April 21, 2021 | by sandeep
Explaining Spots, Futures, Options, Exchange Traded Funds (ETFs) & Bonds
There are many ways we can trade Forex. In this post, we’ll provide you with some introductory information on each.
Defining Futures Contracts
We can trade Forex in what is known as the Futures Market.
Futures are contracts to buy or sell an asset in the future. In order to do that, we must agree to a price now and make the trade, and then we pay to complete this trade in the future.
To better understand this concept, let’s use the automobile industry as an example.
Take BMW. They sell cars at a set price. The raw material used to build the car is aluminum. Now aluminum is a commodity. As a commodity, the price of aluminum is not set and it changes quite often. BMW can’t change the price of the car every other day just because the price of the raw material moves up and down. Instead, BMW offers one fixed price, which includes the raw material and manufacturing costs.
So how does BMW price their product without risking the cost of aluminum and wiping out their profit margins?
They do it using something called a Futures Contract.
BMW makes an agreement with the aluminum producer to buy aluminum six months in advance at an agreed price. By having this sort of arrangement, the aluminum producer and BMW have agreed to lock the price of aluminum at a level that will benefit both respective businesses in the future.
A futures contract is also used widely in other manufacturing sectors.
For example, cereal manufacturing. In order to curb the price of wheat from fluctuating every time, the cereal company goes into a locked futures contract to buy wheat from the farmer in the future at an agreed set price.
With this agreement, the farmer is happy to know exactly how much they’re going to get in terms of profits when all of their wheat is harvested, while the cereal company is also happy because they know how much wheat is going to cost them further down the line and they can work out what their profits are going to be. So, whenever the cereal company goes into the manufacturing of cereal, regardless of good or bad weather, both parties are pretty much assured that the price of wheat will be stable and not spike one way or the other.
Futures Contracts with Currencies
And this works the same with currencies.
Let’s say, for example, the cereal company is based in Europe and they want to open a huge factory in the US.
The cereal company will have to pay for all of its operations and manufacturing costs in the US in dollars and not in euros.
In order to do this, they will have to convert their euros to dollars. So let’s say it’s going to cost the cereal company $100 million to start operations in the US. Given the exchange rate, $100 million will amount to 90 million euros. So they set aside 90 million euros in their planning and, in the midst of building the factory, the euro starts to weaken and now the exchange rate has moved to 1:1 against the US dollar. 90 million euros is now 100 million euros with the new exchange rate.
It’s still going to cost the cereal company 10 million additional euros to build the factory, so the cereal company has to find another 10 million euros somewhere just because the exchange rates have changed adversely. This could mean the factory’s construction could run out of funding, and the cereal company could go bankrupt and face some severe consequences.
Now, by looking into the exchange rate, the cereal company can use a futures contract and make sure that the factory will cost them 90 million euro, no matter what happens to the euro-dollar exchange rate.
Similarly, for someone who imports health products from the US to the UK, they would price all of their products in the pound but buy everything from the US in dollars. So, if the pound weakens, the products bought from the US will cost more money and therefore a lot more pounds. To avoid a possible loss of profits, the company could then use a futures contract to lock in the price of the health products from the US to protect it from exchange rate fluctuations.
As currency traders, we may not be interested in building a factory in the US or buying large quantities of health products. However, should you forecast that the Eurodollar will go down in the next few months, you could take advantage of this situation, place a sell and go short with a futures contract.
Futures contracts are basically very standardized. They are traded in an exchange. They are transparent, regulated and traded in 100,000 standard sizes for 1 lot. So, if someone wanted to trade Eurodollar futures for the month of June, for example, they would have to place the trade in a 100,000 standard lot.
A futures contract may not be attractive to the retail trader because of the size of the contract. The futures contract size might not be the kind of size that most retail traders want to trade. To solve this problem, retail traders can trade smaller contract sizes of 10,000 units, which are not quite as liquid as that of the standard contract. Hence, all in all, the futures market might not be the most suitable place for us to be trading Forex.
Another way we can trade Forex is by using Options. With options, we have the right (or an option) to buy or sell whatever the asset is.
For example, it’s Christmas and that cereal factory we wrote about earlier is due to start building work in June. So, the company needs to prepare its dollars in June for when the building begins. They have the futures contract in place, which means they’re exchanging 90 million euros for $100 million in June. Everything is set in stone.
Suddenly, something goes wrong. An earthquake takes place and there is a change of plans. The building site’s planning permission has been revoked and the factory is not going to be built. The company still needs to change their money. If they sell the futures contract, then they will trade it at the current market price. So they could still potentially face a loss if the exchange rate has moved against them.
What is the cereal factory going to do with $100 million and no factory to build?
In this scenario, it might have been better to buy an option, which gives the cereal company the option to exchange 90 million euro instead of a futures contract. If anything goes wrong, then the company does not have to exchange their euro into dollars.
