How do financial markets work?

The five important elements to understand how financial markets work are market structure, market participants, liquidity, pricing and the spread.

Market Structure

Financial markets are typically sub-divided into various categories based on the kind of instrument that is being traded. Futures markets, for example, started as a place to trade commodities like oil, metals and agriculture but now include stock indices like the Dow Jones Industrial Average, FTSE 100 and DAX.

The foreign exchange market, the largest and most liquid in the world, is where investors trade global currencies and is open for trading 24 hours per day, 5 days per week. Finally, through equity and debt markets, investors can trade assets including individual company shares, options and government bonds.

Market Participants

The financial markets consist of various participants including governments and central banks, major global banks, hedge funds and retail traders, each of which has a different motive for trading. These motives can range from speculation on the markets to hedging business risk. For example, the corporate treasurer at a global company might be hedging currency exposure on foreign transactions, like the acquisition of equipment or a sale to an overseas customer. A central bank, meanwhile, may be purchasing a currency to top up its reserves.

Professional market participants are typically split into the ‘buy side’ and ‘sell side’. The buy side is made up of hedge funds and pension funds. Their goal is to make a return for their investors and partners by investing funds in the market. The supply side is dominated by the major global banks, whose job is to facilitate the trading of investors.

Retail traders are typically non-professionals who are trading with their own capital in order to make a return on their investment. They gain access to the market through online brokers and may trade full-time or part-time to supplement their main income.

Liquidity and Pricing

Market liquidity is directly correlated to the volume of trades taking place at any given time. High liquidity means that an investor can place their trade easily at the desired price and indicates there is a high number of matching trades to be paired with. Low liquidity, meanwhile, means that trading volume is low and it will be difficult to match an investor’s transaction with that of another.

Spread

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