Introduction To Financial Markets

This write up is ideally suited for readers with no background in finance. If you are new to this domain, this article would serve as a first step in learning about it. If you already have some working knowledge of investing/trading, you can use this as a refresher before you move on to more advanced topics in the world of trading. Let’s get started.

Consider that you have decided to invest/trade in the financial markets but are unsure how to begin. A useful starting point is to ask yourself some pertinent questions and then seek answers to them. Let’s enlist them.

• What is a market?
• How can I access the markets?
• What gets traded on an exchange?
• How can one track the markets?
• What are the different types of markets?
• Who are the participants?
• Who regulates the markets?
• What are the types of analysis market participants perform?
• What is strategy backtesting?
• What are different corporate actions and their impact on prices?
• Commonly used terminologies

• What is a market?

Colloquially speaking, markets are places where stuff gets traded, usually, for profit.

In our day to day life, we deal with stuff all the time. We’re transacting bus tickets, groceries, phones, apartments, lease agreements, employment contracts, and what have you. Notice the use of the word ‘transact’. Since we are buyers some of the time and sellers at other times.

In financial markets, we metaphorically gather together to transact in financial instruments. In our world of finance, the market can be an online marketplace (similar to say, Amazon in the real world)  or an actual physical premise.

Some examples of financial markets are stock markets, commodity markets, currency markets, derivative markets, etc.

The market where we trade the share or stock of a company is known as a stock exchange or stock market or simply a market.

All of these terms are used interchangeably and quite loosely used in finance.

The following is a list of some of the major stock exchanges in the world.

Now that you have some idea about markets and also know a little bit about various stock exchanges across geographies, the next question you might ask is how do I access them?

Onward we proceed.

How can I access the markets?

There are various ways in which you can connect to a stock exchange, however, we will discuss the two most common approaches: first, via a broker, and second, via direct market access.

Accessing via a broker

A broker is an institution apart from the exchange which allows you to connect to the exchange to trade.

For providing this service to get connected and place trades on the exchange, it charges you a fee in the form of a brokerage or a commission.

In most parts of the world, traders (both individuals like you and me, and institutions like small to medium-sized banks) usually use this channel to connect to the markets. This is both convenient and cost-effective.

Here are some points to keep in mind when you choose a broker for your trading account.

Brokerage or Commission

Different brokers charge different commissions or brokerage based on the services they provide.

The number of exchanges (markets) that a broker is associated with or provides access to.

You might have an investing/trading strategy that needs to be carried out across multiple exchanges and so it’s essential to check if the broker you are considering provides access to all of them.

Most modern brokers provide web-based trading platforms along with mobile applications and their platform-specific programming APIs.

In addition to this, most brokers also often provide desktop applications and a call to trade facility. The tools and services that brokers provide for facilitating trades are account specific. There can be a broker who provides all such facilities, or selectively some of them.

Full-Service or Discount Broker

Again, one of the distinctions that one can make between brokers is based on the services. As the name suggests, full-service brokers additionally also provide trading or investment recommendations and carry out much of the work of a trader.

However, these services come at a cost. Full-service brokers, therefore, charge higher fees. In contrast, discount brokers leave most of the investment/trading decisions to the traders themselves. Their services are hence cheaper. Their income is driven by high trading volumes.

Examples of Brokers

Examples of brokers include Interactive Brokers, Robinhood, Merrill Lynch, Charles Schwab, etc. It would be an interesting exercise for you to search for and explore various brokers in your geography.

Note: QuantInsti is not associated with any of the above brokers and does not endorse any of them.

Direct market access(DMA)

DMA is the other way by which traders (not just High Networth Individuals(HNIs), large financial institutions, or hedge funds, even retail traders) access stock markets. This typically involves obtaining a membership with an exchange in order to carry out trading activities.

Though anyone can take this path, it is generally costly and involves various prerequisites that need to be met. Prerequisites differ from exchange to exchange and the cost for membership also varies accordingly. Hedge funds, proprietary trading desks, and other such institutions generally opt for this path.

