226
LISTEN TO THIS ARTICLE:Trading on financial markets has evolved over time. Let’s now take a look at what a regular brokerage house offers and see the multitude of markets in one place.
Back in the day, trading was all about the stock market and commodities. Corn, cattle, coffee, and even gold were traded extensively. When bartering disappeared and various forms of money became popular, trading and speculating started too.
The evolution of financial markets is nothing short of spectacular. From the pen-and-paper trading on the stock market in the early 1900s to the complicated futures contracts over a hundred years later, the markets have changed dramatically.
Oil discovery led to massive innovation in our societies, and the change extended to financial trading too.
Nowadays, we use powerful computers to execute trading strategies and get access to sophisticated financial markets. Because of the Internet and our massive computing power, financial markets react almost simultaneously to news and input from around the world.
We can say, without a doubt, that trading in the 21st century isn’t something isolated anymore. This trading academy focuses on the currency market and trading, investing, and speculating to profit from the moves of currencies.
But we also cover topics related to other markets (e.g., oil), as they heavily influence monetary policies around the world. For this reason, this article aims to explain the interdependence between various financial markets. We also cover the various markets that exist and that a trader may access from the same trading account.
Only a few years ago, Forex brokerage houses offered access to the currency market only. However, as technology advanced, the same brokerage houses now offer the possibility to trade gold, oil, silver, and other commodities, bonds, cryptocurrencies, stocks, stock indices, ETFs (exchange-traded funds), and CFDs (contracts for difference).
Explaining the Financial System – Functions and Purpose
Forex accounts don’t cover the currency markets only. For this reason, it has become mandatory for a currency trader to understand the correlated markets and what trading in the 21st century implies.
Think of a huge M&A (merger and acquisition). Let’s suppose a large U.S. corporation intends to take ownership over a French one.
To pay for the deal, valued in billions of euros, the U.S. corporation hires a consortium of investment banks to raise the amount. These banks use their trading departments to buy euros using the funds provided by the U.S. corporation.
The corporation in the U.S. has global operations. Thus, it has reserves in various currencies across the globe.
In other words, an M&A that seems harmless at first glance for the currency market may have huge implications in the overall flows in and out of various currencies.
The Financial System in the 21st Century
Trading in the 21st century is a story of the evolution of the financial system. The thin line that exists between the different markets makes modern trading a challenge for everyone involved.
But why do people use the financial system, and how come our societies need one? The answer to this question is both complex and exciting.
First, people use the financial system to move money from the present to the future. For instance, savers expect to use the money they have now for future consumption.
For this, they invest in bonds, real estate, certificates of deposits, currencies, and so on. By investing, they become traders, only with different time horizons (short-term-oriented traders in the case of certificates of deposit, long-term-oriented traders in the case of real estate).
Second, people that need money in the present use the financial system too. Called borrowers, they take advantage of what the people in the first category have to offer.
The main idea is that people will return these loans with the income and money they earn later. Thus, they “trade” future earnings for money in the present.
Obviously, everything earns interest. In the case of both savers and borrowers, people receive interest on their actions.
Central banks set the general interest rate level, and then the lender changes it depending on the product’s characteristics (e.g., maturity).
Third, people use the financial system to speculate. If the price of something moves regularly, we might as well speculate on its changes.
Over time, financial speculation evolved from basic concepts to complicated psychological theories. We’ve already covered that subject in depth in the previous article of this trading academy. Perhaps now’s the time to read it again.
Financial Markets in the 21st Century
We intentionally didn’t mention one of the biggest functions of the financial system as we know it: to raise capital.
Companies use the system to raise capital for various purposes: to expand operations and enter new markets, to launch new products, etc. For this, they come to the financial markets and raise equity (by launching an IPO, or an initial public offering) that, in some cases, valuates the company’s assets and activity at billions of dollars.
All the activities mentioned so far in this article influence the prices of financial assets. Consequently, someone trading on financial markets must know what makes the markets move in the first place.
Trading in the 21st century involves trading commodities, real assets, contracts, and currencies, as well as securities. Each category has evolved over time, just as the financial system has.
At the beginning of the 21st century, many of these markets didn’t exist, or if they did, they were just in an embryonic phase.
Nowadays, knowing the complexity and interdependence of various markets is mandatory for successful speculators. For instance, a sudden and abrupt move in the fixed-income sector can cause large volatility in the currency market.
