How does trading work?

As a trader, you'll come into contact with various individuals and bodies, and in some cases need their services to gain access to the markets.

Retail traders

The terms 'retail trader' or 'retail investor' generally mean a private individual who buys and sells financial instruments using a personal account, not on behalf of an organisation. So that will probably be you.


Trader work place

Retail traders generally deal in relatively small sizes, often in their spare time.

However, some become semi-professional and use sophisticated technology and techniques from the comfort of their own homes.


As a retail trader you have access to an incredible range of financial markets, and can trade them in multiple ways to suit your preferences.


Let's say you decide to buy some shares. Would you be hoping to see long-term growth, accepting that the shares' value may fluctuate in the meantime? Or would you be hoping for a fast profit from short-term price movements, regardless of longer-term trends?


If you're looking for long-term growth, you're more of an 'investor', but if a fast profit is your goal you can call yourself a 'trader'. Investors are interested in overall price trends and the fundamental value of the assets they trade. Traders generally prefer to capitalise on volatility and the market reactions triggered by news events.


Brokers

As a retail trader, unfortunately you can't just stroll into your local stock exchange and start dealing in shares.


To buy or sell in the stock market, and other financial markets, you'll generally need an authorised intermediary or broker to act on your behalf. You may be picturing a bowler-hatted City gentleman, but in fact it's more likely to be a company that provides an online trading platform.


Broker

A broker can be either a firm or an individual, and might offer:


Full service – actively managing your investments and providing personal advice

Advisory management – providing recommendations but leaving the final decision to you

Execution-only dealing – simply carrying out your instructions to trade, on demand

Of course, the greater the input you want from your broker, the higher the fee you'll need to pay.

As well as representing you and executing your trades, some brokers also separately buy and sell on their own account. A broker who does this is known as a broker-dealer.


Trading on exchange versus OTC

Suppose you want to trade shares in a FTSE 100 plc. As the company is listed on a formal exchange, in this case the London Stock Exchange, you trade its shares 'on exchange' through your stockbroker.


An exchange has a central physical location – often in an iconic building – where brokers and dealers come together to buy and sell. Most market participants transact remotely and electronically, but some deals can be made in person by traders on the exchange's trading floor.


Traditionally, trading at exchanges was conducted using the open outcry method, in a part of the trading floor known as the pit.

Traders shouted buy and sell orders to each other or used coded hand signals. A contract was made when one trader called out that they would sell at a particular price, and another replied that they would buy at that price.

This method has largely been replaced by electronic trading systems, but is still used in a few exchanges such as the New York Mercantile Exchange and the London Metal Exchange.

Although electronic trading is faster and more efficient, some argue the open outcry system provides more opportunity for traders to get the best prices.

Market makers

Suppose you want to buy a particular financial instrument, but nobody is selling.


Fortunately this situation is unusual: there's generally a party who'll take the other side of your trade, and it's often a market maker - otherwise known as a liquidity provider.


Market makers help keep the markets moving smoothly.


A market maker is a firm or individual that holds an inventory of a particular security and quotes continuous prices to buyers and sellers.


So if you place an order that goes through a market maker, it either deals from its own holding or seeks another party's order to offset yours. This happens electronically, almost instantaneously.


Most market makers operate within exchanges, so your broker will transact with them on your behalf. The only market makers you're likely to deal with directly are forex trading firms, which offer clients the facility to buy or sell currencies OTC.


Institutional traders

Institutional investors or traders are organisations that deal in the financial markets, generally on a much larger scale than retail traders. As a retail trader, you may have little contact with these institutions, but it's useful to be aware of their activities.


Institutional traders manage pools of money on behalf of individual investors, and this means they sometimes make trades of a magnitude such that they influence market price movements, particularly in shares.


Institutional traders include:


Banks

Life assurance companies

Pension funds

Mutual funds

Hedge funds

The large size of these institutional traders' positions means that they can sometimes receive benefits such as reduced commission rates.


Did you know?

Typically institutions have a high level of trading expertise - but just occasionally this isn't the case.

In the 1990s, UK institutional investor Barings Bank employed the now infamous Nick Leeson as one of its traders in Singapore. Leeson amassed losses totalling £827 million through unauthorised speculation on the Japanese markets. He successfully concealed his fraud until the Kobe earthquake caused Asian markets to crash, and with them Leeson's trades. When his losses were revealed, they resulted in the bank's collapse.

High-frequency trading

The development of ever-more-sophisticated technology has given birth to a specialised kind of institutional trading: high-frequency trading (HFT).


HFT uses computers to automatically apply trading strategies and algorithms, finding and exploiting patterns, trends and tiny fluctuations in the market. Instead of employing teams of analysts and traders, an HFT firm relies on technology that can make multiple trading decisions in a fraction of the time it takes a human brain.


This means HFT firms can open and close positions in the space of seconds, milliseconds, or even microseconds. They make these ultra-short-term trades in immense volumes, often aiming to capture just a tiny profit on each one.