Alright! We are done with the two parts of a multi-part process. The goal here is to enable you to get started in the smoothest manner possible.

At this stage, a curious mind might ask, now that I know What a market is and How to access it, What do I trade there? Let’s check that out.

What gets traded on an exchange?

An instrument can be a stock of a company, a derivative contract, a bond, an ETF, etc. Each instrument has a unique symbol on each exchange where it gets traded.

For example, the symbol for the stock of Microsoft is MSFT on the NASDAQ exchange. It is also possible that the stock of a company gets traded on multiple exchanges.

There are thousands of instruments that are traded on any given major stock exchange. Exchanges like NASDAQ and National Stock Exchange of India have tens of thousands of instruments available for trading at any given point in time.

The discussion of each and every type of instrument that gets traded on an exchange is out of the scope of this article.

However, we will discuss some of the common types of instruments.

Stocks

The primary investment vehicle that gets traded on an exchange is the stock of a company. When a company decides to go public,  it lists itself on an exchange, by offering a certain number of shares to which the general public can subscribe to.

For example, The Happy Meal, a (fictitious) company located in Mumbai, India decides to go public to expand its business. It needs a total investment of  INR 10 million to do so. So it decides to offer 10,000 shares each priced at INR 1000 to prospective investors among the general public. This process is called the Initial Public Offering(IPO).

The market where the company offers shares for the first time is known as the primary market. Once a company is listed on the exchange, its normal trading activity starts.

• The market where trading activity happens is known as the secondary market.
• All of the above trades almost always takes place via an exchange (which we have seen earlier).

If you observe carefully, you would see that I have used the words stock and share interchangeably. Shares are also known as equity shares or equities only. And that is how they are referred to by various participants of the stock market.

The IPO process explained here has been deliberately oversimplified. The detailed process differs from geography to geography. It can be a fun self-study exercise for you to go look up this process in detail.

Derivatives

A derivative (contract) is a financial security that derives its value from some other security. This other security is commonly referred to as the underlying or the underlying asset. The underlying asset can be anything: a stock, commodity, currency, etc.

Derivatives are traded on a derivatives exchange (these are also known as a derivatives market).

Some exchanges offer derivatives trading only, whereas other exchanges allow trading multiple types of instruments such as equities and derivatives.

Below I list some of the common derivatives traded across the globe.

Forwards

Forwards are the simplest form of a derivative. The buyer and seller of a forward enter into a contract to exchange the underlying asset for cash.

The transaction happens at a specific price on a specific future date. The price at which the transaction happens is decided on the day they enter into the contract.

Additional parameters such as the quantity of the underlying asset to be exchanged (aka lot size), the date on which the transaction should happen (aka expiry date) also get fixed.

These parameters are decided by the buyer and the seller mutually with no intervention of any third party. This is called an "Over the Counter” or OTC transaction.

Forward contracts are traded in the OTC market only where individuals/institutions trade based on a private contractual agreement between the two parties to the trade.

In a forward transaction, the buyer is obligated to buy the underlying asset and the seller is obligated to sell the underlying on the date that has been decided while entering into a transaction.

Example of forwards:
For example, The Happy Meal (THM) company wants to try and reduce its expenses. So it decides to procure vegetables directly from farmers. For this purpose, THM chooses The Fresh Veggies (TFV) as its vegetable supplier.

On 5th January 2020, TFV enters into a contract with THM to supply one metric ton (1000 kilograms) of carrots in two months time (5th March 2020). They fix the price of carrots at the current market price, which happens to be 12 monetary units per kilo.

Hence, as per this agreement, on 5th March 2020, THM is expected to pay TFV a sum of 12000 in return for one metric ton of carrots. The agreement is executed on 5th January 2020, hence irrespective of the price of carrots on 5th March 2020, both THM and TFV are obligated to honour the agreement at the pre-decided price of  5th October 2018.

The potential risk associated with a forward contract is the counterparty risk. After entering into a contract, both buyer and seller are required to honour their obligations for a transaction to happen.

