Hello and welcome to my YouTube channel – Trading Software Tutorials.

This is the fifth and last in an introductory series to set the scene for the various types of trading software. The first tutorial was a general introduction to what sort of software platforms are needed to trade effectively. The second tutorial provided information about trading data: what types of data you need and where you can obtain the right data for scanning and backtesting trading systems. The third tutorial provided information about charts: the difference between static and dynamic charts, and where to find the right charts for your type of trading. The fourth tutorial provided information about brokers, especially what to look for to find the right broker for your style of trading. You’ll find links to these tutorials in the description below.

This final introductory tutorial provides more detail about financial instruments:

• the difference between the two basic types – equities and derivatives
• the most commonly traded equity securities and derivative securities
• the way in which contractual arrangements differ between derivatives
• the mechanisms for trading derivatives which differ between countries, and
• the way in which financial instruments are individually coded with ticker symbols.

Historically, the first products to be traded were agricultural commodities and precious metals. Rather than buyers having to carry out their own negotiations with sellers, commodity exchanges emerged which would act on behalf of both parties to facilitate an agreed transfer price and conditions. While commodity markets had been around for thousands of years, the earliest known formal commodity exchange was established in Amsterdam in 1530. Eighty years later, the Dutch East India Company sought to raise money by selling small shares in the business upon which dividends would be paid, thus establishing a precedent for companies to become publicly owned and grow through the sale of shares which then increased in value as the company increased its profitability.

In addition to the exchange of commodities and shares in companies, there is now a broad range of other financial instruments which can be traded. These are collectively called securities. There are four main types of securities: debt, equity, derivative and hybrid. As retail traders, we are only concerned with equity and derivative securities.

The difference between equity securities and derivatives is that you own an equity security outright as a monetary asset, whereas you do not own a derivative. Instead, you own a contract that can be traded. The price of an equity security is based on the market sentiment for that particular instrument at any particular moment in time, whereas the price of a derivative security is dictated by the price of its underlying equity security or, in some cases, a basket of equity securities. While you trade equity securities as a product, you trade derivatives as a contract. Equity securities are usually traded through an exchange whereas derivatives can be traded either through an exchange or in over-the-counter (OTC) transactions. However, you need a broker for both types of trades.

The five major classes of equity securities are stocks, bonds, commodities, mutual and exchange-traded funds, and currencies. For retail traders, the most commonly traded equity securities are stocks and exchange-traded funds (ETFs).

The six* major classes of derivative securities are options and warrants, swaps, futures and forward contracts, spot contracts, and the broker-derived version of spot-trading called contracts for difference or CFDs. For retail traders, the most commonly traded derivative securities are options, spot contracts, futures contracts and CFDs, plus the UK has a form of CFD called spread-betting. *Five, six or seven, depending on how you count.

However, to trade a derivative it must have an underlying equity asset. The most common underlying assets in derivative markets are stocks, bonds, commodities, funds and currencies. While interest rates and market indexes are not assets in themselves, derivatives of them have been created so that they can also be traded. For example, America’s four major indexes are the Dow Jones, S&P500, Nasdaq and Russell 2000. Derivatives of these indexes can be traded in either the spot market or the futures market.

There is currently debate as to where cryptocurrency lies in this schema. Is it a security or a derivative? Unfortunately, there is no consensus on this. However, in practice, while cryptocurrencies can be bought outright and held as tokens, making them an equity security, they are more commonly traded in the form of derivatives, either singularly as a spot contract, or in pairs against the US dollar as a futures contract.

With derivatives, therefore, there is a matrix between the type of contract and the underlying equity asset. For example, you can trade gold in a spot market or in a futures market. Indices can also be traded in a spot market or a futures market. Whereas FX is usually traded in a spot market.

In summary, for retail traders, the most commonly exchanged financial instruments are:

• equity securities of stocks and exchange traded funds (ETFs)
• derivatives of stocks in the form of options
• spot, futures and CFD contracts as derivative instruments for commodities, currencies, cryptocurrencies and indexes.

