Trading in the huge foreign exchange or forex market typically involves operating in either the spot forex market or the currency futures market. Even though the underlying assets in the futures market are the same currency pairs that trade in the spot forex market, some key variations exist between the two markets and how they trade. In this article, we examine the differences between these markets and explain which would probably be a better fit for you as a trader.
What is Spot Forex?
The spot forex market consists of the physical or cash market for currencies and it operates through a worldwide and largely unregulated network. The decentralized nature of the forex market also means that transactions do not occur on a central exchange like stock market transactions do.
Instead of using a formal exchange, forex market operators trade via electronic communications networks (ECNs), dealing systems, phone, brokers, trading desks and online trading platforms. Forex market participants include major financial institutions, large corporations, hedge and investment funds, high net worth individuals and even retail forex traders.
Traders agree to the terms of a spot forex transaction at the moment it occurs. Most currency pairs traded in the forex market settle “on the spot” or “spot,” which is 2 business days after the transaction (T+2). Some currency pairs are exceptions because they typically trade for next day settlement (T+1). The most notable example of this is the U.S. dollar versus the Canadian dollar (USD/CAD), although the Turkish lira (USD/TRY), the Russian Federation ruble (USD/RUB) and the Phillipine peso (USD/PHP) can also trade for T+1.
Currencies trade in pairs, so when you take a forex position, you simultaneously go long one currency, while going short another. Once you take a position in a currency pair, you then make (or lose) money depending on the movement of that pair’s exchange rate.
You can trade just about any currency pair in the Interbank spot forex market by contacting a market maker or dealing desk at a major financial institution. The currency pairs that retail forex traders can operate in are limited to those their online broker offers, however.
Online forex brokers and internet market makers generally don’t charge a commission, but they make their money by quoting a dealing spread. The dealing spread is the difference between the bid exchange rate and the offer exchange rate for a currency pair. You can save on transaction costs by selecting a counterparty that offers tight dealing spreads, although some online forex brokers will add a commission on top of the dealing spread, especially if you will be getting very tight dealing spreads directly from an ECN.
The types of orders most commonly used in forex trading include:
- Market orders: These are buy or sell orders placed “at the market.” That means the trader will take the best exchange rate available in the market for their dealing amount at the time the order was entered.
- Limit orders: This type of order is placed when the trader wishes to purchase a currency pair below the prevailing market exchange rate or sell it above the current rate.
- Stop orders: A buy stop order is entered above the prevailing market exchange rate, while a sell stop order is entered below the current market. Stop orders become market orders when the stop rate is triggered.
Many traders use stop-loss orders to limit their risk and liquidate existing positions to cut losses. For example, if you’re long the EUR/USD currency pair, and the exchange rate declines significantly, you can limit your losses by placing a stop-loss order at a reasonable level to reduce your losses. Sometimes, your stop-loss orders are not executed at the level they were placed at, which is an undesirable phenomenon commonly known as slippage.
If you plan on trading medium- to long-term strategies where you regularly establish positions for more than 1 day, you may have to pay rollover fees. These fees depend on the difference in interest rates between the currency that you’re long and the currency you’re short. Depending on the currency pair and your position, you might either receive or pay out funds when your positions are rolled over.
For example, if you buy a low interest rate currency against a high interest rate currency, you receive a payment of the difference in the 2 interest rates for every day you hold the position after the end of the U.S. session at 5 p.m. EST. This income is known as “positive carry” and is the basis of the carry trading strategy used by some forex traders.
What are Currency Futures?
Currency futures are contracts where 2 parties agree to exchange a specified amount of 1 currency for another at an agreed upon exchange rate on a specific future date. The counterparties of the contract consist of the buyer who takes a long position in the currency pair, and the seller who holds a short position in the underlying currency pair.
Unlike the Interbank or retail spot forex market, currency futures trade on a centralized exchange where exchange rates are very transparent. Currency futures also have associated options contracts. Since currency futures and options trade in special margin accounts, you must establish a relationship with a futures broker to operate in these contracts.
Currency futures contracts can be traded out of before settlement occurs, so trading them does not necessarily entail going through the delivery process. The seller of a currency futures contract has the obligation to make delivery at the buyer’s request, so sellers will typically offset the trade in the futures market by closing it or by rolling it out to a later delivery month before the contract matures if they wish to avoid delivering currency into the contract.
