This article looks at the different methods of currency trading which involves the spot, futures and forwards markets.
One of the unique aspects of the currency trading market is that there is no central exchange. In the stock markets, trades are done via stock exchanges, such as the New York Stock Exchange. In the currency market, trades are done electronically between traders, market makers and large banking institutions.
Individuals, corporations and large institutions use three main methods to trade in this market. These are called the spot, futures and forwards markets. The largest of the three is the spot market and the other two are based on the spot market.
Spot Currency Trading Market
The spot market is where most traders work. This is where you buy and sell currencies at the price that is on the market. The trades are usually executed immediately. The price that you are quoted in this market is based on supply and demand. Some of the other factors that may influence this price include:
- Interest rates as they currently stand
- A country’s economic climate
- Local and international political climates
- The perceived future movement of currencies
Once a deal has been completed in this particular market, it is called a ‘spot deal’. This two-way transaction involves the sale of a specific amount of one currency and the purchase of a specific amount of another currency. It is stated that the spot market operates with deals that are done immediately, but you should bear in mind that it often takes a period of two days for the settlement of trades.
Futures and Forwards
These markets are very different to the spot market. The trades that are done in these markets specify completion dates in the future. Instead of purchasing a currency at the current price on the market, the buyers and sellers are able to specify the amount, price and date for delivery of the contract.
In the forwards market, two parties are able to purchase and sell over the counter, at prices and dates predetermined by them. The contracts related to futures are done on standard delivery dates and sizes. The purchase and sale agreements are handles via a central exchange, such as Chicago Mercantile. This particular market is regulated by the National Futures Association in the US. The contracts detail specifics about the deal, such as the minimum price movements, the number of units, delivery dates and settlement dates. Both contract types are binding on the two parties involved. These contracts are normally settled in cash on the delivery date. It is possible for the parties to agree to buying and selling before the expiry date. The central exchange becomes involved in the clearance and the settlement of this type of contract.
It is possible for speculators to enter all the markets. The forwards and futures markets minimises the risks involved with currency trading.
The spot market is used by large institutions, banks, central banks and individual traders. The futures and forwards markets are more often used by large corporations as a method of hedging against the risk of fluctuating currency prices. With a suitable strategy, it is possible for individual traders to enter the futures and forwards market and trade profitably.