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Financial Instruments to Trade – Day Trading Lingo of the Day

What do the world of music and the world of day trading have in common (besides relentless practice and repetition needed to succeed in both)?

Instruments!

We all know what musical instruments are all about. So what in the world are instruments in the trading circles?

That’s what I want to discuss in this post as well as:

  • what financial instruments are 
  • what are the common financial instruments out there 
  • the importance of understanding financial instruments for traders

Understanding financial instruments is another piece of the puzzle for day traders trying to make sense of the many trading terms and concepts. It is important to know about and understand (which is why I wrote this post) but even more important for a trader is to have a strong foundation in the fundamentals of day trading principals and financial markets. 

This foundational knowledge is the ‘golden thread’ that ties everything together for you in trading – no matter what asset class or strategy.

But back to the focus of this post which is financial instruments and what they mean for day traders.

What are Financial Instruments?

Financial instruments are tradable assets that represent a financial agreement between two parties. These instruments can be used to raise capital, transfer risk, or provide investment opportunities. 

Examples of financial instruments include stocks, bonds, derivatives, commodities, currencies, and options.

The term “financial instruments” originated from the world of finance and economics to categorize various types of assets based on their characteristics and functions. 

It encompasses a wide range of assets that have different risk profiles, returns, and liquidity. Financial instruments play a crucial role in the global economy by facilitating capital formation, investment activities, and risk management for individuals, businesses, and governments.

Financial instruments are tradable assets that represent a financial agreement between two parties.
Financial instruments are tradable assets that represent a financial agreement between two parties.

Types of Financial Instruments to Trade 

When it comes to day trading, there are tons of different things you can trade, and they are called instruments. For example, my instrument of choice to trade is the ES Mini Futures (which is the S&P 500 index).

Indices are another commonly traded financial instrument i.e Russell 2000, Dow, S&P 500, NASDAQ.

All these are instruments that can be traded individually. Just like in music, you have different instruments to play on.

The truth is there are quite a lot of financial instruments each that cater for different investment objectives and market participants.

Below are some of the more common financial instruments out there. But these are just a few examples as the world of financial instruments is vast and very diverse.

Common examples of financial instruments

Stocks (Equities): Represent ownership in a company and entitle the holder to a share of the company’s profits and voting rights at shareholder meetings.

Bonds: Debt securities issued by governments, municipalities, or corporations to raise capital. Bondholders receive periodic interest payments (coupon payments) and repayment of the principal amount at maturity.

Stocks are financial instruments that represent ownership in a company and entitle the holder to a share of the company's profits and voting rights at shareholder meetings.
Stocks are financial instruments that represent ownership in a company and entitle the holder to a share of the company’s profits and voting rights at shareholder meetings.

Derivatives: Financial contracts whose value is derived from an underlying asset, index, or reference rate. Examples include futures contracts, options, swaps, and forwards. Derivatives are often used for hedging risks, speculation, or gaining exposure to specific assets or markets.

Mutual Funds: Investment funds that pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other securities. Investors own shares in the mutual fund, and the fund is managed by professional portfolio managers.

Exchange-Traded Funds (ETFs): Similar to mutual funds, ETFs also pool money from investors to invest in a diversified portfolio of assets. However, ETFs are traded on stock exchanges like individual stocks, providing liquidity and flexibility to investors.

Options: Contracts that give the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specified price (strike price) within a certain time period.

Futures Contracts: Agreements to buy or sell a standardized quantity of an underlying asset at a predetermined price on a future date. Futures contracts are commonly used in commodities trading and can also involve financial instruments such as stock indexes and interest rates.

Foreign Exchange (Forex) Instruments: Involve the trading of currencies in the foreign exchange market. Forex instruments include currency pairs such as EUR/USD (Euro/US Dollar), GBP/JPY (British Pound/Japanese Yen), and USD/JPY (US Dollar/Japanese Yen).

Commodities: Include futures contracts on commodities like gold, oil, agricultural products, and more. Day traders in commodities leverage futures and options for speculative trading, hedging against price risks, and capitalizing on supply-demand dynamics.

My financial instrument of choice to trade is the ES Mini Futures (which is the S&P 500 index).
My financial instrument of choice to trade is the ES Mini Futures (which is the S&P 500 index).

Importance of Understanding Financial Instruments for Day Trading

For day traders, having a solid understanding of financial instruments is crucial for several reasons. 

Firstly, it allows traders to identify and capitalize on short-term trading opportunities across different asset classes. 

By understanding the characteristics, risks, and potential rewards of various instruments, day traders can develop informed trading strategies tailored to their goals and risk tolerance.

Also, understanding financial instruments helps day traders to interpret market trends, assess market liquidity, and implement risk management strategies such as stop-loss orders and position sizing. 

Having a good understanding of financial instruments empowers us as day traders to make well-informed trading decisions and adapt to changing market conditions swiftly.

Related Read: Day Trading Terms And Definitions 

3 Key Reasons Why Understanding financial instruments is important for Trading

i) Diversification Benefits Across Different Asset Classes

One key advantage of leveraging financial instruments in day trading is the ability to diversify across various asset classes. By trading different types of instruments such as stocks, bonds, currencies, and commodities, traders can spread their risk and reduce exposure to any single asset or market sector.

Diversification helps mitigate the impact of market volatility and specific asset movements, leading to a more balanced and resilient trading portfolio.

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ii) Tailoring Trading Strategies Based on the Characteristics of Financial Instruments

Each financial instrument has its own unique characteristics, including volatility, liquidity, trading hours, and risk-reward profiles. Day traders can tailor their trading strategies based on these characteristics to optimize their performance. 

For instance, highly liquid instruments like major currency pairs in Forex or actively traded stocks may be suitable for rapid scalping strategies, while less liquid instruments might require longer-term positional trading approaches. 

Understanding these nuances allows day traders to align their strategies with the specific features of each instrument, enhancing their chances of success.

iii) Understanding Risk and Reward Dynamics in Day Trading with Various Instruments

Effective risk management is paramount in day trading, and different financial instruments present varying risk and reward dynamics. Day traders need to assess factors such as volatility, leverage, margin requirements, and market conditions when trading different instruments. 

High-volatility instruments may offer greater profit potential but also come with increased risk, requiring disciplined risk management practices such as setting stop-loss orders and managing position sizes. Conversely, more stable instruments may provide lower returns but with reduced risk exposure.

Understanding Financial Instruments for Day Traders

After reading through this post I hope you have a better understanding of what financial instruments are and why they are important to know about and understand as day traders.

We have looked at the most common financial instruments out there that we should know about as day traders even if we don’t plan on trading them.

And we have also explained the importance of understanding financial instruments as day traders including how this can help us diversify our use of financial instruments, our trading strategies and risk and reward.

There are still many concepts and day trading that need to be understood but taking it one step at a time is the best way to learn these concepts and applying them to trading is best done through simplifying day trading strategies, technical analysis and indicators to become a more consistent and profitable trader over time.

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If you want to learn more about my journey and how I started day trading or you can watch on my YouTube channel.

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