Different ways to trade Forex
DIFFERENT WAYS TO TRADE FOREX
You might find it surprising to hear just how big the foreign exchange market it, or as everyone calls it, the forex market. It’s estimated that over US$5 trillion is traded every day on the market, which is open 24-hours a day, five days a week.
You can trade forex on the spot, in the future, electronically or manually. You can also take an option on trading it but without being obliged to actually buy or sell the currency. The choice is yours and the way you trade will come down to your circumstances and what trading strategy you adopt.
Forex is predominantly traded online by retail brokers and bypasses the traditional stock market exchanges. This is what is known as the over-the-counter (OTC) market. It means you can trade forex off an electronic trading platform wherever you are in the world and any time of the day when the forex market is open.
The forex market was once the domain of the highly-capitalised investment fund management enterprises and the large specialised banks. Today, anyone can trade forex online via a reputable retail forex broker. The barriers to entry are low and the forex market is wide open for anyone to trade.
All you need is a good Internet connection, a trading platform like MetaTrader 4 connected via a broker’s server and a disciplined trading strategy that you have acquired starting off your trading experience using a free demo account.
Trading forex through a broker
There’s no getting around it. You need to trade forex through a broker. It’s a simple process of registering and opening an account with a broker, depositing funds into your trading account and setting up your trading platform on their brokerage site to start trading.
There are two types of brokers:
As the name sounds, market makers are brokers that set or make your bid for you, taking a commission on top of whatever you make. Market makers are the cornerstone of the foreign exchange market because they continuously buy and sell currencies at an openly-quoted price on the OTC market.
Basically, a market maker acts as a counter-party to most of the trades made by retail forex traders. In other words, they are the middleman in the forex world. When retail traders buy a currency, the market makers sell it. And vice versa.
Another way to describe market makers is they are the wholesalers of forex. Each bank has dedicated market makers for each major currency pair who are responsible for securing the open-quoted price for the currency which is then sold onto the retail forex market.
Electronic Communication Networks (ECN)
ECN’s is the term used for what we call trading platforms. The most popular example of an ECN is MetaTrader 4. These advanced trading platforms allow forex brokers to automatically match and compare their clients buy and sell orders at agreed prices.
The agreed prices are obtained from different banks and market makers, including other traders using ECNs. Each time a particular sell or buy order is initiated, it is matched automatically to the best bid/ask price on the forex market.
ECN transactions are cheaper than transactions through market makers, due to a combination of small commissions and tight spreads.
Top 4 ways to trade forex
Forex traders have come up with a number of ways to trade forex over the years. The four that have stood the test of time are currency exchange traded funds (ETFs), currency options, currency futures and spot forex.
Currency futures are contracts to buy or sell an underlying asset at an agreed price on a future day. The fact that the position is traded in the future is why they are called future contracts.
Future contracts were introduced to the forex market in 1972 by Chicago Mercantile Exchange. This method of trading became popular because future contracts are standardised, strictly supervised, can be easily accessed and are known for their transparency.
What makes currency futures different to currency options is they oblige the contract buyer to go long (buy) on the base currency and go short (sell) on the quote currency. The contract seller has to do the same but in reverse. All this is done on a specified date in the future.
Profit is made or lost on the difference between the agreed price and the actual price on the day the contract expires. Future trades require a margin that must be deposited into a trading fund to secure the futures contract. The margin acts like a deposit on the contract and ensures both the contract buyer and seller fulfil their obligations.
You’ll hear the word ‘option’ often on the financial markets. It basically means taking an option on a trade but with no obligation to transact.
An option is a popular financial instrument that gives traders the right to buy or sell an asset at a specified price (exchange rate) on the option’s expiration date but the traders are under no obligation to take up the position. For this option, traders pay a premium to the currency seller.
The transaction is only concluded on the expiry date if the option is sold by the trader. Unlike spot or future trading, the options are not as liquid as the other two and trading of certain options is restricted to certain times of the day (intraday, meaning when the forex market is open).
