Basic Terminology of Online Trading
Leverage is the practice of putting a small amount of money down (as a deposit) to trade a much larger amount. For example you could put down £1000 to trade a £100,000 deal. The smaller amount put down is called the margin and you may have heard of the term ‘margin trading’. The ratio between the smaller and larger amount is the leverage. For example, a £1000 deposit to trade a deal size of £100,000 is 1:100 leverage; that is £1000 fits 100 times into £100,000.
Why do we have leverage? You don’t actually need the full deal size to be able to trade it you only need to cover the risk. Leverage allows you to take advantage of small moves in the market and to increase your investment return. Of course at the same time your risk is also increased. Short-term traders sometimes only hold a trade for a few minutes! However, the duration of your trade will entirely depend on your market outlook.
The spread is the difference between the price you can buy at and the price you can sell at. If there was no spread the sell and buy price would be the same, this doesn’t exist in the financial markets. The bank or broker will apply a spread as their charge for providing you with a trading service. If you are trading via an exchange you may also have to pay commission as well as the spread. If you are trading currencies (also known as forex) or commodities on an online platform usually no commission is applied.
Liquidity is simply a statement of how much a certain product is traded. A product that is traded often is said to be liquid which means there are plenty of buyers and sellers available in the market making it easy to find prices to trade at. A product with a smaller number of buyers and sellers, therefore traded less, is known as illiquid. The prices of illiquid products are more likely to jump around as there isn’t enough ‘flow’ in the market to support smooth pricing.
How does liquidity affect you? Products that are more ‘liquid’ tend to come with smaller spreads, i.e. smaller charge to trade. This is because the high turnover of trading in the product makes it possible for banks and brokers to lower costs. For example, Euro against US dollar (EUR/USD) is the most traded currency pair in the world and comes with the tightest spread whereas US Dollar versus the South African Rand (USD/ZAR) is less liquid and therefore has a higher spread.
Now that you learned about some basic definitions, let’s talk about some risk management tools.