Choosing a Market to Trade

Trading the markets is, potentially, a great way to grow your capital, as long as you learn how to invest properly and have a good system to manage your risk whilst maximising your profits.  An individual setting out to do so needs to :-

1.    Know the market that they wish to trade.

2.    Understand how to determine the opportunities available through technical analysis.

3.    Have the funds with which to do so and know that this could be lost without any danger to their current or future lifestyle

4.    Know how to control risk.

5.    Have a plan.

Considering these five points will help to determine the market to trade so let us take each one in turn.

If the individual has been a successful investor in a particular market then, on the face of it, they are in a strong position to be able to trade it.  However if their investing was long term, as measured in years, they will need to have a different approach when trading as the information needed and the psyche involved are quite different.  It may be better to choose a market that they are not familiar with as they are less likely to be influenced by long term thinking getting in the way. If they choose to go with the market they understand then ready access to information about the market will be essential as will be the time to read and analyse it.  If the market chosen is equities then company announcements and economic statistics relating to the wider economy as well as the specific company must be readily accessed. Shorter term traders will need the information to be in a timely fashion because markets react very quickly to anything that influences the perception of value.

Choosing a market that they are not familiar with, however, then requires a good knowledge of technical analysis.  True technical analysts can trade any market that they have the data of price and volume for. It is also entirely possible to trade markets without a deep understanding of technical analysis. Indeed too much knowledge by way of indicators that seek to further analyse the raw data can get in the way and make a simple decision very complicated, confused and wrong. By with the right training technical analysis can be a very powerful way to trade.

Some markets are more volatile than others but all represent a high level of risk so that the market chosen may be determined by the level of risk and funds available to the potential trader.  Commodities and Foreign exchange markets tend to be very volatile and may represent the higher risk markets.  Sometimes the trader will need high minimum stakes which makes it impossible to manage risk efficiently without having large initial levels of funds.

Managing risk is absolutely essential for anyone to be a successful trader.  This involves two elements in the managing of the trader’s funds.  First of all they must limit the amount that they risk on any one trade so that they cannot be wiped out by one rogue trade.  Trading involves many lost trades and, usually, fewer winning trades for most traders.  So the approach is to ensure that the expected gain exceeds the potential loss on each trade by a significant margin. Losses should be limited by the use of a stop loss on every trade.  The margin or deposit required will be based on the risk that the trade represents and the amount that is to be traded per unit.  All of these are considerations in choosing the market to trade as they may be beyond the sensible use of the funds available. They do, however, allow the trader to ‘fall asleep’.

So what markets are available to be traded? The equity market in the UK and overseas, foreign exchange, commodities are all available and are widely used. 

In the equity market there is a choice of individual companies and indices.  It is possible to gain exposure to specialist areas with the use of ETFs (exchange traded funds) which can offer exposure to global areas such as Asia, Emerging Markets, Europe, America and others. 

ETFs can also be used to gain exposure to commodities such as particular metals eg nickel or copper or the precious metals of gold and silver.  Exposure to soft commodities such as wheat, coffee and soya etc. can also be gained in this way.  Commodities whether they be soft or hard are the subject of many influences that are often hard to predict and can be very volatile as a result.

The foreign exchange market is the largest market in the world with some $4trillion dollars traded every day.  It is the market that is most closely associated with the pure form of technical analysis because of the large amount traded each day.  Even so, as the trade is in currency pairs it is the major currencies that best fit as smaller currencies are less widely traded and be more likely to be ‘surprisingly’ volatile.  Individuals that are new to trading will often pick this market as it usually offers opportunities every day and the choice from a list of major currencies is considerably smaller than the choice within the equity market.  The spreads (difference between the buying and selling price) are generally smaller than they are in other markets and prices are volatile enough to be able to make a profit (or loss) each day in each currency pair.

Bonds Versus Shares .... Which Is The Right Option For The Investor?

Should you be investing in bonds or shares? That’s a tough question to mull over.  Let’s take a look at both financial instruments.