Similarly, a few percentages drop in the DJIA (Dow Jones Industrial Average) almost always triggers a move to safety on the currency market. As a result, JPY and other currencies viewed as safe havens (e.g., CHF, the Swiss franc) appreciate abruptly.
Moreover, a bubble in the real estate market can cause massive disruptions. As recently as 2008, a housing bubble in the United States triggered a massive global financial crisis.
Furthermore, the fall of oil prices from over $100 to below $30 in less than one year created chaos around the world. It triggered a deflationary wave that central banks are still fighting to this day.
The Currency Market
Let’s start with the currency market not because it is the most important one (it isn’t!) but because it is the largest one. Over 170 (!!!) currencies exist at the moment in the world.
With a daily volume of trillions and trillions of dollars, it has grown exponentially since the United States dropped the gold standard in 1971.
The currency market is home to the biggest financial players in the world. Investment banks, sovereign wealth funds, commercial banks, and central banks are all responsible for the currency market’s fluctuations.
The king of the currency market, the U.S. dollar, is also the Forex dashboard’s pillar. It is a reserve currency, meaning central banks and other monetary authorities around the world hold it in significant quantities.
Because currencies around the world free-float against each other without much intervention from central banks, currencies are assets for various financial products. Trading on the Forex market as we know it today takes place on what are known as spot exchanges.
But other financial products, such as derivatives, have also evolved based on the fluctuations of the currency markets.
- Trading Derivatives Based on the Currency Market’s Fluctuations
A trading derivative is a financial product “derived” from an underlying asset. Because currencies are popular in the world of financial markets, derivatives based on currencies are traded in large volumes.
Derivatives markets are extremely complex. The reason we’re mentioning them here, as well as the primary purpose of this article in general, is to point out the importance of currency trading in the overall financial markets.
If, at the end of this trading academy, you end up having a better understanding of the currency market, that means you have a clear advantage when trading other financial products, too, such as derivatives.
Derivatives trade on the OTC (over-the-counter) market and on exchanges. However, currency-based derivatives trade mostly on OTC markets.
Some currency traders, when asked where they trade, answer that they trade on the Forex market. Well, there are various ways to trade on Forex. Spot or futures?
- The Forex Futures Market
The Forex futures market has exploded in popularity in recent years. Futures derive their value from the spot prices.
Futures contracts based on currencies are an alternative of forward contracts. In a forward contract, the possibility of a loss is more significant than in the case of futures. Because futures settle daily, traders are subject to limited losses.
Many brokerage houses nowadays offer futures contracts to retail traders. The only difference between spot and futures is that futures contracts have a predetermined expiration date.
In other words, let’s assume you believe the EURUSD rate will decrease. Therefore, you go short or sell the pair.
When trading spot, the execution takes place immediately, and you can keep the trade open for as long as necessary.
But on the futures market, the short position has a deadline. Acting like an expiration, it differs from contract to contract.
It could be a quarter, six months, one month, and so on. Let’s assume that at the expiration date, the EURUSD did move lower, but it didn’t reach the final take-profit limit.
As a result, the broker (who acts as a clearinghouse) closes the contract, and the profit is credited to the trader’s account. If you still want to go short on EURUSD to reach the target, you need to trade a new contract.
Limitations like this don’t exist on the spot market. So why do some traders prefer futures?
One explanation comes from the swaps paid on most currency pairs. A swap is the interest rate differential based on the two currencies that form the pair.
A swap can be negative or positive. For instance, going short on EURUSD throughout 2018 paid a positive swap. That means that at the end of each day, traders received interest based on the open position’s volume.
- Swap and Options Contracts
Futures don’t pay swaps, neither positive nor negative.
Hence, on trades paying positive swaps, traders prefer spot Forex trading, and on trades paying a negative swap, traders use Forex futures, thus avoiding additional costs.
But swaps paid on the spot Forex market differ from swap contracts. A swap contract acts like a series of cash flows. Basically, it is an exchange of periodic cash flows based on the value of a currency pair.
Swap contracts are complex financial instruments based on commodities, currencies, and even on equities. In a currency swap, for instance, the payments are denominated in different currencies. The swap basically represents the exchange from one currency to another, with an emphasis on the interest rate in the two countries.
