Foreign Currency Trading Basics

By : Frank Vanderlugt


Foreign currency trading involves the trading of the currencies of various countries on the Foreign Exchange Market (Forex). In the Forex market, you see the simultaneous buying and selling of the different currencies at an agreed rate of exchange. Foreign currency trading is executed with currency pairs, such as US dollars (USD) for UK pounds (GBP) or European euro (EUR) for Japanese yen (JPY).

No financial market is larger in the world than the Forex market. The estimated volume of foreign currency trading per day is more than $2 trillion per day. This staggering volume has been estimated to be three times the combined volume of the stock and other futures markets.

One of the most important foreign currency trading issues you may have to decide as an investor is to choose the right marketplace. The three distinct vehicles where a foreign exchange occurs are the Interbank, futures, and options.

The Interbank. The bulk of foreign currency trading takes place in the interbank, a huge network of banks dealing in foreign currency trading for their own or their customers' needs, thus creating the market for all currencies. The interbank is also termed as the spot or cash market because settlements of all trades are made outright. It is likened to primary dealer markets in government debt.

For decades, the Interbank was accessible only to the very large traders - corporations, central banks, commercial banks, and huge dealers (brokers). It was difficult for small investors to participate as they could not afford the large cash blocks involved in the Interbank foreign currency trading.

Computerization made the dealing and matching system more efficient. Now, big dealers could subdivide large cash blocks into smaller chunks that the computerized foreign currency trading system could match automatically and track accurately. Eventually, the banks became comfortable dealing in transactions below $1 million, and opened cash trading to a broader range of investors, speculators and hedgers.

Futures. The advent of currency futures ranks among the most significant developments in foreign currency trading. Futures are contracts to make or take delivery of a particular commodity at an agreed price on a certain agreed date. These contracts are negotiable so you can trade them. Trading in futures is done on regulated commodity exchanges through clearing members who guarantee transactions. This mechanism means that futures have little counter-party risk.

Options. Like the futures market, options in foreign currency trading came about to help corporations and institutions cope with increasing volatility in the Forex markets. Fundamentally, an option is a choice: investors who buy options have the right, if they choose, to buy a specific amount of at a specific price on or before a specific date.

Corporations have used options effectively to hedge against currency fluctuations. Options allow them (or any option buyer) to lock in an exchange rate, and then exercise the option only if the situation calls for it. The buyer, however, has to pay a premium at the outset to purchase the option.



About the author:
frank j vanderlugt owns and operates http://www.lazytrader.com Day Trading