What markets can I trade – Part 2

What markets can I trade – Part 2

Futures trading
Photo by @andreyyalansky19

We’ve discussed how you can trade markets like forex and commodities online and we’ve talked a little about trading derivatives through the options and futures markets. Here, in part two  of this lesson, we’ll say a bit more about options and futures and get into detail on the relatively new cryptocurrency market. 

What markets can I trade online?

There are very few financial products that you can’t trade online. In fact, online trading is now used by most institutions. Because it gives such easy access to markets, it is also responsible for the significant growth in retail trading that we have seen in recent years. 

Online trading also makes exposure to different asset classes much easier. Futures and options are often traded online by institutions. As each contract tends to be of high value and therefore relatively costly, you tend to see fewer retailer traders trading these markets online.

What is options trading?

Options sound more complicated than they are. They are simply the exchange of a contract between a buyer and a seller. In the contract, the buyer has the right, but not the obligation, to buy or sell the underlying asset. The parties agree on a price that will expire on or before a specific date. 

Options are used to hedge risk, for speculation or more straightforwardly, to generate income. They are a kind of derivative, that is their value is derived from the underlying asset.

How do options work in trading?

Options are a kind of insurance policy and tend to be used to hedge or reduce your risk and total exposure. 

It’s a bit like a car insurance policy. You pay a set sum to insure the car. Should you need to claim a large amount to cover an accident, you can and it won’t cost you anything extra. Your losses are capped. 

It is much the same happens with your options contract. If the market goes against you, you won’t have to pay any extra and your losses are capped. If the market goes in your direction, (that is the way you bet it would go), then, great news, you’re in profit.

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How options expiries work

With options contracts, market players try to predict future price movements (like all traders!). But in this case, the price of the option will vary depending on how close it is to its expiry date. 

As the option expiry date approaches, the value of the option reduces, Why? Because, the nearer to the expiry date the less likely it is that the price of the underlying asset will move.Understanding this concept is critical to knowing how to use and value options.

Another way to explain it is the flight example below. Imagine you’re in first class on a plane and it’s just taken off. Someone from the back of the plane asks to buy your seat for £500. You’re tempted but say no. You like a little luxury. But half way through the flight they come back and offer you £250. The price has dropped because the person will get less time in your seat. The same applies to options, the closer to expiry (the plane landing), the less the option is worth (less time in the seat).

Time is crucial to the price of an option; a one-month option is less valuable than a three-month option. With more time until expiry, the probability of a price move in your favour increases, and vice versa.

Are options and volatility linked?

In the financial markets, price volatility means significant swings, up and down in the price of a security. If volatility increases, then the likelihood of more significant price swings increases. As volatility increases, so does the price of the option because there is a higher chance that the price will move in a profitable direction. By contrast, low volatility means that this is less likely to happen and the option will be cheaper. So, options trading and volatility are intrinsically linked.

 

Options trading
Photo by @RLTheis

What are calls and puts, and how do they work?

It sounds like more jargon but it’s not that hard to understand. A call option is an option contract that gives the option buyer the right, but not the obligation, to buy a stock, commodity or other security or financial instrument at a specified price within a specific period. The asset is called the underlying asset, and the call buyer profits when the underlying asset increases in price. 

Puts are the opposite of call options; they give the buyer the right to sell the security under the same type of conditions.  

For instance, a call option on stocks, will give the holder the right to buy shares of the nominated company at a specific price, referred to as the strike price, until a specified date called the expiration date.

One example might be a call option contract that gives a trader (the holder) the right to buy 100 shares of Google stock at 3,000 up until the expiry date in two months. As the value of Google stock goes up, the option price contract goes up, and vice versa. 

The call option buyer could hold the option-contract right up until the expiration date. They could then take delivery of the 100 shares of stock. Alternatively, they could sell the options contract and bank the profit at any point before the expiration date at the market price at the time of selling.

The premium is the name we give to the market price and cost of a call option. It is the price paid for the rights that the call option provides. At expiry time, if the underlying asset is below the strike price, the call buyer loses the premium paid. Importantly, the maximum loss they can suffer is the premium paid to buy the option because they’re under no obligation to purchase the shares and take the loss.

Suppose the price of the underlying asset rises above the strike price on the expiry date? Then profit is calculated by taking the current stock price, subtracting the strike price and the premium, and multiplying by the number of shares the option buyer controls.

Put options work in reverse. So, instead of buying a contract to purchase the shares in Google you’d buy an option contract to sell the shares at the strike price.

What is futures trading?

A ‘future’ is an agreement to buy or sell something at a price you set today but at a specified time in the future. Financial futures trading is the buying and selling of futures contracts. For instance: 

  • You agree to buy a car in six months from a dealer. 
  • You agree to pay £10,000 when you receive the car in six months time. 
  • Whatever happens to the price of the car between now and when you take delivery, you will only pay £10,000. 
  • That’s a futures contract, a price agreed now but paid in the future.

