An introduction to financial markets

The forex market​ is the world's largest and most active trading market, as well as being the most liquid. While foreign exchange trading has long been dominated by large global banks and institutions, it has become increasingly popular and accessible to individual investors.

Trading currencies is done slightly differently to other asset classes. Trading in other assets involves trading in one market with profit and loss based on absolute returns. For example, if you buy and the market goes up, you make money. If you buy and it goes down, you lose money.

Forex trading is done using currency pairs​, with one currency being traded against another. Returns in currency markets are relative, with profit and loss being measured by how one currency performs relative to another. For example, on a given day, the US dollar (USD) could appreciate relative to the euro (EUR), Swiss franc (CHF) and British pound (GBP), but decline relative to the Japanese yen (JPY), Canadian dollar (CAD) and Australian dollar (AUD).

As the world's reserve currency, trading in US dollar-related currency pairs is the foundation of currency trading around the world. The most active pairs​ (also known as the major forex pairs) include EUR/USD, GBP/USD, USD/CHF and USD/JPY. Currency pairs that don't involve USD are known as cross pairs. Popular cross pairs include GBP/EUR, EUR/JPY and AUD/CAD.

Pricing in currencies is based on the first currency in the pair, also known as the base currency. In the case of EUR/USD, this means how much USD it would take to buy one EUR. When EUR/USD goes up it means that EUR is gaining in value and when it goes down, it means EUR is losing value against the USD.

Trading in resource currencies such as AUD/USD and USD/CAD is also popular, as the valuation of these currencies with those of other resource-producing nations such as the New Zealand dollar (ZND), Norwegian krona (NOK) and South African rand (ZAR) tend to be influenced by commodity prices. These represent a significant part of the goods traded by these countries. Note that CAD and NOK tend to be more sensitive to energy prices, AUD and NZD to metal and grain prices and ZAR to precious metal prices.

There are two main types of participants within the commodity market​; hedgers and speculators. Hedgers are those who want to lock in a price for a product that they intend to deliver or use at a future point in time. For example, a farmer about to plant wheat may want to lock in a price for when they deliver it in September, while a baker needing wheat for June may want to lock in their price before that for planning and budgeting purposes. This financial market tends to be dominated by industry participants.

Commodity prices are mainly impacted by changes in supply and demand of the particular goods being traded. Speculators are those interested in attempting to profit from changes in prices as supply and demand conditions change and have no intention of delivering or taking delivery of physical goods. Most investors fall into this category.

Commodities tend to fall into a number of groups that share similar influences:

Another type of diversification is to invest in global stock indices​ across a wide variety of industry groups, in order to gain exposure to wider business opportunities and mitigate the risk that one sector may encounter difficult times.

For example, investors only looking at the energy sector could have problems when commodity prices fall, but this risk can be lessened by also having exposure to areas that benefit from falling energy prices, particularly transportation companies and anyone that consumes fuel.

Although sector trading has become more popular in recent years, trading broad market indices is the primary means that equity investors use to increase their diversification over individual shares. Most indices that are tradeable are based on a basket of the largest and most actively traded companies on a particular exchange or in a particular country. Another advantage of index trading is that they are usually widely followed in the media, so there tends to be a lot of information available.

Government bonds​, also known as gilts or treasuries, form part of another very active trading market, giving investors the opportunity to trade off grander macroeconomic trends in various countries.

Most large investors such as banks and institutions tend to purchase bonds with the intention of holding them to maturity and viewing the interest rate on the bond as the primary return on their investment. Over time, bond prices tend to fluctuate along with economic conditions, creating promising opportunities for investors. Learn more about the treasury market​.

The compensation through interest rates that investors demand in order to purchase a bond tends to be driven by two major factors, inflation and repayment risk. In order to earn income over time, investors need their bonds to return at least the rate of inflation in the issuing country. In addition, investors tend to demand a premium to cover the risk that the bond issuer may default on either the principal or interest payments, since you can't imprison debtors in most countries.