So let’s look in detail at these six different classes of financial instruments. After that we’ll look at contract sizes which vary between underlying asset and type of contract.

When a private business decides to raise capital by becoming a public company, shares are issued to the market via a stock exchange. This is called an initial public offering and after listing, the shares change value depending on the public’s perception of the performance of the company. Owning shares makes the purchaser a part-owner of the company. Note, the terms shares and stocks are used interchangeably, but shares is the more correct term.

Equity securities are cash contracts and were traditionally traded on regulated exchanges, but now shares can also be traded on an over-the-counter exchange through a mechanism such as contracts for difference or spread betting.

In theory, you can buy as few shares as one but, in practice, your broker may require a minimum number, plus you need to consider that you will usually be charged brokerage on a set minimum number that will be well above one, so the ratio of brokerage to profit will be uneconomic if you only trade a few shares that are low in individual value.

There are two ways in which you can make money from stocks. The first way is directly when you trade the shares either long or short and make a profit. The second way is if the company issues dividends from its operational profits. In this instance, a per-share payout is made to the investor, usually either annually or biannually.

An exchange traded fund, or ETF, is a marketable security that tracks an index, a commodity, bonds, or a basket of equities, and is traded on the stock exchange like stocks during regular market hours. When you invest in an ETF, you get a bundle of assets you can buy and sell as a whole. The advantage of an ETF is that they help diversify your investment portfolio and thus potentially reduce your risk. ETFs generally have a low expense ratio, high liquidity, a broad range of investment choices, a low investment threshold, and a payout of bonuses from underlying assets such as stock dividends.

Some of the most popular ETFs are index funds based on the Standard & Poor’s 500 index and the Nasdaq 100 index, which contain high-quality businesses listed on American exchanges. In addition to index funds, popular areas for ETFs are real-estate investment trusts (REITS), technology stocks, bond ETFs that can provide a fixed income stream, and commodity ETFs in metals. Do note, however, that buying overseas ETFs is likely to be more expensive than buying ETFs on your local market. Like shares, ETFs are subject to broker fees, so you need to ensure that the amount of money you invest will bring you more than sufficient profit to cover the fees.

An options contract is an agreement between two parties to buy or sell a financial asset, such as a parcel of shares, at a predetermined future date for a specific price, known as the strike price. Call options provide the option to buy, whereas put options provide the option to sell.

Unlike other forms of derivative contracts, an options contract does not oblige the buyer to buy or sell. The owner of the contract can simply let the option expire and forfeit the premium that they have paid to buy the option.

Options contracts are usually traded on regulated exchanges. Options can be taken out on shares, indices, forex and commodities, though the most commonly traded option for retail traders is share options. Not all listed stocks provide options contracts. In fact, the majority don’t, with possibly less than 10% of companies on any exchange offering them. While they are quoted in per-share prices, options are only sold in 100-share lots.

Spot contracts are so called because the exchange is made immediately or ‘on the spot’. Note, the term spot market is also often called a cash market or an undated market. Spot markets can take place either on a regulated exchange or in relatively unregulated over-the-counter (OTC) transactions. They are common for trading CFDs in commodities, currencies and cryptocurrencies.

A futures contract is a standardised agreement between two parties for the purchase and delivery of an asset at a set price at a future date. It factors in the potential future value of the underlying equity. However, not all futures contracts are settled at expiration by delivery of the underlying asset. If both parties in a futures contract are traders, rather than taking delivery of a bulk commodity, oil or corn for example, they can end their obligation to purchase or deliver the underlying commodity by closing their contract before it expires in a cash settlement. This is the way that most retail traders buy and sell commodities. The futures market uses standardised contracts that trade exclusively on exchanges.

Traditionally, commodities and foreign exchange were traded in large contracts at high prices which were too expensive for retail traders to participate in. Margin lending was thus introduced by brokers so that retail traders only had to invest a fraction of the cost of the financial asset, with the broker providing the rest. With margin lending, retail traders can take a position in a market while only paying a very small part of the cost up front.

