Financial Spread Trading: An Introduction
In the past, trading on the movement and price direction of financial markets was largely the preserve of major banks, high net worth individuals and sophisticated investment houses. However, the advent of online applications like the Internet has now made it possible for retail investors with limited capital to trade worldwide financial markets in exactly the same way these sophisticated investors did in the past. This form of online trading is widely known as Financial Spread Trading/Betting.
What is Financial Spread Trading?
Financial Spread Trading is a highly leveraged form of trading that has become a mainstream investment tool for retail investors around the world. Effectively, it is a mechanism for ordinary individuals with limited capital to gain access to worldwide financial markets. You can actually trade shares, options, indices, currencies, commodities and just about any other financial instrument through an online financial dealer.
Unlike the traditional way of investing the stock market, Financial Spread trading is based on a simple concept. Individuals get the opportunity to back a trading judgment that they may have, that a particular market is going to rise in value or is going to fall in value. For instance, if you believe that the shares of Microsoft are going to rise in value, you would “buy” Microsoft shares. Conversely, if you believe that Microsoft shares are going to fall in value, you would “sell” Microsoft shares. You don’t actually own the underlying asset. You are simply trading on the price direction of the financial instrument. If your prediction is correct, you make a profit. If you are incorrect, you suffer a loss.
There is also provision of posting a “stop loss order” on every trade you initiate. A stop loss order is a way of reducing your risk exposure to the markets, which means that you can effectively limit your loss in the event of the price moving against your perception.
Spread trading is most easily explained through an example - the concept is the same whatever the market. Let’s assume that it’s October, and due to an imminent breakthrough in the cure for bird flu, the shares of XYZ Corp have been rising steadily over the past few weeks. You’ve been following the market closely, and decide you want to get in on the action. The shares of XYZ are currently selling at .14 per share. In order to buy shares in any listed company, you need to buy a minimum of 100 shares. This means that you need a minimum of 14 just to buy 100 shares. However, you only have 0 risk capital. What can you do?
Well, given your limited capital, you can simply place a spread trade with a financial dealer on XYZ Corp shares to rise. Financial spread trading enables you to be highly leveraged because you actually trade on margin. Leveraged trading, or trading on margin means that you are not required to deposit the full value of your trade in order to open a position, so buying XYZ Corp shares at a point is actually the equivalent of purchasing 100 shares of the same company. Thus if you are looking to buy 1000 shares of XYZ shares, instead of paying ,140 for the shares, you can place a spread trade on XYZ shares to rise at a point.
Let’s assume that you contact a dealer for a price on December contract futures in XYZ Corp and get a quote of 4214/4219. You always buy at the higher price, so you buy per point at 4219. This means that each penny movement in the price of the shares is worth to you. To limit your risk exposure to the market, you also place a stop loss order of 30 points, which means that should the market go against you, the maximum you could lose is 0. Over the next few weeks, the stock of XYZ Corporation continues to rise. Six weeks later, you contact your dealer, and the quote for December XYZ Corporation is now 4293/4298.
Because you’re trading futures, it means that the contract expires in December. However, this doesn’t mean that you have to wait until December before you close out the trade. You can close out the trade the same day or at any point before the contract expires.
You decide to take your profits and sell to close at 4293. Because the market went in your favor, you get your full deposit of 0 back. In addition, your profit on this trade is calculated as follows:
Closing level 4293
Opening level 4219
Difference 84 points
Your profit: 78 x = 6
Financial Spread Trading is a derivative product. This means that you are trading on a price that is actually derived from the underlying product. Therefore, if you are trading Microsoft shares, a financial dealer would give you a “derived” price of Microsoft shares. As the prices of those shares go up and down, so would the dealer’s derived price of Microsoft shares go up and down.
About the Author: Jide Hospedale writes for Spread Trading. , a site dedicated to developing your skills as a spread trader over the long-term. You can find out more about Financial Spread Trading at Stock Market Trading.