Bonds are supposedly less risky to invest compared to shares. This is so because in the unfortunate event of business insolvency/bankruptcy, the bond holder (investor in bonds) comes ahead of the equity shareholders in terms of payouts should the entity be made insolvent. On the other hand, the equity investor is last in line to be paid and more often than not business failure to an equity investor equates to an almost certain loss of their entire capital that he/she has invested in the failed business. With respect to bonds, the bond holder is promised by the party receiving the money (the Issuer), to repay the face value of the bond (the principal) at a specified date (maturity date.) In view of this, it becomes apparent that capital is more exposed to risks when it is invested in shares rather than bonds.  

In terms of providing an income there is also a distinction between shares and bonds. In the latter, the investor in bonds is often provided with fixed yields, the main advantage here being that he/she is able to predict income from their investments. This is an attractive feature for investors approaching retirement, when regular income from their investment is more favorable investment strategy than exposing their capital to higher risks.                                     

For example, if an investor where to buy a bond with say 10% coupon at its 1,000 USD par value, the yield is 10% (100 USD/ 1,000 USD).  That seems straightforward. But the investor in bonds needs to bear in mind that the price of bonds fluctuates on the bond market. So assuming the bond price goes down to 800 USD, then the yield goes up to 12.5%. This occurs because the investor receives the same guaranteed 100 USD on an asset worth 800 USD (100 USD/800 USD).

Conversely, if the bond goes up in price to USD 1,200, the yield shrinks to 8.33% (100 USD/1,200 USD).

Shares do offer income to the investor in terms of dividend payments, but income from this is not predetermined and can be unreliable.  Note that dividend payments on shares usually depends on the performance of the company throughout its financial year and the amount of income paid, if any, is recommended by the company’s board directors. So the investor has no real way of deriving a stable income from shares. In some years the shares may pay dividends, whilst in other years, little or no dividends may be paid out. 

Despite the uncertainty of income that shares offer investors their main attraction as an asset class is their potential to offer the investor capital growth. However, the general rule of thumb for investing is applicable in share investing, that being the higher the potential risk to the capital the higher the rewards received by the investor and visa versa.

In other words, there is a positive relationship between rewards and risks. 

If the investor is willing to forsake higher risk for the potential of greater returns, then equities may be the suitable financial instrument for him to achieve his goal. This is one of the main advantages of share investments compared to bonds-the potential of capital growth.  A young investor, a long way from retirement may prefer an investment strategy where their investments are more geared towards growth, rather than immediate income. This means that their investment portfolio may be orientated more towards shares rather than bonds.  So the investment goal of the investor could determine whether investing in bonds is more suitable than shares. 

Indeed, volatility is another distinction between the two financial instruments. Share can fluctuate widely on the future potential profitability of the business, on the expected earnings.  Technology stocks, pharmaceutical stocks investigating in new drugs for say cancer, or prospecting oil/ mining stocks share prices have the potential of gyrating widely on the stock market based on the prospects of positive events influencing the company’s profitability.  Investing in these types of companies before the positive event has been factored into the share price offers investor the potential of large capital gains. A photo looking like a bunch of long haired hippies, featuring micro soft founders in 1978, states, “would have you invested.”

 

If an investor were fortunate enough to have bought 100 shares at 21 USD in MicroSoft in 1986, an investment 2,100 USD, those shares over the course of nine stock piles would have mushroomed to 28,800 shares. Assuming the investor then sold those shares in December 1, 1999 he would have bagged a massive 1.4 million USD.  Sure, this is easier said than done, but no doubt this will probably wets the appetite for shares, even amongst the diehard cynics among you.    

Another bonus of share investing is that the investor owns a piece of the company. There are different classes of shares with different voting rights. Shareholders are invited to attend annual meeting of the company, they can vote on issues that influence the business, such as takeover and acquisitions of the business, changes to members of the board. Naturally, the larger the shareholdings in a company the more voting clout the shareholder investor has in selecting senior executives who will run the company and voting on import issues that could influence the business.   In contrast, a bond holder doesn’t acquire ownership in the business; they have no voting rights and no way of influencing the business.

So the theory goes that bonds are a supposedly the safer bet than shares-they are the more preferred asset by the grey haired people among us.  But so is gold considered the ultimate safe haven, the ultimate rat hole to climb into when things go pair shaped. Despite this common held view gold investors eroded 28 percent of their capital in 2013, it was the worse year for gold since 1981. Bond investors also experienced the worse year in living memory in 2013.  Indeed, playing safe last year has left some investors feeling very sorry for themselves, but will the appetite for risk continue into 2014…?