Types of Forex Trading Instruments

Most novice traders who first encounter financial markets have little understanding of the pricing mechanism of trading instruments, which negatively affects their trading profitability. As a result, conducting trading operations on this or that instrument turns into a kind of casino with the goal of guessing the direction of the trend and making several tens or hundreds of dollars on directional price movements. The place of balanced decisions that should be at the heart of the trading activity of any trader is occupied by spontaneous trading operations based on emotions, which inevitably leads to the financial collapse of a beginner.

By definition, a trading instrument is an asset that can be the subject of a trading operation, for example, a currency pair, security, physical goods, derivatives, etc. In fact, a trading instrument is a means of transferring something of value from a buyer to a seller.

Currency pairs


The most common trading tool for online trading in the last decade is currency pairs. Trading in currency pairs is offered by the vast majority of brokers and is carried out on the international Forex currency market. In fact, all transactions in the Forex market involve the simultaneous purchase of one currency and the sale of another currency, however, a currency pair is considered an independent tool that you can sell or buy. If a trader buys a currency pair, he buys the base currency (the first in the currency pair designation) and sells the quote currency (the second in the currency pair designation), if it sells, then vice versa. The purchase price (direct quote of a currency pair) reflects the required amount of the quote currency to purchase the base currency. For example, if the EUR/USD currency pair is trading at the rate of 1.5, and the trader acquires this pair, this means that he receives 1 euro (EUR) for every 1.5 US dollars (USD).

"Dollar pairs"


All currency pairs are divided into subcategories according to their liquidity. The most liquid currency pairs are the so-called "dollar pairs", that is, pairs containing the American dollar, such as EUR/USD, USD/JPY, GBP/USD, etc. The high liquidity of these financial instruments is the reason for the high volatility required by private traders to make a profit. These highly liquid instruments are included in the group of so-called “majors”, or major currency pairs.

Cross courses


Another large group are cross rates, that is, currency pairs that do not contain the American dollar. Quotations of such currency pairs are determined through the third currency (US dollar), that is, through the ratio of two currency pairs containing the US dollar. For clarity, I’ll give an example of determining the EUR / JPY cross rate:

EUR/JPY = EUR/USD * USD/JPY

Suppose the current EUR / USD quote is 1.3600, and the current USD / JPY quote is 100.00. The EUR / JPY quote in this case will be 1.3600 * 100.00 = 136.00. Similarly, cross rates of other currency pairs that do not contain the American dollar are calculated.

As a rule, the need to use cross-rates arises for currencies, the volume of direct trading between which is quite low compared with the volumes of dollar currency pairs. The volume of direct EUR-JPY exchange operations (and vice versa) is significantly lower than the volumes of the main currency pairs EUR / USD and USD / JPY, therefore EUR / JPY is classified as a cross.

Trading in the foreign exchange market is over-the-counter; accordingly, foreign exchange transactions of traders are not regulated by state supervisory authorities, which significantly increases the risks of fraudulent actions on the part of brokers against traders in the event of a conflict of interest. A conflict of interest arises if the broker conducts internal clearing of traders' transactions without entering the interbank market. In this case, it acts as a counterparty, that is, if a trader wants to buy a currency pair, the broker is forced to sell it to him if there is no counter request from another trader. As a result, the broker does not earn on the spread, but at the expense of the trader’s losses, which can cause a shift in quotations and the use of other unscrupulous schemes against open positions of the trader.

Preferred trading instruments are stock exchange instruments, such as stocks. Trading operations with shares are conducted on the securities market, the actual place of their exchange between sellers and buyers is the stock exchange. The activities of exchanges are regulated by national supervisory authorities, for example, exchanges in the UK are regulated by the FSA (Financial Services Authority – United Kingdom Financial Regulation and Supervision Authority), in the United States – by the Securities and Exchange Commission (SEC), in Russia – by the Bank of Russia. The main advantage of the stock market compared to over-the-counter markets is the possibility of legislatively challenging unfair actions of market participants, that is, the legal protection of a trader from fraudulent actions by brokers, insiders, etc.

Another, certainly no less significant advantage is the greater predictability of price movements. This is due to the fact that the value of a share is formed by a much smaller number of market participants, in addition, the indicators of a particular company whose shares are operated by a trader are taken into account, that is, the pricing of a share occurs according to a more understandable algorithm with a more or less clear finite number of influencing variables. If the value of currencies can be affected by almost anything – from the actions of central banks to political or natural disasters, then the price of a particular company’s stock is affected by a much smaller and, as a rule, quite a specific number of factors.

