Forex is a market to trade foreign currencies. It is traded 24 hours electronically over-the-counter, meaning the transactions are performed over the networks around the world. One way to trade the forex market is for one party to buy a currency, and the other to sell it. This method is referred to as spot forex trading. Apart from this, there are other ways to trade the Forex market. And in this lesson, we shall discuss these different ways.
Forex market and its types
If we were to consider the primary forex market asset types, we could find four. They are:
Spot Forex Market
Currency Exchange-traded funds
Now, let us explain the working of each one of them in detail.
Spot Forex Market
As discussed, in the spot forex market, currencies are bought and sold for a short period of time, based on the current market price (CMP). The prices in this market are settled in cash, on the spot, bases on CMP. Hence, the spot market is also called a ‘cash market’ and ‘physical market.’ The settlement of orders in the spot market takes two days, while in the futures market, it takes much longer.
Spot trading is the most popular form of trading where the majority of the retail traders trade on. There is great liquidity in this market, and brokers even offer tight spreads on them. Apart from retail traders, other participants in this market include commercial banks, central banks, arbitrageurs, and speculators.
Currency futures market
In the currency futures market, the buyer buys a contract of one currency by paying another currency. While the seller of the contract holds the opposite obligation. And this obligation is due on the expiration date of the future. The ratio of the currencies is settled in advance between both the parties (the time when the contract is made). The parties make a profit or a loss depending on the difference between the real effective price on the date of expiry and the settled price.
A currency option is a type of options contract that gives the buyer the right, but not the obligation, to buy or sell a currency pair at a given price before a set time of expiry. To get this right, the holder of the option pays a premium to the seller who is known as an option seller.
There are two types of currency options, ‘Call option’ and ‘Put option.’ A call option gives the buyer the right to buy a currency pair at the strike price before the expiry date. A put option gives a buyer the right to sell a currency pair at the strike price before the expiry date. Currency options are a popular way of protecting against loss.
Since the options are a bit complex, let’s understand them with an example. If you believe that the price of the Euro will rise against the US dollar, you can buy a currency call with a strike price of 1.31000 and expiry at the end of the month. If the price of EUR/USD is below 1.31000 on the expiration day, the option expires worthless, and you would lose the premium paid. On the other hand, if EUR/USD increases to 1.50000, you can exercise the option and buy the currency for 1.31000 (At strike price). By doing this, you have generated high returns on your investment by using options.
Currency exchange-traded funds
Back then, Exchange-traded funds (ETFs) were only available for the stock market. But in the present, ETFs have expanded to the Forex market as well.
A currency ETF is a fund that clubs a single or typically a bunch of currency pairs. These funds are managed by financial institutions and are offered to the public for purchase on an exchange board. Hence, one can trade ETFs just like any share on the stock market.
These are the four primary ways of trading the Forex market. Now take the quick quiz below to know if you have understood the above concepts.