Two of the most popular methods for supplying the margin for derivatives trading are contracts for difference (CFDs) and spread betting, both of which suit retail traders because of the easy access to leverage and the ability to trade over the very short term. Leveraged products are particularly popular in trading derivatives of foreign exchange, cryptocurrencies, commodities and indexes. With the exception of America, Belgium and Hong Kong where they are banned, CFDs are almost universal. Spread-betting is available only in the UK and Ireland.

A CFD is a derivative contract that pays the differences in the settlement price between the open and closing positions. If the difference is positive when the trade is closed, the profit is automatically paid into the trader’s account. Equally, if the difference is negative, the loss is automatically deducted from the trader’s balance. A minimum deposit to trade mini or micro contracts ranges between 100 and 500 US dollars, and many brokers offer demo accounts for retail traders to practice before committing money to their trading strategies.

CFD accounts are highly flexible, there are no restrictions regarding the timing of entry or exit and no restrictions on time over the period of exchange. There is also no restriction on entering a trade buying long or selling short. However, CFDs have a higher inherent risk than stocks owing to the degree of leverage they allow. Leveraged investments amplify the effects, that is the gains and losses, of price changes in the underlying security for investors.

While a trader is required to only meet the margin, if the trade is allowed to go into a significant loss, the trader can potentially lose more money than is in their account. Because so many people do lose large amounts of money trading with CFDs, some countries, such as Australia, have regulated the CFD market to force brokers to close out a losing trade before the trader loses more money than is in their account. However, at the same time, regulations in Australia were amended to decrease the margin, meaning that the trader must put in more of their own money. While there are no brokerage fees involved in CFDs, the difference between the bid and ask prices – known as the spread – is always larger than in equity security transactions.

While CFDs are allowed in many countries, they are not permitted in America owing to restrictions by the Securities and Exchange Commission on over-the-counter financial instruments. Because US regulation prohibits US citizens from trading CFDs both within and outside the country, most foreign CFD providers do not allow US residents to even open a CFD account, though dual citizens may be able to if they’re not living in America. Alternatives to CFDs for Americans include regulated spot forex, forwards and futures trading, leveraged ETFs, options and binary options.

Because CFDs are instruments created by a broker to trade against the price action (it essentially replicates the instrument), you are one step removed from owning the underlying equity when you trade them. In America, however, you trade foreign exchange through a broker and thus actually hold the equity asset of the currency.

However, before US forex brokers can accept traders as clients, they must become registered as a Retail Foreign Exchange Dealer (RFED) by the financial regulatory body, the Commodity Futures Trading Commission (CFTC) and also be regulated by the National Futures Association (NFA) as a Futures Commission Merchant (FCM).

Spread betting, which is legal in the UK and Ireland, is a very similar trading mechanism to contracts for difference where there is significant leverage, the ability to trade long or short, and wide variety of markets available. Curiously, as spread betting is considered a gambling activity by UK law, there is no tax payable on earnings.

Because derivatives are traded as contracts, each one has a designated minimum contract size and set monetary value. You can buy as many contracts as you like, for the specified value in a specified currency. In the example shown of crude oil futures offered by IG Markets, for the expiry date of 23 March, there are five contracts offered for different monetary values: New Zealand one dollar, Australia one dollar, Australia ten dollars, America ten dollars and America five dollars. This set is repeated for each month.

When you open a deal ticket for, say one Australian dollar, you find that the number of contracts has a minimum of zero point five, or half a contract, and you can increase this to one or more contracts.

The minimum contract for foreign exchange is usually one. For a full contract this is $10, for a mini contract it is one dollar, and for a micro contract it is ten cents. This means that for every point that the instrument you are trading moves up or down, you gain or lose $10, one dollar or ten cents, respectively. Note, not all brokers offer micro contracts, and in forex trading the points are called pips.