In our example, if TFV is unable to provide one metric ton of carrots to THM on 5th March 2020, THM might have to bear a loss depending on the current price of carrots.

Futures

Futures are standardised forward contracts. By standardised, we mean there is an involvement of a third party (i.e. the exchange) who regulates every aspect of the contract.

In a futures contract, the quantity (lot size), the date of transaction (expiry date), the place of transaction, etc. are determined by the exchange. Also, you would probably not be surprised to know that futures are exchange-traded.

The buyer and seller of a futures contract are involved in the trading activity only, rather than deciding on its other aspects.

Futures can be classified based on the underlying types of assets. For instance, the futures on stocks are called stock futures.

Other common futures are commodity futures, index futures, and currency futures whose underlying assets are commodities, indices, and currencies respectively.

Options

Options are a contract in which a buyer has an option to buy or sell the underlying asset on or before a specified date in future depending on the type of contract. And the seller is obligated to buy or sell the underlying.

The buyer pays a premium to a seller to obtain this choice. If the buyer of the options contract does not exercise her option, the seller gets to keep the premium.
Similar to futures, options are also classified based on the underlying assets. For example, index options, stock options, currency options, commodity options, etc.

Apart from what we have discussed above, other derivatives include

- which are largely traded over the counter.

An Exchange-Traded Fund(ETF) is a collection of securities which tracks the index (to be discussed next). They are an alternative investment vehicle that can be traded similar to stocks which try to replicate the market index.

The examples of ETF include Nifty50 ETF which tracks the NIFTY50 index, SPDR S&P 500 ETF (SPY) which tracks the S&P 500 index.

Phew! That’s a lot of instruments. Okay, that’s nice, but how are we going to keep track of them? Let’s find out.

How can one track the markets?

Consider that your friend asks you how the markets are performing. Is it going up or down?? It would be practically impossible for you to look at every instrument being traded on the exchange and assess the situation.

A better approach would be to look at the stocks of some mjor companies, assess them, and report your findings. Based on this overview, your friend would be able to gauge how the market is doing. This is precisely what a market index does.

An index is a statistical indicator that measures the relative changes in the stock market. It is computed from the prices of some of the major stocks traded on an exchange. Each exchange has its own index. It is a tool used by investors and financial managers to summarize market movements.

For example, the National Stock Exchange (NSE) of India trades around 1700 stocks. Its flagship index NIFTY50 stock index comprises of 50 stocks based on weights allocated by the market capitalization (number of shares * price of the share) of each stock.

The stock selection criteria could be the type of industry, the size of the company, past performance of the company, and such factors. Based on daily trading activity on those underlying fifty stocks, the index value would change, and this relative change depicts the investors’ sentiments.

Any change taking place in the prices of those stocks would impact the value of the index. Also, there can be multiple indices on a single exchange computed on different criteria.

The following is a list of some of the world’s major stock indices:

Indices show how the market is doing, and are generally not tradeable. However, there are derivatives contracts on indices that get traded on various exchanges. For example, Index futures and index options on the NIFTY index.

The stock market index acts like a barometer reflecting the overall condition of the market. It facilitates investors in identifying the general pattern of the market. It can also be used as a benchmarking tool. Investors can use the index to gauge the performance of their investment.

Most of the indices follow either a price-weighted or market-capitalization-weighted construction approach. A price-weighted index assigns more weights to the stocks with higher prices—for example, Dow Jones Industrial Average.

In contrast, a market capitalization-weighted index assigns weight to each stock based on its market capitalization. An example of it includes the S&P 500, where large companies such as Apple and Microsoft make the significant part of the index, and the stocks with small market capitalization make a lesser contribution to the index.

Now that you know how to track a market, let’s discuss what the different types of markets that you can track are.

What are the different types of markets?

Markets can be classified based on various factors like the place of transaction, the types of instruments traded therein, and so on.

One of the conventional classification criteria is the place of transaction. Similarly, another criterion is the type of instrument that gets traded in a market.

