Equities vs. Derivatives vs. Forex

It’s not uncommon for me to receive an inquiry from someone who’s curious as to whether or not equities, derivatives or forex is the best instrument for them to trade. Ideally, I’d say trade all three but that’s not an option for a lot of people, so I’m gonna break it down for those that may be curious. Before you go on to learn what type of instrument may be advantageous to your agenda, it would help you to find out what of trader you may be. To do that, check out my article titled Day Trading vs. Swing Trading. Before I start, let me make something CRYSTAL clear — what I’m about to express is only my opinion. I’m not telling you to invest your money anywhere. So, if you happen to place your money in one of the vehicles that I’m going to discuss and lose your money, don’t come to me crying about it. Now let’s proceed.

First, we’re going to discuss an investment/trading vehicle with which your average person is fairly familiar — Equities (stocks). On the most rudimentary level, you should know that an equity is a common share in a publicly traded company. When you buy a share on any of the stock exchanges — actually, when you’re buying or (short selling) any instrument whether it’s stocks, futures or Forex, what you’re doing is betting on the future direction of that instrument’s price. One thing I usually tell people about stocks is that if you want to successfully TRADE stocks, you need deep pockets. That’s why a large part of the stock market’s volume comes from Hedge Funds, Mutual funds, HFT firms, etc. By the way, there’s a difference between investing in stocks and trading in stocks. But the subject here is trading.

Anyways, you need deep pockets to be a stock trader because in most cases, you’d have to buy a lot of shares in order to see a decent profit…we’re talking thousands of shares. But this of course depends on a lot of factors like that particular stock’s daily price range, your trading strategy and time frame, etc. This is why a lot of stock traders prefer options. A trader can control a substantial amount of shares by paying only a premium for the option. However, I’d highly suggest that you study options in depth before considering that route. Besides, trading options isn’t as profitable as buying the shares outright but it does help to cut risk. If a person is interested in stocks but don’t have deep pockets, they’re better off investing in stocks for the long haul instead of trying to trade them. A lot of people have taken this route and have been able to retire millionaires.

Due to the need to have deep pockets to trade stocks, many individuals immediately think to play the penny stock market. A penny stock is any stock that trades for under $5 a share. In many cases, penny stocks are issued on the pink sheets or OTC (over the counter) and not by any reputable stock exchanges, which makes them lightly regulated. Penny stocks are also low volume, which means that they are thinly traded…making liquidity a problem. Because of the lack of regulation in penny stocks, they are often highly manipulated by unscrupulous characters. For instance, I know some of you have saw the penny stock newsletters which attempts to persuade you that some random no-name company who’s shares are trading at $.50 could become the next Apple or Google. This might appeal to the small investor because, at $.50 a share, he or she can take $500 and buy 1,000 shares and if the stock’s price move up to $1.50, they’ve profited a $1000 dollars. Not so fast because here’s what is REALLY happening behind that newsletter:

Because that penny stock they’re telling they’re newsletter subscribers about is thinly traded, if they can persuade enough people to buy shares of that company, even the smallest amount of buying can push that stock’s price up. As the price of the stock rises, the newsletter authors begin selling their shares, which causes the price of the stock to plummet…and you’re left holding the bag because penny stocks tend to be very illiquid (which makes getting out of them difficult). This is your classic “pump and dump” scheme. There have been people who have figured out how this scheme works and have been able to make a lot of money off of it by shorting penny stocks as they peak in price. But that could be problematic because finding shares of penny stocks to borrow for a short sale could be difficult. The scheme which I described would be illegal, EXCEPT, for the fact that penny stocks don’t trade on major exchanges…remember? My opinion is that you should leave penny stocks alone unless you understand their movement.

Now let’s talk about Futures (Derivatives). A future is a contract entered into between a buyer and a seller to lock in the price of an asset (gold, silver, wheat, corn, treasuries, currencies, etc.) for future delivery. The value of that contract is derived (hence the name derivative) from the underlying asset being bought or sold. For instance: If I’m a gold dealer and I see that the price of gold has fallen, I’ll buy a gold future to lock in that cheaper price. That way, even if the price does go back up at a later date, I would still receive my gold at the cheaper price. But…as a futures trader, your intention isn’t to actually receive shipment of any asset. What I described prior is what is referred to as hedging, but those who seek to profit from price fluctuations of futures contracts are speculators. Whenever you hear a trader say that they’re buying oil, gold, silver, wheat, pork bellies, etc., chances are, they’re referring to futures unless that person is trading in the spot/cash market. Futures is the first market that moves whenever something goes on across the world and allows one the opportunity to capitalize on whatever that may be. If the price of some commodity is moving, futures will respond first. If there’s a Fed announcement that affects interest rates, treasury (bond), currency, precious metal and interest rate futures will respond first. When you look at it in that fashion, the futures market allows you to act on any event taking place in the world because you can trade not just commodities but also stock indexes, currencies, bonds, metals, etc.

