The Different Ways To Trade Forex

Because forex is so awesome, traders came up with a number of different ways to invest or speculate in currencies.

Among the financial instruments, the most popular ones are retail forexspot FX, currency futures, currency options, currency exchange-traded funds (or ETFs), forex CFDs, and forex spread betting.

 

It’s important to point out that we are covering the different ways that individual (“retail”) traders can trade FX.

Other financial instruments like FX swaps and forwards are not covered since they cater to institutional traders.

With that out of the way, let’s now discuss how you can partake in the world of forex.

Currency Futures

Futures are contracts to buy or sell a certain asset at a specified price on a future date (That’s why they’re called futures!).

A currency future is a contract that details the price at which a currency could be bought or sold and sets a specific date for the exchange.

 

Currency futures were created by the Chicago Mercantile Exchange (CME) way back in 1972 when bell-bottoms and platform boots were still in style.

 

Since futures contracts are standardized and traded on a centralized exchange, the market is very transparent and well-regulated.

This means that price and transaction information are readily available.

You can learn more about CME’s FX futures here.

Currency Options

An “option” is a financial instrument that gives the buyer the right or the option, but not the obligation, to buy or sell an asset at a specified price on the option’s expiration date.

 

If a trader “sold” an option, then he or she would be obliged to buy or sell an asset at a specific price at the expiration date.

 

Just like futures, options are also traded on an exchange, such as the Chicago Mercantile Exchange (CME), the International Securities Exchange (ISE), or the Philadelphia Stock Exchange (PHLX).

However, the disadvantage in trading FX options is that market hours are limited for certain options and the liquidity is not nearly as great as the futures or spot market.

Currency ETFs

A currency ETF offers exposure to a single currency or basket of currencies.

Currency ETFs allow ordinary individuals to gain exposure to the forex market through a managed fund without the burdens of placing individual trades.

Currency ETFs can be used to speculate on forex, diversify a portfolio, or hedge against currency risks.

Here’s a list of the most popularly traded currency ETFs.

 

ETFs are created and managed by financial institutions that buy and hold currencies in a fund. They then offer shares of the fund to the public on an exchange allowing you to buy and trade these shares just like stocks.

 

Like currency options, the limitation in trading currency ETFs is that the market isn’t open 24 hours. Also, ETFs are subject to trading commissions and other transaction costs.

Spot FX

The spot FX market is an “off-exchange” market, also known as an over-the-counter (“OTC”) market.

The off-exchange forex market is a large, growing, and liquid financial market that operates 24 hours a day.

It is not a market in the traditional sense because there is no central trading location or “exchange”.

In an OTC market, a customer trades directly with a counterparty.

Unlike currency futures, ETFs, and (most) currency options, which are traded through centralized markets, spot FX are over-the-counter contracts (private agreements between two parties).

Most of the trading is conducted through electronic trading networks (or telephone).

The primary market for FX is the “interdealer” market where FX dealers trade with each other. A dealer is a financial intermediary that stands ready to buy or sell currencies at any time with its clients.

The interdealer market is also known as the “interbank” market due to the dominance of banks as FX dealers.

The interdealer market is only accessible to institutions that trade in large quantities and have a very high net worth.

This includes banks, insurance companies, pension funds, large corporations, and other large financial institutions that manage the risks associated with fluctuations in currency rates.

In the spot FX market, an institutional trader is buying and selling an agreement or contract to make or take delivery of a currency.

A spot FX transaction is a bilateral (“between two parties”) agreement to physically exchange one currency against another currency.

This agreement is a contract. This means this spot contract is a binding obligation to buy or sell a certain amount of foreign currency at a price that is the “spot exchange rate” or the current exchange rate.

So if you buy EUR/USD on the spot market, you are trading a contract that specifies that you will receive a specific amount of euros in exchange for U.S dollars at an agreed-upon price (or exchange rate).

It’s important to point out that you are NOT trading the underlying currencies themselves, but a contract involving the underlying currencies.

Even though it’s called  “spot”, transactions aren’t exactly settled “on the spot”.

In reality, while a spot FX trade is done at the current market rate, the actual transaction is not settled until two business days after the trade date.

This is known as T+2 (“Today plus 2 business days”).

It means that delivery of what you buy or sell should be done within two working days and is referred to as the value date or delivery date.

For example, an institution buys EUR/USD in the spot FX market.

The trade opened and closed on Monday has a value date on Wednesday. This means that it’ll receive euros on Wednesday.

Not all currencies settle T+2 though. For example, USD/CAD, USD/TRY, USD/RUB and USD/PHP value date is T+1, meaning one business day going forward from today (T).

Trading in the actual spot forex market is NOT where retail traders trade though.

Retail Forex

There is a secondary OTC market that provides a way for retail (“poorer”) traders to participate in the forex market.

Access is granted by so-called  “forex trading providers“.

Forex trading providers trade in the primary OTC market on your behalf. They find the best available prices and then add a “markup” before displaying the prices on their trading platforms.

This is similar to how a retail store buys inventory from a wholesale market, adds a markup, and shows a “retail” price to their customers.