HFT

HFT traders are the polar opposite of the traditional long-term investor, as they never accumulate portfolios or hold positions overnight. Their bread and butter is momentary market changes, rather than steady growth.


HFT firms are so far removed from the world of retail traders that their activities have little significance for you. HFT is occasionally thought to contribute to general market volatility, and HFT firms can also benefit the market by acting as liquidity providers, but neither of these things will affect your trading decisions.

As the saying goes, 'it takes two sides to make a market'. The two sides concerned are:


Buyers, who usually believe an asset's value is likely to rise - known as 'bulls'

Sellers, who generally think an asset's value is set to fall - known as 'bears'

Bear and bull

The relationship between them powers the movements in market prices. Let's look at how that works.


Suppose you were buying a car – you'd look for the lowest price on the model you wanted. And if other buyers were thin on the ground you might strike a good deal. On the other hand, if you were trying to bag a rare and sought-after vehicle, you might have to pay the seller a high price.


In the same way, the balance of demand from buyers and supply from sellers influences prices in financial markets.

The spread

So why do different prices apply for buyers and sellers?


The gap between the bid and ask prices occurs because buyers and sellers often have contrasting views about the value of an asset:

The bid price is the highest price at which a buyer is prepared to buy

The ask price is the lowest price for which a seller is willing to sell

The difference between the two prices is known as the 'spread', and also as the 'bid-ask spread' or 'bid-offer spread'.


The spread may also incorporate a broker's fee for handling the trade. The broker quotes clients a price slightly lower than the fundamental bid price or slightly higher than the ask price, keeping the difference to cover its costs.

As a trader, you'll be looking to buy or sell at the narrowest possible spread – in other words, when the bid and ask prices are close together. Let's look at why:

As a trader, you'll be looking to buy or sell at the narrowest possible spread – in other words, when the bid and ask prices are close together. Let's look at why:


Spread example

Imagine you buy the asset shown in this diagram at an ask price of 1.2873.


If you were to sell again instantly, you'd do so at only 1.2872. This means you need the market to rise by one point (the size of the spread) just to break even on your trade.


If the bid price overtakes the price at which you bought, you're on the road to profit. In this example, the bid price rises from 1.2872 to 1.2875 (three points), so your gain is based on a two-point movement.

The tighter the bid-ask spread, the quicker you can profit if the market moves in your favour.


What affects the spread?

An asset's liquidity, or the ease with which it can be traded in the market, is the key factor that determines the spread.


In general, the higher the current volume of trades on an asset, the narrower the spread tends to be.


The reason is that if more traders want to buy and sell, more bids and asks are posted – increasing the likelihood that the lowest selling price and the highest buying price will converge.


Of course, the spread is also affected by the size of any dealing fees it includes. Fees generally rise when a market is illiquid, to compensate the market maker in case it can't immediately find a party to take the other side of your trade. That's another reason why liquid markets mean smaller spreads.

Prices in OTC markets

Lastly, it's worth noting that in OTC markets such as forex, where you don't have to deal through a centralised exchange, an array of different bid/ask prices are usually available for a given asset at any particular time.


You may have already noticed this when buying currency for foreign travel – different rates appear on the boards in various foreign exchange bureaux.


So if you wanted to trade GBP/USD, for example, you could shop around the different forex dealers to find the best quote for the pair. This is in contrast to trading an asset like an exchange-listed share, which is available at a uniform value – the only cost difference being in the various stockbrokers' own fees.

Most people think about trading in just one direction. They imagine buying an asset ('going long') before the price begins to rise. Then they imagine selling it just as it reaches its peak to reap a profit.


Going long and short

While this is an excellent goal for any trader to aim for, it's by no means the only potential way to capitalise on market movements.

Opportunities can also arise in markets that are heading for a downturn, and in this section we'll see how you can trade these by 'going short' or 'short selling'.


What is short selling?

When you go long, you open your trade by buying an asset whose value you expect to rise and close it by selling - hopefully for a higher price.


To go short, you do the opposite.


You sell to open a short trade and buy to close it.


So, if you believe an asset's price is set to fall, you might decide to sell it now in the hope of later buying it back at a lower price to make a profit.

Of course, you may logically assume that you first need to own the asset concerned in order to sell it. But in fact this isn't the case: it's possible to effectively borrow the asset so you can sell it short.

How does short selling work?

The easiest way to explain this is through an example.


Let's say that shares in XYZ plc are trading at 1000p. Jonathan decides to borrow 100 XYZ plc shares from his stockbroker to short-sell, as he believes the price will soon fall.


Jonathan's broker lends him the shares, borrowing them from its own inventory, another client's holdings, or perhaps another brokerage. It sells the shares for Jonathan and credits his account with the proceeds (£1000).


The XYZ plc share price then falls to 800p, and Jonathan decides to close (or 'cover') his trade. The broker therefore buys 100 shares for him, deducting the purchase cost of £800 from his account and returning the shares to their original owner.


This leaves Jonathan with a gross profit of £200 in his account. His broker will also charge commission for handling the transaction, the lender will require a borrowing fee, and there could be other costs for the trade.