Let’s look up what trading is and how it works in this beginner’s guide: we’re going to divide the existing types according to strategies, time horizon, financial instruments traded and analysis conducted.
What is Trading?
The first thing to know about trading online, is to avoid the promises of fake online ‘gurus’. Reject the ‘easy money’ scams, because there are no foolproof methods or secrets:. The answer to “what is trading” is simple: it’s the buying and selling of listed financial instruments or the negotiation of their value, usually through online platforms, with the aim to make a profit. However, this aim is absolutely not guaranteed.
Today, trading is mainly done on the internet, where unfortunately it is easy to be deceived: this is why government authorities regulate and control the market. To participate in trades, traders rely on authorised banks, securities brokerage firms or other online brokers. The latter enable the matching of supply and demand: they look for a counterparty for the trades their clients want to make. Brokers, in a nutshell, match buy and sell orders, on the best terms, in exchange for the payment of a commission. Knowing the role of these brokers is fundamental to defining what trading is, but there are many other ways to trade online.
In the financial market, there are other ‘players’: traders do not only trade with each other, through brokers, but also with dealers. The latter, unlike brokers, actively participate in trading for their own profit. In particular, they hold a portfolio of securities, called inventory, and fix the value at which they intend to buy a certain asset (bid price) or at which they are willing to sell it (ask price). The meaning of trading, therefore, is completed by dealers who, in practice, provide liquidity to the exchanges: market makers are a particular type, entities that undertake to continuously trade certain securities at predefined prices, thus enabling daily trades on trading platforms.
Every market needs constant liquidity to function, so the quotes offered by market makers (MMs) are essential. By simply crossing the orders of retail traders, in fact, the market might get ‘stuck’ on some occasions, which is why the ‘quote-driven’ version, allowed by MMs, is more efficient than an ‘order-driven’ one. Of course, to explain what trading is and how to do it, we must also consider the participation of large investment funds (such as hedge funds), which aggregate the savings of many, whose operations have a greater influence on price movements.
Types of trading: quantitative, algorithmic and leveraged
Now that we have an idea of what trading is, let us try to delve into what it means and how to do it by considering the different types. First of all, we can distinguish traders on the basis of the depth of analysis carried out before conducting trades. Technical analysis tools, in fact, allow one to recognise patterns in price movements: for example, from supports and resistances, trendlines or moving averages one can pick up so-called trading signals, so as to direct their strategy.
Discretionary traders, therefore, apply the basics of technical analysis to anticipate changes in the market and profit from them, but when the study requires high computing power, it’s called quantitative (or just ‘quant’) trading. In the latter case, this activity is based on complex mathematical and statistical models, which suggest the probability of certain events. Buy or sell positions in quant trading are opened manually, but could be managed independently by a programme.
This is the case with algorithmic trading, which, based on the analysis of price charts, consists of securities trading without human intervention. This mode is not, however, to be confused with automatic trading, which instead refers to the programming of buy or sell orders, through buy limit and buy stop (or sell) operations.
To learn more about what trading is and how it works, however, we need to go beyond simple buying and selling: some brokers allow traders to make money even from bear market phases. In jargon, this strategy is called shorting: in a nutshell, you borrow an asset at a certain price and sell it ‘short’, expecting it to lose value, in order to buy it back at a lower level. In this way, you return the security to pay off the debt, keeping the price difference as profit.
Short selling, therefore, is based on borrowed capital, just like leverage: a mode of trading in which the possible gains (and losses), which a certain sum could generate, are multiplied by the value added by the broker. In practice, leverage allows you to be exposed for more than you own, the so-called margin: for example, opening a buy position for €100 with x50 leverage would actually give you €5000 of buying power. A 2% rise in price would therefore double your capital, but a drop of the same magnitude would cause a complete loss of your initial funds.
Margin trading, therefore, is a very risky strategy, not suitable for beginners, especially with high leverage. Beginners or those who lack the skills to analyse the market correctly, however, could take advantage of copy trading: as the name suggests, it consists of reproducing the same actions of experienced traders. Some platforms offer similar solutions but, if you understand what trading is, it’s clear that nobody is infallible and no prediction is a certainty.
The difference between trading and investing: the time horizon
To really understand what trading is and how to do it, however, we still need to clarify the difference with investing. The distinction is in the objectives and the time horizon: given a certain financial instrument, traders seek to profit from price fluctuations in the short to medium term, while investors aim for profits over a longer period of time, thanks to dividends, coupons and compound interest, as well as the simple resale of the instrument. In addition, we know that traders can profit from both market rises and falls, whereas an investor only buys in anticipation of a rise in the price of a security or currency.
Furthermore, the duration of transactions determines different trading styles:
- Scalping – the buying and selling of the asset is separated by a very short period of time. In general, scalping frames flash trades, in the order of seconds or a few minutes, exploiting the volatility given by known events. For example, monthly announcements of US inflation data, such as the CPI index, can lead to rapid market movements, intercepted by scalpers;
- Day/daily: trading takes place within a maximum of one trading day, from the opening to the closing of the exchange, or generally within 24 hours. The narrow time window reduces potential gains, given usually small market movements, so multiple trades are made to try to add up profits;
- Swing or trend: positions are opened to follow prolonged price fluctuations (swings) beyond the day. This strategy can be part of a bullish or bearish market cycle or trend; when the trade is not completed within 30 days, it is also referred to as ‘position trading’.
Furthermore, we can use the example of arbitrage to appreciate what trading is from a time perspective. Basically, each asset can be quoted on different platforms or exchanges and small price differences can be observed between them. Thus, by buying a security where it is ‘discounted’, and then immediately selling it at a higher price elsewhere, it is possible to make a profit.
In general, time is an important factor in trading: world stock exchanges are generally open for only 6 to 8 hours a day and 5 days a week. Some traders, therefore, take advantage of the volatility given by the first and last hours of market activity, or the so-called ‘monday’ effect, to conduct trades. However, just as the right time to invest does not exist, it is also impossible in trading to find the perfect moment: timing the market to anticipate it is not the best strategy.
The financial instruments of trading: Forex and CFDs
One last distinction can be made to clarify what trading is: depending on the financial instruments traded, we can recognise different types and operations. The most famous example is trading in shares or based on stock exchange indices, such as the Nasdaq or the S&P500. Furthermore, it is possible to trade bonds, ETF holdings, commodities or cryptocurrencies such as Bitcoin (BTC) with a trade.
Trading of fiat currencies, on the other hand, takes place in the Forex market (Foreign Exchange Market): in practice, profits are generated by exploiting the exchange rate between two currencies. Each trade, in fact, has as its object a pair, such as selling dollars to buy euros (USD-EUR) or vice versa. In particular, the ratio (or spread) between the two values, given by the bid and ask prices of the pairs, is measured in percentage points (called PIP). For many, Forex represents trading par excellence: it is by far the most liquid and participated market with a daily volume in the trillions range.
To trade the value of any asset, opening long or short positions, one usually does not ‘physically’ buy the security, but derivative contracts that reflect its price changes. These are called CFDs (contracts for difference) and are essentially an agreement between counterparties, who are obliged at maturity to exchange money based on market movements. CFDs replicate the performance of a stock, commodity or Forex pair, so that a trader can profit from both rises and falls.
To complete this guide in which we have discovered what trading is, it is important to remind you of the risks of this financial activity: it is estimated that 90% of traders lose their money, so consider this possibility before deploying your capital. Do your own research (DYOR), define your risk profile, a personal strategy and evaluate your savings options first.