These two criteria are discussed below:

Place of Transaction

• The place of trading determines whether a market is OTC or regulated.
• Over The Counter or simply OTC markets are decentralized and unregulated markets where transactions happen directly between directly two entities without any intermediate party. Such transactions can take place anywhere. It has no central physical location. Forex / FX market is the perfect example of this type of market.
• Exchange-based financial markets are centralized and regulated markets where transactions happen on a centralized physical place between various entities via either physical trading floor or electronic systems. Any stock exchange can be an example of this type of market.

Markets can also be classified based on the instruments that get traded therein.

For example, it can be:

• Stock/Equity markets where stocks of companies get traded. For example, the New York Stock Exchange (NYSE), Shanghai Stock Exchange (SSE), etc.
• Derivatives markets are the one where derivatives contracts get traded. Some of these markets only trade futures contracts, whereas others may trade one or more types of the derivatives contract. Examples of such markets are the Chicago Board Options Exchange (CBOE) and the National Stock Exchange of India (NSE).
• Commodities markets are the one where commodities such as gold, silver, corn, etc. get traded. Typically derivatives on such commodities get traded on these markets - for example, the Chicago Mercantile Exchange (CME), Bursa Malaysia (MDEX), etc.
• Currency markets are the ones where currency and their derivatives get traded. Such markets are generally OTC in nature.

Most exchanges operate multiple markets listed above under one roof.

For example, the National Stock Exchange of India (NSE) is a stock exchange where equity gets traded; hence, it is an equity market. It also facilitates the trading of derivatives contracts on stocks, hence, it is also a derivatives market. In addition, currency and commodities derivatives also get traded; hence, it can also be referred to as a currency market and commodity market respectively.

Who are the participants?

Traders and investors. They are the main participants who engage in buying and selling in the financial market. We use the term traders to describe those who frequently trade in the market to earn profits.

In contrast, We define investors as the ones who invest their money in financial instruments to create wealth over time’. A person can be a trader, an investor or both based on the activity that he carries out.

Based on the type of activities they perform, they can also be classified as follows:

Speculators

Speculators speculate in the market. They are traders who trade to profit from the information they have about future prices. Some analysis usually backs such information.

They believe that the market will move in a specific direction, and based on it, they trade. Well-informed speculators can predict futures prices better than other traders.

Then they choose to buy or sell based upon which side they expect will be profitable.

Arbitrageurs

Arbitrageurs are traders who attempt to make a profit from price inefficiencies in similar financial instruments. Arbitrage profits are, by definition, riskless, and that makes it a special type of trade.

Spotting an arbitrage opportunity in the financial markets is difficult and requires high trading speed and accuracy in order to realize profits. For this reason, arbitrageurs are generally very experienced investors. They generally buy the cheaper instrument and sell the expensive instrument, thereby capturing the spread between the cheaper and expensive instrument.

For example, if one knows that, the price difference between two similar instruments or for that matter two different futures contracts of the same underlying is X on an average, and if the current spread between the two is greater than X, there might be an arbitrage opportunity.

Hedgers

Hedgers are investors who take steps to reduce the risk of an investment by making an offsetting investment. They try to avert the risk in the market by taking the opposite position of what they already hold and make themselves neutral to market movements. -

Until now, we have discussed various types of markets and their participants, along with their respective roles. We also discussed that exchange-based markets are regulated markets.

Let’s now find out more about market regulators.

Who regulates the markets?

Various players play significant roles in the trading ecosystem. Exchanges, being the key component within this ecosystem, provide a range of facilities, right from trading various instruments to clearing them between buyers and sellers and ensuring that the whole process runs smoothly.

But who oversees or regulates various exchanges?
- The answer is regulatory boards or agencies.

Regulatory agencies exercise regulatory or supervisory authority over a variety of activities in the economy.

Examples of regulatory authorities pertaining to securities market include

• U.S. Securities and Exchange Commission (SEC),
• Securities and Exchange Board of India (SEBI)

It is worth noting here that these boards are specific to the geography they operate in. In the above examples, SEBI regulates only the Indian stock markets and not the stock markets of any other countries.

