Futures For You
| INSIDE THE FUTURES
WORLD
Want to learn how the futures markets really work? Dan
O'Neil, a principal at online futures and forex broker Xpresstrade (www.xpresstrade.com),
responds to your questions about today's futures markets.
To submit a question, post your question to our website
at http://Message-Boards.Traders.com. Answers will be posted there, and
selected questions will appear in a future issue of S&C. |
Dan O'Neil |
MONEY TALKS
I'd like to start trading foreign currencies, but I'm not sure whether
the futures market or the spot forex market is a better choice. What are
the pros and cons of each?
With transactions representing nearly $2 trillion each day, the foreign
exchange market affects almost every nation's economy and is the world's
largest financial market. Many economic forces affect the world's currencies,
including interest rate differentials, domestic money supply growth, comparative
rates of inflation, central bank intervention, and political stability.
In times of global uncertainty, some currencies may benefit from perceived
"flight-to-safety" status. Or if one country's economic outlook or political
conditions are perceived as strong by market forces, its currency may be
firmer than another country's currency.
Financial institutions, investment managers, corporations, and private
investors use both currency futures and transactions in the spot forex
market as hedges to manage the risks associated with currency rate fluctuations,
and to take advantage of profit opportunities stemming from changes in
currency rates. Speculators are also active in both the currency futures
and spot FX markets, attracted to the opportunities that volatile and changing
market conditions create. Currencies can also be an excellent way to help
diversify an investment portfolio. While many traders are active in both
the currency futures and spot FX markets, there are advantages and disadvantages
to consider with each.
Currency futures contracts have the same defined characteristics as
grain futures, energy futures, or any other commodity futures contracts,
and trade on the same regulated exchanges. The Chicago Mercantile Exchange
(CME) has been a leader in currency futures and options trading since the
early 1970s, and today offers the largest market for exchange-traded futures
in dozens of global currencies, including the US dollar, the British pound,
the Swiss franc, the Japanese yen, and the Australian dollar.
The forex market, on the other hand, has no physical location or central
exchange. Rather, it is an over-the-counter (OTC) or interbank market,
due to the fact that participants deal directly with one another via the
telephone or an electronic network. This constitutes the main difference
between the forex and currency futures markets, but there are a number
of other clear distinctions between the two:
Trading hours: Like many futures exchanges, the CME conducts official
trading sessions during the business day while also operating an after-hours
all-electronic market overnight. The spot FX market, on the other hand,
is a truly around-the-clock market, featuring live, active, continuous
trading 24 hours per day for most of the week. Because of this, the spot
FX market tends to be more continuously liquid than the futures market.
Quoting conventions: Currency
futures are always quoted as the currency versus the US dollar. In the
spot forex market, meanwhile, some currencies are quoted this way, while
others are quoted as the US dollar versus the currency.
Margin: While the currency
futures market offers an attractive margin situation compared to many other
investment possibilities -- generally requiring a trader to put up only
5% to 8% of the amount he or she will control -- the forex market allows
for large positions to be controlled with as little as 1% margin. Of course,
because margin is a double-edged sword, the spot forex market can also
be a riskier proposition in this regard.
Execution: While delayed
fills, partial fills, and slippage tend to be more common in the open outcry
futures markets, the all-electronic spot FX market generally features more
instantaneous execution and tighter spreads by eliminating intermediaries.
Fees and costs: Because there
is no centralized exchange in the spot forex market, traders don't face
the exchange or regulatory fees on every transaction the way currency futures
traders do. In addition, since most forex dealers are compensated by the
bid/ask spread, there are no commissions to pay.
As you can see, despite the similarities in the underlying vehicles,
the spot forex and currency futures markets present investors with a number
of important differences to consider. While foreign exchange tends to offer
greater liquidity and access, many commodity traders feel more comfortable
operating within the parameters of the exchange-traded contracts with which
they're accustomed when adding currencies to their portfolios. In the end,
like any other investment, the ultimate decision should be based upon the
trader's personal goals and risk tolerance.
Originally published in the June 2007 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2007, Technical Analysis, Inc.
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