Investors looking to diversify their portfolio to include more than traditional stock trading and retirement investment accounts may be considering foreign exchange trading (also called forex trading, or FX trading). While this form of foreign currency trading can be high-risk, it can also be high-reward for investors who are willing to commit to educating themselves about the process and taking time to find the strategies that work best for their markets. Let’s look at how forex trading works, what options are available to traders, how to hedge currency, and what risks are associated with the trade process.
Forex Trading: An Overview
FX trading is very like stock trading. Trades are made based on foreign currency market predictions through FX brokers or banking institutions. However, it is important to note that banks limit their FX trade option availability to larger corporations. So, if you are an individual trader or a SME looking to exchange foreign currency, working with an online FX broker or money transfer company is going to be in your best interest.
In FX trading, investors are constantly comparing currency rates of their selected exchange markets. Foreign exchange rates are read in pairs, or by comparing two units of exchange at a time. FX trades are also made in increments of 1,000 units, and all trades are made with borrowed money. The trades cost “pips,” or measurements of profits and loss.
Within the FX trade industry, there are two types of options used for trade. First, there is a call/put option. Second, there is a SPOT (single payment option). A call option means a trader can buy currency at a given rate on a future date. A put option means a trader can sell at a given rate on a future date. The key in call/put options is predicting the market well in advance, sometimes as far out as two months. Several factors can come into play when trying to predict foreign exchange markets that far in the future, often changing political situations, economic boosts, or regional volatility play large factors. Knowing what your foreign currency market is going to do can help prepare you to buy or sell currency at a rate that turns a profit.
SPOT options, on the other hand, are much easier to execute, but come at higher costs. SPOT options are based on market predictions, usually only a few days in advance, and if the prediction is accurate, the option pays out. FX options can be used to either protect against loss or make a profit depending on the currency you’re trading.
Hedging Currency with Forex Options
As a FX trader, when you want to protect yourself against a move in foreign exchange markets, you can enter a trade to help you do so. This kind of a trade is called a forex hedge. To hedge effectively using options, it’s important to keep in mind that SPOT trades, while they’re easier than traditional call/put forex options, aren’t your best bet for protecting against market moves. As mentioned before, SPOT trades have very quick expirations, usually only two days at the most, and won’t help you in predicting or protecting against long term unwanted market movement. Instead, traditional call/put options can help you protect against long-term market moves based on your existing position.
Hedging strategy varies, as do most investment strategies. The main key is to analyze the risks involved in your option trade, and determine your personal risk appetite or tolerance. No trader will have the same take on how much risk their portfolio can handle, and you can decide for yourself whether you prefer to trade conservatively or aggressively.
The Risks Involved & How to Minimize Them
The primary risk that investors face when using FX options to hedge currency is that they could lose more than their initial deposit. In general, the industry is highly volatile because the foreign currency market is constantly making dramatic shifts based on a wide variety of global factors. Investors must also consider liquidity risks. Based on what’s going on in any given market, a partner trader may start limiting trade sizes, or stop offering trade quotes.
However, the volatility of the foreign exchange trade shouldn’t scare away an interested investor. With online FX brokers and money transfer companies who all have transparent fees and processes, forex trading is made simpler. There are also steps that an investor can take to protect themselves against potential risks. First, a trader should start with a short list of markets they look to trade in. By limiting their list, they can better focus on market moves and currency shifts to prevent losses. Additionally, investors can only work with well-regulated, reputable brokers to ensure fair trading. In general, foreign currency exchange is an excellent option for investors looking to expand their portfolio. Currency hedging allows active investors to participate in international markets and reap the local equity returns.