Based on this, investors tend to demand higher interest rates from countries running high rates of inflation. As seen during the European sovereign debt crisis, issues such as high government deficits or high national debt levels can increase the risk of insolvency and lead investors to demand higher interest rates to compensate them, as part of their risk strategy.

While sometimes equity investors can fall in love with their stocks and be more forgiving of failure, bond investors tend to be extremely strict about the quality of their investments and are sometimes referred to as 'bond vigilantes'.

Due to the fact that interest rates on most bonds are fixed after issuance, bond prices change over time to reflect changing interest rates. Suppose a ten-year bond is issued at 5.0% interest and a year later, new nine-year bonds are being issued at 4.0%. Because the 5.0% bond carries a higher interest rate, all else being equal, investors would be willing to pay more for that bond. On the other hand, if investors could get 6.0% on new nine-year bonds, they would not be willing to pay as much for the 5.0% bond.

Bonds tend to be issued at a price of 100.0, known as par, and are expected to be redeemed for the same price at maturity. If interest rates on new bonds increase, the price of existing bonds tends to drop so that they trade below 100.0, or at a discount. The potential for capital appreciation offsets the lower interest rate. Similarly, if the interest rate on new bonds falls, the price of existing bonds tends to rise to trade at a premium to par with the capital loss over time offsetting the higher interest rate. Understanding this inverse relationship between interest rates and bond prices is key for bond traders.

The time to maturity is also an important factor. Central banks often use short-term rates to speed up or slow down economic growth. Because of this, the difference between short-term and long-term rates can fluctuate quite a bit. Most of the time, long-term rates are higher to reflect the risk of changing developments over time but sometimes short-term rates can rise above long-term rates, particularly when central banks are trying to slow economic growth or control inflation. Read more about the bond market and bond trading​.

Most people first become familiar with the world of investing through individual stock trading on the share market. Companies around the world issue shares to the public for many reasons, primarily to raise capital for expanding their business. Additional benefits for corporations of being publicly traded include generating a higher profile with potential customers and the public at large, the sharing of risk among more investors, reducing the company's capital costs, succession planning for founders and many more purposes. The sale of shares from a company's treasury to shareholders is known as the primary market.

Once a company completes its initial public offering (IPO), its shares then usually trade on a traditional stock exchange such as the New York Stock Exchange (NYSE) or London Stock Exchange (LSE). It can also be listed on an over-the-counter exchange such as NASDAQ, where trades are executed directly between brokerages. Both of these are known as secondary markets.

There are two methods to help individuals looking to make money within the stock market. Capital gains from making a profit on a favourable price move either from the long side (buy low and sell higher) or short side (sell high and buy back lower). Income can also be earned from dividends that companies pay to their shareholders out of net profits. See a list of the best dividend stocks to trade here.

Generally speaking, investors tend to bid up the prices of shares where positive things are expected to happen to a company, such as improved earnings in future from increased sales, new contracts, higher dividends, takeover bids or other developments. On the other hand, expectations of negative developments, such as a slowdown in the business, regulatory changes, losing contracts and political changes, can lead investors to want to sell and push down the share price.

With a buyer and seller involved in every transaction, at any given time, share prices tend to reflect the balance of the expectations of all market participants. Share prices may change as expectations change.

Factors that can impact market expectations can include macroeconomic factors that influence business environments. This includes industry factors such as changing commodity prices, and company-specific factors such as earnings, dividend changes, and other business developments.

One regular development that tends to influence trading is a company's earnings report. The timing of these reports tends to be publicised well in advance, and analysts who follow the company weigh in with their expectations. Many companies also publish their own expectations, known as guidance. How a company's results and future guidance fare relative to expectations can have a major impact on short-term and long-term trading trends.

Deciding which financial markets to trade can seem like a complicated process, but there are a number of factors that can simplify this decision.

Get started trading on the financial markets by opening a live account with us. Alternatively, you can first practise with £10,000 worth of virtual funds by opening a demo account.