How to choose the right product
The complexities of trading
Another aspect to think about when choosing the right product is how complex it is. In other words, do you understand exactly how it works? If not, you might need to learn the ins and outs of the product before adding it to your strategy.
Think about buying shares in a listed company – it’s often regarded as market participation in its simplest form. There are several aspects that might influence which shares you purchase, including:
- Price charts and movements
- Historical and current financial data
- Relevant macro-economic events
- Any first-hand experience of the company’s product
Add currency conversions and the impact of interest rates to this list of considerations and suddenly a basic investment can start to look complex.
As soon as you step into the realm of speculative trading, the level of intricacy goes up a notch. By studying the drivers in any product or asset, you can better comprehend it.
Some assets, like cryptos, are appealing precisely because they seem simple. However, the extreme volatility in this market adds complexity to these assets – not to mention the growing number of ‘alt coins’ and their different use cases.
Commodities can also appear to be valued according to supply and demand. However, neither of these are constant. Production can occur at different price points, constantly changing the equation.
Let’s look at what contributes to a product’s complexity and how that impacts the way you trade.
Price
Historical and live charts like these track price movements.
Price is usually the first thing that comes to mind when you choose a product.
You can usually find a trade’s pricing and cost information on your deal ticket before you take a position.
Assets like shares are listed on an exchange, so you can look up their prices and get historic charts. However, pricing isn’t always straightforward.
Some prices aren’t easy to get a handle on. Rhodium is a small part of the platinum group metals (PGMs) along with its better-known counterparts, platinum and palladium. Trading rhodium may be more difficult than other commodities because you might battle to get a live price for it.
Occasionally, there’s more than one source for the price of an asset. West Texas Intermediate (WTI) and Brent are different types of crude oil and therefore trade at different prices. If you plan to trade on this market, you need to make sure you know which price to reference.
Other markets with complex pricing include bulk commodities and cryptocurrencies. If you choose to trade an asset that falls into either of these categories, it may be worth your while to look into how its price is sourced and structured by your provider.
News and events
Another element that may contribute to the complexity of your trading and investing is the news. Economic data releases and breaking headlines often contribute to volatility in specific markets affected by the event.
This can add complexity to your trade as you’ll need to monitor not only the relevant price chart but also any economic events that might cause the price to fluctuate.
In some cases, a release about one market can affect another. For example, a US tech company could report positive earnings but still depreciate because the overall industry is suffering severe losses, affecting sentiment in tech stocks.
But what if you’re trading a foreign exchange (FX) pair like USD/GBP? Currencies can see increased volatility because of interest rate announcements, employment data releases and economic growth statements.
To stay on top of this, you can keep an eye on economic calendars and business news sites. Your chosen trading platform may also provide you with a live data feed where you can select your preferred sources, but you might need to pay extra for this service.
Did you know?
‘Trading the news’ is a strategy used to take advantage of increased volatility in markets caused by relevant events and economic data releases.
This strategy is best suited to short-term positions as the outlook for the market can change rapidly, especially if the shared results are unexpectedly high or low.
While trading the news doesn’t require you to have advanced technical analysis skills, it may not be the best way forward if you’re new to trading.
The news is unpredictable and the resulting price fluctuations can be brief, increasing your risk. There’s also no guarantee that the market will shift in the way suggested by an announcement.
Before you choose which asset to trade, you may want to add which economic events might affect it to your research process as well as when those announcements are scheduled to take place.
Remember, you can’t prepare for everything. Things like natural disasters and war can’t be predicted or prepared for and will likely affect your open positions.
Derivatives
Trading derivative products amplifies the complexity inherent in the market. This is because they derive their price from an underlying asset using different methods.
With products like spread bets and CFDs, the price tries to mirror that of the underlying asset. Here, the reason for any difference between the asset price and the cost of trading it is due to the fees involved with opening a position.
However, once we enter the realm of options, it gets trickier. They use complex mathematical formulas to determine the price of a single contract. Many of the inputs for the formula – like the risk-free rate, volatility and assumed dividend – are hard to determine.
Did you know?
The risk-free rate represents how much interest you could expect to receive from an investment if there was no risk involved.
This number is theoretical as there’s always some risk involved in any investment.
