How To Trade Forex

How do individuals get involved in the forex market?

Having gained an understanding of what the forex market is, its vast size, the various types of currencies, and how they are traded in pairs, the next question arises: How does one actually trade forex?

Let's explore the ways people participate in forex trading as traders.

 

Due to the appeal of the forex market, traders have devised various methods to invest in or speculate on currencies. Among the popular financial instruments, the following are commonly used by retail traders: retail forex, spot FX, currency futures, currency options, currency exchange-traded funds (ETFs), forex CFDs, and forex spread betting.

It's worth noting that we are focusing on the different ways individual ("retail") traders can participate in forex trading. Instruments like FX swaps and forwards, which cater to institutional traders, are not included in this discussion.

With that clarification, let's now explore how you can become involved in the exciting world of forex trading.

 

Currency Futures

Futures in the financial market are agreements to buy or sell a particular asset at a predetermined price on a specified date, hence the term "futures."

In the context of the forex market, currency futures represent contracts that establish the price at which a currency can be bought or sold, with a specific date set for the exchange to take place.

The concept of currency futures was introduced by the Chicago Mercantile Exchange (CME) back in 1972, during a time when bell-bottoms and platform boots were in vogue.

One of the key advantages of trading currency futures is that they are standardized contracts traded on a centralized exchange. As a result, the market is highly transparent and well-regulated, providing easy access to price and transaction information.

For those interested in delving further into CME's FX futures, more detailed information can be found on their platform.

 

Currency Options

An "option" is a financial instrument that grants the buyer the right, but not the obligation, to either buy or sell an asset at a predetermined price on the option's expiration date.

If a trader chooses to "sell" an option, they become obligated to buy or sell the asset at the specified price upon the option's expiration.

Like futures, options are also traded on specialized exchanges such as the Chicago Mercantile Exchange (CME), the International Securities Exchange (ISE), or the Philadelphia Stock Exchange (PHLX).

However, trading FX options comes with certain drawbacks. The market hours for certain options are limited, and their liquidity is not as extensive as that of the futures or spot market. This can affect the ease and efficiency of trading in FX options.

 

Currency ETFs

A currency ETF (Exchange-Traded Fund) provides exposure to a single currency or a group of currencies.

By investing in a currency ETF, ordinary individuals can participate in the forex market through a managed fund, eliminating the need to make individual trades.

Currency ETFs serve various purposes, such as speculating on forex movements, diversifying an investment portfolio, or hedging against currency risks.

Financial institutions create and manage these ETFs by purchasing and holding currencies in a fund. They then offer shares of the fund to the public, which can be bought and traded on exchanges, much like stocks.

However, similar to currency options, trading currency ETFs has certain limitations. The market for currency ETFs is not open 24 hours, and investors should be aware of trading commissions and other transaction costs associated with these investments.

 

Spot FX

The spot FX market, also known as the over-the-counter (OTC) market, is a large and highly liquid financial market that operates 24 hours a day. Unlike traditional exchanges, there is no centralized trading location for spot FX, and transactions are conducted directly between parties.

In the spot FX market, customers trade directly with counterparties, and the majority of trading occurs through electronic networks or telephone communication. The primary market for FX is the interdealer market, dominated by banks and financial institutions that trade with each other.

Spot FX transactions involve bilateral agreements to physically exchange one currency for another at the current exchange rate. These agreements are binding contracts, specifying the amount of currency to be exchanged and the agreed-upon price, known as the spot exchange rate.

It's important to note that in spot FX trading, individuals are not trading the actual underlying currencies but rather contracts based on those currencies.

Despite the name "spot," settlement of spot FX trades does not happen immediately. Transactions are typically settled two business days after the trade date, known as T+2. This means that delivery of the currencies involved in the trade is completed within two working days after the trade.

Although spot FX trading involves settling trades within the T+2 timeframe, it's essential to understand that this type of trading is typically not accessible to retail traders. Retail traders usually engage in spot forex trading through forex brokers, who provide access to the market and facilitate trading on behalf of individuals.

 

Retail Forex

The forex market operates as a secondary over-the-counter (OTC) market, where retail traders can participate through forex trading providers, commonly known as forex brokers. These brokers act as intermediaries, facilitating trades between retail traders and the primary OTC market. They find the best prices in the primary market, add a markup, and then display these prices on their trading platforms.

In spot forex trading, actual physical delivery of currencies does not occur. Instead, positions are automatically "rolled" over to the next delivery date. Retail forex traders take advantage of leverage, which enables them to control larger positions with a relatively small initial margin. With leverage, traders can open positions worth much more than the amount they have in their trading accounts.

The rollover process performed by retail forex brokers allows traders to maintain their positions indefinitely until they decide to close them. This type of transaction is known as a "rolling spot forex transaction" or "retail forex transaction."

When traders wish to close their positions, they enter an opposite transaction with their forex broker, effectively offsetting the trade. If a position is left open at the end of the trading day, it is automatically rolled over to the next value date.

This rollover procedure, also referred to as Tomorrow-Next or "Tom-Next," may lead to the payment or earning of interest by the trader, known as a swap fee or rollover fee. Retail forex trading is considered speculative, as traders seek to profit from fluctuations in exchange rates without intending to physically possess the currencies involved.

 

Forex Spread Bet

Spread betting is a derivative financial product that allows traders to speculate on the price movement of an underlying asset without owning it. In the context of forex, a forex spread bet enables traders to speculate on the future price direction of a currency pair.

The price used for the forex spread bet is derived from the currency pair's price in the spot forex market. Traders make a profit or incur a loss based on how far the market moves in their favor before they close their position, and the amount of money bet per "point" of price movement.

Spread betting on forex is offered by spread betting providers. However, it's important to note that spread betting is illegal in the United States. Although regulated by the Financial Services Authority (FSA) in the United Kingdom, spread betting is considered internet gambling in the U.S., and therefore, not allowed.

 

Forex CFD

A contract for difference (CFD) is a financial derivative product that allows traders to speculate on whether the price of an underlying asset will rise or fall. The price of a CFD is derived from the underlying asset's market price. In a CFD contract, one party agrees to pay the other the difference in the value of the asset between the opening and closing of the trade.

A forex CFD specifically pertains to the exchange of the price difference of a currency pair from the trade's opening to its closing. The price of a forex CFD is also derived from the currency pair's price in the spot forex market.

With forex CFDs, traders have the flexibility to take both long and short positions, enabling them to profit from price movements in either direction. If the price moves in the trader's favor, they make a profit, but if it moves against them, they incur a loss.

Regulators in the EU and UK have classified "rolling spot FX contracts" as different from traditional spot forex contracts because there is no intention to physically own the currency. The primary purpose of trading rolling spot FX contracts is to speculate on price movements without owning the underlying currency. Therefore, these contracts are treated as CFDs, allowing traders to gain exposure to currency price fluctuations without taking ownership.

Forex CFD trading is offered by CFD providers. In the U.S., CFDs are not permitted, so similar transactions are known as "retail forex transactions." Outside the U.S., retail forex trading is typically conducted using CFDs or spread bets.