Along with choosing a trading strategy and a currency pair, investors also need to choose a market in which to trade currencies. There are several different markets available to trade currencies including the Forex market, derivatives markets and exchange-traded funds. Here is a brief description of each market.
A majority of currency trading takes place in the Forex spot market. In this market, large banks and other financial institutions trade currencies among themselves either for immediate delivery (spot market) or for settlement at a later date (forward market).
Trades in the Forex market occur over the counter, and the minimum size of the trades is very large. In the past it has been impractical for individual investors to trade in the Forex market for these reasons.
However, over the past several years, a new retail Forex market has developed. This market allows individual investors and small institutions to trade in the Forex market with smaller volumes than those that were previously available.
Derivatives include futures, options and exotic, customizable derivative contracts. The more exotic derivatives are usually designed for institutional investors, while individual investors often trade futures and options.
The most popular currency pairs have both futures contracts and options on those futures contracts. Individual investors are able to buy or sell the futures or the options to speculate on the direction of the currency pair. These futures and options usually feature reasonably good liquidity, transparent pricing and moderate capital requirements.
For these reasons, futures or options are a viable choice for individual investors interested in the currency market.
When using futures or options, it’s very important to understand the risks involved in using these financial instruments. Even though large gains are possible, the majority of investors using these securities eventually lose money. Futures contracts also carry the possibility of potentially unlimited losses.
Investors should carefully consider their risk tolerance and thoroughly understand potentially adverse price movements, before considering a futures trading strategy.
Exchange Traded Funds (ETFs)
ETFs have been popular vehicles for tracking stock and bond indexes for years, however, they are a relatively new addition to the world of currency trading. A currency ETF can be bought and sold just like any other stock.
An investor who believes a currency is about to rise in price should buy the ETF. On the other hand, an investor who believes a currency will decline in value should sell the ETF.
An advantage to trading ETFs is that they are more familiar to the average investor than the Forex or derivatives markets. ETFs also carry stricter margin requirements, so they may appeal to more risk-averse investors.