Forex Investment and Currency Trading

Foreign Currency Options
You don’t have to actually buy any currency to speculate in the foreign currency market. You can buy a foreign exchange or currency option contract. This contract gives you the right but not the obligation to buy or sell a specified amount of one currency for another at a specified price on (or in some cases, depending on the contract, before) a specified date.

Options don’t have to be exercised (meaning to actually buy or sell the currency). The holder can decide not to exercise his or her option. If the holder decides not to exercise the option on the specified date, the option expires. The holder doesn’t have to come up with any funds on the specified date, but does lose any money spent to buy the option.

There are two types of options. A call option is the right, but not the obligation, to buy the underlying currency on a specified date. A put option is the right, but not the obligation, to sell the underlying currency on a specified date.

The person who purchases the option is the holder or buyer. The person who creates the option is the seller or writer. The price of the option is set by the seller and includes a premium that the buyer pays the seller in exchange for the right to buy or sell the underlying currency.

The buyer of the option only risks losing the amount of money he or she paid in premium to buy the option. The writer of the option’s risk is unbounded because he or she must come up with the underlying currency if the option’s buyer decides to exercise his or her right on the specified date in the contract — even if the cost of buying or selling that underlying currency is considerably higher than when the option was originally written.

Options have been around for a long time, but only started to flourish in the foreign exchange market in the 1980s. Their popularity was aided by an international environment of floating exchange rates, deregulation, and financial innovation. Currency options started on the U.S. commodity exchanges, but are available in the over-the-counter market, too. Options are very popular, yet they make up a very small share of foreign exchange trading.

you want to trade in options, your best place to start is through one of the U.S. exchanges. In the United States, options on foreign currencies are traded on the Philadelphia Stock Exchange (www. phlx.com) and the Chicago Mercantile Exchange (www.cme.com). You can also trade options on the U.S. dollar index and on the euro index at the New York Board of Trade |www. nybot.com).

Exchange-Traded Currency Futures
Another way you can get involved in the foreign currency exchange market without actually exchanging foreign currency is through exchange-traded currency futures. These are contracts between two parties to buy or sell a particular non-U.S. dollar currency at a particular price on a particular future date.

When you actually enter into the contract, no one is buying or selling any currency; it’s just a contract with a promise to purchase a foreign currency at some future date. In reality, most futures contracts are canceled before maturity, and only about 2 percent result in delivery. Futures contracts are primarily used as a tool to hedge other financial positions or to speculate in the foreign exchange market.

You may think that futures seem to be the same as outright forwards, but they are not. Futures are traded on organized centralized exchanges that are regulated in the United States by the Commodity Futures Trading Commission. Forward contracts are traded over the counter and are largely self-regulated, so they can be a much more risky transaction.

The Commodity Futures Trading Commission (www. cftc.gov) is a U.S. government entity that protects market users and the public from fraud, manipulation, and abusive practices related to the sale of commodity and financial futures and options. The commission’s mission also includes fostering open, competitive, and financially sound futures and options markets.

The fact that futures contracts are channeled through a clearinghouse with the guarantee of performance on both sides of the contract makes them a much safer bet than forward contracts. It’s much easier to liquidate a futures contract, too, because there is an established futures market. Also the high degree of standardization for the futures contracts means that traders only need to discuss contracts one wants to buy and the price for the contract. Transactions can be arranged quickly and efficiently.

Forward contracts do provide more flexibility- in setting delivery dates. They tend to be for higher amounts, sometimes for millions of dollars. Futures contracts are much smaller and are usually set at about $100,000 or less. A trader who wants to buy more than that buys the number of contracts needed to hedge or speculate in the dollar amount desired.

Forex Hightlights

• Most developed-country currencies are sold at floating exchange rates on the spot market.
• You can arrange to buy Foreign currencies at some future date using a forward transaction
• You can swap foreign currency or an interest stream from foreign currency using one of three types of swaps: Fores swaps, currency swaps, or interest rate swaps.
• You can get involved in the foreign exchange market without actually buying and selling foreign currency by using options and futures contracts.