Pipruit: Commander, I have an assumption, but I’m not sure if it’s correct… I just continuously return to the numbers that you’ve said to me about daily turnover and the share of spot market. But you also have talked about futures, swaps and other stuff that I don’t remember currently. It seems that the FOREX market is tremendously attractive as different members come there to trade in different ways…
Commander in Pips: Your quick eye is worthy of a compliment, son. You are absolutely right.
Pipruit: So, can you give me, some definition of different ways to trade FOREX, at least briefly?
Commander in Pips: Sure, why not:
We already know something about the spot market. The spot part of the market is the most simple in our sense of understanding. Currencies are traded immediately, that’s why it is called “Spot”. The attractiveness of the spot market lies in its liquidity, simplicity, tight spreads and running around the clock. You can easily participate in this part of FOREX, because retail brokers offer to open spot trading accounts, some for as little as $5-25 in assets!
Pipruit: Cool! Can you wait a couple of hours – I’ll just run to nearest broker and open an account! I want so much to try out all this stuff.
Commander in Pips: Stop right there son and don’t move! Have you accomplished our school already, or maybe you already know all lions on the path better than me? If you just want to give all your money to someone else – that’s ok, go ahead (you can give it all to me, for example, ha ha). But if you don’t, then listen carefully and hang on. We will talk in detail about opening trading accounts and funding them in latter lessons.
Commander in Pips: …So. Besides the low-volume spot account brokers usually provide their customers with charts, technical analysis tools and news. That being said, trading on the spot FOREX market represents a “direct exchange” between two currencies that has the shortest time frame.
Commander in Pips: Now let’s shift to forward/futures trading. In general, forward/future contract assumes making a deal to buy or sell particular currency at specified exchange rate (i.e. price) on a future date (that’s why they call futures/forward!). Conditions are fixed in contract directly. For example, if the current EUR/USD rate is 1.38 and today is April 20th. Currently I would like to buy EUR for USD (assume that you would like to sell it) in on June 20th for 1.33. So, today we’ve come to agreement (i.e. made a deal) with a future date of execution and a future price. If today we will sign a corresponding contract on paper, then this will be a forward contract on EUR/USD.
Pipruit: If I understand correctly, a forward contract is an agreement to make a deal at specified price and date in the future, but the particular date and price are agreed on today?
Commander in Pips: That’s right.
Pipruit: And why there are two words that are specified that. What is the difference between a forward contract and a futures contract?
Commander in Pips: Good question son. The nature of forwards and futures is the same. There is only a difference that futures contracts are traded via different exchanges. Futures is an organized market and forwards are not. A forward is a contract that trades on an over-the-counter market. This specification leads to some different qualities. First of all, futures contracts have strict specifications by exchange – dates of expiration, value of contracts, delivery dates and other specifications are fixed and well known ahead of time. And the Exchange itself is counterparty for both parties. For the seller and the buyer on their trade, the exchange is the intermediary. On the over-the counter market there is no such tight specification for contract conditions. In fact, you may apply any conditions of your choice if those conditions are acceptable for both parties of the deal – buyer and seller. And you can choose the counterparty for your trade by yourself.
Pipruit: Ok, I’ve got it. It looks like a future contract is an exchange traded forward with standardized contract sizes and maturity dates. This is because contract sizes and maturity dates are determined by the exchange itself and its rules of trading.
Commander in Pips: Right you are. Ok, let’s go further. Swaps and options…
Commander in Pips: I want to remind you, that swap is a most common type of transaction on FOREX. It’s even bigger than the spot part of the market. The reason is in the high convenience of such kind trade. In general a swap is a transaction when counterparties exchange different currencies for a definite period of time and agreed to make a reverse exchange on predetermined future date. Also they agreed to pay to each other corresponding annual percent rate. For example, if today is November 01 and the EUR/USD rate is 1.33, we could come to an agreement to make a swap with the notional amount of 100 000 EUR and reverse the transaction 30 days later. It means, that I have to transfer to you $133 000 USD and you have to transfer to me 100 000 EUR. When these 30 days have passed – we will have to make a reverse transaction – I will return to you 100 000 EUR plus interest for using them, and you, in turn, return to me USD $133 000 and interest for using this sum during the period of the swap. These are not standardized contracts and are not traded through an exchange. As you understand, banks are the major participants on the swap market.
Options are also a contract with future date of execution. It’s not a spot kind of trade. It is different from any other types of contracts, since the rights and obligations of buyer and seller of option are different. The buyer of option has right but not an obligation to exchange one currency into another one at a pre-agreed exchange rate on a specified date. But the seller will have to do the transaction (seller has an obligation) if the buyer will ask him to fulfill it. Options exist as both an over-the-counter FX option market as well as an exchange traded one. Options on many FX pairs are traded on the Chicago Mercantile Exchange. As you already know, exchange traded options are highly structured as are futures.
Pipruit: Hm, sounds strange. It sounds unfair. Why does the seller have an obligation but the buyer has no obligations, just rights?
Commander in Pips: The reason for that is in price of option, also known as the premium. The buyer has to pay a premium to the seller to get such a feature. In other words, the buyer purchases these choices to have only rights but not any obligation by paying the option premium to the seller. The buyer then has the option to exercise the contract on the specified date.
Pipruit: Oh, that explains it. Now it sounds more logical.
EXCHANGE-TRADED FUND (ETF)
ETF’s or exchange traded funds are a relatively new approach to trading. These funds can be invested in different markets – stocks, bonds, currencies, commodities, real estate etc. Some of them can invest in many different assets simultaneously. The shares of these funds are traded at different exchanges. If you, for example do not want to trade FOREX personally, or do not have sufficient confidence for that yet, you may buy shares of some ETF that invests in the FOREX market. In this case, if this ETF does well and its assets will grow during the time - you will receive profits, because the shares of this fund also will rise in price. Also take a note that ETFs are traded only via exchanges. It means that this market has time breaks and does not operate in 24/5 mode like spot FX. Liquidity there is also lower than on the spot FOREX market and transaction costs are higher.
Pipruit: Sounds interesting, but I’d like to try the FX spot market personally.