Alright. We’ve come a long way now.

Now that you are equipped with some ground knowledge, let’s try to put this to good use. Consider that you have almost everything in place and want to beat the market. You want to have an edge over other traders. For that purpose, you decide that your trading decisions should be data-driven and based on some analysis.

What sort of analysis, you might wonder? Let’s get started.

What are the types of analysis market participants perform?

Almost all traders and investors out there in the financial wild follow some analytical approach to make their trading decisions. Those who do not, are just gambling and trying their luck.

A convenient method of classifying analysis is into three types viz. fundamental analysis, technical analysis, and quantitative analysis.

Let’s discuss each in brief:

Fundamental Analysis (FA)

As the name suggests, this approach involves studying companies at a fundamental level. It involves a study of various financial and economic factors in which a company operates.

Factors like cash flow, profitability, balance sheet size,  the effectiveness of the company’s management, etc. are studied in FA. The goal of any kind of analysis is to determine whether a particular security is correctly valued or not.

FA is usually done from a macro to micro perspective in order to identify whether the securities are correctly priced or not. A fundamental analyst tries to determine the fair value of the security in comparison to the overall state of the sector or economy.

If the fair value of the company is higher than the current market price of the stock, then it is considered to be undervalued, and a buy recommendation is given.\

Otherwise, if the fair value of the company is lower than the current market price, then it is considered to be overvalued, and a sell recommendation is given.

Technical Analysis (TA)

The price of an instrument is the key component in technical analysis. It heavily involves the study of variables like historical price patterns, the volume of trades over time.

Practitioners of TA use charting software to visualise price patterns and movement.

It is based on the following three assumptions:

• The market discounts everything: Everything in TA revolves around prices. It also assumes that the current price of an instrument reflects all available information in the market.
• Prices move in trends: TA tells that based on the information flow about the price of an instrument, it follows some patterns, and hence, it moves in trends over time.
• History tends to repeat itself: TA also assumes that what has happened in the past, will happen in the future. It is loosely based on the human psychology that what traders and investors have done in the past, will keep on doing in the future as well. Hence, to profit from this repetitive behaviour, it tries to study past price patterns, and look for such patterns in the future and take trading decisions accordingly.

Quantitative Analysis

This field of analysis involves the study of financial events through mathematical and statistical modelling. Trading opportunities are identified using statistical techniques.

Quantitative traders take advantage of modern technology, mathematics, and the availability of huge historical datasets for making trading decisions. These techniques are immensely powerful, and involve closely monitoring market movements, trading patterns,  news feeds.

Trading strategies based on QA often transact a large number of orders within a fraction of a second.

The above-mentioned are some of the commonly used techniques that traders and investors use to generate new trading ideas. They tend to combine strategy ideas using multiple techniques.

It is worth mentioning that strategy ideas can come from multiple sources, it can come from research papers, trading journals, by looking at trades of other traders, and so on. Consider that you got a trading idea from the analysis that you have been doing lately.

How would you validate whether the trading idea that you have on hand would be a success or not?
Answer: Backtest the strategy and see how it would have performed in the past on historical data. If the strategy would have worked in the past, there’s a good chance that it would continue to do so in the future.

That is what we will learn next.

What is strategy backtesting?

The validation of a strategy idea is one of the essential steps in the trading life cycle. The strategy idea can be validated by backtesting it on historical data.

Backtesting

Backtesting is the process of testing a trading strategy using historical data to determine the effectiveness of that strategy.

Backtest results usually show the strategy’s performance in terms of some popular performance statistics like Sharpe Ratio, or Sortino ratio which help to quantify the strategy’s return on risk.

If the results meet the necessary criteria, the strategy can be implemented with some degree of confidence. If the results are not up to the expectations, the strategy can be modified, and optimized to achieve a desirable result.

There are mainly two forms of backtesting systems:

Backtesting not only provides you with insights about the strategy but also allows you to fine-tune various parameters, if any, that go into the strategy. Based on the backtesting performance, you might change various parameters that the strategy uses, and again backtest it and check the performance.

