Introduction to Financial Markets and Speculation
Introduction
Welcome to this introduction to the fundamental concepts of financial markets and speculation, crucial for anyone interested in trading. Our focus is on speculation, which means trading for profit rather than intrinsic investment gain. Understanding this is vital to comprehending why trading exists and the role of speculative traders within the market.
Speculation simply means that we are trading for profit rather than any intrinsic gain of investment. This understanding is essential to grasp the underlying reasons for trading and to identify where speculative traders fit into the overall market. Even though we trade for pure profit, we serve a vital purpose to the market. Without speculators, there would be no stability in the global financial markets.
The Role of Speculators in Financial Markets
The futures market is where all modern forms of financial speculation began. Understanding this market will allow you to understand all related markets, especially Forex (FX). The futures market provides two absolutely vital economic functions: risk transfer and price discovery.
Understanding Futures Contracts
A futures contract is a legally binding agreement to buy or sell a standard quantity of an underlying asset—such as a currency, an interest rate, a bond, an equity index, or a commodity—at a future date but at a price agreed upon today.
Buying a future is also known as going long. The buyer has two choices:
- Take physical delivery of the product at the end of the contract.
- Sell the contract before it expires for a profit or a loss.
Selling the future is also known as going short, and the seller also has two choices:
- Deliver the underlying asset to the buyer.
- Sell the contract before it expires for a profit or loss.
It’s important to note that the ease with which futures contracts can be bought, sold, and exchanged is one of the main advantages.
The second step involves fully grasping the overall fundamental outlook. Ask yourself: What is the central bank likely to do next with its monetary policy? Will this action be positive or negative for the currency? This step is closely related to understanding the recent price movements. If recent changes don’t alter the fundamental outlook, you have a clear opportunity to trade at a better price. Mastering this concept helps you value currencies accurately and identify profitable trading opportunities.
Risk Transfer and Price Discovery
The futures market provides two absolutely vital economic functions. The first is risk transfer, also known as hedging in the trading world. Hedging is buying and selling a futures contract to offset the risks of changing prices in the underlying assets. Price risks exist in virtually every type of business. For example:
- The price of crops fluctuates in relation to factors such as weather or transportation costs.
- Manufacturing is at risk from labor problems or tax law changes.
- Banks and other financial institutions are at risk due to fluctuations in the prices of underlying assets they hold.
- The values of equities and bonds constantly react to the forces of supply and demand.
Hedgers using futures can easily and efficiently transfer these risks to speculators and other hedgers. For example, a US pension fund with large holdings of European equities fears a short-term economic downturn in Europe. The diversity of their portfolio and sheer size of their holdings doesn’t allow for a simple unwinding or selling off of their position. To counter this, they can simply enter a calculated short position on a carefully selected combination of FTSE, DAX, and CAC futures, which are European indexes. This provides a short-term hedge against the expected downturn in the share prices of their European stocks.
Futures prices and cash prices tend to move in tandem since they react to the same supply and demand forces. In terms of price discovery, a futures market provides a central forum for the exchange of risk at agreed-upon prices. Whether the futures trades are executed on a computer screen via an electronic exchange or via old-style pits and trading floors, the concept remains the same: the exchange of standardized risk at an agreed-upon price. This price becomes the benchmark for all previous and subsequent transactions for that futures contract, as well as providing an easily accessible way to price the underlying asset at a given time or day in a given quantity. The price itself becomes a valuable piece of information, giving insight into the future expectations and fears of the market participants.
For example, a Eurodollar is a futures contract for interest rates, not to be confused with the Euro/US dollar currency pair, also called the Eurodollar. Interest rate futures allow companies and banks to lock in interest rates today for money they will borrow or lend in the future. The price of the Eurodollar is determined by the market’s forecast for a three-month US LIBOR interest rate. A price of 95 implies an interest rate of 5% because the benchmark price is always 100, and you simply subtract whatever the current market price is.
For instance, if the current US interest rate set by the Federal Reserve is 3.5%, and the September 2023 Eurodollar futures contract is trading at a price of 96.40, the December 2023 contract at 96.23, and the March 2024 contract at 96.05, this indicates that the market expects interest rates to rise. By December 2023, the market expects the Fed to raise its rate to 3.75%, as indicated by a futures price of 96.25. By March 2024, the market expects the Fed’s interest rate to be 4%, indicated by a futures price of 96. The futures prices are not exact for various reasons, which will be covered later in your training.
Because every transaction involves a buyer and a seller, each transacted price results from two different parties having opposing views that the prices are reasonable for a trade. This is crucial to bear in mind when entering a trade: Do you think it’s a good and reasonable price based on your overall view of the market and the reasons for taking the trade?
The Role of Speculators
Speculators, including you and me, fulfill several vital functions by facilitating the marketing and trade of futures. Speculators don’t create risk; they assume the risk from hedgers and other market participants in the hope of making a profit from subsequent market fluctuations. For example, a large bank (Bank A) may have 50 Eurodollar contracts to sell to cover some risk in their outstanding debt and are only prepared to sell at 94.25. Another bank (Bank B) wants to buy 50 Eurodollar contracts but will only pay 94.15. Speculator X thinks the Fed will cut interest rates soon and is prepared to pay 94.20 for those contracts, while Speculator Y is convinced no rate cuts are coming soon and is willing to sell at 94.22.
