The History and Purpose of Trading

The origins of trading are ancient, dating back to prehistoric times when exchanging goods—like an arrowhead for paint, or cacao leaves for shiny stones—was common practice. For thousands of years, trading has been a primary method of making profits.

[Image of Evolution of trading timeline]

What is Traded?

Historically, people traded everything:

• Real estate, cattle, sugar, cotton
• Gold, oil, food, clothes, weapons, technology, and art

Today, the scope is even wider, allowing for the trading of money for money, often facilitated online, anytime, and anywhere.

Understanding Financial Markets

The financial market is the venue where financial assets (such as stocks, bonds, currencies, and commodities) are traded.

Types of Traders and Motivations

People engage in trading for several key reasons:

• Speculation: Speculators anticipate price movements, trying to profit by buying low and selling high.
• Hedging (Risk Management): Hedgers trade to protect an existing asset (e.g., a farmer selling his crop before harvest).
• Challenge and Savings: Some trade for the mental challenge, while others trade simply to save.

Financial Market Structures

Financial trading occurs via two main structural mechanisms globally:

1. Centralized Exchange (Traded Markets): These are regulated exchanges where transactions take place at a physical or virtual central location.
   • Examples: New York Stock Exchange (NYSE), London Stock Exchange, Tokyo Stock Exchange.
2. Over-The-Counter (OTC) Exchange: These are decentralized markets consisting of networks of competing dealers. Dealers act as "market makers," quoting prices at which they will buy and sell a security or currency.

Major Categories of Financial Markets

Financial markets are often categorized based on the type of security being traded:

1. The Foreign Exchange (Forex) Market

• Activity: Currencies (like the Euro and Dollar) are exchanged for one another.
• Structure: It is the biggest market globally (exceeding $5 trillion/day volume) and operates 24 hours a day, five days a week (Monday to Friday).
• Mechanism: It is primarily an OTC market. Most currencies are freely floating, with prices determined by supply and demand.
• Drivers: Transactions are driven by international trade, tourism, borrowing and lending, and speculation.

2. The Equity (Stock) Market

• Activity: Shares or stocks are traded.
• Definition of a Share: A financial asset providing evidence of ownership in a company and a share in its profits.
• Price Determination: Share prices rise if a company is profitable (or expected to be), indicating higher demand. Prices drop if the company is unprofitable or not expected to grow.

3. The Commodities Market

This market trades raw materials rather than manufactured goods. Commodities are typically divided into three main groups:

• Agricultural Commodities: Grains, food, and fiber (e.g., corn, soybeans, cotton), plus livestock (e.g., cattle).
• Energy Commodities: Crude oil, Brent oil, natural gas, and propane.
• Metal Commodities: Industrial metals (e.g., copper, zinc) and precious metals (e.g., gold, silver).

4. The Bond (Fixed Income) Market

• Activity: Investors and traders trade debt securities.
• Purpose: This market connects borrowers (governments, corporations, municipalities) who need cash with investors who have a surplus of cash.
• Mechanism: When you buy a bond, you are lending the issuer money. They promise to pay you back in full with interest in the future.

5. The Derivatives Market

• Definition: An instrument whose value is derived from the value of some other instrument, called the underlying asset (e.g., oil derivatives derive value from the price of oil).
• Categories by Asset Type:
  • Commodity Derivatives: Based on physical commodities (e.g., energy contracts).
  • Financial Derivatives: Based on financial instruments (e.g., stock and index contracts).
• Common Types of Derivatives:
  1. Futures: A standardized contract to buy or sell an asset at a predetermined price at a specified future date.
  2. Options: A contract giving the holder the right (but not the obligation) to buy (call) or sell (put) a security at a specified price.
  3. Contracts for Difference (CFD): A derivative contract used speculatively against changes in the value of an underlying asset.
• Benefits and Risks: Derivatives offer benefits like margin trading and the ability to go long or short. However, margin trading significantly increases both profit potential and risk. Traders must remember: the higher the risk, the higher the return.