Share Market Toolbox
There are a number of financial instruments in which we
Shares, hybrids, CFDs, currencies, futures...?
So you are thinking about investing or trading in the financial markets, and you have heard about a variety of different instruments... shares, CFDs, options, bonds, warrants, futures, forex, foreign currency, etc.. But which one(s) should we look at, and which should we avoid?
This topic potentially opens a can of worms, because of the sometimes complex nature of some instruments. The discussion here will only just scratch the surface. But it is hoped that it will help to clear any fog.
Perhaps the simplest instrument to consider is the simple company shares.
Shares - example
By way of a simple example, consider the case where a person (let's call him Fred Smith), wants to build up a company so that he can manufacture some widgets. But he needs some money. In fact, he thinks he needs about one million dollars to get started.
Fred could arrange to set up a company structure where he has one million shares valued at $1 each, and he offers these shares for sale to his friends. If he listed his company on a public share market then his shares would be available for sale to more people than just his friends. Someone might be able to buy 500 shares for a total cost of $500 (plus any brokerage fee), or as many as 100,000 shares for a cost of $100,000. Anyone owning as many as 100,000 shares would be owning 10 percent of all the shares on issue. Once all shares had been sold, Fred would have $1,000,000 in cash that he could use to run the company.
Of course, over time, as the company operates and sells product, Fred would hope that his company makes a profit so that his shareholders could potentially be paid a dividend. And the perceived value of the shares might rise higher than the original value of $1.
So, shares are one financial instrument in which we could invest. When we refer to company shares and the share market, we could also call them equities, equity securities and the equity market. Shares are also referred to as an "asset class", and a "primary instrument".
Shares - a comment
For many investors and traders in the financial markets, public company shares are the instrument of choice. They are simple instruments - you pay an amount of money and you are allocated a specific number of shares. If the company is a publicly listed company on a stock exchange, then you can follow the performance of the share price. And from day to day and week to week you could observe the value of your capital investment increasing over time, or perhaps decreasing over time.
Many investors and traders prefer share investing because shares are relatively simple, and the shares in publicly listed companies can be relatively liquid, so that they might be able to sell their shares quickly if they want to. Provided appropriate risk management and money management principles are put into place, investing or trading in the share market is nothing like gambling.
Share prices have a personality
The perceived value of any company's shares can change quickly during the trading day, and from day to day and week to week. It is dependent on many things. The one thing that is certain is that the actual consensus value of a company's shares is the share price that is shown on the price chart. The opinion of the market participants is reflected in the share price chart. If a majority of the real market participants believe that a company's shares are worth more than a particular price level, then the shares will trade at a price that is equal to or higher than that price. Perusing a price chart over time can reveal these price levels. (The study of technical analysis is based on notions like this.)
The term "hybrid security" is used to refer to a variety of instruments which combine elements of both debt securities and equity securities. Some listed companies in Australia issue hybrids from time to time, an doften in the form of capital notes. Many investors in hybrids don't fully understand the inherent risks, and risk losing some or all of their funds.
Options (stock options)
A stock option is a contract that gives the owner of the option the right (but not the obligation) to buy or sell an underlying financial instrument (such as company shares) at a specific price and date. Stock options are often used to hedge against adverse share price movements to protect the shares in a share portfolio. Many investors choose not to get involved with options and sell their shares in times of adverse share price movements. Many investors make good income from selling options. Read more at Wikipedia.com
A futures contract is a basically an agreement to buy or sell something at an agreed price at a specific date in the future. This usually applies to a commodity, but also to other financial instruments. Read more at Wikipedia.com
Foreign currency (forex)
A number of online currency exchanges exist where a trader can trade in currencies. For trading purposes, and when referring to currencies, it is normal to refer to a pair of currencies - such as the Australian and US dollar pair, where the value of one of these currencies is quoted in relation to a unit of the other one. For example, at about the current time, the Australian Dollar has been trading around about 76 to 80 US cents.
Forex - a comment
From time to time, investors and traders develop an interest in trading currencies as a perceived way to make money. In reality, this is not easy. To be successful, one needs to have a very good feel for the consensus view of the currency value. This is very difficult because of the many factors that different forex traders use to determine the value. Many people see short-term trading in currencies as akin to gambling.
Bonds come in a variety of different types, but in each case a bond is simply a debt security, where the entity that issues the bond is basically borrowing money from the holder of the bond, and agrees to pay back a level of interest, and eventually the actual value of the bond. Read more at Wikipedia.com
CFDs - Contract For Difference
A Contract For Difference (CFD) is basically an agreement between an investor and the issuer of the CFD to exchange the difference in price of the underlying instrument. An investor/trader can buy a CFD contract for a specific company's shares, and pay a small amount of money up front. At some time down the track the investor can close the contract and if the underlying share price has increased, then the price difference is paid to the investor and the investor has won. If the share price has fallen, and the investor closes the contract, then the investor pays the difference to the issuer and has suffered a loss.
CFD contracts are offered by a number of CFD providers in various countries. It is normal to have CFD contracts available on share in public listed companies on various stock exchanges, as well as CFD contracts on equity indexes, currency pairs, and on commodities. In some countries CFD trading is referred to as spread betting, and is seen as gambling. Read more at Lexicon.FT.com.
A warrant is a type of security that entitles the holder of the warrant to buy the underlying stock at a fixed price until the expiry date of the warrant. Buying a warrant can be a way to buy shares on a "down payment" plan - pay some now and the rest later. Read more at Wikipedia.com.
For more information on various financial instruments and asset classes, see Wikipedia.com.
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