What is Financial Trading?

Part 1 What is Financial Trading?
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Financial trading can seem like a large and complex topic. However, the goal is simple – to make a profit. By defining it from the point of view of the ordinary person – the retail trader – we can come to a full understanding of what financial trading is and how to benefit from it.

Financial trading is the buying and selling of a derivative product on an OTC market (through a broker) based on an underlying asset’s price, with the intention of making a profit and without taking delivery of any product, except money (profit).

So what on earth does all that mean! In this article, the first in our Trading Basics series, we will break down the meaning of financial trading from a retail trader’s perspective.

We will explain what you trade when participating in the retail market, who you trade with and make sense of some common terms.

Table of Contents

The Standard Definition Of Financial Trading

If you have searched this topic before you may have come across a slightly different definition. Something like this:

Financial trading is the buying and selling of a financial asset via an exchange or the over the counter (OTC) market.

It is by looking at the differences between this standard definition and our own that we can start to identify some key elements that will help us understand what financial trading is for the ordinary person. These include:

  • What are we actually trading?
  • What are derivatives?
  • What does the retail trader have access to?
  • How can we get access?

What Is A Retail Trader / Investor?

A good place to start is to describe what we mean by “Retail Trader”. A retail trader is anyone that trades their own account (their own money). This compares with Institutional traders / investors who are responsible for trading other people’s money.

Note: In this article we will use the term Retail Trader rather than Retail Investor. These terms can be used interchangeably when referring to a non professional trader.

There is a difference between trading and investing though and we cover this in more detail in the 5th unit of the Trading Basics series which you can read here: Trading vs Investing.

When we talk about retail traders on Nothard Trading, what we are referring to is the ordinary person. But why is this an important distinction?

There are two main reasons:

  1. A retail trader is usually defined in regulation in most countries. This means that retail traders are treated differently to institutional traders.
  2. Because of this difference in regulation, retail traders will have limited access to financial markets and products and those that you do have access to will be more regulated.

These are important facts to know – Why?, well because why waste your time trying to understand complex financial products that you are not likely to have access to anyway!

Retail traders are sometimes called unsophisticated investors, which is a bit of an unfair term but basically means that the regulators feel that more restrictions should be in place to protect retail traders from losing money in the markets.

These restrictions can mean:

  • No direct market access
  • No access to complex financial products
  • Less leverage
  • Higher costs to carry trades (buy and hold) over a long period of time
  • Higher commissions or spreads when trading.

These are not all necessarily a disadvantage as trading is very risky and having less ways to lose money is not a bad thing!

Another point is that given current technology and competition the costs and opportunities for retail traders has expanded significantly whilst still protecting retail traders from the risks that professional traders need to consider.

For example, a retail trader can safely trade the oil market without running the risk of having to take delivery of 1000 barrels of oil.

We can do this safely due to the use of derivative products. But before we explain derivatives let’s look at an example that illustrates what financial traders actually trade.

What Are We Buying And Selling In Financial Trading?

In most cases, the retail trader is not actually buying or selling any physical product or asset. So what are we trading then? Let’s look at an example to illustrate:

Fresh Fruit Market Example

Let’s imagine you go to the market to buy a box of apples.

Is this financial trading? No, of course not. This is simply a transaction between you and the fruit trader. You may fill your stomach, but you are not making a profit.

So what about the fruit market trader that you are buying the apples from, she is making a profit hopefully, so is she participating in financial trading?

Also no, she is a trader but not a financial trader. Ok, so let’s take it up a level – what about the wholesalers where the market trader bought all her apples? Are they financial traders?

Still, no! So what about the farmer, who sells apples to the wholesaler, is this financial trading?

Still no. So, we have a whole market system here from production through processing, distribution and eventual sale.

If none of this is financial trading then what do financial traders buy and sell? Well, they trade one thing: the price itself! 

It may seem crazy and another world compared to your consumer experience of buying and selling where you expect to get some product in exchange for money.

But you are not here because you want to be a consumer, are you? In financial trading, we are in the business of money – price is our market and profit is our goal.

In financial trading, we are in the business of money - price is our market and profit is our goal.

In the example of fresh produce, a financial trader would be trading the current and expected future value of that box of apples, without ever touching – or eating – a single apple. From this we can come to the first part of our definition for financial trading as it relates to retail traders:

Financial trading is the buying and selling of an asset’s price with the intention of making a profit and without taking delivery of any product.

So if all we want to do is trade the price of an asset and not touch the asset itself, then we are going to need a way of doing that.

  • We need a product to trade – these products are known as derivatives.
  • We need people to trade with – there needs to be a market. The market that we use is the OTC market.

Derivatives

What is a derivative?

Derivative products are financial instruments that derive their price or value based on the price or value of an underlying asset.

So, for example, instead of trading apples, we could create a market that tracks the price of real apples then create and trade contracts between people based on the underlying price.

This contract would be a financial product that breaks the link between the delivery or possession of the underlying asset (such as apples, gold, oil, company stocks or anything really) and the price.

