Trading is a process where we buy and sell financial assets for monetary gains.
There are 3 general aims of trading
Trading to generate profits
This essentially involves either buying financial assets at lower prices and selling them at higher prices or to short financial assets at higher prices and buying them back at lower prices.
Example: A trader believes that an upcoming president will implement policies that will be positive for the stock market. He then buys a stock index.
Trading to facilitate transactions
This is mostly done by banks and large financial institutions. These institutions trade in order to help their clients (usually other financial firms or large companies) buy and sell assets.
Example: Bank A has a client (a large corporation) that is closing down their British operations because of Brexit. They want to sell $200 million worth of British Pounds. Bank A will then help them sell their Pounds (for a good price) by efficiently matching them to buyers.
Trading to hedge
Hedging is a process where we buy or sell assets to offset the risk of holding another asset. Banks might trade to help their clients hedge away unwanted risks.
Example: Airline company X uses 10 billion gallons of jet fuel a year. They are worried that the price of jet fuel might rise in the next year. Thus, they employ Bank X to long 10 billion gallons worth of jet fuel futures. This will effectively protect them from any price changes in jet fuel.
Algorithmic vs Manual Trading
Algorithmic trading is a method of trading where computers make decisions on what to buy and sell in the financial markets.
In manual trading, humans know when and how much to buy or sell. This decision-making process usually involves qualitative work; such as reading companies’ annual reports.
- Stock Index