Options contracts differ in the sense that the holder of the contract has the right (i.e., the option) to trade the currency pair at the expiration date. However, there is no obligation to do so.
An options contract based on the currency market has a striking price and an expiration date. Two types of contracts exist: call and put.
The striking price is the current price of the underlying asset (i.e., the currency pair).
If traders buy a call option, they want the currency pair to move higher. If at the expiration date set in the future, the price did move higher, it is said that the option expired in the money. The trader was right and earned a profit – the initial price paid for the option.
If not, the option expires out of the money. Thus, the trader marks a loss.
What we have provided here are very basic definitions of futures, swap, and options contracts. Other contracts exist too, like CDS (credit default swaps), forward contracts, and more.
However, the three types mentioned here are the most popular ones that use currencies as the underlying asset.
The Commodity Market
Commodities have evolved tremendously over the last years. At first, trading commodities mainly meant speculating on agricultural products.
Next, precious metals surged in popularity, with brokers offering contracts on gold, silver, platinum, etc. Energy products followed, with the opening of markets like oil, natural gas, and the like. Industrial metals like aluminum, mercury, and copper made their presence known, too. Finally, the latest “innovation” in the commodity market is carbon credit.
Traders use commodities to hedge against inflation, and to this day, commodity products play an essential role when trading on financial markets.
Perhaps you’re wondering what the price of a commodity has to do with trading on the Forex market. A couple of examples solve this mystery.
Consider the price of oil. For oil-producing countries, it has a significant impact on GDP. Hence, it impacts the value of the respective currency.
The Canadian economy, for instance, is an energy-driven economy. Oil plays a crucial role in the well-being of Canadian citizens and influences the value of CAD, the Canadian dollar.
There is a direct correlation between the two: a higher oil price leads to a higher CAD, and lower oil prices lead to a lower CAD. On the foreign exchange market, USDCAD rises when the price of oil drops and falls when the price of oil increases.
Gold is another commodity correlated with a currency pair. The AUDUSD pair moves in a correlated manner with the price of gold.
Therefore, significant moves on the commodity market have a strong impact on the currency market. A clear understanding of these relationships keeps traders on the right side of the market.
- Explaining the Oil-Inflation Relationship
Oil is the ultimate resource. When it was discovered, it forever changed the way we live.
Petroleum products are responsible for almost everything we do every day. People only think of the gasoline we use to drive cars, but that’s only one product derived from oil. Hundreds of by-products exist, and a single barrel of oil is responsible for a broad array of end-user goods.
Few people know that oil dictates monetary policies around the world. Thus, we can say that the financial system as we know it depends on the price of oil.
All central banks have a mandate that considers inflation. Because oil is everywhere and in everything we do, changes in the price of oil mark changes in inflation.
Higher oil prices lead to higher inflation. Central banks intervene to fight high inflation and raise interest rate levels.
When their interest rate level is raised, currencies get stronger. A new order is established on the currency market, with funds flowing from low interest-rate currencies to high interest-rate ones.
From central banks to retail traders, everyone keeps an eye on the oil market. A saying among traders goes that if you have more than two screens at your trading desk, one should be monitoring the price of oil.
When the price of oil drops, central banks react immediately by lowering the interest rate level. The currency depreciates, and the first place to see the changes is the currency market.
Debt Market
The debt market, or fixed-income market, is a massive driver of market sentiment. In turn, market sentiment influences traders’ perspective of the overall financial markets.
Fixed-income instruments are issued by sovereign governments, corporations, and banks. They have different maturities that range from short-term to long- and very-long-term.
Bills and bonds are the blood of the fixed-income market. A bond has a yield and a maturity day.
The benchmark for the financial markets, the 10-year bond yield is directly correlated with the risk in the market. Risk, on the other hand, is represented by safe-haven currencies and the risk-on or risk-off currency pairs part of the Forex dashboard. This trading academy will cover all these terms in great detail in future articles.
At this point, what matters is to understand that the debt market influences the currency market in more ways than the average retail trader thinks.
Equities
The equity market is an important pillar of the current financial system. Companies use the equity market to raise capital, people use it to own rights in companies, and traders use it to speculate or invest for the future.
Some traders prefer passive investing. That means that they buy an index that represents the overall market and treat it as an investment that will pay off in the future.