In contrast, some commodity futures have a larger minimum contract size, such as iron ore which is 10 contracts, Chicago wheat and soybeans which are 20 contracts, and corn which is 30. However, some minimum contract sizes are smaller, such as high grade copper which is zero point two five of a contract, and palm oil which is zero point one of a contract.

In addition, while the minimum monetary per-point value of most contracts is one dollar, some are larger. For example, while you can buy one contract of lead, zinc or aluminium, their per-point value is US$5, for oats it is US$25 and for London wheat it is 20 pounds.

Finally, it’s important to understand the naming conventions for financial instruments with ticker symbols. You may be familiar with the fact that stocks are given a letter-based symbol when they are first accepted by a trading exchange. In America, these symbols are from one to four letters. For example, Microsoft Corporation is MSFT and Google is GOOG, while American Airlines Group is AAL, Alcoa is AA and Citigroup is just C. Most exchanges in the rest of the world use three letters, or letter/number combinations for their financial instrument symbols. In Australia, for example, the symbol for a2 Milk Company is A2M and for the mining company South 32 Limited, the symbol is S32.

In international trading, the code for a stock includes the exchange that it is traded on, although, just to be confusing, the appended code can vary between major brokers and news outlets. For example, when Vodaphone Group is traded on the London exchange it’s symbol is designated as VOD.L by Reuters, whereas Bloomberg designates it VOD:LN. On the Singapore Stock Exchange the symbols are VOD.SI and VOD:SP, respectively.

Currencies are allocated symbols according to whichever pairs are matched. For example, the symbol for the European euro matched against the American dollar is EUR/USD in the currency market. With the exception of the euro, a currency code is made up of its country symbol for the first two letters and that country’s currency symbol for the third letter.

Commodities are similarly coded. For example, American crude oil is CL while London crude oil is LCO. Coffee Robusta is LKD, whereas Coffee Arabica is KC, and Chicago Wheat is C, whereas London Wheat is LWB. When the two precious metal commodities gold and silver are traded against the US dollar in the spot market, their symbols are XAUUSD for gold and XAGUSD for silver.

Derivatives of indexes are similarly coded: the derivative of the UK stock exchange top 100 stocks is UKX, the derivative of the German exchange top 40 stocks is DAX, and the derivative of the Hong Kong stock exchange is the Hang Seng.

Financial instrument symbols are often amended for smaller contract sizes. For mini and micro contracts, brokers will usually change the symbol, either to indicate the size of the contract in brackets, to add ‘M’ to the name to indicate a micro contract, or to change the symbol completely. For example for natural gas, IG Markets uses the code NG, but also includes in the title the full name ‘Natural Gas’ and the specific contract value afterwards. In contrast, Ninja Trader uses the code NG for full $10 natural gas futures contracts and QG for E-mini natural gas futures. Note too, that very few brokers, if any, will offer all financial instruments, and not all brokers offer micro contracts.

In this overview, we’ve had an in-depth look at the variety of financial instruments available for retail traders:

• the two types of securities traded by retail traders are equities and derivatives
• as a retail trader, you will probably trade the equity securities of shares and exchange traded funds and derivatives contracts of commodities, currencies, cryptocurrencies and indexes through some form of margin account such as contracts for difference, spread-better or broker-supported leverage
• contract sizes and unit values vary between instruments so check you have the appropriate contract before opening a trade
• every financial instrument has its own ticker symbol which sometimes vary between brokers and other agencies.

Please let me know if you are aware of a trading software package that lacks good educational resources. I am always open to creating video tutorials in areas of need.

DISCLAIMER

This video is made available for educational purposes only. It does not provide financial advice of any sort to any person. The narrator of this video is not a qualified financial advisor. Any opinions expressed during this tutorial are the personal views of the narrator and you should not take anything that is said on this video to be advice regarding any investment in any financial product. Should you wish to invest in any financial market, you should seek professional advice from a qualified financial advisor or broker.