Derivatives of the Forex trading system are spot trading,
futures trading, forwards trading, options trading and swap
trades. Many inexperienced Forex traders tend to focus on
spot trading. Spot transactions are over-the-counter
transactions, handled outside of an organized exchange.
Spot Trading - Spot trading in the Forex trading system is
what is termed Forex. A Forex currency trade is a simple
simultaneous transaction that involves the exchange of one
currency for another. Forex currency trades may be settled
within 2 days, except in Canada where exchanges may be
settled within one-day.
There are two parties and two positions with any trade. The
party who delivers a commodity holds a short position. The
party who receives the delivered commodity holds a long
position. In other words, the seller holds the short
position and the buyer holds the long position. There are
no restrictions and limitations in Forex spot trading as
long as there are parties willing to a trade and liquidity
in the currencies being traded. Spot trades incur a
transaction charge per trade called a margin or spread. A
margin is calculated as the difference between the current
bid price and the asking price.
Forwards Trading - A forwards trade is a trade in which the
traded commodity has a date of delivery some time in the
future. Typically, a forward contract may have a date of
delivery one, two, three, six or twelve months into the
future. Traders use forwards to take advantage of interest
rate differences between countries and this difference is
usually factored into the cost of a forwards trade. The
value of a forward is determined by the difference in
interest rates offered by the countries whose currency is
involved in the trade. The cost of a forward may be higher
or lower than the current spot price of a currency. When a
higher price is charged for a forward, it is called a
premium while a lower price is a discount.
Futures Trading - A futures trade is similar to a forward
trade where a buyer and seller trade currencies for a
predetermined price, at some time in the future. The
difference between a futures and forward trade is that
futures are traded on a regulated exchange and forwards are
not. Futures trades incur round-turn commissions that are
generally higher than the margins required for spot
trading. You must make a deposit on futures to serve as a
margin or bond for the trade. If market events indicate
that a currency will increase in value over the term of a
future, a lower price will have more worth when it is
traded. The difference between the price for a future and
the market price of currency is added or subtracted from
the margin value. You must replenish any loss in margin in
order to continue to hold a position in the trade.
Options Trading - Options are a form of currency trading
where you are given the option to buy a specific amount of
currency before a specified date. Options differ form
forwards and futures because options give you the right to
buy or not buy. Generally, traders will seek options when
there is an indication of stability in currency exchange
rates while speculators may assume the risk in hopes of
making a profit. As a buyer, you are required to pay a
premium for options and that premium is forfeited if you
fail to exercise the option. Premium prices are established
based upon how likely the market perceives that the option
will be exercised. Premiums may be calculated as the
difference between the current spot price and a future
strike price or they may be involve more complex
calculations, based on market conditions and the timeframe
before the expiry date.
Options include both a call and a put. The right to buy
currency is a call option while the right to sell currency
is put option. The option to buy US dollars and sell
Japanese yen, for example, is a yen call and dollar put.
The price that the buyer agrees to pay is called the strike
price or exercise price and the amount of currency that may
be bought or sold is called the principal. Options may be
purchased on an exchange or over-the-counter and then
bought and resold. US style options are purchased on an
exchange and have a strike price, expiry date and contract
size. Options bought over-the-counter are bought in
interbank. Options offered in the interbank market are
usually European style options where the terms of the
contract are negotiated between the seller and buyer.
Swaps - A swap is a combination of a spot and forwards
trade. A swap involves the trade of currency on a specified
date and an agreement to trade it back at a later date. A
swap provides you with an alternative to borrowing foreign
currency. If you need liquidity in a currency, you may swap
for the needed currency. This involves a spot transaction
to initiate a trade and a forward transaction to buy back
the currency in the future. Large banks and corporations
tend to favor swaps. Individual investors rarely engage in
swaps.
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Andrew Daigle is the creator and author of many successful
websites including ForexBoost at http://www.ForexBoost.com
and http://forex-trading-system.typepad.com , Free Forex
Training Resource for the Novice and Advanced Forex trader.
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