In this scenario, the speculators narrow the market gap from 94.15/94.25 to 94.20/94.22, providing crucial liquidity. In a market without these risk-takers, it would be almost impossible for other participants to agree on a price because sellers want the highest price and buyers want the lowest. Speculators bridge this gap between bids and offers, making the market more efficient and competitive. In short, speculators increase the number of ready buyers and sellers.
Understanding Risk
Investment risk can be defined as the exposure to the chance of loss. This possibility is higher when the potential returns are greater. There are two types of risk:
- Specific Risk: Risks specific to a particular investment.
- Nonspecific Risk: General market risks present in all portfolios.
A primary feature of futures is that they can be used to diversify away from risk in an efficient manner with lower transaction costs. For example, in FX markets, currency risks can be hedged with currency futures. In the stock market, portfolios of stocks can be hedged with index futures such as the FTSE, S&P, and DAX.
Futures were one of the first methods used in risk management, making them popular and vital in their modern forms.
The Concept of Leverage
Leverage is another primary feature of futures contracts. For a small sum on deposit, known as the margin, a trader can control a significantly greater valued asset. Measured as a percentage of the capital invested, the profit or loss potential on a futures contract is much greater than a similar investment in the underlying asset itself.
For example, to hold a basket of stocks in the FTSE 100 index trading at 7450 would require holding physical stock at a cost of £74,500. However, holding one FTSE futures contract requires an initial deposit of just £3,000. A 5% gain in the price of FTSE would give both the shareholder and the futures trader a gain of £3,725. The percentage return is significantly different: the shareholder has a 5% return on capital invested, while the futures trader has a 124% return. This leverage works similarly for losses.
Importance of Liquidity
Liquidity refers to how easy or difficult it is to trade a particular market without significantly changing the price and in a quantity that suits your purpose. A liquid market has large numbers of buyers and sellers and very small buy-sell spreads. Liquidity can change due to various factors. For example, during holiday periods, most traders and speculators are away from their desks, creating a low liquidity environment, which makes price moves more volatile and spreads higher.
In FX markets, high-impact news events create a similar environment as everyone stands on the sidelines waiting for the release. Understanding liquidity and why it’s important will protect you from entering the market at dangerously illiquid times when you are unlikely to get the price you want and will pay a far higher spread.
Trading Contracts
When trading, you will do so on something called contracts. Each market exchange designs these contracts to meet the needs of market participants as a whole. For a futures contract to trade successfully, it must appeal to a broad range of market users, including institutions, individuals, hedgers, and speculators.
For example, a standard contract or lot in FX is 100,000 units of whatever currency is being traded. This can be broken down further in the spot market to units of 10,000 and 1,000, accommodating the growing number of smaller retail traders. In futures and other markets, the minimum fluctuation in price is called a tick, representing the minimum up or down movement in a contract. The FX markets use the term PIP (percentage in point) to describe the same thing.
For instance, the FTSE tick is 0.5 of an index point. So the price of 7452.0 can be followed by 7452.5 or 7451.5 and so on. The tick in the DAX is 0.1, so the price of 16234 can be followed by 16233.9 or 16234.1 and so on. The tick value is a monetary value assigned to a tick. The profit or loss of any futures contract is translated into movement in ticks multiplied by the tick value.
For example, a pip value in FX on a standard Euro/US dollar contract (100,000 units) is roughly $10. So if you’re buying one standard contract of Euro/US dollar and make three pips profit, this equates to roughly $30 banked. If you buy ten contracts and make three pips, your profit is roughly $300 and so on.
Clearing and Settlement
Financial markets coincide with the quarters of March, June, September, and December. These delivery dates are set on a particular day in the month or potentially over a period of days through the month. The last trading day is set by the exchange on a particular day of the month, usually around the end of the month.
Unlike in FX, the clearing and settlement of exchange-traded futures is highly centralized, and clearinghouses fulfill two important roles:
- The clearinghouse becomes the legal counterparty to the original transaction.
- The clearinghouse guarantees the performance of contracts, acting as the seller to all buyers and the buyer to all sellers.
There are three distinct roles in the clearing process:
- Clearing House: The administrative center that coordinates delivery and settlement.
- Clearing Member: Members of the relevant exchange authorized to clear business, typically large brokers or investment banks.
- Non-Clearing Member: Smaller entities such as traders who do not satisfy the capital requirements for clearing membership. They gain access to the clearing system by using the services of a clearing member.
Margin Requirements
There are two types of margin in trading:
- Initial Margin: A returnable good faith deposit paid in cash or collateral required from all those entering into a contract on the exchange. The amount of initial margin may vary subject to market volatility. If the market suddenly becomes highly volatile, additional margin may be called at short notice (intraday margin). Initial margin is due to the clearinghouse immediately after a position is opened. The clearing member usually requires that the margin be in place before that position is opened.
