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Behind the Trade

Excerpt from The Essentials of Trading

OK. So we’ve done a trade, but what does that mean? The financial markets bring together buyers and sellers. Some transactions are very straightforward, as in the stock market. The buyer pays the seller money and receives shares in return. Even when using leverage and margin, the basics of the transaction remain very simple. This is not always the case.

The stock market is what can be referred to as a cash market. That means the buyer gives the seller cash now to receive an asset immediately. It may take a period of time for the actual exchange of the assets to take place (three days in the U. S. stock market), which is referred to as settlement, but the buyer is considered to have taken ownership at the time of the trade.

The forward market is a kind of deferred cash market in that the traders agree to exchange assets at some future time, generally with a set of specific terms (price, date, transaction size, asset quality). An example could be a gold transaction. The agreement could be that Trader A commits to buy 100 ounces of certified gold bullion from Trader B at a price of $400/oz for delivery in three months. Note that when the agreement is made, no exchange of assets takes place. Trader A does not own the gold yet. That will not happen for three months when he gives Trader B $40,000 and takes delivery.

The buyer of stock is considered to be long because ownership generates benefits through price appreciation. When entering in to a forward or futures trade, however, no asset changes hands until some future time. Even so, the party who agrees to be the buyer takes on a long position. In the above example, Trader A will be the buyer. He is therefore considered to be long due to the fact that he will benefit from a rise in the price of gold. If gold were to rise to $410 by the time he has to buy those 100 ounces from Trader B, he could take possession and immediately turn around and sell for a $1000 profit ( 100 x $10 ). Trader B, on the other hand, would be short. Were gold to fall in price to $380, she would benefit in that she could buy the gold in the market and turn right around to deliver it to Trader A under the contract terms and make $2000 ( 100 x $20 ).

In most cases (all for the individual trader) forward/futures agreements require margin. This is to protect the counter-party against default of the agreement (for futures the exchange is the counter-party)

The options market differs from the forward/futures market in one very meaningful way. Like a forward contract, an option is an agreement to exchange assets at some future time. The difference, however, is that in options one of the parties – the buyer of the option – does not have to fulfill the contract – hence the “option”. The option market, however, is a cash market in its own right. Options are bought and sold in the same manner as stocks, with the buyer paying the seller for the right to conclude a future transaction or force the seller in to a future agreement (forward/futures for example).

Excerpted from <>The Essentials of Trading