Forex futures are forex-based financial derivative securities. These derivatives are standardised. They are contracts that specify when a party must buy or sell a currency and for how much.
The main difference between forwards and futures is that the latter are standardised. This means that forex futures come in set sizes and they do not allow for customisation. Also, clearing houses settle forex futures according to standard settlement procedures.
What Are Forex Futures?
Futures are a form of derivative. A derivative is when a financial instrument derives its value from the price fluctuations of another instrument. So, for example, the value of a derivative linked to a foreign exchange pair, say USDGBP is simply a function of price movements between those currencies.
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Spot Forex vs Futures
Many traders ask what the difference is between trading currencies using spot forex or futures. There are some significant differences:
Forex vs Futures
- Price. Spot forex is trading on the exchange rates as they stand now. Futures prices are based on what they will be in the future (or what participants are willing to trade at).
- Timeframes. Spot forex trades effectively ‘swap’ currencies when the trade is made. Futures exchange currency at the point specified in the contract – which will be some point in the future.
- Scale. Retail traders can trade spot forex, using margin, for relatively small amounts. Futures generally require a much larger capital outlay and attract larger institutions (who might be hedging) and speculators trading larger sums.
How Do Investors Use Forex Futures?
Retail and institutional investors use forex futures for hedging and speculation. These derivatives do indeed lend themselves well to both of those uses.
Hedging With Futures
Investors who hedge through forex futures aim to reduce exposure to currency exchange-rate fluctuations. This use best lends itself to institutional actors. Retail traders can take advantage of it as well, on a smaller scale.
While forex futures-based hedging always makes mathematical sense, on a smaller scale, its effects may be insignificant.
Let us consider the following example: A US company expects to receive EUR 1 million for its services rendered in Europe.
The payment will be made in 5 months. The current EUR/USD exchange rate is 1.12. That means the EUR 1 million translates to USD 1,120,000. Any drop in the exchange rate would mean significant losses for the US company. If the rate were to drop to 1.10, it would generate a $20,000 loss.
The spot forex market does not offer the company a practical way to protect the transaction.
It can, however, sell eight EUR 125,000 forex futures, which would all result in a profit, if the exchange rate were to drop. This profit would then offset the losses resulting from the transaction itself.
The mentioned example also makes clear the limitations of the practice for small-time, retail traders.
Many traders use the forex market for speculation. They buy a certain currency, and when the relative value of that currency goes up, they sell it for profit. The problem with this approach is that it is impossible to profit off a currency when it goes down.
Futures address this issue. Traders who believe a currency will drop in value can sell futures instead of buying them.
Forex futures are subject to exchange regulations, unlike the forex market. Because of their diverse contract size, forex futures are suitable for early, small-time investors. On the other hand, because of their liquidity, they are also well suited for institutional investors looking to take large positions.
Forex Futures Contract Specifications
As mentioned, forex futures contracts are standardised. They feature a set size, date of expiry, settlement rules, and many other characteristics that differentiate them from other contracts.
One of the most essential characteristics is tick. The tick is unique to each forex futures contract. It represents the minimum price fluctuation. The best way to understand the tick is through an example.
On the CAD/USD pair, the tick size is $0.0001 for every CAD. With contracts standardised to CAD 100,000, this translates to $10 moves up or down.
Regular forex futures contracts are cumbersome for retail traders. Fortunately, there are mini contracts available too. These are half the size of regular contracts. E-minis are 1/10th of the size of a regular contract. These suit small-timers much better.
What Is Margin In The Context of Forex Futures?
The clearing houses that settle forex futures contracts require an initial margin from traders. This margin acts as a guarantee on the part of the trader, that his/her account can afford to support the trades.
The maintenance margin is tracked and when it drops below a set amount, it triggers a margin call. At this point, traders need to deposit more, to raise their margin level back above the preset mark. If they don’t, the exchange closes their trades.
Exchanges, such as the Chicago Mercantile Exchange (CME) list exact maintenance requirements for all supported contracts at their sites.
Where Can Investors Trade Forex Futures?
The CME seems to be the global hotspot for forex futures. In addition to “conventional” forex futures, the exchange has been experimenting with crypto/fiat futures as well. In the fourth quarter of 2017, the Group added bitcoin futures to its already impressive selection of forex futures.
Other exchanges with high volumes of forex futures are the Intercontinental Exchange and Eurex.
Forex futures can be traded live, though an open cry-out system. Many exchanges have already phased out this option, however.
The most straightforward way to trade forex futures is through electronic means, on the internet.
Forex futures represent just another way to trade currencies. Investors can trade forex through:
- The spot market.
- Forex futures.
- Currency ETFs.
Where Can I Trade Forex Futures?
These brokers all offer futures trading ;
The Best Forex Futures Brokers
What Is A Currency Futures Contract?
A currency futures contract is an agreement between two parties to exchange currency on a preset date in the future, at an agreed exchange rate.
The contract enables both parties to mitigate risk and fix an exchange rate today, for a currency exchange in the future.
This contract can subsequently be brought and sold for speculation, but ultimately, on the day of expiry the currencies will be exchanged at the agreed rate.
Are Futures Settled Daily?
Futures are marked to market daily, and changes are settled accordingly until the expiry date of the contract.
Can Futures Be Sold Before Expiry
Yes. A futures contract can be sold prior to expiry. The contract can also be nullified if a contract of the opposing direction and value is opened – thus ‘closing’ the original.
Why Do Futures Expire?
The expiry date is the day on which goods or currency actually change hands. The transaction must ultimately take place or there is no underlying trade for the derivative to ‘derive’ a price from.