Futures For You

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


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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