Derivatives of Currency Trading and the Forex

By: Andrew Daigle

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.

Foreign Exchange
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