Nevertheless, stock trading requires more thorough training from the trader, as fundamental analysis comes first, and technical analysis is used only for profit in the short term in a speculative manner. Stock transactions are longer-term, since the leverage provided by brokers in the stock market is ten times less than the leverage of foreign exchange brokers. Thus, the trader must have a sufficiently large net worth to receive any significant average annual profit, however, the risks of large losses are significantly lower compared to the risks on Forex.

CFD


A more cost-effective alternative to expensive stock transactions is the so-called “contracts for difference” or CFDs, which in recent years have become a very popular trading tool on offer. CFD brokers are increasingly offering this financial instrument to their clients. A CFD trader is trying to guess the direction of the price trend of the underlying asset of the contract and make money on the price difference between the current and future points in time. In fact, the trader avoids the expensive administrative and other expenses associated with the acquisition of shares, but in this case he also loses all the possible benefits available to the actual owners of the shares (dividends, voting rights, etc.).

The main advantage of CFDs is the ability to use leverage; accordingly, a trader needs much less equity to trade. On the other hand, CFD is an over-the-counter tool with possible problems for the trader arising from this fact.

Depositary receipt


Depositary receipt – a certificate issued in the form of a security that provides ownership of a certain number of shares of a foreign company. The most famous and popular depositary receipts are the American Depository Receipt (ADR) and the Global Depository Receipt (GDR), which are traded mainly in European markets. Using depositary receipts allows you to reduce the size of commissions associated with the acquisition of foreign securities.

Mutual funds


Units of mutual investment funds occupy the third place in terms of trading volume on the exchanges after stocks and bonds. A unit is a registered security document certifying the investor’s right to receive a certain amount of the fund’s money based on its current value. The main advantages of this investment instrument are its accessibility for private investors, high profitability reaching 50-60% per year, and strict regulation by the state. The main disadvantage is higher investment risks compared with the risks of fixed income securities and other investment instruments endowed with state guarantees.

Derivatives


The trading instruments discussed above belong to the group of basic instruments (except for depositary receipts, they occupy a separate niche in the classification). There is another large group of trading instruments – derivatives, or derivative trading instruments. By definition, a derivative is a security whose value depends on the value of one or more assets. The most commonly used underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates and market indices.

Typical derivatives are futures and forward contracts, options and swaps. Despite the fact that the main purpose of derivatives is to hedge risks (for example, currency), traders actively use them for trading speculation.

Futures contract


A futures contract is a derivative financial instrument used by the parties (seller and buyer) to fix a certain value of the underlying asset at a certain point in the future (delivery time). The quantity and quality of the underlying asset is negotiated by the parties in the contract specification at the time of conclusion of the contract. The futures contract is executed at the end of its validity (delivery time), as a result, the seller of the futures either delivers the underlying asset to the buyer or pays the difference between the price fixed in the contract and the current market price of the underlying asset. Thus, when purchasing a futures contract at a certain price, the trader is betting on the growth of the value of the underlying asset over a certain period of time. If at the time of execution of the contract the value of the underlying asset exceeds the value of the futures, the trader makes a profit, and vice versa. Futures contracts are traded on the stock exchange.

Forward contracts


Forward contracts differ from futures in that they are not standardized and are an OTC trading instrument. As a result of the execution of the forward contract, only real delivery of goods is carried out, that is, speculative operations with forwards are not possible. Forwards are usually used by enterprises to hedge the risks of price fluctuations in the production of goods.

Options


Options are derivative financial instruments that allow the seller (buyer) to obtain the right to sell (purchase) a certain product at a predetermined price in a certain period of time. The most popular companies offering trading in this trading instrument are binary options brokers.

Conclusion


The most preferred trading tool for novice traders with sufficient capital are stocks. The process of becoming a professional trader takes a fairly long time, during which a potential speculator must study all the features of financial markets and the necessary tools, including fundamental and technical analysis, principles of money management, risk hedging, etc. Thus, the main task of a novice trader is not to make profit, but to survive in the market.

The foreign exchange market, CFD and other instruments promoted by brokers carry increased risks due to the use of large leverage, which practically leaves no chance for beginners in the financial market.

Author: Kate Solano, Forex-Ratings.com
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