You get two types of currency options: currency put options and currency call options.
- A currency put option is a hedging contract that gives the holder of a specific currency the right but not the obligation to go short (sell) on the currency at a specific price within an agreed time period.
- A currency call option is a hedging contract that gives the holder of a currency the right but not the obligation to go long (buy) on a currency at a specified price within a specific time period.
A premium is charged to allow traders to exercise their rights to decline the opportunity to buy or sell the currency in the options contract. This makes currency options a more expensive hedging method. Retail forex traders tend to combine futures contracts and spot forex trading for much the same effect.
Currency options are traded on an exchange such as the Chicago Mercantile Exchange (CME), the International Securities Exchange (ISE) and the Philadelphia Stock Exchange (PHLX).
Currency options are the most common ways retail brokers, banks and large corporations can hedge against unfavourable price movement on currency pairs.
Currency exchange-traded funds (ETFs)
ETFs have only recently been introduced to forex trading. They’ve become more popular because they increase a traders exposure by offering a basket of currencies as well as a single currency. In other words, ETFs expand the scope of investment by not limiting traders to currency pairs.
How EFTs work is the financial institutions buy and hold currencies in a fund and are responsible for creating and managing the EFTs. The banks offer the EFTs to the retail traders in much the same way investors are offered stocks.
ETFs have a few limitations. Transactions costs as well as commissions are levied on the ETFs which make them more expensive, and they are subject to specific opening and closing times in a trading day.
Spot forex market
The spot forex market is basically trading ‘on the spot’ using the current market price. It’s a simple form of trading forex with attractive advantages of high liquidity, tight spreads and any-time-of-the-day transactions.
The forex market is open 24-hours a day, 5 days a week. Therefore, spot traders can trade currency pairs any time of the day or night using this type of trading. It’s easy to enter the spot forex market so it’s the best trading tactic for beginner traders.
Most retail forex traders are spot traders. Spot forex trading is conducted in real time and these traders mostly rely on technical analysis using charts and indicators on their trading platforms.
Difference between currency futures and options
Currency futures and options are both derivative contracts, meaning they derive their values from the underlying asset. For forex, this means any major or exotic currency pair.
Foreign currency is always traded in pairs, the most popular being the Euro and US Dollar pair (EUR/USD). Trading on a currency pair means going long (buying) on the base currency and going short (selling) on the quote currency.
For EUR/USD, this would involve going long (buying) on the Euro and going short (selling) on the US Dollar. A trader makes money when the long currency appreciates against the short currency. In other words, you get more Euro for your American bucks.
The main difference between futures and options is future traders are obliged to go long (buy) or go short (sell) on the currency pair. Option traders make a bid on the position but are under no obligation to conclude the transaction.
This means option buyers do not put up any margin (funds) and any financial loss is limited to the purchase cost or premium on the option. They may have to buy or sell the underlying asset if the trade goes against them. However, the premium of an options contract is generally lower than the required margin on a similar futures contract.
Options on currency futures
Options on currency futures is where traders have an option to buy and sell currency pairs on a future date but without any obligation to conclude the transaction. The option buyers benefit from the futures market because they don’t have to put down any margin (funds).
If the futures contract appreciates, the currency call holder goes short (sells) on the call for a profit but never actually buys the currency. A put buyer profits if the futures contract loses value.
Currency futures versus Spot forex trading : Which is best?
The majority of retail forex brokers trade in spot currencies and foreign currency futures. There are pros and cons to the two types of forex trading and it’s important you know the difference. One is trading ‘on the spot’ and one is trading at a future date but that’s not all.
Spot forex trading is the most popular type of forex trading, mainly because it does not require a trader to put up a large amount of capital. In fact, you can start spot currency trading for as little as US$ 100 (R1 000) on a trading platform like MetaTrader 4.
