Trading is great, but which financial instrument suits it best? That’s the big question.

Good news: we’re pretty good at solving dilemmas.

While no perfect instrument exists, each one has its own pros and cons.

Some are easy to use but come with liquidity issues, while others may not be regulated yet offer excellent diversification...

In short, there’s something for everyone.

What are we doing today? We’re ranking some of the most important financial instruments, from S (the highest grade) down to F (the lowest).

Which ones? Here’s the list:
-Stocks
-Forex and CFDs
-Futures
-ETFs

Ready to learn more?

Enjoy the video! 😉

Transcription

What instruments should we trade?

We’re always talking about trading, but the first question we need to ask is: what financial instrument should we trade?

In this video, we’re going to rank different instruments based on their trading potential, with a specific focus on systematic trading.

Here’s how it’ll work: we’ll look at the pros and cons of instruments like stocks, futures, CFDs, Forex, and ETFs, then rank them from “S,” the top tier, down to “F,” the lowest.

One of the coaches at Unger Academy here, and let’s kick off with the pros and cons of trading stocks.

Stocks: simple but inflexible

So, let’s look at the first big pro: they’re relatively simple to understand, especially compared to derivatives.

When we consider derivatives like futures, which involve expiry dates and rollovers, or options, with multiple strike prices and Greeks, stocks are definitely much simpler by comparison.

In fact, stocks are straightforward. When we buy a number of shares, our profit or loss depends on the stock’s price movement—plain and simple.

The second pro? Stocks have a long-term upward bias.

This is an advantage because simple strategies with just a few lines of code can generate profits by leveraging the market’s natural growth tendency over time.

For example, buying during oversold conditions and selling a few days later often yields good results.

This provides a solid foundation for developing a strategy.

The third pro: liquidity in certain stocks. Some stocks are highly liquid, enabling rapid trades with minimal slippage.

On these stocks, an average trade size of around 0.4-0.5% is achievable with simple ideas.

Now let’s look at the cons, starting with survivorship bias.

If you create strategies using only stocks that have survived over time, your results may appear overly optimistic.

For instance, building a strategy over 15 years on Tesla alone might show high returns, but it’s unlikely you’d have chosen Tesla 15 years ago without knowing its trajectory.

Next disadvantage: limited diversification.

Most stocks tend to move similarly, following that long-term upward trend, which makes diversification challenging.

Lastly, some stocks have low volatility, reducing trade opportunities.

Low-volatility stocks may require holding positions for several days to achieve an average trade value large enough to cover operational costs like slippage and commissions.

This isn’t ideal for those who prefer intraday trading. Stocks do offer good trading opportunities but aren’t necessarily the best option due to several significant drawbacks.

That’s why I’m placing them in Tier A.

Forex and CFDs: unregulated markets

Now, let’s examine Forex and CFDs, starting with a major con: these are over-the-counter markets.

This means that, unlike regulated markets like futures, they’re less transparent, often have wider spreads, and can sometimes entail trading against your broker.

On the plus side, Forex and CFDs have low barriers to entry, making them accessible to traders with limited capital.

In fact, many brokers allow small-scale investors to trade these markets.

That’s not the case with futures, where a minimum margin is required to hold a contract.

Another downside to Forex, in particular, is the limited edge available.

Given the market’s efficiency and competitiveness, classic approaches like trend-following or mean-reverting strategies are hard to apply.

It’s a challenging market for strategy development, often yielding unsatisfactory results.

On the other hand, Forex and CFDs allow for solid diversification.

With access to various global currencies and assets, CFDs offer a wide range of trading options.

For instance, you can find CFDs on stocks, indexes, commodities, and more, enhancing diversification potential.

Considering all the pros and cons, I’m debating between placing Forex and CFDs in Tier A or B.

I’m personally leaning towards Tier B—let me know if you’d rank them differently in the comments.

Futures: the special level!

Now, let’s look at futures’ pros and cons.

First, futures provide access to a wide variety of markets, including commodities, indexes, interest rates, and currencies, allowing for trading on non-correlated assets.

Stocks tend to move similarly, as we discussed earlier, but that’s not the case with futures. Futures enable portfolio diversification across decorrelated instruments.

Another benefit of futures is built-in leverage, allowing you to control a large position with a relatively small amount of capital.

In futures, you’re leveraging a substantial notional value by providing a margin, much smaller than the full position size, making it effective for capturing small movements in intraday strategies.

Futures markets are also regulated.

For example, the CME Exchange lists the e-Mini S&P 500, currencies, and more, ensuring better price transparency—unlike Forex.

As for downsides, futures require an understanding of contract dynamics, like expiry dates and rollovers.

Since contracts have expiry dates, you’ll need to manage rollovers, which involves selling and buying a new contract, adding to trading costs.

Another con is the double-edged nature of leverage. While it magnifies small gains, it also exposes you to potential significant losses.

Now, where do futures fit in our ranking?

Given that futures have fewer drawbacks compared to other instruments, I’m ranking them in Tier S.

For systematic trading, as we’ve seen, they offer substantial benefits.

ETFs: disadvantages in Europe

Lastly, let’s assess ETFs.

For these instruments, we need to make a distinction based on where we operate as retail traders.

If we’re in the U.S. or outside Europe, ETFs can be a compelling trading tool offering a good level of diversification. Instruments like SPY and QQQ, for instance, which track the S&P 500 and the Nasdaq, are highly liquid and also suitable for automated strategies.

Conversely, for traders based in a European country, ETFs present several drawbacks, primarily because of the need to use what are known as harmonized ETFs.

Due to recent regulations, non-harmonized ETFs like SPY and QQQ aren’t accessible to retail investors in Europe anymore.

So, as European retail investors, we’re limited to harmonized ETFs.

This isn’t necessarily a disadvantage on its own but leads to other drawbacks. Let’s look at a few of them.

First, liquidity. Harmonized ETFs can have lower liquidity, especially for less popular or sector-specific options.

If you want to track the S&P 500, for instance, you need a harmonized ETF, which might not match SPY’s liquidity, increasing trading costs and slippage.

Another con is fees.

Some brokers, like Interactive Brokers, charge higher fees on harmonized ETFs, making these instruments less cost-effective.

Where should ETFs rank?

Well, while they allow for a fair amount of diversification and work well on the long term, for many traders these instruments are unfortunately less tradable and have notable costs.

So, I would definitely place them toward the bottom of the ranking, let’s say Level E.We’ve covered an overview of some financial instruments available for trading.

Let us know your thoughts in the comments and if you would have ranked them differently.

See you in the next video!

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