Forex is traded worldwide, twenty-four hours a day, to the volume of over $6 trillion dollars per day in a market that opens every weekday. Around 30% of that volume takes the form of forex spot transactions. Spot FX remains one of the most popular FX products, and for retail traders in particular, it is vital to understand what it is and how it works.
Most retail traders will start their careers dealing with spot contracts. For most of them, even those using complex strategies, they are the only contract type they ever need to master. Therefore, learning to get to grips with spot FX is one of the most important things an aspiring trader can do.
What is a spot transaction?
First things first: a spot FX trade is a deal made and executed instantaneously at a public and agreed price. It does not involve the use of options, derivatives or any complex products; one currency is exchanged for another at the prevailing rate.
You have likely carried out a spot FX transaction yourself if you’ve ever bought a foreign currency on holiday. Most forex trading on platforms like MetaTrader involves spot FX, and the spot market for the most liquid currencies is highly liquid.
Standard spot FX contracts settle the traded sum two days after the transaction is agreed (T+2) – certain USD pairs can be settled in one day, but the most traded currency pairs all remain T+2. The value at which the currency is sold does not change in that period – it is the prevailing rate at the time of the deal which sets the price.
Almost all spot FX trades are today carried out using electronic systems; in the past voice brokerage, where forex brokers dealt with counterparties via telephone, and earlier still face-to-face transactions accompanied every FX deal. The spot market has changed in significant ways over the centuries, but its core function remains identical.
What does it mean for retail traders?
As a novice retail forex trader, some may say that it is better if all your trades use spot FX contracts. This is because it is possible to become a very proficient and successful trader without dealing in any other products.
Indeed, with retail options traders regularly losing money, spot FX is probably the best start and end point for most retail traders. The recent growth in derivative products aimed at the retail market, including CFDs and options, has been a mixed blessing, with many new traders losing money on products they don’t completely understand and then quitting trading.
The relative simplicity of spot FX allows retail traders to focus instead on other, more important matters, like mastering technical and fundamental analysis, confirming charting patterns, and working on their trading psychology.
However, just because spot FX is easy to understand doesn’t mean it’s easy or quick to master. There are a few conventions that retail traders need to be aware of when dealing with the spot FX market; quoting precedence, contract size, and lot size are just a selection. Many of the seemingly unusual features of spot contracts can be understood better by looking at how they have developed over time.
How did spot contracts develop?
Spot FX is the oldest form of currency exchange. Originally, private contracts between money-changers and businesses took place ‘on the spot’ at a physical location – a sum was exchanged immediately with an exchange of coins and later banknotes.
After the end of the gold standard in the 1920s, the forex market became considerably more important as currencies were able to fluctuate more, albeit still to a limited degree, against the price of reserve currencies and gold. In the later part of the 20th century certain currencies, especially those of developing markets, liberalised considerably and began to see drastic price swings on the open market.
From the 1970s onwards, options, futures and forward contracts were created to deal with the needs of institutional investors who couldn’t be sure of future cash flows. These were traded in open-outcry trading pits before gradually moving onto online platforms in the latter part of the twentieth century.
Who trades spot FX today?
The forex market takes place between many participants, with the most important firms offering to consistently buy and sell forex known as ‘market makers’. Market makers include investment banks, forex brokers, and algorithmic trading companies. Some of their largest customers are central banks, as well as investment firms like pension funds and corporate clients.
Because forex is traded ‘over the counter’ (directly between individuals, without a central exchange), margins can vary quite widely. Particularly for retail customers looking to make small currency purchases, a wide range of rates can be found. Banks and forex brokers which ‘make a market’ for a particular currency pair will quote a bid and ask price for each currency; the bid is the price they are willing to pay to buy a currency, and the ask their price to sell. The difference between these is variously called the bid-ask spread, margin, or simply spread.
In the modern FX market these spreads are normally tiny, tenths of a cent on the dollar or even less. For less-liquid exotic currencies, spreads will increase to reflect the increased costs and risks of dealing in these markets. Of course, for retail traders they tend to be higher than for central banks; this is because the transaction sizes are considerably smaller.
How are spot contracts quoted?
FX spot contracts are quoted as a currency pair, following several conventions:
- The first currency quoted is known as the base currency. In a EUR/AUD trade, the Euro is the base currency, and the Australian Dollar the quote currency.
- The number quoted after the letter symbol is the amount, in terms of the quote currency, which can be exchanged for the base currency. If EUR/AUD is 1.48, that means you can exchange one EUR for 1.48 AUD.
- Conventions exist for which currency is quoted first: Before 1999, this was always GBP and related currencies such as AUD or NZD. After the introduction of the Euro EUR is always quoted first, followed by GBP, AUD and then others like NZD and CAD.
Despite quoting conversions, the world reserve currency is the USD, with over 80% of all FX transactions including the American dollar as one part of the trade. The original rationale for the order of precedence was that the highest value currencies go first – nearly a century of inflation and price swings mean this relationship no longer holds true.
Retail spot forex traders
Retail trading first developed in the equities markets, but towards the end of the 1990s, more and more retail traders began to be interested in trading spot forex to diversify their portfolios and find new sources of income.
The launch of platforms such as MetaTrader, a version of which is still used by major brokers, including Rakuten, transformed the market, allowing millions of retail forex traders to access the market for the first time and at a very low cost. Soon, retail traders were able to benefit from leverage and other capabilities previously limited to wealthy or institutional investors.
Spot forex is in many ways a natural choice for retail traders as it typically works very well with technical analysis, is less liable to insider trading than equities, and doesn’t have the same barriers to access as the commodities or debt markets.
The growth of retail FX derivatives has changed the market again for retail traders. While considerable profits are possible using these tools, they should be treated with caution – and understood thoroughly before even thinking of adding them to your portfolio.
Why should I stick to using spot trades, initially?
Simply put, it can be a way of protection against new traders losing vast amounts of money. By limiting the complexity of the products that you trade, it allows you to focus on honing your underlying technical and fundamental strategies. An overwhelming majority of retail options or CFD traders lose money – this is often because they leap into using advanced products without first mastering the basics.
The same skills which you will develop as a spot trader will be transferable into options trading later, should you choose to go down the route. By maintaining simplicity in the products that you use, it is easier to keep an eye on your risk management and position sizing practices, which ultimately will make you a more successful and more profitable forex trader.
How Rakuten can help
Forex spot trading is a great place to start for beginners and those who prefer to stick to and master the basics. At Rakuten Securities Australia, you can do exactly this by opening a free demo account, where you can start placing trades in real time without the risk of losing your capital.