- Variation Margin: Represents the profit or loss on an open position each day. At the close of each day’s trading, a settlement value is assigned to each contract. The clearinghouse calculates the profit and loss for each position for that day based on the net movement from the previous day’s statement.
Most futures contracts never go all the way to the point of delivery and are closed out with an offsetting trade in the market. Those positions still open at the expiration of trading will be fulfilled by cash settlement or physical delivery.
With physical delivery, a feature of all futures markets is that delivery is the option of the seller. The seller (short) may determine anytime during the delivery period that they will issue a notice of intention to deliver. The amount of money paid by the buyer to the seller for delivery is fixed by the exchange on the delivery day. This is known as the Exchange Delivery Settlement Price (EDSP). The EDSP is a figure determined by the exchange, often an average of prices set over a fixed period of time.
Physical delivery exists for most bond and commodity futures. With cash settlement, many contracts such as equity index products and short-term interest rates are cash settled. No physical delivery takes place. Contracts are closed out against the EDSP, and cash changes hands as a variation margin from the settlement of the previous day.
Understanding Bonds and the Yield Curve
Short-term interest rate products, like Eurodollar, Short Sterling, and Euro Swiss, are futures based on the rate at which banks trade instruments in their corresponding denominated currency. This is particularly the rate at which banks will lend and borrow money from each other for upcoming one-month and three-month periods. The cash market is also an important concept to understand because it will constantly be referenced in daily research and analysis.
Money market instruments traded in the underlying cash markets are debt instruments with typically twelve or fewer months to maturity. These include fixed deposits, certificates of deposit, bankers’ acceptances, commercial paper, repos, Treasury bills, and so on. In the cash market, we can also have the concept of fixed income securities such as bonds.
A bond is a loan document that bears interest, essentially a sophisticated IOU. Bonds are issued by companies, governments, and other supranational organizations to raise money. Bonds are categorized according to their lifetime, issuer, interest payment details, credit rating, and other factors. Fixed income bonds bear a fixed interest rate payment called the coupon, based on the nominal value of the bond. These interest payments are either annual or semiannual.
The bond futures that we look at are based on a basket of government-issued fixed income bonds. For pricing purposes, government-issued bonds are considered to be free from default risk, making them the benchmark for pricing risk in all other financial assets. Bond yields are dependent on the issuer’s creditworthiness and the remaining lifetime of the issue. Since the futures we look at are based on government debt, creditworthiness can be dropped from the equation. The correlation we will look at is between yield and remaining lifetime, known as the yield curve.
Bonds with a longer remaining lifetime tend to yield more than those with a shorter remaining lifetime. This is a normal yield curve. A flat yield curve is where all remaining lifetimes have the same rate of interest. An inverted yield curve is where longer-dated bonds yield a lesser rate of interest. A yield curve is a picture of where interest rates are today and, to some, a picture of where interest rates will be in the future. The yield curve shows the rate of return that can be locked in now for various terms into the future. The investments to construct a yield curve should all have the same risk, features, and coupon rate. For instance, to construct a yield curve of German government bonds of varying coupon rates, the variance in those coupon rates can be factored out so the prices are comparable.
There are four basic shapes of yield curves you need to learn:
- Normal Yield Curve: Characterized by nearby yields being lower than further-dated yields, progressing from the shortest-dated, lowest yield to the longest-dated, highest yield in a relatively smooth curve.
- Inverted Yield Curve: Shorter-dated investments yield more than longer-dated yields, with a relatively smooth curve.
- Flat Yield Curve: Indicates that yields for short, medium, and long-term investments are all approximately the same.
- Humped Yield Curve: Characterized by increasingly higher yields for the first few periods and then lower yields for longer holding periods.
There are also three basic explanations for yield curves:
- Liquidity Preferences Hypothesis: Investors dislike having their money tied up and demand extra return for longer holding periods. The longer the person has to defer current consumption, the more marginal compensation they demand. Investors prefer liquidity and accept a lower return to get it.
- Expectations Hypothesis: The yield curve is a picture of what people expect rates to be in the future. For example, a humped yield curve with a peak at two years out means that people generally expect interest rates to rise for two years, after which they will then trend down again.
Market Segment Hypothesis: Based on the idea that there is not one continuous debt market but several discrete segments with different players in each segment. For example, the short-term market is dominated by banks and money market dealers who, through very competitive supply and demand, arrive at a series of short-term interest rates. The mid-term market includes mutual funds, corporations, and casualty insurers, typically borrowing and investing in the mid-term. The long-term market is influenced by businesses with long-term projects and liabilities like pension funds, life insurance, and property companies, which vie with each other to set rates in the long end of the market.
Conclusion
We have explored the essential concepts of financial markets, including the role of speculation, the mechanics of futures contracts, risk transfer and price discovery, the importance of liquidity, and the use of leverage. We also delved into the clearing and settlement process, margin requirements, and the significance of bonds and the yield curve. Understanding these fundamentals is crucial for anyone looking to navigate and succeed in the world of trading. These concepts form the foundation of financial trading, providing the knowledge needed to make informed decisions and effectively manage risk.