Getting a handle on the terminology involved in financial trading can be confusing, but it's important for traders who need to understand the instruments they may wish to trade and their potential. The terms forex and futures are among the terms commonly used by participants in financial markets. They may be heard spoken in reference to the same or varying contexts, so traders will want to have a clear understanding of what each represents.
What Is Forex And The Forex Market?
Anyone who has traveled or bought and sold goods abroad will have an awareness of foreign currencies and their differing values. Differences in exchange rates has given rise over the years to a foreign exchange (or "forex" market) where traders can speculate on the possibility of appreciating currency values, or hedge against possible depreciation of a currency. Over the years, the forex market has grown into the world's largest financial venue.
How Does Forex Work?
Unlike in the past, when someone who wanted to buy and sell currency might have to go to a currency exchange operator or a major international bank, traders nowadays can open a currency trading account through a forex brokerage or full-service financial brokerage. For the retail trader, it's become popular and more common to utilise the services of licensed and regulated forex brokers.
When trading forex, there are a few items to be aware of. First, currencies are traded in pairs, meaning that if you are buying one, you are simultaneously selling another. On the forex market, traders can buy and sell pairs from countries all around the world, and the pairs don't need to include the currency in which their main forex account is denominated.
For example, someone holding an account in British pounds (GBP) could buy American dollars (USD) while simultaneously selling euros (EUR). The transaction is facilitated by the forex broker, with profits and losses being the responsibility of the trader. Some currencies are known as "majors," meaning they are more commonly traded and customarily have liquid trading. Other currencies are known as "minors" or "exotics," but many can be traded against each other through cross pairings with majors.
Retail forex is a lightly regulated, over-the-counter market, where parties trade directly with each other or through brokers. Some brokers will allow trades in sizes as small as micro lots of 1,000 currency units, or nano lots of 100 currency units. The reduced position sizes are attractive to many forex day traders who aim to limit risk in the pursuit of reward.
What Are Futures?
Futures are a derivative trading instrument, meaning their value is based on the value of another asset known as the "underlying" asset. Accordingly, futures trading is conducted on margin, furnishing the trader with the ability to leverage risk capital.
Like other "derivative" investments, future are traded through contracts. And as their name implies, they are contracts whose price is determined according to an estimated future value of the underlying asset. Unlike forex, futures are normally traded on organised exchanges. As a result, all futures market transactions are executed at the exchange and finalised through a regulated clearinghouse.
Futures first evolved from trading in the commodities markets in the 19th century, when farmers sought to guarantee a future sale price for their goods. They can now be traded for several different types of assets, including commodities, bonds, equities and currencies.
How Do Futures Work?
Futures for any type of assets are bought and sold by contract.
Each futures contract comes with an expiration date. One party in the contract agrees to buy a given amount of given asset and take delivery of it on pre-defined date, while the other party agrees to sell it on that date at the agreed-upon price.
Futures contracts are typically scheduled to have expirations four or more times per year. After their initial purchase, the contracts can be further bought and sold on the secondary market until expiration. Upon a contract reaching its expiration, it comes off-the-board and is no longer listed for trade on the futures market. This is a key difference to be aware of in the forex vs futures comparison.
Futures contracts are frequently sought by "hedgers," who wish to guarantee they will receive a given price for an asset at a future date. The counterparties to the contracts are "speculators" who hope to buy an asset at a future date for a price that is lower than the price agreed to in the contract. In most cases, active day traders operate as speculators, trading futures in the pursuit of short-term profits.
Traditionally, when futures were bought and sold, the seller agreed to make delivery, and the buyer agreed to take delivery of the underlying asset when the contract expired. However, except for occasional physical deliveries on some commodities-related contracts, most futures deals nowadays have cash settlements after expiration. A few examples of cash-settled futures contracts are equity index and currency futures.
Futures vs Forex: Key Differences
The forex and futures markets are two unique atmospheres. Although both markets facilitate the trade of derivative products, the futures vs forex contrast is significant.