To calculate your risk-free rate, you can subtract the inflation rate from the yield of a Treasury bond that matches your investment’s period.
The latter is a type of debt-based investment product issued by the government. In essence, you loan them money in exchange for interest and the promise of your initial investment back when it matures.
Futures also use a derived price but with a simpler calculation than options. Like other derivatives, these instruments closely follow the underlying market.
There’s also another layer that makes these products riskier and more sophisticated: leverage.
Leverage
As explained in the previous lesson, leverage requires a relatively small outlay, increasing the exposure to a market, which amplifies the potential profit or loss in a trade.
If a market is volatile, your position’s value can change rapidly. That speed means you might need to monitor it closely and act quickly – or have other risk management strategies in place.
Online trading providers typically give you access to several different tools to help you manage your risk. Remember, you could have conditional orders, such as a stop loss, in your provider’s system to act for you when you're away from your screen.
If you choose to use a stop loss, you’ll need to know where exactly you want to exit the trade to minimise your loss if the market moves against you. Remember, if you’d prefer to avoid slippage as well, you can use guaranteed stops, but they’ll cost you if the stop is triggered.
This may seem like a simple fix, but if your losing trade triggers your stop order and then the markets recover and move in your favour again, you won’t benefit from this. Your position will already be closed and your loss, which might’ve been reversed, will stay.
How an instrument’s complexity affects you
As a trader or investor, deciding how much complexity you’re comfortable with is part of your journey. Remember, you can always build on to your knowledge, experience and confidence over time, gradually adding more complex instruments to your portfolio.
While trading leveraged derivatives can amplify your returns over time, some successful market participants only buy and sell shares and can still make a profit.
If you’re just setting off on your trading adventure, you may prefer the latter.
Did you know?
Have you ever thought that a car with built-in gadgets and add-ons was automatically better than any other? This phenomenon is called complexity bias.
It’s when we place our preference on complexity over simplicity, even though it’s not necessarily better.
To battle the bias, try focusing on what you need a product to do and if you know enough about it to achieve that aim. Often, a more basic solution is easier to manage and can be effective for you.
On the other hand, it’s possible to become an expert in pretty much any product, regardless of its complexity. The internet is full of videos, articles and other information that can help you understand how a product works or where to find a broker that offers it.
Homework
Want to get a sense of how different products work and how you can add them to your overall portfolio? Try implementing a risk-scoring system based on how complex different products are.
Each product can be rated with a general risk level, ranging from low to high.
Start at the low end of the range and slowly work your way down the list. Tally how many products of each type you plan to use and compare them to your risk profile.
If you’re more risk averse, your product choices will likely fall into the lower risk categories.
The goal is to match the complexity of your portfolio to your risk appetite, so if it doesn’t, you might need to reassess your strategy.
Remember, the core risk associated with each product isn’t the only one that you’ll need to consider.
A complex portfolio might give you more ways to access the markets, but it'll take more time to manage and might carry a higher level of risk.
Product type |
Core risk |
Risk level based on complexity |
|---|---|---|
Passive investment products like managed portfolios |
The combined assets within an investment portfolio can underperform or lose value over time |
Low |
Company stocks and ETFs |
These can decline in value over time, and companies can be liquidated |
Moderate |
Exchange-traded derivatives like turbos, covered warrants and constant leverage certificates that have built-in risk-management mechanisms |
If the markets move against you and you keep your position open, you can lose your entire initial investment |
Moderately high |
Over-the-counter leveraged derivatives like spread bets, options and CFDs |
If the markets move against you and you keep your position open, you could lose more than your initial investment |
High |
Cash cryptos |
These markets can become illiquid at any time should demand disappear because they’re not regulated by any authority |
Very high |
Lesson summary
- When choosing a market to trade (and which product to use) you’ll need to consider how well you understand it
- There are several factors that may affect the complexity of your trade, including pricing, the structure of the product and the use of leverage
- It might be useful to monitor relevant news reports and economic events as they can affect your chosen market’s volatility
- If you’re new to trading, it might be preferable to choose simpler products, like an investment portfolio, and build your confidence first
- A more complex portfolio means you could be taking on more risk and could require more of your time and attention
© 2003-2024
