This article looks at the differences between FX futures and traditional futures and looks at strategies to use with this derivative.
A derivative of this massive financial market is FX futures. The FX futures market is only a hundredth the size of the spot market.
Traditional vs. FX Futures
Both futures work in the same way which is the purchase of a contract to purchase or sell a set amount of currency on a predetermined date at a predetermined price. The one difference between these two is that futures are not done through a centralised exchange, but rather through a range of different exchanges in the US and other international centres. Most of the futures are traded via the Chicago Mercantile Exchange. This does not imply that it is done over the counter. The contract is bound to a designated size and can only be offered in whole numbers. All futures quotes are done against the US dollar, unlike the spot market.
Your forex broker should provide you with the specs for your contract. This should include the contract size, trading hours, time increments, pricing limits and other info related to the deal.
Speculating vs. Hedging
Forex derivatives are used for two main reasons and that is hedging and speculating. Hedging is used to protect against future price movements. Speculating is done to make profits.
Speculating is driven by profit. There are a few advantages and disadvantages linked to trading futures in the forex market.
The spreads are lower
The transaction costs are lower
You are offered more leverage
You are restricted by the trading session times of the exchange
You may be liable for National Futures Association fees
You need a higher investment capital as lots are valued at $100,000
Strategies for futures are very similar to those used in the spot market. The most common strategies are those based on technical analysis as these markets normally trend well. There are some more advanced strategies you could use, such as arbitrage.
One of the main reasons for hedging is to limit the effect of currency movements on profits. This is normally used by businesses with overseas interests in an attempt to protect against currency movements which could affect their profit levels.
Traders who wish to use hedging strategies have to make a choice between futures and forwards. There are many differences between these two, but the most important ones are:
- Forwards allow more flexibility as regards the dates and contract size. This provides you with the opportunity to tailor the contact to what you need, rather than having to use a set contract size as with futures
- The cash that you use to back a forward is only due upon contract expiration. The cash backing futures is calculated on a daily basis. Both the buyer and the seller are liable for these daily cash settlements. If you make use of futures, you have the facility to re-evaluate your contract as and when you wish. If you make use of forwards, you have to wait until the expiration date of the contract.
Forex futures are very similar to stock and commodity futures. There are distinct advantages and disadvantages to using this method in the forex market.