For most traders, currency trading is all about spot forex and the MT4 or other trading platforms. Buying and selling, the trading strategies and economic data are what usually comes to mind with traders when they are speculating in the spot forex markets.
Although spot forex market trading has become widely popular among retail traders, there are many different ways in which one can trade the currency markets. Here is a brief primer of the different ways of speculation or hedging in the currency markets.
The spot forex market, which is the most common way to trade, is basically an agreement between two parties. Both parties involved, buy one currency and sell the other currency.
The rate at which this transaction occurs is known as the spot exchange rate. The settlement for this transaction is usually two business days after the transaction has been completed.
Spot Forex can be executed electronically or over the phone and usually occurs between financial institutions or a bank and a company.
The currency forward market is fairly similar to a spot market. The main exception is that in a forward market, the agreement is completed in the same day with delivery and payment specified at a future date.
A forward rate is used to the quote in the agreement and the prevailing spot rate is taken on the future date.
Forward market trading is usually done by export and import businesses or companies that are expecting a foreign currency payment coming in the near future. This enables the businesses to get a favorable rate than the prevailing rate.
The options market in Forex is one of the most popular ways to hedge or speculate. Designated as a derivative instrument, Forex options operate on almost the same concept of ‘call’ and ‘put’.
However, the ‘calls’ and ‘puts’ in the Forex options markets slightly differs when compared to buying ‘calls’ and ‘puts’ in a stock. Due to the Forex market instruments comprising of two currencies, when you buy a ‘call’ or a ‘put’ in Forex options, you are buying and selling on one of the two currencies.
Forex options are widely used as a hedging tool as the risk is limited to the premium that you pay to the seller. Businesses and even traders can use this as a speculative or a hedging instrument or both.
When the option expires in the month, it can be exercised in order to make a profit. Forex options are available in American style (where the option can be exercised only on the expiry date) or the European style where the option can be exercised anytime within the expiry date.
Non deliverable forwards
The non-deliverable forwards, or NDF’s as they are popularly known, are widely used by businesses that have exposure to a less liquid currency.
Some of the currencies widely used for NDF transactions include the Brazilian Real, Indonesian Rupiah, Indian Rupee, and the Korean Won to name a few. The NDF’s are ideal as you can engage in buying or selling the non-deliverable currency to settle for a deliverable currency.
Non deliverable forwards, as the name suggests, usually have a non-deliverable currency transacted against the U.S. dollar. There are other variations to this, where you can use the non-deliverable currency against the euro or other cross currencies.
Forex futures are another popular currency derivative instrument that is widely used speculatively. Forex futures are centralized and standardized. The biggest exchange for trading Forex futures is the CME Group.
Although Forex futures sound similar to the Forex forward market, there are some big differences. The main aspect is the way in which these transactions are executed. Forex forwards are usually traded over the counter (OTC) whereas futures are accessed at a futures exchange.
When it comes to the amounts required to trade, Forex futures are the least investment intensive, as it allows traders to speculate with as little as $1000 when trading through a retail broker.
In conclusion, the above forex derivatives are different ways in which one can gain exposure to either hedge or speculate the volatility in the currency markets.