Forex Walkthrough

Level 3 Trading - Trading Currencies

So, now you understand what the forex market is and how to read a quote, which is great. Now comes the time to learn how to put that info to use. Though you may feel a little intimidated trading currencies at first, you'll see how easy it can be after a few orders have been placed.

Trading
One unique aspect of this huge international market is that there is no central marketplace for foreign exchange. The majority of regular stocks trade on defined markets like the New York Stock Exchange. Currency trading, on the other hand, is conducted electronically over-the-counter (OTC), meaning all transactions around the world occur via computer networks between traders, rather than on one centralized exchange. The market is open five and a half days a week, 24 hours a day.

Spot Market and the Forwards and Futures Markets
There are actually three ways that institutions, corporations and individuals trade forex: the spot market, the forwards market and the futures market. Don't worry, it isn't as complicated as you might think. Let's start with the spot market, which always has been the largest forex market because it is what the other two (forwards and futures) markets are based on. In fact, when people refer to the forex market, they are usually actually talking about the spot market.

The Spot Market
The spot market is simply where currencies are bought and sold, according to the current price. That price determined by supply and demand, and is a reflection of many things, such as:

  • Current interest rates offered on loans
  • Economic performance of countries
  • Ongoing political situations (both internationally and locally)
  • The perception of the future performance of one currency compared to another
A completed deal is known as a "spot deal." It is a bilateral transaction by which one party sells some specified amount of currency and receives a specified amount of another currency in cash. Although the spot market is thought of as transactions in the present, these trades actually take two days for settlement. For example, Bob buys 3,000 U.S. dollars with 4,000 Australian dollars.

The Forwards and Futures Markets
Unlike the spot market, the forwards and futures do what their names suggest, for delivery in the future. Also unlike the spot market, instead of buying the currency at today's price and getting it now, these contracts allow you to lock in a currency type, price per unit and a date in the future for settlement.

In the forwards market, contracts are bought and sold over the counter between two parties who have determined the terms of the agreement between themselves.

In the futures market, futures contracts are bought and sold on an exchange, such as the Chicago Mercantile Exchange, and are based upon a standard size and delivery date. The National Futures Association regulates the futures market in the U.S. The contracts have specific details, including the number of units, settlement and delivery dates, and minimum price increments that cannot be customized. Both types of contracts are binding and, upon expiry, are typically settled for cash, although contracts can also be bought and sold before they expire. The exchange acts as a counterpart to the trader, providing clearance and settlement. (For more, check out Futures Fundamentals.)

Putting Theory into Practice
Speculators may take part in these markets, and the forwards and futures markets can reduce the risk when exchanging currencies.

For example, let's say "CompanyUSA," based in the U.S., agreed sell a machine for 200 million euros. It will take one year to build the machine and deliver it. CompanyUSA will receive 200 million euros, but if the euro losses value against the USD during that time, when converted they will not be worth as much. These markets could be used in order to hedge against future exchange rate fluctuations.

- If received today, 200 million euros at 1.6393 USD/EUR = $122 million

- Risk of euro losing value: 200 million euros at 1.7391 USD/EUR = $115 million

CompanyUSA could enter into a futures contract to deliver 200 million euros at an acceptable exchange (1.6529 USD/EUR), thus, the company is guaranteed 121 million, and could hedge against the risk of receiving substantially less. (For a more in-depth introduction to futures, see Futures Fundamentals.)

This is a basic example of a futures contract, and more in depth explanations will come later. Investors usually want to know more about what to look for to make trading decisions. Next up is a look at charting patterns that could point you in the right direction.



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