Trading is the buying and selling of various financial instruments namely currencies, futures, options and stocks, with the goal of making a profit from the difference between the buying and selling price. There are different styles of trading which depends on the personality of the trader. An array of Forex (FX)/ Precious Metals (PM) products that are available in the forex market can be summarized as follows:-
|Products||Foreign Exchange||Precious Metals|
|Non-Deliverable Forwards (NDF)||x|
|Non-Deliverable Swaps (NDS)||x|
|Exchange for Physical|
|Options - Vanilla|
|Options - Exotics|
A spot contract is a binding obligation to buy or sell a certain amount of foreign currency at the current market rate, for settlement in 2-business days. To enter into a spot contract, one has to define the amount to be transacted, the two currencies involved as well as to which specific currency to buy or sell.
The spot market is traded on a 2-business day value date. For more than 2-business day value date, it will be termed as outright forward contract. Outright forward rate is calculated based upon the interest rate differential between the two currencies involved and the spot rate.
FX swap market is where one currency is swapped for another for a period of time, and then swapped back, creating an exchange and re-exchange. An FX swap has two separate legs settling on two different value dates, even though it is arranged as a single trade. The two counterparties agree to exchange two currencies at a particular rate on one date (the "near date") and to reverse payments, usually at a different rate, on a specified subsequent date (the "far date").
Non-Deliverable Forwards (NDF)
Those currencies which cannot be settled due to their countries specific convertible regulations are traded offshore on non-deliverable basis. NDF is a cash-settled forward contract on a non-convertible foreign currency for an agreed notional amount. The profit or loss of the NDF is calculated at the time of the settlement date by taking the difference between the agreed upon exchange rate and the fixing rate at the time of settlement. All NDFs have a fixing date and a settlement date. The fixing date is the date at which the difference between the fixing rate and the agreed upon exchange rate is calculated. The settlement date is the date by which the payment of the difference is due to the party receiving payment. NDFs are commonly quoted for time periods of one month up to one year, and are normally quoted and settled in U.S. dollars.
Non-Deliverable Swaps (NDS)
Non-Deliverable Swap is a swap done on non-deliverable currencies.
Exchange for Physical (EFP)
Exchange for Physical (EFP) is the exchange of a long or short position in a futures contract for an equivalent position in the cash market. EFP gives the flexibility of transferring positions from the cash market to futures market, or vice versa. This product is widely used by hedge funds for reasons such as to mitigate counterparty risks, access liquidity and consolidation of positions to one market.
Options - Vanilla
An option is the right, but not an obligation, to buy or sell a currency pair, at a pre-determined price and by a pre-determined date in the future. Predominantly there are two types of options known as the Call Option and Put Option. Call Options are contracts that give the owner the right, but not the obligation to buy a currency pair at a specified price (also known as the strike price) on the date of expiration. When one is buying a call option, the price you are paying for it is called as the option premium. Your call options secure your right to buy that particular currency pair at the strike price. If you decide not to use the option to buy the currency pair on the expiry date (take note that you will have no obligation), your only cost will be the option premium. Call options usually will gain in value as the value of the underlying instrument goes up. The second type is the Put Options. They are contracts that give the owner the right to sell a currency pair at a specified price, also called the strike price, on the expiry date. Put Options are used when you are expecting the price of the underlying currency pair to drop. They will increase in value as the value of the underlying instrument decreases. With Put Options, you can "insure" a currency pair by fixing a selling price. In the event that the currency price falls, you can exercise your option and sell it at its "insured" price level. If the currency price goes up, then you do not have to exercise your options, knowing that your only cost is the premium which you have paid. In summary, options allow investors ways to manage their risk.
A combination of call and put options can be adopted to create different options trading strategy that best suits a trader. Common option strategies are detailed in table below.
|Vertical bear spread||Buy a call (put) option and sell a call (put) option with a lower strike price. All options have the same maturity.|
|Vertical bull spread||Buy a call (put) option and sell a call (put) option with a higher strike price. All options have the same maturity.|
|Straddle||Buy(Sell) a call and a put option. Both with the same strike price and maturity.|
|Strangle||A short put and a short call or a long put and a long call with the same expiration date and different strike prices.|
|Butterfly||A combination of a vertical bull and vertical bear spread with the same maturity on all options and the same strike price on all short options.|
|Time (Calendar) spread||Sell one call (put) and buy another call (put) with a longer time to expiration. The options have the same strike price.|
Options - Exotics
An option contract which has features making it more complex than commonly traded products like plain vanilla put or call option. Also known as a non-standard option that generally trade over-the-counter (OTC).
One popular type of exotic option among others is Barrier Options which is explained below.
Path-dependent option with both its payoff pattern and its survival to the nominal expiration date is dependent not only on the final price of the underlying but also on whether or not the underlying sells at or through a barrier (instrike, outstrike) price during the life of the option. Barrier options are always cheaper than a similar option without barrier. Barrier options were created to provide the insurance value of an option without charging as much premium.
"In" options start their lives worthless and only become active in the event a predetermined knock-in barrier price is breached. "Out" options start their lives active and become null and void in the event a certain knock-out barrier price is breached.
The four main types of barrier options are:
Spot price starts below the barrier level and has to move up for the option to be knocked out.
Spot price starts above the barrier level and has to move down for the option to become null and void.
Spot price starts below the barrier level and has to move up for the option to become activated.
Spot price starts above the barrier level and has to move down for the option to become activated.
Common barrier option strategies are detailed in table below.
|Knock-In Option||An option that becomes valid only when a predetermined price level (usually different from the strike price) is touched during the lifetime of the option. Down-and-in or up-and-in barrier options activated at specific price or rate levels.|
|Knock-Out Option||An option which is automatically terminated or 'knocked out' if the price of the underlying asset reaches a predetermined level (usually different from the strike price) during the lifetime of the option. Down-and-out or up-and-out barrier options activated at specific price or rate levels.|
|One-Touch Option||A type of exotic option with barrier that gives an investor a payout once the price of the underlying asset reaches or surpasses a predetermined barrier. This type of option allows the investor to set the position of the barrier, the time to expiration and the payout to be received once the barrier is broken.|
|Double No-Touch Option||A type of exotic option that gives an investor an agreed upon payout if the price of the underlying asset does not reach or surpass one of two predetermined barrier levels. An investor using this type of option pays a premium and in turn receives the right to choose the position of the barriers, the time to expiration, and the payout to be received if the price fails to breach either barriers. A double no-touch option is the opposite of a double one-touch option.|
|Double One-Touch Option||A type of exotic option that gives an investor an agreed upon payout if the price of the underlying asset reaches or surpasses one of two predetermined barrier levels. An investor using this type of option is able to determine the position of both barriers, the time to expiration, and the payout to be received if the price does rise above one of the barriers. Either one of the barrier levels must be breached prior to expiration for the option to become profitable and for the buyer to receive the payout. If neither barrier level is breached prior to expiration, the option expires worthless and the trader loses all the premium.|
For example, a European call option may be written on an underlying with spot price of $100, and a knockout barrier of $130. This option behaves in every way like a vanilla European call, except if the spot price ever moves above $130, the option "knocks out" and the contract is null and void. Note that the option does not reactivate if the spot price falls below $130 again. Once it is out, it is out for good.