Various indexes exist in the world. The most famous ones come from the United States (DJIA [Dow Jones Industrial], S&P500, and Nasdaq), but each country or region has its own important ones (such as Nikkei in Japan, Xetra Dax in Germany, and FTSE in the United Kingdom).
Global indexes, the sector index, and many other types exist as well. Passive investors build their portfolio and don’t alter it.
Active investors believe they can continuously beat the market. By “beating the market,” they mean earning higher returns than the benchmark (typically the S&P500).
Such investors actively trade stocks based on fundamental and technical analysis. Their trading mostly involves individual stocks rather than indexes.
An index move dictates the direction of other individual stocks as well as affects the currency market.
A sharp appreciation of the DJIA index almost always triggers a sharp rise in the USDJPY pair. The two enjoy a direct relationship that functions due to JPY having a lower interest rate than USD.
- Exemplifying the Equity and Currency Market Correlation
In 2016, two significant events affected the global markets: the Brexit referendum and the U.S. presidential elections. Trump’s election later in the year sparked a tremendous rally in one of the major equity indexes in the world, the DJIA.
The bullish DJIA sentiment immediately sparked a similar rally on the currency market. More precisely, the USDJPY pair rose almost 2000 pips, playing catch-up with the DJIA.
Hedge Funds and Mutual Funds
Hedge funds, mutual funds, and other pooled investments move large amounts of capital in and out of the financial system. Therefore, they have the power to drive important market moves in all markets, including the largest market in the world, the foreign exchange market.
Mutual funds use pooled money from investors to trade a portfolio. Open-ended mutual funds actively trade with investors, but they can be either open-ended or closed-ended.
Investors also can trade among each other, using an ETF as a vehicle on the secondary market.
Hedge funds use leverage. A lot of it. That means that hedge funds place large bets, both long and short, and follow various strategies to speculate, invest, and thereby profit from the market.
Because they pool money from various investors (with amounts ranging from small, medium, and astronomical), such funds have a big influence on market prices. Market participants trying to anticipate a change in market sentiment watch their moves closely.
High-Frequency Trading
One of the significant changes to the trading industry was the emergence of automated trading. As technology advanced, currency pairs became able to display many more than five digits for a quote.
To get an idea of how trading has evolved on the retail side, consider that a decade ago, the quotes of the currency pairs on the Forex dashboard exhibited only four digits, and the spread (the difference between the bid and ask prices) was as wide as three pips for EURUSD.
Nowadays, all retail traders have access to a five-digit trading account, and the spread has narrowed to 0.1 pips on the EURUSD pair for the most competitive brokers.
The difference in the spread tells you all you need to know about the technological breakthrough in the trading universe. But that’s not all.
On the institutional side, things also changed. Large institutional players with huge amounts of resources started investing in servers and computing power for their trading floors.
We all remember (if not, just give it an Internet search) how the old trading floors looked in for big investment banks: A football-sized field filled with people and trading desks, phones on all desks, and everything connected to the market.
Nowadays, the only thing that has remained the same is the football-field size of the trading floor. Super-fast computers quickly replaced traders’ desks.
The computers’ ability to execute trades is nothing short of formidable. They can interpret a currency pair’s quote up to the ninth digit.
Moreover, they take thousands of trades per second, scalping their way in and out of the market extremely fast. Human trading can’t compare with algorithmic trading of this scale.
Humans merely supervise the computers’ execution and take care of some malfunctions. Trading itself has become 100% automated.
- Quant Firms
So-called quant firms rely on mathematical formulas to build trading strategies. Armed with huge funds and resources, these firms employ the best mathematicians, physicians, and IT experts around the world.
Inspired by quant firms but operating at a much smaller scale, retail traders began building their own trading algorithms, too. Called expert advisors (EAs), these algorithms are attached to one or more currency pairs and execute trades automatically.
Later in this trading academy, we’ll touch on the subject of algorithmic trading (especially on the retail trading side) in more detail. We’ll cover everything related to it, from the development of an expert advisor, to how to install and run one, and to the challenges of trading with a robot.
What to Expect from Now on When Trading Currencies?
So far, we’ve covered aspects related to what trading is nowadays. We’ve also looked at various markets that influence currency trading.
The idea behind the article was to illustrate the complexity of the current financial system and the interdependence between different markets that have no obvious connections.