This process is repeated until you get the desired results. This process is known as optimization.

For example, the strategy idea on hand is: buy if the current price of a stock is higher than the high price of the last five days, and sell if the current price is lower than the low price of the last five days. This is a simple strategy idea.

The backtesting result shows that the performance of the strategy is not so good. Hence, you want to tweak the strategy to see if you can make it profitable. In this case, the parameters for a strategy can be, the number of days used for comparison, that is the last five days. You change this parameter to six and backtest the strategy with new parameters and look for its performance.

Another parameter could be instead of the lowest price; you can use the close price of the last five days.

Next, we will discuss different corporate actions that firms undertake over a period of time.

What are different corporate actions and their impact on prices?

A corporate action is an event undertaken by a public company which likely brings a change in the prices of shares issued by them. Corporate actions are agreed upon by a company’s board of directors and authorized by the shareholders. Examples include dividend, stock split, bonus, rights, etc.

These events happen at the company’s discretion. It is not necessary that every company will undertake the said actions.

Let’s discuss each of them in brief.

Dividend

A Dividend is the distribution of a company’s earnings or profits to its shareholders. The amount that is being paid to its shareholder depends on the number of shares held by a shareholder and the amount being paid per share.

Companies usually pay a dividend when their earnings are good; however, it is not necessary. A company might also pay a dividend if they have incurred a loss, but they are holding good cash.

It is not obligatory for a company to pay it. Usually, early stage companies do not pay it as they prefer to reinvest most of their profits back in the business to spur higher growth. On the other hand, mature companies often pay regular dividends to their shareholders.

Dividends are a signal that the company is stable enough to share excess profits and has good future prospects. Further, there are certain investors who prefer investing in companies that pay regular dividends.

On the other hand, we must note that dividend payments by a company reduce its retained earnings and limit its growth capacity.

For example, the stock of a company is trading at $101. It decides to pay a dividend of$5.40 per share to its shareholders. The shareholder holding 10 shares of the company will receive a dividend of $54 =$5.4 x 10 when it is paid by the company.

Stock Split

Stock Split is an event which increases the number of shares in a company. The price is adjusted such that the market capitalization, before and after the event remains the same.

For example, a company may split its stock, when the price per stock becomes so high that its trading volume decreases significantly and illiquidity increases.

For example, a company which has 2000 issued shares, trading at $100 per share, has a market capitalization of 2000 x$100 = $200000. If the company decides to split its stock 2-for-1 (2:1), there will be 4000 shares after the split. Each stockholder will have twice the shares after the split. The price of each share will be adjusted to$50 = $200000 / 4000. The market capitalization will remain the same, i.e., 4000 x$50 = 200000, the same as before the split.

Bonus Shares (aka Bonus Issue)

Bonus Shares (aka Bonus Issue) are shares distributed by a company to its current shareholders free of charge. Bonus shares are usually issued when companies are short of cash, and shareholders expect a regular income.

Shareholders may sell bonus shares and meet their liquidity needs. Bonus shares are issued according to shareholder’s stake in the company.

For example, a company might decide to offer n bonus shares for each x shares already owned by the shareholder. Because a bonus issue does not represent an economic event – no wealth changes hands. The current shareholders receive new shares, for free, and in proportion to their previous share in the company.

In addition to the above mentioned corporate actions, the list can include Spin-off, Rights Issue, Change in shares outstanding, Merger / Demerger / Amalgamation and so on which are out of scope for this article.

We have completed answering almost all the questions which one might ask when it comes to financial markets.

But before we conclude, let’s take a look at some of the commonly used terminologies in the trading universe.

Commonly used terminologies

Bull Market / Bullish

If you are expecting the prices of stocks to go up, it is said that you are bullish on these stocks. From a broader perspective, if the stock market is going up during a particular time period, it is said to be a bull market.

