What is trading?
Trading is one of the key features of the global financial economy. It creates liquidity across the financial markets, is one of the main sources of profit forand is done by many institutions (investment banks, hedge funds, commodity companies etc.). Traders tend to use technical and fundamental analysis to price assets and to attempt to predict the future movements. If a trader is in large enough quantities, their trades can actually move the market, thus giving them a comparative advantage over smaller traders.
As opposed to investment banking, trading tends to be extremely performance orientated and if you perform well, you will be promoted quickly whereas if you consistently lose money or are risky, you will not last long. The most common way to break into trading at anis out of undergraduate study with a quantative degree and having completed a trading internship.
Types of Trading
Trading can be done in three main forms:
- Market Making
- Agency Trading
- Proprietary Trading
Below is a brief description of each kind of trading.
Market making is where a trader finds a buyer and a seller of an asset and does the trade on behalf of each. The trader will buy the asset from one individual, then sell it on to another at a higher price, thereby making a market. There is some risk associated with this, namely that the asset will change in value before the trader can make both sides of his deal. To compensate for this risk and to make some profit, the trader will offer a spread price (bid price below offer price). To be a market maker, it is extremely advantageous if not essential to have a list of clients you know well and can buy (sell) assets from (to) in order to execute fast trades and not have to spend a long time searching for investors.
Agency trading is the most restricted form of trading. It is literally executing the orders of clients. An agency trader will have a portfolio of clients, and if one of them calls the trader and says he wants to buy x amount of asset y at price z, the trader will execute that order for him on his behalf. There is almost no risk associated with it, but almost no profit. The profit comes from a small commission the investor pays the trader on a per-trade basis.
Proprietary trading is one of the most risky but also most profitable forms of trading. Essentially it is informed (sometimes uninformed) speculation about the movement of asset prices. Prop traders will open a position based on how they think the markets are going to move. If they are correct, they make a lot of money, if they are wrong they lose money. In order to attempt to reduce risk, prop traders tend to hedge their positions either using derivatives or inversely correlated assets. Many firms are dedicated purely to prop trading, and most investment banks and hedge funds have prop trading desks.
Areas of Trading
At an investment bank, traders usually work on their own trading floor and do not interact much with the rest of the departments. Different sectors of trading are referred to as ‘desks’ and they cover different products or areas. Some examples of different things traders deal in are:
- Equities - stocks and shares of publicly traded companies
- Fixed Income - bonds, securities and any other fixed income asset
- Forex - currency pairs
- Commodities - oil, metals, food etc.
- Derivatives - options, futures, ETFs, and more
Of all these areas, equities tend to be the least risky and least volatile, with derivatives being the most “dangerous”. A brief rundown of each sector of trading follows.
This is what is most commonly referred to by the general public as ‘trading’, but it is also the kind that is done least by financial institutions. The reason it has lost it’s popularity is the lack of volatility and the general lack of profit potential from stocks and shares. It is rare for any equity to move more than 10% in a day, and trading is a very short-term game. People trading equities are highly subject to insider trading laws as well as other regulations imposed by the SEC and other financial regulators. Equities trading desks are split into sector (technology, pharmaceutical etc.) and location (European, Asian, US).
Traditionally, fixed income meant bonds and bonds only. Nowadays it can refer to literally any asset where the holder receives a fixed amount over a period of time for lending money to someone in some form. One of the most notorious forms of fixed income trading in recent times is CDOs (collateralized debt obligations) which was one of the main causes of the 2008 financial crisis. The prices of fixed income assets are affected by interest rates and the stability of the borrower. Fixed Income desks are further divided up into government, corporate, municipal, mortgage and more.
Forex is an abbreviation of Foreign Exchange, and as such the forex traders spend their time trading currency pairs. Currencies are always traded against another currency in pairs (i.e. EUR/USD or GBP/USD). The way in which currencies move is simply dependent on the strength of the economy which uses that currency, i.e. if the US announces extremely poor GDP growth, it is likely that USD will depreciate against other currencies. The key concept for forex trading is appreciation and depreciation, which can sometimes seem counter-intuitive at first. If the Dollar depreciates against the Euro, then EUR/USD will go UP as 1 Euro buys more Dollars than it did before.
Commodities cover a vast range of assets, all of which are tangible. The most popular one is oil, but there is also copper, iron, wheat, and almost any other product which is homogenous across the world, used for production purposes and produced en masse. Commodity traders have been blamed for the rise in global food prices, as speculation tends to push up prices of assets. Commodities are usually traded as futures, and the futures are not held to maturity, as no trader wants to have 10,000 barrels of oil turn up at their desk when the future expires,
Derivatives are one of the most popular instruments to be traded, due to their highly leveraged nature and small capital requirements. The most common forms of derivatives are options and futures, although there are many many more. As of 2008 it is estimated that there is around $600 trillion worth of derivatives being held and traded around the world, roughly 10x that of global GDP. You can read more about the different types of derivatives by following the links at the bottom of the page.