Why Trade the Financial Markets
What are shares?
When you hear people speak about trading or investing, most likely they'll be talking about share trading. It's one of the most popular - and most traditional - ways to trade the financial markets. Particularly among individual investors.
As we saw in the previous lesson, if you've got a pension plan, the chances are you're already investing in shares in some capacity. But what are shares? And how do they work?
Total Company Value
A share is a unit of ownership in a company.
So, if a particular company is worth £10,000 and has issued 2000 shares, each share would be worth £5 (10,000 ÷ 2000).
As the share price fluctuates, so does the value of the company. Investors who buy shares in a company are hoping it will grow in value, enabling them to sell the shares at a higher price.
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Question
Company ABC is currently worth £1,200,000 and 3,000,000 shares have been issued. How much is one share worth in pence?
Reveal answer
Why do companies offer shares?
To raise money
By allowing investors to buy part of the company, the management are able to raise capital to put back into the business. For example, they may need extra cash to expand into other territories, or launch a new line of products.
If the funds are used wisely and the company becomes more profitable as a result, the value of the share price - and therefore the business - should rise.
This means the company and its shareholders are heavily reliant on each other. The company needs shareholders to raise funds, and the shareholders hope the company will use their investment to grow the business - so they can make a profit.
Why do share prices move?
Share prices can stay fairly stable for months, or move rapidly. The amount a share fluctuates is known as its volatility.
Whether a share price moves up or down is based fundamentally on the laws of supply and demand. Essentially, if more people want to buy a share than sell it, the price will rise because the share is more sought-after (the 'demand' outstrips the 'supply'). Conversely, if supply is greater than demand then the price will fall.
Supply and demand
How levels of supply and demand move prices?
Supply and demand can be influenced by many factors, but the main two are:
Earnings
These are the profits a business makes. If the earnings are better than expected, the share price generally rises. If the earnings disappoint, the share price is likely to fall. Companies tend to release earnings announcements for a specific time period, usually a quarter, half or full year. The firm's share price can be particularly volatile immediately before and after the announcement, especially if the figures are significantly better or worse than anticipated.
You can use an economic calendar to see when certain companies are releasing earnings results.
Sentiment
This is perhaps the most complex and important factor in a share price. Share prices tend to react strongly to expectations of the company's future performance. These expectations are built on any number of factors, such as upcoming industry legislation, public faith in the company's management team, or the general health of the economy.
Lesson summary
A share is a unit of ownership in a company
Companies offer shares to raise money, usually to invest back in the business
Share prices are influenced by: supply and demand, earnings figures and market sentiment
Why trade the financial markets?
Imagine that one day you decided to put all your savings under the mattress for safekeeping. If you then forgot all about that money, and left it alone for a year, it wouldn't have grown. There would be exactly the same amount of money as you put there in the first place.
In fact, in real terms, it would probably be worth less than when you put it there, because the cost of living is likely to have risen in the interim.
Now, imagine you had instead used that money to buy financial assets such as shares or commodities. Instead of lying dormant, your money would have a much greater potential for growth as the value of those shares or commodities could go up. Though, of course, there's always the risk they could drop in value as well.
Trading the financial markets is all about balancing that risk with the potential reward, and picking assets likely to move in your favour. As we'll see, if you do this sensibly and intelligently, the rewards could be much greater than simply letting your money sit in a bank account (or under the mattress).
Investing vs trading
What we've described above is called 'investing', essentially a long-term form of financial trading which involves buying and holding financial assets over a number of months or years.
In fact, it's quite likely that you're already investing in the financial markets in some capacity - possibly only passively. If you have a pension plan, for example, then you're investing the money you're earning now with the expectation it'll grow and be worth more when you retire.
Pension firms generally invest this money for you in return for a management fee. In most cases however, you can have a say in which financial instruments you put your money into. And as the chart below shows, a few simple decisions now could have a dramatic effect in the future.
Looking at the chart, you can see that £100 saved in cash in 1986 would be worth just £38 in 2014 due to inflation. If you'd invested that £100 in the UK stock market you could have received a return of around £1120.
But long-term investing isn't the only way of participating in the financial markets, there's also active trading, sometimes known as speculation.
While investors generally focus on the long-term value of assets and attempt to build a portfolio that will perform well in the future, active traders tend to focus on short-term market movements, with some participants placing hundreds of trades per day.
Whether you choose to focus on the long game, making only a few trades per year, or whether you believe that every tiny movement in price represents an opportunity, is entirely down to you, your personality, and how much time you can devote to trading.
We look at this topic in detail in the 'Planning and risk management' course, but for now it's important to note that there are many different ways to trade, and many different types of trader. And whatever your interests, skills or priorities, there's always a form of trading that will suit you.
One of the main differences between traders is the type of asset that they trade, and that's what we're going to start looking at in the next lesson...
Lesson summary
• Financial trading provides the potential for your money to grow, but there's always the risk you can lose money as well
• Investing focuses on the long-term value of assets
• Active trading focuses on shorter-term movements in price