The contract is a derivative product based on the price of apples. Common examples of this type of derivative are Contracts for Difference (CFDs), ETFs, Futures Contracts and Options.

All of these are common retail products that you can trade (depending on where you are in the world). They are not marketed as derivatives because the only point of these products is to allow you to speculate on the movement in the price.

The key point is that the derivatives that we trade (like CFDs) will simply track the price of an underlying product – so if oil is physically trading at $50 a barrel then the CFD will very closely track that price.

The Differences Between Exchanges and Over The Counter (OTC) Markets

There are two main types of (regulated) markets. Exchanged and OTC markets.

What Is An Exchange?

An exchange is a formal (regulated) and centralized marketplace for the fair trading of securities (assets) which can include stocks, debt, commodities, derivatives and other financial instruments.

You have all heard of the more famous exchanges like the New York or London Stock Exchange and there are many of these exchanges (markets) across the world where you can trade a huge range of products.

The key characteristics of exchanges are that they are centralised and highly regulated. Exchanges are regulated by their relevant governments and will usually have very specific rules that determine what can be traded on that exchange and also who has direct access to the exchange.

A key word used in the definition of an exchange is fair. What this means in practice is that transactions through these exchanges require a level of transparency in pricing and a guarantee of completion (settlement).

To say it simply: you know what you are getting and you know you are going to get it at the agreed price.

In order to do business with an exchange, an entity will need to have a licence and trades will be of a minimum size with lot sizes of $10,000 or $100,000 not being uncommon.

In many exchanges, particularly the futures market in commodities. The settlement of a trade can result in the buyer having to take delivery of that asset whether it be a 1,000 barrels of oil or 10,000 bushels of corn.

This is very much the remit of professional entities.

What Is An Over The Counter (OTC) Market?

An OTC market is a decentralised marketplace where participants can trade financial securities (stocks, debt, commodities, derivatives) without going through a formal or centralised exchange.

The old definition of OTC markets focused more on a direct exchange of goods between two participants without a broker.

However, in reality there is always a broker or intermediary of some sort. Due to technology and the application of scale most OTC markets are facilitated by formally regulated brokers.

In a very broad sense, an OTC market can be any marketplace that trades a financial product outside of the formal exchanges. As retail traders you will most probably be participating in financial trading via the OTC market.

As mentioned, OTC markets are not unregulated. The decentralised network is a network of broker dealers who themselves will need to conform to regulations when offering products to the market and especially to retail traders.

Other Markets

There are of course other markets that would be classified as OTC markets that are not regulated and facilitate – with minimal intervention – trading between two parties directly.

However, unless these are black markets, they will still have to limit the types of products that can be traded by retail traders.

How Derivative Products Are Made Available To Retail Traders

So now we can bring together the pieces to understand what retail traders have access to in financial trading.

Most retail traders will be looking to trade in much smaller quantities than would be required on an exchange and are only looking to speculate (trade) the price, we are not looking for physical goods.

As such we need to trade derivative products such as Options or CFDs. This is made possible by brokers who facilitate a decentralized market that of thousands of traders in an OTC market.

The brokers will use the formal exchange prices to determine the value of their derivative contracts but the trades themselves will be between the participants of the OTC network and will not be via the purchase of the asset on the exchange.

And so we come back to our definition of financial trading for a retail trader:

Financial trading is the buying and selling of a derivative product on an OTC market (through a broker) based on an underlying asset’s price, with the intention of making a profit and without taking delivery of any product, except money (profit).

Related Questions

Do Brokers Settle All Transactions With An Exchange Or Counterparty? Do Brokers Bet Against Their Clients?

This is a very interesting and contentious question. Many traders who have seen their stops wiped out just before a market turns will be convinced that the brokers are working against them.

The truth is that the way brokers conduct their trade settlements are very complex and are often handled by computer programs. There is some truth in the statement that brokers bet against their clients.

It is not a direct conflict of interests, but programming and AI is at such a level that brokers will use them to make decisions on whether or not to offset all positions with a counterparty.

It is more likely that they are pooling thousands of transactions and using computer programs to balance their current positions many hundreds of times a second.

Does this mean I should not trust my broker?

No, what you should do is ensure that you are trading with a regulated broker. This will give you a measure of protection against unscrupulous practices that directly disadvantage you.

And more important than anything else, you should educate yourself so that you make smart bets in the market!

More Trading Basics

There is loads more to learn and we will uncover more terms in the rest of the Trading Basics blog series.

In the next unit – Types of financial markets we cover:

  • What are primary and secondary markets?
  • What are spot, futures, money and capital markets?
  • What are the different types of financial assets?
Justina Nothard

Justina Nothard

Hi, I’m Justina Nothard, a retail investor trading Stock Index Futures.

I understand how hard it can be for the ordinary trader to learn the basics and find useful tools and practical information.

This is why I decided to create Nothard Trading to help you take control of your trading.

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