Introduction to financial markets
Financial markets explained
- What are financial markets?
- Types of financial market
- What drives financial markets?
- Who trades financial markets?
- Traders vs investors
- How are financial markets traded?
What are financial markets?
Financial markets are places where people and companies buy and sell assets like shares, bonds, commodities, currencies and more.
There are hundreds of different financial markets around the world, facilitating the trading of thousands of assets. Some are vast and open to anyone; some are small, secretive and private. You’ll use different markets depending on what you want to trade – and how you want to trade it.
Whereas financial trading used to take place mostly face to face, today the vast majority of markets are entirely digital. Old-school trading ‘pits’ do still exist, but they’re dwarfed in volume by seamless online systems.
Types of financial market
Financial markets are split into asset classes. Let’s take a look at the main types of asset class.
Shares are probably the best-known asset class of all. Shares are units of ownership in companies that are listed (quoted) on major stock exchanges. When you own an Apple share, for example, you own a tiny percentage of the entire company. If Apple becomes more valuable, then your share is worth more. If Apple falls in price, your share will be worth less. You might also see shares referred to as stocks or equities.
A stock index is made up of a group of shares, averaging out each company’s performance into a single tradable market. By buying and selling indices, traders can speculate on the changes in price of hundreds of shares at once. For example, the S&P 500 – one of the most widely traded indices globally – measures the performance of roughly 500 of the biggest, best-known businesses in the US.
The forex (FX) markets represent the constant exchange of currencies between banks and other market participants. Currencies are quoted as a currency ‘pair’ – for example GBP/USD is the value of the pound vs. the US dollar. The currency markets are open 24 hours and see huge volume each day, with trillions of dollars’ worth of currencies bought and sold.
Commodities are the raw materials that power the economy, such as oil, metals and wheat. They are split into ‘hards’ (such as gold, silver and oil) and ‘softs’ (such as soybeans, wheat and coffee). Each commodity market will have its own particular cycles, determined by specific factors like harvests or energy demands.
Bonds are debt instruments issued by governments and companies. When you buy a bond, you lend money to the issuer, who pays you a regular return (called a coupon) then gives you back your money when the bond expires. Government bonds are popular among investors as they’re seen as lower risk, but they are used by traders too.
Interest rates are set by central banks – such as the Federal Reserve or Bank of England – and represent the cost of borrowing or return from saving for currencies controlled by those banks. The interest rates of the UK, US and eurozone rates are frequently traded.
What drives financial markets?
Financial markets are driven by the laws of supply and demand.
Supply refers to how much of an asset is currently available for purchase. If supply is abundant, then prices tend to be driven down as there isn’t much competition among buyers. This can be what’s known as a buyers’ market.
Demand refers to how many market participants are attempting to buy an asset. High demand usually means lots of competition among buyers, which will drive prices up. This is a sellers’ market.
Supply and demand don’t exist in isolation though, and it is the relationship between both that sets prices. For example, when high demand is matched with high supply, prices may not increase – there are a lot of buyers, but plenty of the asset to go around.
Low supply, on the other hand, won’t see prices spike if there’s no demand.
When you’re trading, you’ll want to watch out for a number of factors that can affect supply and demand. A few common examples include:
- News: Financial markets are often affected by news. Governments can announce new restrictions that harm businesses, a new conflict could halt production of a commodity, or countless other news items could impact markets
- Central bank policy: Central banks control interest rates, which have a profound effect on the flow of money around the world – and will have a big impact on markets
- Company results: Companies listed on stock exchanges will release regular results, giving insight into performance and seeing their share prices rise or fall, with a subsequent impact on indices too
- Economic data: Stocks, indices, commodities and currencies are all heavily influenced by the world economy. Government data such as GDP, employment and inflation will see prices move
What is volatility?
Volatility describes how much a given financial asset’s price is currently moving and is a key concept in trading. A highly volatile market will see large swings in its price, while a market with low volatility should be calmer and more stable.
Some asset classes tend to see more volatility than others. Government bonds and interest rates, for example, are seen as stable classes – while forex and stocks can see more price action.
Your attitude to volatility will depend on how you want to trade. In general, volatile markets can bring more opportunities and enable you to target higher profits. However, they will also bring higher risk.
Who trades financial markets?
There are a wide range of people and companies that trade in financial markets.
Pension funds, asset managers and mutual fund providers participate in financial markets to make profits for themselves and their customers
Banks act like brokers for other companies, such as fund managers. Plus, they often trade for their own benefit
Brokers and trading providers:
These are specialists who place trades for their clients. Stockbrokers, for instance, enable you to invest in global shares
You and me:
Everyday investors and traders can participate in financial markets through investing in funds, buying shares, or actively trading the markets through spread bets and CFDs
Traders vs investors
You might hear the words trader and investor used interchangeably, but there’s actually a distinct difference between the two.
A trader is an active participant in the markets, who often uses leveraged products such as CFDs and spread bets to target short- to medium-term profits. An investor, on the other hand, is usually more passive, buying stocks or funds over the long term.
How are financial markets traded?
Typically, markets can be traded in two ways:
In the past, these were actual buildings where brokers met to buy and sale shares in companies, or other assets such corn or livestock. Now most trading on exchanges takes place online, with orders being placed from all over the world. Trading on exchange means that contracts are standardised with a clear guidance on the quality, quantity and when you will receive the goods.
This is where two parties agree to buy/sell to each other directly, without trading on an exchange. There are lots of different forms of over-the-counter trading. In forex, for example, a vast network of banks handles the buying and selling of currencies without ever needing to involve an exchange.
Test your knowledge
- A Buyers' market
- B Sellers' market
- C Both
- D Neither
- A Trader
- B Investor
- C Neither