Bear Market / Bearish

In contrast to bullish, If you are expecting the prices of stocks to go down, it is said that you are bearish on these stocks. From a broader perspective, if the stock market is going down during a particular time period, it is said to be a bear market.

Long Position

Long position or simply a long refers to the direction of your trade. For example, if you are buying a stock of a company, it is said that you are going long on that company. If you are already holding stocks of the company, it is said that you are long on that company.

Short Position

Similar to a long position, a short position, or simply a short also refers to the direction of your trade. For example, if you are selling a stock without owning it, it is said that you are going short on the stock. Or you are short-selling the stock. If you have already sold the stock, it is referred to as you are short on the stock.

Square Off

Square off refers to exiting an existing position, buy or sell, any. If you are long on a stock, squaring off a position means, you sell the existing bought stock and nullify your position. If you are short on a stock, squaring off would require you to buy the stock in order to neutralise your position.

Volume

Volume refers to the total number of transactions (buy and sell put together) for a particular time period. If the daily volume of the stock THM is 1.5 million, it means 1.5 million shares were traded through the day.

OHLC

An abbreviation to Open, High, Low, and Close (OHLC) refers to the dataset of stock prices where we have all four prices for each data point. For example, if you have a daily price dataset of a particular stock from 2013 to 2018, each data point (each day) would have four prices referring to Open price, High price, Low price and Close price.

Often times, this data can also have volume as a part of it. In such a case, it can also be referred to as OHLCV data.

Trend

Trends refers to the particular direction in the prices of a security. If the prices are moving in an upward direction over a period of time, it can be said that the security is in the uptrend. If the prices are moving in a downward direction, the security is said to be in a downtrend.

Arbitrage

Arbitrage is the process of simultaneously transacting in multiple financial securities to make a profit from the difference in prices. This can be done in various ways such as:

• the purchase and sale of the same securities in different markets (Spatial Arbitrage) or
• simultaneous buying and selling of spot prices and futures contract of security or buying the stock of a company being acquired while selling the stock of the acquiring company (Merger Arbitrage)

Arbitrage is a risk-free strategy, although this is not always the case. There is always a possibility of execution risk, i.e., risk due to high volatility in the market and a sudden change in price makes it impossible to close the trade at a profitable price. Other risks involved are counterparty risk and liquidity risk.

Order

An order is an instruction by an investor or a trader to a broker or a brokerage firm or directly to the trading venue (exchange) to buy or sell securities like stocks, bonds or derivatives. Orders can be placed over the phone or online manually/through the algorithms. Most common types of orders are limit order and market order.

Portfolio

Portfolio is a collection of financial instruments such as stocks, bonds, cash equivalents, funds held by an individual, investment company or financial institution.

An investment portfolio can be regarded as a pie which is divided into various parts, each representing a financial instrument with an objective of achieving a particular level of risk and return. Investors should construct a portfolio according to the investment objectives, risk tolerance, and time frame.

In finance, the spread can be defined as the difference between any two prices. It is also defined as the difference between the current bid and current ask prices for given security (bid-ask spread).

In the context of options, it is the buying and selling of an equal number of options contract of the same asset class, on the same underlying security but with different strike prices or expiration dates (option spread).

Liquidity

Liquidity refers to the ability and ease with which assets can be converted into cash without affecting the current asset price in the market to a great extent. Market liquidity refers to the extent to which a market allows assets such as stocks, bonds, or derivative products, to be bought and sold without paying a huge bid-ask spread. Algorithmic trading also plays a big role in providing up to 70 % of liquidity seen in the markets.

Basis Point (BPS)

One basis point is equal to 1/100th of 1%, or 0.01%, or 0.0001, and is used to denote the percentage change in a financial instrument.

Conclusion

We started off with the definition of a market and went on to learn about its participants, types, regulators, and the different types of analysis used in it.

We’ve just scratched the surface of a deep and evolving field. We hope you enjoyed reading it and would urge you to check out our courses, writings and other content.

To start learning Python and code different types of trading strategies, you can select the “Algorithmic Trading For Everyone” learning track on Quantra.