Home Finance Risky Financial Market Instruments That Beginners Must Avoid

Risky Financial Market Instruments That Beginners Must Avoid

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Financial instruments are contracts with monetary values that can be purchased, created and traded. They include equity or shares, fixed income such as bonds and treasury bills, derivatives such as CFDs, futures and options etc.

These financial instruments have different risk exposure and your broker is expected to offer suitable products to you depending on you level of knowledge.

If you jump into complex financial instruments for the fun of it or due to greed, it will likely leave you with huge losses.

Binary Options

It is important to first know that Binary options are banned in the UK, so any brokers promoting it are illegal & must be avoided. But we will explain more so you can understand the risks involved.

A binary option is a speculative contract with a fixed payout in which you predict the outcome from two possible options: yes or no. If you are right with your prediction, you will receive the agreed payout but if you are wrong, you will lose your initial stake.

The duration of trades can be as short as 10 seconds, and you choose the payout you want to earn if your bet is right. Binary options don’t use leverage, so you have to bet with money you have and this encourages gambling.

Brokers can also manipulate binary option outcomes in their favour. When there is a possibility that you might win a bet, the cost of the option becomes very high such that when subtracted from your winning, you are left with almost nothing. However, when chances of winning are slim, the cost of the binary option is made cheap so that you keep trying.

In April 2019, the Financial Conduct Authority (FCA) banned the sales, marketing and distribution of binary options by brokers to retail consumers in the United Kingdom. This ban is expected to save retail consumers from losses of about £17million yearly.

However, there are still some offshore brokers that are promoting it illegally & you should avoid these brokers & report them to the regulator.

Leveraged Spread Betting

Spread betting is a derivative financial instrument which you can use to speculate on the financial market without taking ownership of the underlying asset. Spread betting involves the use of leverage or borrowed funds from your broker, and you can bet on asset classes like currencies, stock, indices or commodities.

In the UK, spread betting is tax free and this has attracted many people to it and unlike binary options, spread betting is not banned in the UK, but the FCA often showcase how risky it could be for retail customers.

In spread betting, you will be speculating whether the price will rise or fall. The key takeaway about spread betting is that the broker charges you a spread, and you also bet a particular amount of money on each pip move.

This means for EUR/USD, if you bet $10 on each pip move and the exchange rate falls from 1.0002 to 1.0000 which is a 2pip move, you have lost $20. The further the exchange rate drops the more your loss increases till you close your position.

It’s also important to note that in spread betting, when you keep positions open overnight, you pay margin interest on the loan from your broker, and this can erode your profits if it accumulates.

The use of leverage will expose you to enormous risks as you can lose more than what you deposited. The FCA has taken steps to reduce losses due to leverage by restricting the leverage brokers can offer to 1:30 max.

Following its bankruptcy in 2012, the FCA publicly censured the CEO of World spread bets a UK based financial spread-betting firm, for falsifying data about its liabilities and cash holdings. By the time the bubble burst 15.9 million of client funds were compromised.

Without proper regulation, spread betting can be prone to fraud. There are a few spread betting brokers in the UK are considered trustworthy to manage client funds based on factors like regulation, fees, ease of withdrawals has shown.

The case of World spread bets highlights the importance of trading with an FCA licensed spread betting broker as they are now required to abide by the 1:30 leverage cap to help you manage your risk when you bet. If the broker should become insolvent the FCA will get involved to ensure you get your money back. You should avoid unregistered spread betting firms as you could lose your funds.

High Yield Corporate Bonds

A high-yield corporate bond is a debt security issued by private companies with a low credit rating. They often offer high interest rates because of their high risk of default.  A high-risk bond is also known as a ‘Junk Bond’.

Bonds are rated by independent credit rating firms such as Moody, Standard and Poor, and Fitch. These ratings are done according to their risk of default.

Most high-yield bonds carry a rating of B1, B2, B3, B- or CCC. Any rating of D means the bond is already in default.

Although high-yield bonds are not out rightly bad, they are however associated with huge risks since their defaulting rates are high. Hence, they might not be suitable for beginner investors.

Risk of Penny Stocks

Penny stock is another type of high risk security because of its small market capitalization. They are sold at a very low price and they are often traded over the counter, on pink sheets and on small exchanges. In the UK, these stocks are traded for less than £1 in with a market capitalization of less than £300 million.

The general sentiment behind penny stock is that the price will rise over time. A hope of buying the next Amazon or the next Tesla. Most times, this is however not the case as they remain worthless.

Penny stocks often have limited information about the company which can help you to make an informed decision. Critical information such as balance sheets, are either not available to the public or not well detailed for public scrutiny. In some cases, they can be doctored to mislead the public.

Furthermore, penny stocks are highly speculative and sensitive to market news which makes them very volatile. They also do not have enough liquidity which can make them difficult to sell for cash. This may force you to lower your selling price to attract a buyer.

Penny stocks are also prone to price manipulation. They can easily be used for pump and dump schemes which may cost you further loss.

Futures Contracts

A futures contract is one that allows you buy or sell a specific quantity of an underlying asset, at an agreed price but at a future date.  At expiration, your future contract can be settled in cash or through physical delivery of the underlying asset. 

Future contracts also allow you to use leverage so you just pay a fraction of the total cost while your broker lend you the balance.

If you believe that the value of oil will drop three weeks from now, you can enter a future contract to sell your desired quantity of oil at today’s price in three weeks. 

However, you should know that trading futures can be dangerous.

Futures have more complex contract specifications compared to trading shares. There are different contract specifications when you trade futures. For instance, one crude oil futures represents 1,000 barrels of oil.

Here are some things to note about futures:

  • Multiplier: what each futures contract represents
  • Tick size: the decimals at which the futures prices changes. If the price is $54 and tick size is 0.01, then the price will in sequence of $54.01, $54.02, $54.03 etc.
  • Tick value: tick size x multiplier. It shows you how much you gain or lose with each price/tick movement
  • Mark to market: this will compel you to make daily payments for any change in price in the underlying asset till you close your position. This is a sort of security in case you choose to default.

 An example of crude oil futures will be as follows:

Product Name Size of One Contract (multiplier) Tick Size Tick value(Loss or Gain per pip movement)
Crude Oil futures 1,000 barrels of oil 0.01 $10

If the current price of a barrel of Crude Oil  is $54, and one futures  contract represents  1,000 barrels, the market value would be $54×1000 = $54,000

If the price drops to $53.60. Your loss per contract will be $54 – $53.60 = – $0.40

This means that your contract has moved by $0.40/0.01 = 40 ticks.

The total loss in dollars will be 40 ticks × $10 = -$400. (Do not forget that your loss or gain is $10 per tick as stated in the table above).

With a small tick move you have lost $400 and this is why futures are very risky for beginners.

Conclusion

Trading profitably takes time & experience. It requires you to build your skills and gain enough experience. 

It is better if you do not rush yourself to trade financial instruments you are not well familiar with. Such can only lead you to loss. Move slowly and steadily. And never forget that experience is the best teacher.