So you keep hearing about forex futures trading but don’t know what it is.
Or maybe you decided to start trading but got confused by the terms: futures, options, spot? What are these things?
In this piece I’ll cover the basics of forex futures.
It’s a market of contracts where the underlying asset is a pair of currencies.
This contract can be bought and sold like any other security.
So if you start forex futures trading, you’re not trading currencies, you’re trading contracts whose price depend on the price of the currency pair the contract is written on.
But before we move any further, let’s first make sure we know what a futures contract is.
A future contract is an agreement between two parties (No, not the booze and Doritos kind of parties).
What do they agree about?
About a transaction they’ll do in the future.
Ok, but why make a contract now, about something in the future, can’t we just leave it for then?
It’s about more than fighting procrastination: it’s about managing risk.
You see, not only do we agree on when the transaction will take place, but we also agree on a price.
Imagine you’re the CEO of a major gold and precious metals mining company.
You just started digging that juicy mine, and you can’t wait for the gold to be ready to sell.
This won’t happen right away though (it’s a lengthy process). You’ll have to wait at least a few months.
But you feel like the price of gold will likely go down by then.
Most reputable analysts seem to be forecasting slight declines, if not outright plummeting of gold prices.
So what can you do? You’re exposing yourself to a ton of risk if prices fall:
You will have to sell your precious gold (my precious… sorry I had to do it) at the (lower) market price once the gold is ready to be sold.
Solution: futures contract
You can buy a futures contract where you agree to sell a set amount of gold at a price you agree on today.
If you do this, once your gold is ready a few months from now, you can sell it at the price in the contract, regardless of what the market price is then.
This way, if prices fall, you can rest assured, you’ll be able to sell at the (higher) previously agreed upon price.
But if prices go up… You will still have to sell at the (lower) previously agreed upon price.
As you can see, you essentially negate the risk of the market, potentially losing out on profit, but staying away from losses (in comparison to where price is now).
You can also buy a futures contract in order to buy that gold.
I fear gold prices might surge, and I need it for my operations a few months from now, so I enter a futures contract to manage my risk in the same way as the seller did.
These contracts are bought and sold through a third party clearance house (Chicago Mercantile Exchange, for example) that matches buy and sell orders.
This can be done because contracts usually have standard sizes.
But enough about futures.
As mentioned earlier, some companies may use forex futures trading to manage their risk. This is called hedging.
If you’re a multinational company, in order to manage foreign exchange risk, you may do some forex futures trading by buying a currency futures contract.
In this fashion, you will agree to sell (or buy) a certain amount of one currency in exchange for another currency, where the agreed upon price is the exchange rate (and thus, the amounts sold and bought).
However, if you’re reading this, it’s likely you just want to speculate and make money, not manage risk.
If that’s so, I’ve got good and bad news for you.
Which do you want first?
I’ll tell you a few things and let you decide for yourself which is which.
Like any other asset, future contracts have prices which move around. This means you can speculate on them.
You have to open a margin account with a broker, and this account will be credited (or debited, ouch!) every day, based on how the contract performs (remember contract moves with price of underlying).
A cool thing about futures is you can cancel a short or long position by entering another contract that cancels yours out.
For example: you buy a future that says you will sell 10,000 barrels of oil three months from now.
Before the contract expires (and you’re liable to deliver those 10,000 barrels) you can buy another contract that states you will buy 10,000 barrels of oil three months from now (the expiration date, and the amount of oil barrels must be the same).
These two contracts offset each other and you’re not liable anymore (someone else will sell the 10,000 barrels).
You can also just sell you initial contract (much simpler no?).
Also, since contracts have fixed amounts, you will likely have to deal with pretty sizeable amounts.
If this intimidates you, or you just don’t have the dough, I’m sorry for you (not really).
And finally, the meats of this meal.
As a speculator, which market should you trade?
Remember, in the spot market, you’re trading the actual currencies, not contracts based on currencies.
Since futures contracts have minimum standard sizes, forex futures trading is less accessible to the average Joe.
Also, even though futures are liquid (daily transactions in the billions), it pales in comparison to the spot market (trillions baby).
So given these two reasons, spot forex trading seems to be the way to go for most people (if you’re a speculator).
A third reason the average Joe should probably stay away from forex futures trading is it simply requires a higher level of sophistication.
You’re not trading the currencies (which is already a pain in the ass no?), you’re trading contracts which derive their values based on the price of said currencies, which brings its own type of valuation tools, among other things.
To top things off, you also have to start considering things such as arbitrage when dealing futures contracts (these are usually exploited by those in the know with trading algorithms as soon as the opportunity is detected).
Thus, since this site caters to normal individuals, I would advise you to stick with the spot market for your speculative trading.
Besides, most of your compatriots are here (me
included), so join the party, and let’s see who makes more pips.
Even though the recommendation is to stick with spot trading instead of futures forex trading, don’t be afraid to check it out more if you’re interested (or if you have the means).
And it’s always good to have a basic concept of what exactly currency futures are and why they’re traded.
Hope you found this article useful.
See you soon,
The Forex Economist
Sep 12, 17 09:09 AM
Learn what you need to know about Forex audio squawk here.
Sep 11, 17 09:48 AM
GBP (pound) traders what can you expect from the Bank of England's MPC vote this Thursday, Sep 2017? Click to find out.
Aug 21, 17 04:41 PM
Three of the eight major currencies are commodity currency. But what is that? Which are those currencies, and how can we trade them? Click to find out.