The 'Where to Trade' Conundrum and How to Crack It

The 'where to trade' conundrum is a very hard one, especially in the current volatile climate. Broadly speaking there are five main areas where you can trade - stocks, options, futures, CFDs and Forex. Viewed all together can be a very daunting task and where to start is a hard conundrum for a novice trader. For that reason here's a simple breakdown of the different options available at your disposal.

Stocks

Plain and simple, stocks represent a share in the ownership of a company. Stocks trade on a stock exchange, which is basically a venue to buy or sell a stock. In this arena, big players such as Warren Buffet, Merrill Lynch and other big banks dominate. That said, don't be scared off because, if you're new to trading, this is probably the best place to start.

It offers the lowest risk because it's unleveraged. There is a tendency for new traders to go for higher leveraged instruments because of the return, but you must remember that higher return the higher the risk. If you haven't traded stocks (and made a profit) you're probably not ready to look at leveraged instruments just yet. In short, start with stocks.

Options

Options are a leveraged instrument that derives its price from an underlying security (such as stocks). They give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date.

So, unlike stocks, which represent equity in a company and can be held for a long time (if not indefinitely), options contracts have finite lives.

Options are the next step up from stocks in their complexity. They introduce the opportunity to leverage your money and increase profits.

A word of advice on options: make sure you are trading liquid options (those that are well traded). You never want to be dealing directly with the market maker because they will put the odds in their favour by setting a wide spread.

Futures/commodities

In a similar vein to options, futures contracts also have finite lives. They are primarily used for hedging commodity price fluctuation risks or for taking advantage of short-term price movements.

The buyer of the futures contract agrees on a fixed purchase price to buy the underlying commodity (wheat, gold or T-bills, etc.) from the seller at the expiration of the contract. This differs from options where the buyer has the right to purchase the underlying commodity but is not obligated to do so.

As time passes, the contract's price changes relative to the fixed price at which the trade was initiated. This creates profits or losses for the trader.

Futures trading is one of the more complex forms of trading, but along with the increase in the skill level required, there are greater rewards (in terms of return on investment). Commodities trading can be a great stepping stone towards trading more advanced markets.

Contract for difference (CFDs)

CFDs derive their price from an underlying security and can be placed on virtually anything. Nowadays, CFD providers allow people to trade almost whatever they want through their own (that is, the provider's) platform.

The CFD provider, in effect, ends up becoming the market, setting the buy and sell prices. They make their money in one of two ways: either (1) they'll set a wider spread - the difference between what you can buy and what you can sell (similar to exchanging foreign currency at the airport) - or (2) they will take equal and opposite transactions to whatever you do (in effect, 100% hedging themselves and making their money on the brokerage and lending rates).

CFDs are popular at the moment because they allow you to trade both sides of the market (long and short). In this case though, there are actually no shares involved; instead, the broker agrees to pay the difference between the starting share price and the price when the contract closes. This method of making or losing money based on a difference is where the name 'contract for difference' originates.

Forex

Forex - short for foreign exchange - is trading where the asset traded is currency. What makes it so unique is that, unlike other financial markets, the forex market trades 24 hours and its daily volume exceeds $1.4 trillion, making it the largest and most liquid market in the world.

This market is extremely attractive because of the high leverage potential. For example, if you put a dollar down, you can control of $100 (so, 1% down). It's obvious why this would be a very interesting proposition, but you must remember that leverage is great when you're making money, but it's tragic when you're losing (you'll lose your money a lot quicker!).

While this sounds exciting, it's not for the faint hearted. Forex trading can be fast and furious. If you're just starting out, unless you have your heart set on trading the forex, I recommend that you prove your trading plan can trade profitability in other non-leveraged markets (such as stocks) before entering this market.

I hope you now have some idea of where to trade.

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