Where spot forex trading differs from currency future trading is the former is transacted immediately in real time. Traders do not wait for an expiry date on a position, meaning they can immediately make a profit (or loss) on any currency price fluctuations.
The most basic form of spot trading is individuals who buy and sell foreign currency for say an export business or travel. The value of the currency pairs is the current price offered by the foreign exchange agency. American Express Foreign Exchange is probably the most widely-known foreign exchange outlet in the world where you can buy and sell currency pairs on the spot.
With currency futures, traders determine the price and when the currency pairs will be exchanged. The currency price is agreed upon when the contract is signed and the transaction takes place at a pre-determined future day.
Therefore, currency futures are more a speculative way of trading forex than spot forex trading. Participants speculate on the price point the underlying asset will close at on a specified date. However, most currency futures contracts do not last until the expiry date as the majority of traders tend to close their positions early to minimise their risks.
Spot forex trading is more suited to beginner traders. It requires less initial capital and the exposure to long-term risk is reduced. More experienced forex traders tend to use a combination of spot forex trading and currency futures.
What is the FX spot?
The FX spot is the foreign exchange spot transaction. In other words, it’s the agreed price that one currency is bought or sold for on the spot. The exchange rate at which the transaction is concluded is called the spot exchange rate.
The simplest example of FX spot is the price a money changer will quote to exchange foreign currency. The transaction takes place immediately at the ‘on-the-spot’ price and the buyer walks away with his or her currency.
Best way to trade forex
There is no best way to trade forex, only the way that suits your circumstances and trading style. If you are a beginner, you’ll take advantage of the free demo account offered by your online broker. Use it to hone your skills and develop your own trading strategy.
Some tips from the forex experts include:
Choose the best currency pair for your needs
The forex market operates 24-hours a day, five days a week. However, if you are trading forex on a part-time basis, you won’t necessarily be sitting at your computer during the peak trading times where the currency pairs with the highest liquidity are active.
Remember, liquidity is vital in forex trading because it allows a trader to go short (sell) on a position far easier than they would on an illiquid asset.
It’s recommended that beginners trade USD/EUR to start with, particularly if they are part-time traders who have a limited trading window. This currency pair is the world’s most-traded duo and there is a plethora of information available for fundamental and technical analysis.
Choose an advanced automated trading system
If you’re new to forex trading, your best option is to register with a broker and sign up for a free demo account that operates through their server. The most popular trading platform on the market is MetaTrader 4. It’s uniquely geared for trading forex, regardless of whether you are trading at a beginner, intermediate or advanced level.
Automated trading software programmes offer a full range of functions that can be used monitor the prices of currency pairs, open and close positions, analyse historic price data and manage your risk.
Until you progress to a more advanced level of forex trading, the ‘set and forget’ programmes as they’re called are perfect. The software makes automated decisions on your behalf and executes structured, disciplined and unemotional trades in your absence.
Adopt a disciplined trading strategy
Regardless of which way you choose to trade forex, discipline is key. Disciplined trading also means dispassionate trading, meaning you take the emotion out of buy and sell positions. In other words, stick to your trading strategy and don’t panic sell or buy when the forex waters get choppy.
Forex trading requires a high degree of self-discipline, particularly in fast trending and volatile markets. Successful traders known when to cash in their profits and don’t push the limits until it’s too late.
As the famous singer Kenny Rogers said,
“You’ve got to know when to hold ’em
Know when to fold ’em
Know when to walk away
And know when to run”
Do yourself a favour and sing Kenny Roger’s famous gambler’s song while you’re trading currency pairs. Forex trading is a leverage product and is associated with high risks. A disciplined and dispassionate approach to trading forex will mean you might walk away with some money in your pocket.
Forex Trading Africa Disclaimer
Trading foreign exchange on margin is risky. Forex trading is not suitable for all investors and traders and a high degree of leverage can result in significant financial losses. With forex trading, there is the possibility that you could sustain a loss of some or all of your initial investment.
12th Oct 2020