The Forex market is so widely used for multiple applications. Some participants, like the hedge funds, use the Forex market to generate pure profits from fluctuating exchange prices. Other participants like commercial companies use the foreign exchange to convert currency for cross country business transactions.
Due to the different type of applications that currency trading facilitates, the market is split up into different types of Forex markets, sub markets if you will. Each sub market caters for specific applications. Let’s have a look at the 3 major sub markets of the Forex market.
The Spot Market
Out of all the different types of forex markets, the spot market is the largest and is what you will trade as the retail Forex trader. Currency is bought or sold for instant delivery, or at least in the very near future. The word ‘spot’ comes from the ‘on the spot’ type trading.
I’ll give you a real life example…
Simon visits a currency booth at the airport to cash in his US Dollars for Japanese Yen. Simon hands the cashier his USD currency, and the cashier immediately gives Simon back the equivalent Yen.
Simon just made an ‘on the spot’ currency transaction with the cashier in the currency booth and this simple analogy is the very basic way of how the Forex spot market operates. Traders exchange currencies ‘on the spot’, with instantaneous transactions.
The spot market makes up about 40% of the total trading activity, and this is where you will find most retail traders.
The Futures Market
Futures are traded in contacts. the currency or commodity is scheduled for delivery on a specified ‘future’ date at a specified price on the contract. The contract future date is also known as the expiration price. The Futures market is centralized so all contracts are opened with a central exchange.
Although retail traders and hedge funds do trade the futures markets for profit, it is more utilized for commercial purposes.
Example 1: A wheat farmer might sell some wheat future contacts set to expire in 3 months. So the farmer has a guaranteed buyer for when his crop is ready to be harvested in about 3 months’ time. The farmer and the buyer have agreed on a set price set by the futures contract.
This is an advantage to the farmer because he doesn’t want fresh crops sitting around while he tries to find a buyer and run the risk of “stock going bad”.
Example 2: Apple is planning to launch its new iPhone, the next big thing to hit the market. To manufacture enough in time for the launch, Apple needs to order parts from some Japanese manufactures, which they have specified 4 months is needed to produce the goods.
Apple will need to convert USD to Japanese Yen to pay the manufactures. Instead of waiting 4 months and paying the exchange rate for USDJPY at the time of completion, Apple buys a JPY futures contract set to expire in 4 months.
This way Apple can lock in a contracted futures price for the JPY instead of running the risk of the Japanese Yen increasing over the 4 month manufacturing period, which would create a more expensive transaction. This is called hedging, and commercial companies do this all the time to protect themselves from changing currency rates changing against them.
The Forward Market
The forward market is one of the last different types of forex markets. Forward markets are another contract based transaction, one that’s similar to the Futures market in most aspects. We discussed how futures contracts are settled through an exchange, where the Forward market is decentralized. The contract details are set directly between the two parties involved.
This opens up a lot of flexibility in the contract agreements in terms of settling price and the contract expiration date. Forward contracts can even go past their expiration date and are valid until one of the parties closes the contract.
The uses of the forward market are very similar to Futures contracts, except forward contracts can be more customized, or tailored to the customer’s requirements.
So the Spot market, Futures and Forwards contract markets make up the majority of the Foreign Exchange market.
Futures and Forwards contracts are usually left for the big companies that have lots of money. As retail traders we only need to worry about the spot market. Out of all the different types of Forex markets, the spot market wins with it’s simplicity, straightforwardness and easy implementation. This is how Forex trading should be.