Types of Forex Trades
Next, we will look at the types of trades within the broad overreaching currency market. The first of these “mini-markets” is the Spot market. Spot market transactions are made immediately on the spot. There is no waiting. This is generally what people think of when they envision a trade and rightly so. Spot trades account for about 90% of the currency market. Even though the immediate exchange rates apply to the trade, the transaction usually takes 2 days to go through. Swap trading is the most common type of trading within the Spot market. This is when currency is exchanged at a forward rate.
A forward trade is a trade that does not take place immediately, but is a rate that is agreed upon for exchange in the future, regardless of the current rate. Obviously, this entails a bit more speculation that Spot trading. Both parties are hoping that the rate they actually trade for will be better than the current exchange rate would be if they had simply Spot traded.
The Futures market is just what it sounds like; a trade that will take place in the future. Like a forward trade, the transaction does not take place immediately. The rate at which the respective currencies will be traded at is agreed on and contracted when the deal is enacted. Because a longer period of time is involved in a Futures trade, daily interest is accounted for in the predetermined rate contract.
A key difference between a Futures trade and a forward trade is that a forward trade is an OTC trade, meaning it does not take place in a formal market. A Futures trade, on the other hand, is a contracted trade that takes place in a specific exchange market. Futures trades are also much lower credit risks since the margin required for them is generally much higher. Forward trades are exposed to credit risk until they are settled since the margin account is more vulnerable. However, periodic margin calls, or updates of your margin account, can be called in by the clearing house if your trade moves against you. Futures are run on a much higher margin, which means you must have invested more money to enact the trade.
There are two types of margin, the first being initial margin. This is the collateral that brokers ask for prior to the beginning of a trade based upon historical price swings. It can be as low as $100 US, or as high as $100,000 US, all depending on the broker’s requirements and the amount of currency to be invested in. A general rule of thumb is that margin requirements range from 1 to 10% of an investment. This means that if you are investing in $100 US, your margin account must cover $1 to $10 (1 to 10% of $100), depending on the broker. Since the initial margin will not necessarily cover all of the losses faced during a trade, there are also maintenance margins. The amount of money to be posted is usually spelled out in a prior agreement with the broker.
An important thing to look at when selecting a broker is whether or not interest is paid on money in your margin account. Most brokers offer interest congruent to the respective national rate.
Figuring out how much of your margin is required is quite simple. If you are trading USD for 100,000 JPY, where the exchange rate is 1:0.0085 with a margin percent offered of 3, the amount of margin required for the trade equals the exchange rate (0.0085) times the amount of units traded times the margin percent divided by 100. In other words:
Exchange Rate x Units Traded x Margin Percent / 100 = Margin Necessary
(0.0085) x (100,000) x (3) / (100) = (25.50 USD)
In other words, you need only $25.50 in your margin account to enact this trade. Remember though, if the trade goes against you, your broker will require you to pay more money than the initial amount asked for. It is advised that you never use your total margin account on one trade. If you have enough for only one trade, you may want to consider either postponing the trade, or trading smaller quantities.
Leverage is the term that describes how much buying power your margin gives you. In essence, the trader borrows money using his margin account as collateral. Some brokers offer leverage of up to 100 times your margin account. This mean that with $100 US in a margin account, you can actually trade for up to $10,000 US. While this amplifies your gains, it works both ways. Losses are also exaggerated by large amounts of leverage. Just because you have the leverage to make a trade doesn’t mean that the inevitable margin call will not come from your broker when it is time to collect losses.