Introduction to Forex Trading Part 3: What to Trade

In forex trading, many different types of securities can be traded, each with its own distinct characteristics and risk levels. These assets range from simple spot market transactions to more complex options strategies. Traders looking to enter forex trading could benefit from learning how to use the different types of assets.

The first type of transaction involves a spot market trade. This kind of trade is simply exchanging one currency for another at the prevailing market rate. So, if investors wanted to express a bullish opinion on the euro and they own dollars currently, they could simply trade the dollars for euros at the EUR/USD spot rate. Such a transaction is rather simple and leaves traders vulnerable to all fluctuations in the exchange rate.

Traders also may consider FX forwards as an alternative to trading at spot. Forward contracts are agreements between two parties to exchange currencies at a future date at an agreed upon exchange rate. Thus, this agreement allows traders to speculate on future exchange rates. If the exchange rate at maturity ends up different than the agreed upon rate, then one side of the forward will profit and the other will suffer a loss.

For example, if two traders agree to trade the EUR/USD at 1.30 in six months and the exchange rate at maturity ends up at 1.28, the trader who is long dollars and short euros gets to short euros 200 pips above the spot price. Conversely, the other trader, who is net long euros, would be long at 1.30 and would lose 200 pips due to the lower market rate. Thus, investors can speculate on future rates and potentially profit from changes in expectations.

FX swaps are another form of forwards. Two parties swap currencies at the initiation of the agreement and then swap back at the end. In the time between the initiation and maturity of the contract, each trader is exposed to market fluctuations. Thus, profit or loss can arise from these market fluctuations as with the forward contract.

Larger traders also could consider futures to trade with. However, futures trading generally involves more risks. One such risk is that of collateral calls, as futures traded on exchanges require parties involved in the trade to post collateral so that the exchange can hedge its own risk. Also, futures trade in large lot sizes, usually in units of 100,000, and so trading futures can sometimes be too much for individual traders.

The last asset class traded regularly in the forex market is that of options. Vanilla forex options are the same as any other type of plain option, having a strike price and maturity date. Traders can use these or more exotic options to express theses on the forex market, as well as to employ certain strategies that are formed out of options. One popular forex options strategy is the Double No-Touch, a strategy in which a trader uses options to speculate on a trading range. If the exchange rate stays within the specified range (determined specifically by the strikes of the options involved), then the owner of the strategy is in the money.

Knowing how to use different types of forex assets can help a trader maximize profitability. Generally, short-term trades are best suited to the spot market, while medium- to long-term trades are better suited to forwards or options strategies. Large traders and institutions could use futures, but futures trading employs lots of risks, such as collateral calls. Trading in the forex market can help traders diversify their activities and help them to maximize profits allowing them to express global theses in the world's largest market.