How do the Financial Markets Work?
The financial markets are a complex system of institutions and individuals that facilitate the exchange of financial assets. Understanding how the financial markets work is crucial for anyone looking to invest in stocks, bonds, currencies, or other financial instruments.
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Market Participants
Institutional Participants
These significant players, often referred to as 'whales,' are the dominant participants in the market, wielding substantial capital that exerts considerable influence on market dynamics. They manage money on behalf of an aggregate of investors and so their trades tend to be large. As they are moving large sums, they tend to influence the price more especially when it comes to equities (stocks).
Types of institutional participants include:
- Pension funds
- Insurance companies
- Banks
- Mutual funds
- Hedge funds
- Commercial trusts
Retail Participants
Retail traders are individuals, usually non-professionals who trade through a broker, bank, or mutual fund. They execute their trades through traditional full-service or discount brokers and trade for their own benefit, not on the behalf of others.
So, this is probably the category of trader you will fall under. Retail has access to a wide range of financial markets with various tools and methods of trading, retail also trades in significantly smaller sizes compared to institutional traders.
Brokers
As a retail trader it is not possible to trade directly on exchanges such as the London Stock Exchange or the New York Stock Exchange. So, to gain access to a financial market such as the stock market you must go through a stockbroker. These brokers are companies registered to trade on stock exchanges and facilitate trades on your behalf.
There are various ways stockbrokers provide access to clients, the most common is by providing an online platform on which clients can place trades. With Spreadex, you can either use our proprietary platform or call in and speak to a dealer.
There are two types of brokerage service:
- Full-service – actively managing your trades and providing professional advice for a higher fee.
- Discount Broker – only carries out your instructions to trade for a lower fee such as Spreadex.
Market Makers
Market makers act as what we call liquidity providers. Say you want to buy some shares but there is no one who wants to sell them to you, a market maker will step in and take the other side of your trade. Most market makers operate within exchanges, so the broker you use will execute trades with them on your behalf.
They are called ‘market makers’ because they contribute to the smooth running of a market – they are ‘making’ the market. Typically, they will hold inventory of a certain asset and quote a bid and ask spread to you (sell price and buy price).
Market makers do not just bring buyers and sellers together, they will take a sell trade from you even if they don’t have a buyer lined up on the other side of the trade for example. However, they can seek out another client order to offset yours. Most market makers have professional and long-term relationships with their clients who are usually institutional market participants.
Bulls, Bears & Speculation
Speculation
Speculation refers to carrying out a financial transaction which has a significant risk of losing value but also the potential of substantial gain. John Maynard Keynes widely considered the founder of modern macroeconomics, said that “speculation is the activity of forecasting the psychology of the market”.
If you are speculating on the price of an asset, then you are either buying or selling the asset with the expectation that the price will move in your favour.
These opposing forces are what form the movements in market prices. When there are equal bulls and bears in a market, the price general stays in a range as they trade between each other. When the bears outweigh the bulls, the price tends to push downwards and we say the market is ‘bearish’. When then bulls outweigh the bears, the price tends to push upwards and we say the market is ‘bullish’.
The Bulls & Bears
- Bull: an investor who thinks a market, specific security or industry is due to rise.
- Bear: an investor who thinks a market, specific security or industry is due to fall.
Think about it like this, let’s say you are at a car boot sale and you’re looking to buy a vintage Lego set at the lowest price possible. The weather is poor and very few buyers have turned up. Do you think you are more or less likely to get a good deal?
Now let’s suppose many buyers have turned up and they are all seeking a vintage Lego set, do you think you’re going to get a good deal or rather end up paying a higher price?
In the same way this logic can be applied to the financial markets and how demand from buyers (bulls) and supply from sellers (bears) influences the price of financial assets.
Shares: What are they and how to trade them?
Learn what shares represent, how stocks differ from shares, and their significance within trading. Explore the dynamic world of stock exchanges, where shares are bought and sold, and how they influence global financial markets. Delve into the process of an Initial Public Offering (IPO) to discover how companies make their debut in the public markets by offering shares to investors.
