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Types of Financial Instruments
"Don't put your eggs in one basket" is fine —but which financial instruments are there?
Published May 21, 2024.
In the world of stocks, bonds, CFDs and other investment vehicles, diversification could help in achieving long-term portfolio objectives and managing risks.
When investors are diversifying their trading accounts, financial instruments play a critical role. The widely accepted diversification approach is to use different types of financial instruments, instead of guessing that a single instrument might be potentially profitable.
Note: Fortrade offers the ability to trade the price changes of instruments with CFDs and NOT to buy/sell ownership of instruments themselves.
» Still wondering about long position vs. short position? Learn stock trading essentials.
Financial Instruments Overview
Exploring financial instruments boils down to evaluating four parameters:
- Liquidity
- Return
- Risk
- Time horizon
By knowing these attributes, you can make informed decisions, in line with your financial objectives. Diversification allows you to spread risk, combine various attributes, and optimize your overall account.
Securities
Securities are the most common financial instrument in the financial markets and represent ownership or debt in an instrument.
Stocks and bonds are primary examples of securities. The former represents ownership in a company, while the latter is a debt that a company or government owes to the bondholder.
1. CFDs
Contracts for differences (CFDs) are financial derivatives that let traders speculate on the price movements of various underlying instruments, such as stocks, commodities, indices, or currencies.
Always remember that with CFDs, you never own the underlying instrument that you are speculating on.
2. Stocks
Stocks represent ownership stakes in companies like Apple or Tesla Motors. A single unit of ownership in one company is called a share.
Stockholders or shareholders will usually receive voting rights and might receive monthly or quarterly dividends if the company distributes profits.
» Learn to calculate annual percentage yield
3. Bonds
Bonds are debt securities issued by governments, municipalities, or corporations to raise capital and fund expansion, infrastructure, or service debts.
The lender (bondholder) will receive regular interest payments on top of the principal upon maturity.
4. Mutual Funds
Mutual funds are professionally managed investment vehicles that pool money from various investors to buy a diversified portfolio of stocks, bonds, or other securities.
Mutual funds differ from exchange-traded funds (ETFs) because you cannot buy and sell shares (or units) of mutual funds throughout the trading session. Instead, you will obtain a stake at the start or at the end of a business day.
» Discover fundamentals of CFD trading (with examples)
Derivatives
Derivatives are the financial instruments that receive their value from underlying assets, whether stocks and bonds or commodities and interest rates. Other popular derivatives, such as options and futures contracts, are used for hedging and speculation.
» Here are our top 4 types of derivatives in Forex trading
5. Options
If you need to hedge or speculate, options might be a good idea. They are defined as financial derivatives that:
Options are defined as financial derivatives that extend to the holder the right (but not the obligation) to purchase (call option) or sell (put option) an underlying instrument at a specified price (strike price) on or before a predetermined date (expiration time).
6. Futures
If you have come across futures, you might be wondering what this exactly is.
Put simply, futures are contracts that require the buyer to buy or sell an underlying asset at a predetermined price and date in the future.
7. Swaps
Swaps are financial agreements between two parties to exchange a series of cash flows or liabilities. They primarily concern currency swaps, interest rate swaps, and credit default swaps.
» Speaking of informed decisions, here's how to use CFD analysis for even better trading decisions
Considering Possibilities for Diversification
The wide range of financial instruments provides several possibilities. At the same time, these financial instruments could potentially reduce the risk. Theoretically, you could make use of all the financial instruments around, from individual stocks to mutual funds.
Before that, the most important thing is to identify your long-term objectives and risk tolerance. This is necessary to not only construct a diverse investment portfolio but also help you build a balanced trading account.
» Struggling to keep up? Here's how to use an economic calendar
Broaden Your Investment Horizons
Diversification is critical to accomplishing two main feats: mitigating the inherent risk or improving profit potential.
There are many financial instruments available, and they go well beyond buying stocks and bonds in different sectors. Optimizing and diversifying your trading account is best done by first exploring the numerous possibilities of financial instruments.
