Forex Markets

Currency trading is one of the most popular foreign currency instruments in the world, making up 37 percent of the total activity. The features of the fast-paced spot market are high volatility and quick profits (as well as losses).

Market share of US spot trading (% of total volume): 1 - Forwards and Swaps; 2 - Options; 3 - Futures; 4 - Spot

A spot deal consists of a bilateral contract whereby a party delivers a specified amount of a given currency against receipt of a specified amount of another currency from a counter-party, based on an agreed upon exchange rate, two business days after the deal date. Don't forget, FX trading operates from Monday morning in Sydney, Australia, until late Friday afternoon in New York.

The exception is the Canadian Dollar, in which the spot delivery is executed next business day. The two day spot delivery for currencies was developed long before technological breakthroughs in information processing. This time period was the minimum time frame necessary to check out all transactions' details among counter-parties.

Although technologically feasible, the contemporary marketplace does not find it necessary to reduce the time to make payments. Human error still may occur and the extra day provides for this potential scenario.

By entering into a contract on the spot market a trading bank serving the trader tells the latter the "quote" - an evaluation of the currency traded against the US Dollar or some other currency.

A quote consists of two figures (for example, USD/JPY = 133.27/133.32 or, which is the same, USD/JPY = 133.27/32). In the example, the price on the left (133.27) is called the "bid" price (that is a price at which the market is willing to buy US Dollars against the Japanese Yen). The price quote on the right (133.32) is called the "ask" price (the price at which the market is willing to sell US Dollars against the Japanese Yen).

The difference between the "ask and bid price" is called the "spread". The spread is measured in points or what is referred to as "pips."

When a trader is quoted this spread by another market participant he can trade by either selling at the bid price or buying at the ask price, or he can "pass" and make no trade at all.

In terms of volume, currencies around the world are traded mostly against the US Dollar, because the US Dollar is the currency of reference. The other major currencies are the Euro, followed by the Japanese Yen, the British Pound, and the Swiss Franc. Other currencies with significant spot market shares are the Canadian Dollar and the Australian Dollar. These currencies are commonly referred to as the "majors." In addition, a significant share of trading takes place in the currencies crosses, a non-Dollar instrument whereby foreign currencies are quoted against other foreign currencies, such as the Euro against the Japanese Yen.

Diagram of the trade activity (% of the volume) of US Forex in time distribution: 1 - from 12 pm till 4 pm, 2 - from 4 pm till 8 pm, 3 - from 8 am till 12 pm.

The spot market is characterized by high liquidity and high volatility. Volatility is the degree to which the price of currency tends to fluctuate within a certain period of time. For instance, in an active global trading day (24 hours), the Euro/Dollar exchange rate may change its value 18,000 times, "flying" 100-200 pips in a matter of seconds, if the market gets wind of a significant event.

On the other hand, the exchange rate may remain quite static for extended periods of time, even in excess of an hour, when one market is almost finished trading and waiting for the next market to take over. For example, there is a technical trading gap between around 4:30 pm and 6 pm EDT. In the New York market the majority of transactions occur between 8 am and 12 pm, when the New York and European markets overlap. The activity drops sharply in the afternoon, over 50 percent in fact, when New York loses the international trading support. Overnight trading is limited to participants outside of their own region's trading hours, as very few banks have overnight desks. Obviously, one man's overnight is another man's daytime so most banks and traders send their overnight orders to branches or other banks that operate in their own active time zones. In summary, the reasons for the spot market's popularity are first and foremost the inherent nature of the spot market's volatility - that enables fast liquidity or profit taking. The second reason is the short time it takes to execute a contract or trade - often just a matter of seconds from the initiation of the contract's execution.

Finally, profit and loss (P"L) is very quickly either realized or unrealized.

  • The realized P"L is the amount of money the trader nets when a position is closed.
  • The unrealized P"L consists of the amount of money that an outstanding position would generate if it were closed at the current rate.
  • The unrealized P"L changes continuously in conjunction with the exchange rate.

Currency futures are a type of "forward outright" deal. Due to the fact that currency futures are derived from the spot price, they are derivative instruments. They are specific with regard to the expiration date and the size of the trade amount. Generally, forward outright deals - those that mature past the spot delivery date - will mature on any valid date in the two countries whose currencies are being traded. In contrast, currency futures mature only on the third Wednesday of March, June, September, and December.

There are many characteristics of currency futures that make trading them attractive. First of all, currency futures are open to all market participants, individuals included. The currency future market is a centralized market, whereas the cash market is a very decentralized market. Futures trading takes place under one roof. It eliminates the credit risk, because the Chicago Mercantile Exchange Clearinghouse acts as the buyer for every seller, and vice versa. In turn, the Clearinghouse minimizes its own exposure by requiring traders who maintain a non-profitable position to post margins equal in size to their losses.

Although the futures and spot markets trade closely together certain divergences between the two occur, generating arbitraging opportunities. Gaps, volume, and open interest are significant technical analysis tools that are only available in the futures market.

Due to these characteristics, currency futures trading volume has steadily attracted a large variety of traders.

Note: Futures are essentially forward outright contracts. Spot, forward and futures prices are available from online service providers that provide real time price quotes. The most popular service providers are Telerate, Reuters, and Bloomberg. Telerate presents the currency futures on composite pages, while Reuters and Bloomberg display currency futures on individual pages that show the convergence between the futures and spot prices.

This content is intended to provide educational information only. This information should not be construed as individual or customized legal, tax, financial or investment services. As each individual's situation is unique, a qualified professional should be consulted before making legal, tax, financial and investment decisions.

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