The Ins and Outs of Foreign Exchange: Understanding the Tools of Forex Trading
Understanding the tools of forex trading available to a business can help ensure that favourable exchange rates are leveraged, thereby maximising profits. For a business just entering the world of foreign exchange, terms like spot rates, forward contracts and FX hedging can seem confusing, daunting and, well, foreign.
But understanding these forex trading basics are critical if a business wants to stay ahead of the game – and it doesn’t have to be difficult.
Spot Rates vs. Forward Rates
The first step in understanding forex trading is to grasp the concepts of spot rates and forward rates (also known as forward contracts), and the difference between the two.
A spot rate is a currency’s foreign exchange rate at the present moment. It is the rate “right now”; the price to be paid (or received) for a particular foreign currency if a forex trade is executed at that moment. In instances that require the urgent or immediate transfer of foreign currency, executing a forex trade using a spot rate is popular because waiting to transfer the foreign currency is not a viable option.
A forward rate is the expected exchange rate for a foreign currency at a future point in time, and is obtained through a forward contract. Essentially, a forward contract is an agreement between two parties to exchange two different currencies at a specified rate on a specified future date. Forward contracts can result in one party receiving the better end of the bargain, depending on whether the exchange rate between those two currencies moves as predicted and what the exchange rate is on the date that the forward contract is exercised.For Example:
Consider a company based in Australia that has contracted to purchase goods from a company in Japan, with payment of 5 million Japanese Yen (JPY) due within 90 days from the date of the contract. The company can decide to pay immediately, executing a spot forex trade of AUD to JPY at the current spot rate. If the Australian company chooses to make the payment later, it becomes exposed to fluctuations in the spot rate between the two currencies. If JPY becomes more expensive to buy in AUD, the company must spend more to pay the contract – though by taking the risk, it might end up paying less. A forward contract offers the opportunity to lock in a rate at which to exchange the currency at a future point in time. In this way, the company can plan its foreign currency transfer needs, while knowing how much it will cost in its home currency.
In this example, if the end of the 90-day payment window came on the day this sentence was written, the Australian company’s 5 million JPY bill would cost AUD 61,262. If the company had paid the bill 90 days ago, the same 5 million JPY would have cost AUD 64,475. By waiting, the Australian company could have saved money – but left itself open to uncertainty in terms of forex trading volatility.
What is FX Hedging?
Using a forward contract to protect a company from forex trading risk, and the associated costs, can give that business a significant competitive advantage. This is referred to as FX hedging. As noted in the example above, a business can use a forward contract to lock in a specific foreign exchange rate on a future date. While FX hedging is not appropriate for everyone, it can be a powerful forex trading tool if used properly. A full explanation of the intricacies of utilising a forward contract, or multiple forward contracts in conjunction to protect a business from fluctuations in spot rates while still leaving the possibility to profit from changes in spot rates, should be discussed with a currency exchange provider.
Dealing in the Spot Market
An effective forex trading strategy does not have to be limited to only forward contracts. At times, trading foreign currency directly in the spot market at the current rate is the most effective strategy for a business to minimise its costs or maximise its profits. Sometimes, it can be more profitable to execute a currency exchange at the current spot rate to take advantage of favourable pricing for a product, or to receive payment immediately from a client, regardless of what the current spot rate is. But even when transacting in the spot market, there are various tools a firm can use to maximise its profit (or minimise its loss) on the currency exchange. There are various types of trade orders a firm can utilise in a forex trading strategy to create flexibility and to prevent surprises should prices rise or fall while the currency exchange is being executed. Some of these trading tools are briefly outlined here:
Limit orders are used to buy or sell a specific amount of a foreign currency at a specified exchange rate (or better). A buy limit order will only be triggered at the specified FX rate (or lower); whereas a sell limit order will only be triggered at the specified FX rate (or higher). For example, a business places a buy limit order to exchange 10,000 Australian dollars (AUD) for euro, but only if the euro spot rate reaches 0.70 euro per AUD, or lower.
Stop Loss Order
A stop loss order protects the value of a business’s currency holding by establishing a “floor” on an acceptable exchange rate. This floor represents the maximum the business is prepared to lose on the currency trade: if the value of its currency holding declines below the floor, the holding is liquidated (sold) to ensure that the business doesn’t lose value (or if the floor is set below an exchange rate in which there is already a loss of value, it can serve to limit further losses).
One Cancels Other (OCO) Order
By combining a limit order with a stop loss order, and adding the condition that if one of these orders is triggered then the other is cancelled, a one cancels other (OCO) order is created. For example, an OCO order can be used to set an upper limit order and a lower stop loss order at which a currency holding is to be sold. If one is triggered, the other is cancelled, thus the currency holding is free to trade within this pre-set range.
These are the basic terms and forex trading tools to be familiar with when seeking to engage in more than just basic spot forex trading in the foreign currency markets.