A Bit Of History
The first Stock Exchange based on modern principles was established in Holland during that country’s booming trading era in the 17th Century. But soon afterwards, in London, shares were traded in two coffee houses – including shares in the infamous East India Company, which was formed in 1688 with a view to undertaking projects ‘as yet undecided’. No wonder the share price languished until it was ‘pumped’ by operators, who promised untold riches to a naive public (sound familiar?). The share price reached over £1,000 (a massive sum then) and then crashed when it was realised there were no profits.
As in most bubbles, the share price crashed by about 90% from high to low, and many investors were wiped out (Isaac Newton, the scientist, was one of them).
Today, the vast majority of financial markets are traded electronically, the main exceptions are in the USA, where in Chicago, agricultural commodities are still traded by open outcry. Here, traders stand in pits (large, round steps) and often scream bids and offers with hand signals, with prices being recorded by observers who are suspended above the pits watching the action. At times, it seems very chaotic, and it is, but trading does take place and prices do reflect the actual flows of trading.
The electronic markets are now open almost 24/7 and turnover in the major markets has exploded over the past 20 years. For us, the important point is that we are all able to participate in these markets either through brokerage accounts, or direct purchase of shares and debt instruments.
We will concentrate on trading the major (very high volume) markets with a wide public participation (this is because they give us the most reliable signals and where government agencies and other large players generally have minor direct impact).
The main markets we are concerned with are:
- Stock Indices, such as the Dow Jones Industrials, the S&P 500 (usually the emini version, since the full S&P future is very large), the NASDAQ, the FTSE 100.
- Fixed Interest Instruments, such as the US Treasuries (10-year and 30-year), the UK Gilts
- Currencies, such as the Euro/US Dollar, and the British Pound/US Dollar (sometimes called “cable” for historical reasons)
- Commodities, such as Gold and Crude Oil
- Blue Chip Shares (like those stocks in the FTSE 100)
So what is actually traded in the financial markets? Let’s take a look at one: the Dow Jones Industrials (one of my favourites for trading).
To a large extent, all financial markets are trading intangibles. They are derivatives of a physical product. Take the Dow Jones Industrial Index (the Dow).
The venerable Dow Jones Transportation Index is the oldest surviving share index, having started life in 1884 (this was the era of the railroad in the booming USA).. Charles Dow was the figure who recognised the need for an overall market index of leading shares. Individual shares of the index would go up, down, or sideways, but the overall average would give a broad indication of the ‘mood’ of the market.
Later, in 1896, Dow saw a need for an index of shares for the growing industrial corporations, and composed an index of the 12 largest companies by simply adding up the share values and averaging. Over the years, the index was expanded to 30 of the biggest capitalisation shares in the USA. Even today, the Dow is a superb indicator of market movements, despite the small number of constituents.
Futures Markets – What Are They?
Because it was recognised that there was a need for a mechanism to determine the value of the index in the future (as firms needed to hedge their portfolios), a ‘futures market’ opened up. Today, the futures markets are among the biggest in the world. For instance, the US Interest Rate futures market at the CBOT handles face value of over $600 Billion per day.
The modern futures market was launched in Chicago in the agricultural markets, where farmers and end-users needed to agree prices at and after harvest-time – often months ahead. To provide vital liquidity (trading volume), private speculators were allowed to participate (hence the term ‘public markets’). At the end, though, there was a real physical product (corn, or wheat) which changed hands on settlement day. One key feature we take for granted is that the price history is openly available to the public at all times.
So the futures market is simply a market where you can trade the underlying product for settlement months ahead. Because most traders will not want delivery or make delivery, most trades are closed out before settlement day. And because no exchange of the physical product takes place, only a ‘contract’ to do so in the future, only a small deposit (the ‘margin’) is required by both buyer and seller to be made to the Exchange clearing house to guarantee performance by both parties (this is all handled today by your broker, or spread betting firm).
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