Understanding Financial Forex Trading Instruments

by Susan Paige
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Most people often join forex trading with the intention of making quick profit. However, this is not always the case and you’re more often than not, required to understand the working parameters, if you want to succeed in the long term.

Foreign financial instruments are vital to the transactions in an online trading platform. They serve as monetary agreement between parties involved and as such, require your closer attention, as the trader.

The most common instruments include:

Exchange Traded Fund (ETF’s)

An ETF provides structured exposure to investors on foreign markets. By exposing you to a basket of assets, indexes, and investment strategies, you are able to know the best time to invest in forex currencies.

Most of these funds, for example, keep track of various trading currencies and always go against the US dollar. Often time, speculators and investors use this information to make better trades.

The associative benefits of ETF’s are:

  • Lower fees
  • Transparency
  • Diversification
  • Liquidity
  • Tax advantages

Forwards

Forward is a contract between two parties who are in an agreement to trade, sell or buy an asset, at a predetermined price. Forwards are used to lower the risk for investors, with no expiry date, or obligation to honor the contract.

Currency Future

A currency future happens when two parties, agree to exchange currencies at a fixed exchange rate, in the foreseeable future.

Normal waiting period for a currency future is 3 months, where an interest rate is usually active during this time. You are however, allowed to close this contract by meeting the demands of the contract, prior to the set date.

Through currency future:

  • Transactions are more efficient and fair
  • Profits are easier to make
  • Diversification is possible

FX Option

While other trading markets like the stock market have less liquidity and options, the forex market is full of them. Options unlike futures, offer both parties the right to buy or sell currencies at a pre-determined date, without any actual obligation to see the transaction through.

Due to the ever fluctuating rates of this derivative, one party can make huge profit, while the other incurs a loss.

Common FX option terms include:

Expiry date

An expiry is the deadline for when options contract obligations should be met. A contract can be settled earlier than the due date, but it can never go beyond the expiry date.

Strike price

Strike price simply refers to the set price of buying and selling the options contract, on or before its expiry. Whether it is a put or call option, you are must honor the obligation of buying or selling a currency pair at the set price.

You should consider the following when determining a strike price:

  • Risk tolerance
  • Reward-risk payoff

Premium

Before an options contract is consolidated, the seller (writer) must receive a fee (premium) for buying or selling underlying options. A fee is agreed upon depending on the intrinsic value of an option and the time value.

Implied Volatility

Every options contract comes with its own implied volatility. It is a risk associated with the options contract in the current market, and it has an influence on the price. Contracts with higher implied volatility often come at a higher price.

Factors that influence implied volatility include:

  • The strike price
  • Time left to expiry
  • The stock price
  • The options market price

Spot

Unlike currency futures contracts that can take months to close, spot requires only 48 hours to see through. When the parties agree on terms, a direct exchange of currency takes place, no interest is included, and cash money is involved.

Currency Swap

In currency swaps two parties come together and agree to exchange currencies for a period of time, which usually takes years. At certain times, a currency swap may involve swapping the principal amount with no interest rate.

Understanding these financial forex trading instruments, puts you at a better chance of making wiser, trading decisions in the market.

 

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