These contracts are derived from an underlying asset and they are therefore classed as derivatives. Typically, assets traded as futures are commodities or financial securities. The set (future) price agreed by the parties for their future transaction is known as the forward price. The future date agreed for the transaction, ie when delivery and payment will occur, is known as the delivery date.

Futures contracts exist right across the business sphere. A property developer might, for instance, build a block of apartments and sell the spaces to investors before the units have been built. The developer might take partial payment, and the futures contract might determine that the remaining balance will be paid once the apartments are built.

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How does futures trading work?

All futures trading is regulated and conducted through exchanges. Whether you are an institution or a retail trader, the reason you engage in the contract is to either reduce your risk or speculate on the price. 

Most futures trading takes place electronically, perhaps at the CME and ICE. But unlike most stock markets and exchanges, futures markets and some trading exchanges operate 24 hours a day.

Futures Market Example

Let’s look at an example of a futures market trade. Let’s say a trader buys a July crude oil futures contract. The deal is the purchase of 10,000 barrels of oil from the seller at an agreed price upon the July expiry date. Whatever the market price is at expiration time the buyer will be obligated to honour the contract and pay the previously agreed price. 

The seller likewise agrees to sell those 10,000 barrels of oil at the agreed price when the contract is made. Of course, either the buyer or seller could sell on their contract on to another party before the expiry date. But assuming this does not happen, then the original seller will deliver 10,000 barrels of crude oil to the original buyer.

 

Futures trading
Photo by @IND

What is cryptocurrency trading?

A cryptocurrency is a digital asset, often referred to as a currency, coin or token. The asset holds value and is traded through exchanges like many other assets. All transactions are recorded on a decentralised ledger.

Today, individual retail traders and investors can trade and invest in several cryptos through their brokers and on their standard trading platforms. You would trade cryptocurrencies through your broker in the same way as you would trade other securities like CFDs or forex pairs. 

Cost of cryptocurrency trading

As cryptocurrencies have become more mainstream the cost of trading them has fallen significantly.

In order to simplify the trading process and to reduce your outlay, brokers now make it possible for you to trade a derivative of a coin (a monetary value), so that you’re not actually taking ownership. With the cost of a single coin often very high, this makes it easier for retail traders to get involved in this market.

Nowadays you’ll see smaller spreads for cryptocurrencies. Those that are most liquid and abundant and invite the largest number of market participants have the largest market capitalisation – Bitcoin, Ethereum, Tether and Ripple. 

How do cryptocurrencies work?

Blockchain technology lies at the heart of cryptocurrencies. A blockchain is a growing list of records, which are blocks linked by the use of cryptography. Each block contains a cryptographic hash and the history of the previous block, a timestamp, and transaction data. 

The data records are managed by networks of computers. Importantly these are not owned by any single entity to ensure that blockchain is an incorruptible ledger which cannot be retrospectively corrupted.

Just as a bank has a record of all the transactions that have taken place in that bank, so the blockchain does the same. And in blockchain, this record is free for anyone to view. 

Bitcoin (BTC) is the most famous and original cryptocurrency. It was apparently created by Satoshi Nakamoto but we still don’t know who he/she/they are!

 

Cryptocurrency trading
Photo by @venner0878

Bitcoins blockchain

Did you know that the blockchain code supporting the creation of Bitcoin ensures that only twenty-one million coins can ever be created or ‘mined’ as they say in the jargon? By May 2020, approximately eighteen million coins had been mined using blockchain technology. Interestingly, blockchain is open source, which means that anyone who has the expertise and computer power necessary could, in theory, use it to create BTC or other coins.

Bitcoin was the first blockchain coin created but it didn’t take long for competitors to appear. Alternative coins then became known as ‘altcoins’! Their creators developed their own ‘improved’ blockchains and helped to grow the industry. Altcoins to look out for include Litecoin, Ethereum and Ripple (XRP). 

Anyone can now use cryptocurrencies online to buy some goods and services. But at the moment there are few high street outlets accepting them as payment.  

How many cryptocurrencies are there?

We don’t know. There could be tens of thousands of new and unknown cryptos. But, based on the September 2020 data, CoinMarketCap estimates there are 6,995 cryptocurrencies in total with a total market cap of $325 billion. CoinGecko states there are a total of 7,916 cryptocurrencies on record which suggests some of them failed prior to September 2020.

As at September 2020 approximately 100 cryptos exist with a market capitalisation of at least $100 million each and about 22 have a market cap of over $1 billion. The top four; Bitcoin, Ethereum, Tether, and Ripple are by far the largest measured by market cap.

How can you trade these markets?

Trading cryptocurrencies is straightforward. Your trading platform will list many coins and, like any other asset, your broker will make a price to buy and sell the coins. 

Trading standard options and futures through your broker is not so simple. But note, if your online broker allows you to trade CFDs (contracts for difference) in various securities, then these derivatives have similar properties to futures and options.

Our next lesson titled “Spread betting & CFD trading” will discuss some of the methods you can employ to trade the markets.

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