Margin accounts for current futures trading have certain requirements that include:
- Initial margin: The upfront amount the broker requires to be on deposit for a client to enter into a futures contract position
- Maintenance margin: The minimum amount required by the broker to continue to hold the position
- Variation margin: Any negative difference between the margin maintained and the minimum margin required is called the variation margin; this needs to be deposited promptly into a trader’s margin account or the broker may close out their position.
If your account falls below any of the minimum margin requirements as a result of holding a futures position, a margin call is made to restore the margin account balance to the maintenance margin amount.
So that a position can continue to be held after a margin call, the account can generally be restored to good standing via a cash deposit, electronic bank transfer or a check by overnight mail for the amount of variation margin requested. The trader can also close out the position, sell other securities to generate cash in the account or take an offsetting (hedged) position in the market.
When trading in the spot Interbank or retail forex markets, you can usually specify the amount you wish to trade in very small increments. In contrast, futures contracts come in rather large set lot sizes that can be excessive for many retail traders, although micro lots of $10,000 are now available for some pairs on the Chicago Mercantile Exchange or CME. Also, trading in futures contracts generally entails paying commissions as well as any market dealing spread, instead of just paying away a broker’s dealing spread.
Currency futures typically have margin requirements that result in lower leverage ratios than those you may be able to use in the spot forex market.
Trading currency futures can require more capital and cost more to trade on balance than a spot forex trade done either via the Interbank market or an online forex broker. In addition, the time element involved in futures contracts since they have fixed future delivery dates that usually differ from the spot value date could add a premium or discount to the currency depending on the prevailing interest rate differential for the currency pair traded.
Nevertheless, if you plan on taking long-term positions in the currency market, especially if you want to do so via options on futures contracts, and you have deep enough pockets to pay commissions, survive margin calls and trade in larger amounts, then currency futures might be a good fit for you.
Diversify Using Both Methods?
Diversification using both currency futures and spot forex could seem like a viable strategy at first glance, although the majority of online retail forex traders will probably find maintaining both types of trading accounts unnecessary. Basically, they would need to justify the added costs and trouble of opening a currency futures trading account when they can far more easily operate in an online forex trading account.
The main potentially profitable trading strategy involving currency futures and spot forex is arbitrage, which is the simultaneous buying and selling of equivalent assets in different markets for a risk free profit. Professional futures traders and financial institutions are generally much better positioned to operate in the 2 different markets as arbitrageurs than smaller retail traders. Furthermore, enough banks already engage in arbitrage to ensure that the 2 markets stay closely aligned in terms of pricing.
Strategies that involve trading over-the-counter (OTC) options and options on futures may require a substantial amount of money to implement. Since only well-funded forex traders can typically qualify to trade OTC currency options, you might want to open up a currency futures margin account with a broker that lets you also trade options on futures if you wish to use currency options in your trading strategy. This will also let you use futures contracts as a suitable hedge to adjust your risk.
Benzinga Best Forex Brokers
In the table below, Benzinga presents its picks for the best forex brokers for trading in the spot forex and currency futures market. Dealing spreads and commissions vary depending on the broker, so make sure you contact the broker for additional information on pricing and minimum deposit requirements for opening an account. Also, many brokers will only accept clients from specific jurisdictions.
Spot Forex or Currency Futures?
Trading in the spot forex market entails buying one currency against another, while trading currency futures involves trading a derivative contract for delivery at a future date. If you’re interested in trading in other assets in addition to currencies, such as indices and commodities, then you might be better off trading futures since most futures markets offer a wide variety of assets to trade.
If you want to trade exclusively in the forex market, then trading either in the OTC spot forex market or via an online forex broker would probably make more sense.
Basically, your choice depends in large part on your available trading capital, whether you wish to use options or plan on trading other assets in addition to forex pairs. Remember that while you can profit from spot forex and currency futures trading, you can also wipe out your entire account, especially if you take on leveraged positions.
Frequently Asked Questions
Is it better to trade forex or currency futures?
The answer will probably depend on your available trading capital and if you want to trade options. If you just want to speculate on exchange rate movements, then online forex trading is an easy way to get started. If you are well capitalized and prefer to trade currency options, then using a currency futures account can make sense. Even though the underlying currency pairs traded are the same, the brokers, the value dates and how you trade can differ considerably between these markets.
What are currency futures in forex?
Currency futures consist of exchange-traded derivative contracts on specific currency pairs with standardized future delivery dates, associated option contracts and typically rather large lot sizes. This contrasts to most online and Interbank forex transactions that trade for value spot (1-2 business days) and can generally be executed in more customizable amounts.
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