How does trading work?

Lesson 1 of 6

Who's involved in trading?

As a trader, you'll come into contact with various individuals and bodies, and in some cases need their services to gain access to the markets.

Here we'll look at these 'market participants', their functions and their motivations – and importantly your relationship with them.

Retail traders

The terms 'retail trader' or 'retail investor' generally mean a private individual who buys and sells financial instruments using a personal account, not on behalf of an organisation. So that will probably be you.

Retail traders generally deal in relatively small sizes, often in their spare time.

However, some become semi-professional and use sophisticated technology and techniques from the comfort of their own homes.

As a retail trader you have access to an incredible range of financial markets, and can trade them in multiple ways to suit your preferences.

Let's say you decide to buy some shares. Would you be hoping to see long-term growth, accepting that the shares' value may fluctuate in the meantime? Or would you be hoping for a fast profit from short-term price movements, regardless of longer-term trends?

If you're looking for long-term growth, you're more of an 'investor', but if a fast profit is your goal you can call yourself a 'trader'. Investors are interested in overall price trends and the fundamental value of the assets they trade. Traders generally prefer to capitalise on volatility and the market reactions triggered by news events.

Let's say you decide to buy some shares. Would you be hoping to see long-term growth, accepting that the shares' value may fluctuate in the meantime? Or would you be hoping for a fast profit from short-term price movements, regardless of longer-term trends?

If you're looking for long-term growth, you're more an 'investor', but if a fast profit is your goal you can call yourself a 'trader'. Investors are interested in overall price trends and the fundamental value of the assets they trade. Traders generally prefer to capitalise on volatility and the market reactions triggered by news events.

Brokers

As a retail trader, unfortunately you can't just stroll into your local stock exchange and start dealing in shares.

To buy or sell in the stock market, and other financial markets, you'll generally need an authorised intermediary or broker to act on your behalf. You may be picturing a bowler-hatted City gentleman, but in fact it's more likely to be a company that provides an online trading platform.

A broker can be either a firm or an individual, and might offer:

  • Full service – actively managing your investments and providing personal advice
  • Advisory management– providing recommendations but leaving the final decision to you
  • Execution-only dealing- simply carrying out your instructions to trade, on demand

Of course, the greater the input you want from your broker, the higher the fee you'll need to pay.

As well as representing you and executing your trades, some brokers also separately buy and sell on their own account. A broker who does this is known as a broker-dealer.

Question

Which type of broker do you think a brand new trader should choose?
  • a Full service
  • b Advisory management
  • c Execution-only
  • d Any of the above

Correct

Incorrect

It really depends on your individual skills, knowledge and preferences. A full service broker could guide a novice trader, potentially selecting more profitable trades – but at a significant cost. The advisory management service provides some support for a lower fee. However, the client must still take responsibility for their portfolio. So an execution-only broker might be better value for traders willing and able to make their own decisions. Bear in mind that there are still costs associated with execution-only trading, such as spreads, commission and financing charges.
Reveal answer

Trading on exchange versus OTC

Suppose you want to trade shares in a FTSE 100 plc. As the company is listed on a formal exchange, in this case the London Stock Exchange, you trade its shares 'on exchange' through your stockbroker.

An exchange has a central physical location – often in an iconic building – where brokers and dealers come together to buy and sell. Most market participants transact remotely and electronically, but some deals can be made in person by traders on the exchange's trading floor.

However, if you want to trade a forex pair, an unlisted stock, or any other instrument that's not listed on an exchange, you'll generally need to do so via a broker-dealer who offers it as an 'over-the-counter' (OTC) market.

OTC markets have no central physical location.

OTC markets exist as virtual networks of participants, who trade with each other electronically or by phone.

In OTC markets, dealers set their own prices, and transactions can be executed privately, with the dealing price invisible to other market participants.

Question

How are these markets traded?

Government bonds (gilts)
  • a OTC
  • b On exchange

Correct

Incorrect

There are no central exchanges for bonds.
Reveal answer

Question

How are these markets traded?

Shares listed on the NYSE
  • a OTC
  • b On exchange

Correct

Incorrect

The NYSE is a formal exchange.
Reveal answer

Question

How are these markets traded?

The pound versus the dollar (GBP/USD)
  • a OTC
  • b On exchange

Correct

Incorrect

Currencies are traded between global banks and financial institutions.
Reveal answer

Question

How are these markets traded?

Crude oil futures
  • a OTC
  • b On exchange

Correct

Incorrect

Commodities are traded on exchanges such as the New York Mercantile Exchange (NYMEX).
Reveal answer

Did you know?

Traditionally, trading at exchanges was conducted using the open outcry method, in a part of the trading floor known as the pit.
Traders shouted buy and sell orders to each other or used coded hand signals. A contract was made when one trader called out that they would sell at a particular price, and another replied that they would buy at that price.
This method has largely been replaced by electronic trading systems, but is still used in a few exchanges such as the New York Mercantile Exchange and the London Metal Exchange.
Although electronic trading is faster and more efficient, some argue the open outcry system provides more opportunity for traders to get the best prices.

Lesson summary

  • Retail traders are private individuals who buy and sell financial instruments using a personal account
  • A broker is an authorised intermediary who executes trades on your behalf and may also give you advice
  • An exchange has a central physical location where brokers and dealers come together to buy and sell
  • OTC markets are traded via a virtual network of broker-dealers
Lesson complete