The foreign exchange market is the most substantial of all markets in trading volume, larger than most stock exchanges combined. There are several methods to essentially exchange currencies.
The most popular of these is the spot market, yet we also have numerous other versions of forex like swaps, options, forwards, and, of course, futures. The latter tends to confuse most people when trying to understand how it functions and its inherent purpose.
Worry not, as this article will provide a brief yet detailed introduction to currency futures trading. If you look at traders speculating in the markets decades before online forex trading, many of them made their fortunes in futures, mostly those based on commodities.
When foreign exchange became increasingly influential over the years, investors could also trade this instrument through futures. Ultimately, the spot market and futures market are a derivative based on actual currencies.
The exception is how both are traded. The former is based on present exchange rates, while the latter is based on when the contract expires. Several reasons exist over why currency futures are quite prominent, which this article will explore further.
What are currency futures?
To understand currency futures, you’d need to grasp the concept of the futures contract. A future is an exchange-traded derivative contract compelling two parties to trade an asset at a pre-agreed expiry date and price in the future.
Regardless of the derivative’s value at the contract expiry, the buyer or seller is mandated to settle it at the predetermined price. So, in the context of forex, investors agree to buy or sell a particular quantity of a currency at a future date and price.
You may be asking yourself, what’s the main purpose of futures? Why would someone purposely buy or sell a currency a few months down the line rather than immediately? Let’s dig into this a bit more in the next section.
The purpose of currency futures
The first futures were invented in commodities where producers desired to lock in the prices of certain goods before producing them. Similarly, participants in currency futures use this market, though it’s more about hedging price fluctuation.
Let’s look at an example to illustrate this point better. Investors who use currency futures for hedging purposes tend to be large financial institutions and mega-corporations holding or expecting substantial quantities of one currency.
Currency futures example
Imagine a Swiss company conducting business in America expecting a $100 000 payment in three months. Of course, anyone would want to ensure this $100 000 will maintain its value against the Swiss francs upon receiving the money.
To mitigate this fear, the corporation would sell their native Swiss francs in a futures contract to lock in the current USDCHF exchange rate. Two things can happen after the three months have elapsed.
The first scenario is the exchange rate at the time may be unfavorable to the company, meaning it would have been a wise choice to enter into the contract since they consequently retained the value of the dollars against the franc.
Of course, the opposite can also occur where the exchange rate could have been favorable to them had they not entered into a futures contract. It’s crucial to note that futures have become less about hedging over the last few decades and have opened the door for speculation.
In simpler terms, anyone meeting the capital requirements can speculate for profit as they would in spot forex because most contracts are cash-settled well before expiry, and no physical delivery of currencies occurs.
There are several advantages and disadvantages of trading currencies this way, which we’ll explore later on.
What’s involved in a currency futures contract
As you can imagine, there are several exchanges to trade futures in currencies. However, the most popular is the CME or Chicago Mercantile Exchange, the largest globally with more than $100 billion in daily trading volume.
Below is a list of the key things making up most futures contracts:
- Unlike in spot forex, where we trade in pairs, currency futures come as standalone currencies. However, these are technically quoted against the US dollar. For instance, a euro future will derive its value from the spot EURUSD.
- For position sizing, forex futures typically come in three contract sizes; standard (100 000 to 125 000 units of the base currency), mini/E-mini (half of the standard), and micro/E-micro (a tenth of the standard).
- While we use pips in forex to measure exchange rate differences, futures use ticks. The tick values will depend on the currency being traded.
- The maximum contract length with most FX futures is three months. As briefly mentioned previously, you have the freedom to settle this before expiration based on the spot price of the currency in question.
The exchange would credit or debit your account as a CFD broker normally does with spot forex according to the difference between the price at the contract start and at settlement (minus any commissions).
- Like spot forex, margin or leverage is also available with futures, albeit being much lower than its counterpart. Yet, aside from the initial margin, traders need also to have the margin to maintain a position (maintenance) and margin for when the maintenance margin falls below the initial one (variant).
One of the main advantages of the futures market is transparency since these are traded on highly regulated exchanges, meaning there is no counterparty risk. This quality is unlike spot forex, which is decentralized and prone to market manipulation, unregulated brokerages, and other malpractice.
Adding further to this point, you have access to real volume with an exchange-traded product that is not like spot forex, where you have no true order flow of the number of participants.
Due to this transparency, many spot forex traders observe the futures market through the Commitment of Traders report. Here, we can observe how the large players operate since their behavior has a massive influence on spot forex prices.
On the downside, futures still have a higher barrier to entry due to the substantial contract sizes, lower leverage, and the somewhat confusing nature of how they operate and their benefits. Hopefully, readers will have found value in this article in understanding this intriguing variant of foreign exchange.