What is forex and how does it work
May 29
/
VT Markets
An FX forward is a method of trading on the forex market. To use a forward, the trader enters into a contract to execute the position at a predetermined rate once the contract reaches its expiration point. This enables traders to set a price for future trade and then speculate on future price movements. When the contract is due, the trader is obliged to complete the transaction according to the terms of the contract.
As the forwards contract derives its value from an underlying currency pair — i.e. two currencies traded against one another, such as USD/AUD (United States dollars against Australian dollars) — it is known as a derivative.
However, forex forwards are a specific type of derivative. Other derivatives, such as FX options, have unique rules and attributes, setting them apart from a forex forward contract.
Derivatives add variation and diversity to a trading strategy. Traders can use different types of derivatives to achieve different aims in the market. But it’s also important to understand that these derivatives add complexity, so traders must recognise what they deal with when they take out a derivative contract like an FX future.
A forex forward can also be known as a currency forward. This is simply because these forward contracts deal with the price movements of different currencies worldwide.
THE DIFFERENCE BETWEEN FX FORWARDS AND FX FUTURES
Different types of forex derivatives work in various ways. FX options, for example, do not carry an obligation for the trader to execute the trade. This makes them fundamentally different from FX forwards, in which the trader must carry out the transaction at the end of the contract period.
Perhaps the closest derivative type to the forward contract is the FX future. Forwards and futures share several similarities:
- Both forwards and futures involve locking in a transaction price for a set period.
- Both types of derivatives carry an obligation to complete the transaction — i.e. the trade must be executed when the contract expiration point is reached.
- Market forces govern both derivatives within the foreign exchange ecosystem, so price movements can be significant and rapid. In other words, there are no guarantees of success when trading, and there is always an element of risk involved.
Despite these similarities, FX forwards and futures are inherently different.
- FX forwards are over-the-counter (OTC) derivatives, which means they are not sold on the exchange itself — instead, they are traded via an agreement between two individuals.
- FX futures are sold across the foreign exchange platform and form part of the platform’s built-in trading features.
- FX forwards can be customised to suit specific needs and requirements. The two parties can discuss the terms and conditions of the forward as part of their agreement.
- FX futures cannot be customised and are instead standardised. This is because they are traded across the exchange, and individuals cannot change the terms and conditions within.
THE BENEFITS OF FOREX FORWARDS
There are several benefits to forex forward trading. However, traders must remain aware that “benefits” are not the same as “guarantees”. Careful and conservative trading is vital to get the best out of your forex strategy, and you should work to minimise risks wherever and however you can. With the right approach, traders can enjoy the following benefits when they use forward contracts.
FLEXIBILITY AND CUSTOMISABILITY
Perhaps the most obvious benefit to a forward contract is its flexibility. Traders can set the time period that best suits them and agree upon a price that matches their own strategy and view of the market. This is because the forward contract is an OTC derivative and is defined wholly according to the respective parties’ needs in the trade — unlike forward futures that are standardised. As a result, traders looking for a way to diversify and customise their derivatives may find FX forwards very interesting.
USEFULNESS IN HEDGING
The foreign exchange market is volatile, and prices are subject to change. Therefore, if an individual wants to speculate on a currency at the current FX spot trading price — i.e. the value of the currency at any given moment — but needs to defer the execution of the position until a later date, they risk losing out. This is because the currency’s value could change significantly between now and the execution point.
Changes in forex are measured in pips — pips in FX are incremental price movements that can travel up or down, depending on the performance of one currency in relation to others. Despite the gradual nature of these movements, pips can quickly build up and translate to significant value changes over time. This can cause a high level of risk and uncertainty for individuals who want to execute a trade at a future date. With FX forwards contracts, the trader can reduce the risk by locking in the current spot price and completing the trade when the contract expires, without worrying about price movements.
Changes in forex are measured in pips — pips in FX are incremental price movements that can travel up or down, depending on the performance of one currency in relation to others. Despite the gradual nature of these movements, pips can quickly build up and translate to significant value changes over time. This can cause a high level of risk and uncertainty for individuals who want to execute a trade at a future date. With FX forwards contracts, the trader can reduce the risk by locking in the current spot price and completing the trade when the contract expires, without worrying about price movements.
SIMPLE AND STRAIGHTFORWARD
FX forwards are generally straightforward to understand. This is because there are only two main parameters — the duration of the contract and the price of the currency — and the only other variable is the currency itself. This means it is relatively easy for traders to utilise and execute forwards contracts after only a short time spent learning the mechanics of the forex market .
CAN BE USED TO MAXIMISE EXPOSURE
As traders grow their understanding of how to trade forex, they can begin to increase their exposure. Increasing exposure essentially means working with a higher level of risk in the hope of a higher reward. By increasing the duration of the FX forwards contract, traders can potentially achieve a better return. However, this also increases the risk involved, as there is more opportunity for the market to move in the opposite direction. This idea of increasing exposure is similar to that of trading with leverage in FX, although the two strategies work differently.
TRADING FX FORWARDS
There are a few steps traders will need to take when utilising FX forward contracts in their own strategy.
DECIDING THAT FX FORWARDS ARE RIGHT FOR YOU
FX forwards are particular derivatives and may not be suitable for everyone. For example, traders may prefer the exchange-traded aspect of an FX future contract or the more open-ended features of FX options. Consider your own targets and strategy before you make your choice.
CHOOSING A TRADING FOCUS
Many traders utilise forex forwards to diversify their trading strategy or to hedge against other positions. Other traders may use FX forwards as their primary or exclusive trading strategy. Make sure you are clear on your personal approach before you begin trading.
BEGINNING THE TRADE
FX forwards trades will need to be conducted along with a second party. This is because the contract is an OTC derivative and is not a standardised instrument sold via an exchange. However, brokerage platforms like VT Markets can help you connect with opportunities to make your FX forward trade. Via a broker, you and the second party will agree on the terms and duration of the contract, and the forex forward trade will be opened.
CLOSING THE TRADE
Once the completion date of the contract is reached, you will be obliged to complete your trade. Unlike with other types of derivatives — such as FX options — you will not be permitted to change your mind.
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Risk Warning: Trading Forex and CFDs carries the risk of losing substantially more than your initial investment and should only be traded with money you can afford to lose. You don't own or have any rights to the assets that underly the derivatives (e.g. the right to receive dividend payments). Ensure you fully understand the risks involved. Trading leveraged products may not be suitable for all investors. Before trading, please take into consideration your level of experience, investment objectives, and seek independent financial advice if necessary. Please ensure that you fully understand the risks before you make any trading decisions. The information on this website does not constitute investment advice or a recommendation or a solicitation to engage in any investment activity.
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