There are two general ways to trade Foreign Exchange, Spot Forex and Forex Futures. While both involve the purchase and selling of currency pairs, there are differences in the way the trades are executed, and the terms of execution. Spot Forex has always been more accessible. However, dealings with Forex Futures are now more and more common. Thus, it’s important to people who’re learning about forex trading, along with active forex traders, to understand the distinction.
When most people talk about Forex trading, they’re generally referring to Spot Forex Trading. The key to understanding what that word means lies in the word ‘spot’. That could be thought of as a derivation from the term ‘on the spot’. These essentially means here, and now. So Spot Forex means that we’re dealing with the level of exchange for any given currency pair at this point in time. So, if the level of a particular Currency Pair, say the EUR/USD-which is perhaps the most popular pair-is at 1.45; then 100 Euros would fetch 145 Dollars. Note that we have made it out spreads from this example, for the benefit of simplicity.
Now, with Forex Futures, the idea is to add time to this equation. We do our trading on the basis of perceived value that a certain currency pair will have at some point in the future. So, let us use the EURUSD Currency pair in a hypothetical situation. As a Forex Trader I might do some study and analysis, looking at the socio-economic environment, as well as charts. Based on this research, I might be led to suggest that, as some point in the future e.g. October 2009, the EURUSD pair will trade at 1.45. I could then agree to buy 145 Dollars at that point in time, founded on the idea that it will cost me 100 Euros. This is what is known as a Futures Contract. The idea here is that, irrespective of what changes take place in the value of the currency pair, I will buy 145 Dollars in October 2009.
The Forex market is a crazy place, full of terms that a lot of people have never heard before. While having some previous experience trading stocks or futures is helpful to a budding Forex trader, there are a few terms that can be misleading to someone with no prior experience. The following is a short list of some extremely basic terms that no one trading Forex can stand to be ignorant of.
With currency futures, the price is determined when the market is signed and the currency pair is exchanged on the delivery date. This is usually sometime in the distant future (typically no more than three months). However, most participants in the futures markets are speculators who opt to close out their positions before the settlement date.
Upon Further Consideration…
The concept isn’t new. It’s been around for centuries. This system was brought into play as a means of reducing risk and essentially stabilizing prices in deals between buyers e.g. Merchants, and producers e.g. farmers. An example scenario is as follows. A Merchant places an order for 100 sheep at the market price. The farmer then agrees to hand over the sheep in 2 months time, as which point the merchant would pay. Shortly after the order is placed, the marketplace is flooded with sheep, for whatever reason. Suddenly, the farmer’s sheep are no longer worth the original price, and the farmer loses money on the deal. He loses money, even if the investment he placed in the sheep was appropriate at the time of the deal. A similar situation could arise, this time at the expense of the merchant. If, after the initial order is placed, large amounts of sheep are wiped out by some disease; the value of the sheep would suddenly increase. They would be worth more. The farmer could demand more money.
Enter, the Futures Contract. This agreement basically says that at the designated delivery time or day, such is the price that will pay for the goods. This contract holds, irrespective of the sudden sheep shortage, or overflow. It’s a commitment that cannot be broken, in theory at least. Both parties have to consider the situation and consider the future, then make an informed decision. Then they must hope for the best. You can see the impact of the Futures concept a lot in the contemporary society. That’s part of the reason that, even though Oil prices might drop suddenly today, it might take weeks for that to filter down to the pumps. The batch being sold was bought at the higher price, so they still sell it like that to consumers. Big Companies tend to do dealings in Futures to help mitigate risks. A similar conception is applied to Forex Futures.
Forex Futures, in practice, aren’t all that different from Spot Forex. Most people tend to close out their positions before the settlement date, as cash payments are calculated and settled on a daily basis. It is therefore possible to re-evaluate your position regularly to decide whether you want to remain in the contract. So, they’re not as final as it might seem. Typically, Futures are more difficult to enter because of some elements such as a larger account balance requirement. They are also traded at an Exchange, so trading is restricted to the Session times of the exchange. However, they tend to offer lower spreads and transaction costs.