges in the world.
They are traded on a contract basis, where a contract specifies a certain amount of the commodity that the trader is trading in - for example 100 ounces of gold, or 1000 barrels of oil, or 20000 pounds of cattle, etc. A Trader buys or sells a contract (for which he requires margin in his trading account) and then settles the price difference between when he bought and when he sold, just like you do with a CFD or a currency. The difference is that the contract has an expiry date (and a delivery date - at some point in time the commodity needs to change hands - the farmer cannot just keep feeding his cattle forever, at some point they need to be put on a truck and delivered to whoever purchased them. The mine cannot sit with its copper forever, at some point in time the copper needs to be delivered to the copper cable manufacturer - live goes on!). Thus the contract has a date, set somewhere in the future, at which trading needs to seize and the commodity delivered. And then we start with a new contract with a new delivery date somewhere in the future.
This nature - delivery date in the future, or contract expiry date somewhere into the future, has given rise to the contract being called a "Futures Contract" or just a "Futures". Thus we talk about commodity futures. (for our Afrikaans readers: 'n termyn-kontrak - wit mielies vir lewering in Desember, as jy die nuus volg)
If you want to make a success out of your trading business, it is quite important that you understand this market and the Options market introduced below. Follow this link to a website that explains these markets in more detail.
Options (Commodity Options)
Options trading is possibly one of the best kept secrets, available mostly only to the institutional trader. Some trading platforms and service providers lately started adding options to their list of available instruments, but in a VERY limited way. YOU - the Trader - is only able to BUY options. If you take a look at this report, you will start getting the picture.
Options are another type of contract. It is a contract that will result in you receiving a futures contract, but at a pre-specified price. It is like an insurance policy that you write to investors to protect them against unforeseen price movements (the writer takes the risk, the buyer receives an assurance that should the price change unfavorably his risk will be covered). Options are freely tradeable just like the underlying futures are tradeable. Buying an option you just need the cash to buy it, selling the option you need to put down the same amount of margin as you would have for buying or selling the futures. As the price of the underlying futures changes, so will the price of the option and you settle the difference in price. However there is also a time component - as time goes by, the option's value will decrease - thus if you sold an option (and received money for it) as time goes by the option will become cheaper and you may buy back the option at a cheaper price, making a profit. One could for example sell an option on a Friday, just before close of business, then buy it back on a Monday at start of business for a cheaper price and make money that way (since there is no price movement over the weekend when the market is closed).