Options are a little bit like an insurance policy in case something goes wrong. With an options contract, they would have had an option to not build the factory in case something went wrong. The options contract will protect the cereal company by not getting stuck financially and losing a catastrophic amount of money.
Buying home insurance is also an option. We don’t want our house to burn down. But just in case something happens, then we’ve got home insurance and the option of receiving some money as compensation in case of a catastrophic event.
What Are Exchange Traded Funds (ETFs)?
ETFs is where financial institutions put together a fund that usually has a diverse selection of assets, and the fund is traded in an exchange similar to company shares.
The problem with ETFs is that it does not allow us to actually make the trading decision on individual assets or asset classes.
The other disadvantage with ETFs and options, for that matter, is that they are not available 24 hours a day. The exchange’s opening hours are limited and not as liquid as the futures or spot markets.
Let’s Explore Spot Markets
The Spot Market involves on the spot trading using current prices.
It’s liquid with very tight spreads. It’s also considerably cheap to trade the spot market. It doesn’t cost us a lot and it’s available 24 hours a day, five days a week. As a trader, it is very easy to participate in this market, which only requires us to open a trading account for very little money, giving us free access to the entire market.
The spot market allows us to trade Forex. A trader can choose to trade as low as 1000 units up to 100,000 units, making it very appealing to a retail trader. The spot market offers a lot of free charts, indicators, newsfeeds and many other tools to assist us when trading.
Since we’re not trading Forex via the futures and options market, why is it important to learn about them?
Although we’re unlikely to be trading anything other than spot, it is very important to understand these other mechanisms. When the futures and options contracts expire, for instance, we see very unusual movements in the spot market. If we’re not aware of the futures and the options markets expiry dates and how large the positions expiring are, we might be in for a nasty surprise. So these need to be taken into account when we develop trading strategies and execute them.
Bonding with Bonds
When the government wants to borrow money, it issues something called a Bond.
In theory, the government uses your taxes to pay for improvements to the country and the lives of its citizens. If the government spends more than it has received in taxes, it has to borrow money through what is known as the bond market. A bond is basically an IOU or a piece of paper that says the government owes a person a certain amount of money.
Let’s say we’ve got $100, the government has borrowed it, and the bond owed to us has a maturity going out to 2025. That’s the fixed date when the government has to pay the $100 back to you. From the time the bond is issued till its maturity date, the government will pay us interest on that bond on a yearly basis. If they pay a 5% interest on that bond, then from now until 2025, we get 5% and we won’t need to wait until 2025 to get our money back. We can then choose to sell the bond on to someone else because the price is changing all the time.
There are various other reasons why we may choose to sell a bond.
One reason is the interest rate. We receive interest on that bond every year until the government pays back what it owes us in the nominal bond value.
Another reason is we might expect the price of a bond to go further up. Just imagine if all other government bonds are paying 2% interest and our government bond is paying 5%. Demand for the 5% bond will surely increase.
Government bonds are very attractive due to their safe-haven characteristics. The government assures that our money is safe. There is no need to worry about bankruptcy. But we know that this is obviously far from the truth.
Take the US bond as an example.
The US is the biggest economy in the world. So, the US government bond is far more likely to be paid back by the US government than that of a smaller country whose government funds are at a higher risk of bankruptcy.
At one point, Greece looked as though they would have a problem with insolvency. It seemed like they were going bankrupt, and there was a time when they were forced to pay something like 36% to issue bonds back in 2012.
So the country and the state of its economy also determine the interest rate you will get on their government bonds. Argentina, for example, has a higher default risk than most countries and, as a result, they have to pay higher interest rates on their bonds in order to attract money or lenders. So, if we choose to buy government bonds, we should know that the US government offers more stability and reliability and is much less likely to go bankrupt.
During a financial crisis, a huge percentage of the sale of stocks and shares are invested in safe-haven government bond assets. It’s called a safe haven when the markets are afraid of risk, and this is when market sentiment goes into a risk-off attitude.
As currency traders, we do not necessarily trade bonds but we need to understand what is going on in the bond market so we can measure the market’s appetite for risk. If we can measure the market’s appetite for risk, then we can predict changes in demand for any particular currency.
If investors around the world are worried and they’re pulling money out of the stock market, which is a riskier investment, then they are going to want to put their money in a safer asset class. They might choose government bonds. In which case, it would be US government bonds since it’s the biggest economy in the world, a stable political system and a military superpower protecting those bonds and the US dollar. So, the US bond market is one of the safest places for an institution or fund to move money from a riskier investment and put it into a safer place.
As a currency trader, should we choose to move our investments to a safer asset class like the US government bonds, then we will have to convert our local currency into dollars so that we can buy these bonds.
Obviously, the US government is not going to accept our local currency. This is why we have to pay attention to this movement because this is where we can come in and buy US dollars in anticipation of that flow of money going from individual countries around the world into the US to purchase their bonds.
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