How does Spread Contract help in Currency Trading?
In the finance world, the term spread refers to the difference between two prices or positions. In simplest terms, a Spread Contract is understood as the simultaneous purchase of a security and the sale of related security. These contracts get executed through Futures and Options contracts, and traders use them to profit from the widening or narrowing of the Spread.
Spreads are also prices in pairs in future exchanges to ensure that the security is bought and sold simultaneously. This also puts an end to the risk that only one part of the trade gets executed, but the other one fails. The term becomes more relevant in Currency Trading, which gets traded in pairs, and the second currency is always expressed as a single unit of the first currency.
For instance, USD-INR August 2021 Futures would mean that traders will pay INR 75 per dollar. In the Indian Currency Market, spread contracts can be seen for the Indian Rupee with US Dollar, British Pound, Euro, and Japanese Yen. Traders can buy or sell a spread based on their understating of whether the spread difference between currencies will widen or narrow.
How do spread contracts work?
The function of these contracts is simple. In Forex Trading, the Spread keeps changing because of the changes in a currency pair's buy and sell price. If the Spread is wider, it indicates a greater difference between the prices of two currency pairs and signals low liquidity and high volatility. In contrast, when the Spread is lower, it indicates low volatility and high liquidity.
Therefore, when traders trade a currency pair with a tighter spread, they incur a smaller spread cost. The traders prefer trading with tighter spreads as that indicates a more affordable trade. Several factors impact the Spread. For example, if the market is too volatile, the currency pair becomes less liquid, resulting in a widening of the Spread. It is crucial to know the factors that can impact the Spread and widen it so that you can make informed trading decisions.
Now, let us say you want to protect yourself against strengthening Euro. In that case, you either purchase Euro-INR Futures or buy the Euro-INR Call option, which provides you with the right to choose to buy or not the foreign currency at the pre-defined exchange rate. Similarly, for a weakening Euro, you will either sell your Euro-INR Futures or sell the Euro-INR Put option that offers the right to choose to sell or not the foreign currency at the pre-defined exchange rate.
Additional Read: What are Currency Derivatives?
For the Euro-INR Futures, you need to consider the Reserve Bank of India reference rate and the difference between the amounts you need to spend to buy Euro-INR Futures. However, remember that hedging in practice is not so effortless as you need to factor in the hedging and statutory costs. However, Spread Contracts minimises the exposure to price fluctuations of different currencies through Currency Futures and Options.
Additional Read: Want to Open a Trading Account Online?
If you want to trade in Currency Futures and Options and benefit from spread trades, open a Trading Account today.
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