As a futures trader, there’s the possibility of making a lot of money. But there exists also the possibility of losing a lot of money. Unlike stocks, a futures contract isn’t so clear cut in regards to profit and loss. If a person buying 100 shares of stock and that stock moves up or down $1, that person has made or lost $100. But when you buy a futures contract, that contract covers a fixed amount of goods. IE: If you were to buy a crude oil future, that contract would control 1,000 barrels of crude oil. So, every time crude oil moves up or down a dollar, you will either make or lose $1,000. Since a futures account requires the use of margin, you would only have to put forth a small amount of the contract’s worth, 5% on average. But also, with the use of a margin account, it is possible to lose not only your principle, but it’s also possible to owe money. But, again, there exists the possibility of making a lot of money in the futures market. Some of the biggest names on Wall Street earned their start by achieving success in the futures market and then moving on to trade and invest in other arenas. In other words, they build up their cash base in the futures market and then achieve their major wealth by expanding into other instruments. Also…there are people who, from home, secretly make millions of dollars a year in the futures market but you’ll never hear of those people.

Before you get excited about the possibility of getting rich as a futures trader, I wouldn’t suggest anyone get involved with futures unless they have a pretty good sum of money to risk. Some would say that you’d need at least $50,000 but that could be the case if you plan to swing trade. But if you plan to day trade, I think $5,000 would be sufficient. Before you risk any real money, you should always paper trade first.

Finally, we’re going to discuss the Forex (Foreign Exchange/Currency) Market. Forex is probably the most well-known market amongst would-be traders largely because it is the cheapest to enter and trading is 24 hours a day, 5 days a week. An estimated $4 trillion dollars a day moves through the Forex market, mostly from big banks and other institutions. Some of the biggest names in the world trade this market (although very low-key), well known people such as Bill Gates.

The Forex market also moves really fast, meaning that money is made or lost in a relatively short period of time. Forex is great for beginners because it is the world’s most liquid market and it is also impossible for anyone to corner it. This is the market that sets the exchange rates for the world’s currencies. Forex trades in pairs, so you are buying one country’s currency and simultaneously selling another’s. IE: If you were to BUY the USD/JPY pair, you’d be buying the USD but selling the JPY. Forex is also a highly technical market which means that technical analysis determines a large part of the way the market moves. Don’t believe me? Even the federal reserve uses technical analysis to keep up with price trends in the currency markets. Although Forex moves largely off of technical analysis, a fundamental report like Non-Farm Payrolls and a central bank speech can shake the markets up in a hurry!

One down side is that the Forex market is unregulated, so a few unscrupulous characters may be able to manipulate the market (although not corner it). That is why some traders prefer to trade Forex futures as opposed to trading in the Forex market itself. Another down side is that you have to be careful when trying to learn Forex trading because there are a lot of scam artists online who claim to have the magical key to riches via the Forex market. These people are usually failed traders or people that haven’t traded at all, who figure that they have a better chance at making money by selling a course rather than actually trading. The same can be said for sellers of courses on futures and stocks as well, but I find a lot more of these people pushing Forex materials. They target Forex because again, Forex is enticing to would be traders because of the low cost to participate.

What is this low cost associated with Forex that I continue to bring up? It’s like this — in the U.S. you’re allowed a maximum leverage of 50:1 in the Forex market. So, you can purchase one lot of $100,000 with only a $2,000 investment. In other countries, some people trade with leverage as much as 200:1. Higher leverage can lead to higher profits but in my opinion, that’s a quicker way to commit financial suicide. Back to what I was saying. A lot of brokers offer mini-lots in the amount of $10,000, for which you’d have to pay a margin of $200 to enter into a trade. As you can see, a few hundred dollars can get you in the game but I wouldn’t recommend trading Forex with only a few hundred dollars. I’d say no less than $2,000. That way, you can trade small enough so that your losses won’t be great and you can still make a decent profit if your trades are successful. One last word about the Forex market concerning brokers — if you can find a broker with low spreads (a narrow difference between the bid and ask price), that’d be great! When I first started trading Forex, one thing that used to irritate me was wide spreads. You’d enter into a trade and already be down 2 pips because of the spread.

Conclusion: Those are the 3 main markets that are traded. As I stated previously, you don’t have to trade just one market, although you funds may limit you to one market for the time being. The most successful traders in the world trade all three — that’s how billionaires are made.

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