But this trading academy is about currency trading. What should we expect in the FX arena in the years to come? Here are some things to consider that may challenge the status quo as we know it today.
Increasing Execution Speed
Execution speed is the name of the game. Looking back at the old days, when traders bought or sold short stocks, they needed to go to a bucket shop or an exchange.
The next step was to find a clerk that marked the buying or selling of a ticket and then register it. The exit from the trade took place in the same manner. A trade like this could have taken minutes, sometimes too long to exit at the desired price.
When trading on the interbank market became possible for institutional players, investment banks quickly opened offices overseas. Traders in New York woke up early in the morning to phone their colleagues in Asia and ask for a quote on the currency pair they were interested in.
Next, they communicated the levels to trade and waited for confirmation. Difficulties in communication resulting from poor telephone connections made it difficult to trade, not to mention that most currency pairs traded with huge spreads.
The Internet changed everything. Trading was one of the industries that underwent a dramatic change as soon as computers arrived.
Nowadays, execution is so fast that high-frequency trading is not even visible to the human eye. The prediction is for this trend to continue, to the benefit of all trading parties involved.
More Precise Execution
For retail traders, slippage is still a problem. By slippage, we mean the brokerage house being unable to execute a trade at the exact level instructed by the trader.
The type of brokerage house is the cause of the problem. True ECN (electronic communication network) brokers guarantee execution, but not the level.
When the market moves fast due to many trading algorithms buying or selling at the same time, a pending order to buy or sell or execute a take-profit or stop-level can’t be executed at the desired level.
This is an area with a lot of room for improvement, so expect new technological breakthroughs to solve most of these issues.
Narrower Spreads
Spreads have narrowed in recent years. As we mentioned already, the EURUSD spread narrowed from three full pip points to 0.1 in some cases. Similar progress has been seen in all other pairs.
However, there’s still room for improvement. Expect the trend to continue. At some point, the prediction is that spreads will disappear altogether.
What about brokers’ fees? Don’t worry, there are other areas brokers will take their fees from, but spreads won’t be one of them anymore.
More Retail Traders Joining Online Trading
It seems like the online trading community is enormous. And it is!
However, trends indicate that more and more people will be connected to the Internet in the years to come. Naturally, Forex brokers will attract many of them due to their aggressive advertising.
Therefore, retail trading will grow in importance, and retail traders will have more to say on the foreign exchange market.
Further Diversification of Brokers’ Offering
Forex brokers currently offer access to multiple markets. However, there’s room for improvement.
As this article showed, many new markets have appeared. Because the financial system has grown exponentially, the products that have appeared are subject to trading.
The prediction is that new products will continue to appear and that brokers will include them in their offering. Even today, few brokers give access to all financial products from the same trading account.
In time, the competition will force the brokers that can’t adapt fast enough to new trends and technologies out of the industry.
Increase in Automated Trading
The rise of AI will change the trading game forever. Already with multiple uses in other industries, AI is predicted to improve all the aspects mentioned above.
The HFT (high-frequency trading) industry is growing by the day, too. The prediction is more technological breakthroughs in automated trading, with both institutional and retail traders investing more capital and time into it.
Conclusion
You probably didn’t expect such a long article about trading in the 21st century. What we wanted to show you was how trading has evolved and reached its current stage and, equally importantly, what the predictions are for the future.
The currency market is currently the largest one. It is why we’ve built this trading academy: to address its complexities and to make it easier for retail traders to succeed.
But nobody knows what the future will bring, and nobody knows how trading will evolve.
We’ve addressed some possible developments based on current trends in the world. But those can change fast.
In any case, one thing is sure. Traders will always exist, and so will markets to trade on.
One of the things that attract people to the market is the ever-changing environment. No day is like any other, and there’s always something new to learn.
For this reason, a trader’s journey never stops with the last trade. Trading theories and indicators adapt to new technologies as people find new ways to use them.
But despite all the technology involved, the human aspect of trading won’t change. After all, it’s humans who program computers.
Moreover, humans build trading algorithms and programs to automatically buy and sell on the market. Hence, the human factor remains, and that’s enough to give an edge to every retail trader that understands how markets function.
Slowly but surely, we are moving deeper into this trading academy. The next article should be of interest to all traders, as we’ll go into what type of brokerage houses exist and how to pick the right one.
Related Lessons
See more from this category