- The forex is an over-the-counter (OTC) market and futures are traded on formal exchanges.
- Futures contracts have finite expiration dates, while forex pairs may be traded into perpetuity.
- Spot forex values are determined with respect to other currencies, while futures products are independently priced.
- The final key difference in the forex vs futures matchup is leverage. Typically, forex pairs are traded with much higher leverage than futures contracts.
Despite their nuances, both markets are attractive venues for the implementation of day trading strategies. However, the pricing of each varies; futures contracts are subject to exchange fees and commissions, while forex pairs are priced with the bid/ask spread. Also, market liquidity varies from product to product, which can impact slippage rates on both spot forex and futures trades.
Pros And Cons Of Forex
As entrants in the world's largest financial venue, forex market participants enjoy a collection of trade-related benefits. Some of the biggest are optimal liquidity, extended trading hours, reduced costs and carry trade opportunities. In these areas, the forex vs stock market or futures market arguments are won by the forex.
On the other hand, the forex does have some drawbacks.
- It's an OTC market that has no centralised regulator or authority.
- Because of central bank and government intervention, extreme volatility can arise quickly. While this may be ideal for some day trading strategies, it can be detrimental to multi-day or swing methodologies.
- Lastly, the availability of high degrees of leverage can exponentially magnify risk exposure. It's not uncommon to see available forex leverage upwards of 200:1; this is vastly larger than found in other modes of trade such as the stock market.
Pros And Cons Of Futures
The futures markets attract participants of all kinds, including forex and stock traders. The primary reasons for this is increased volatility, diversity of trading options and the availability of leverage. When trading futures, you are to apply leverage toward asset classes such as commodities, equities, bonds and currencies. Given this functionality, traders and investors are free to pursue their financial objectives in a regulated, formal exchange atmosphere.
Conversely, the futures markets are renowned for their unpredictability. In fact, the table of contents in any book regarding futures trading has a chapter that deals with surprise volatility. Another key drawback of futures is their complexity. Each contract features specific pricing, trading hours, expiration date and quantity specifications.
These factors, as well as countless other technical and fundamental issues, must all be accounted for by anyone active in futures trading. If one is keeping score in the stock or forex vs futures matchup, market complexity is a major drawback for futures.
Futures vs Forex Summary
|Futures Pros||Futures Cons|
|Consistent volatility||Periods of extreme volatility|
|Wide-range of asset classes||Complex specifications|
|Exchange-traded, regulated||Limited leverage compared to other tradable instruments (e.g. forex, CFDs)|
|Forex Pros||Forex Cons|
|Enhanced leverage||Periods of extreme volatility|
|Products are user-friendly and straightforward to trade||Enhanced leverage can lead to significant loss|
|Consistent liquidity||OTC-traded, lightly regulated|
What are Forex Futures?
As with other types of underlying assets, futures can be used to trade forex. In fact, many retail and institutional traders actively engage the currency futures markets.
Forex futures operate on the same principle as other kinds of futures. In this trading, the two parties to the deal will enter a contract to trade one currency for another for a given price on a pre-established future date. Their prices are calculated by taking into account the carrying costs for the borrowing and purchase of the target currency over the life of the contract as well as the possible investment earnings of the base currency.
In addition to day trading or taking speculative positions, another special use traders may find for futures is to "hedge," or offset, the risk of positions taken in the spot currency market. Some of the major exchanges where forex futures are traded include the Chicago Mercantile Exchange, the Intercontinental Exchange and the Eurex exchange.
Forex futures contract sizes vary according to the value of the currency. Some of the smallest forex futures contracts, called "minis," have minimum sizes of more than 60,000 currency units, and traders may have to put up a margin deposit of US$1,500 or more to begin trading.
Should You Trade Forex Or Futures?
If you're not sure whether to trade forex or futures, don't worry―the forex vs futures question can be a challenging one. However, through a bit of due diligence, you can make an informed, strong decision.
It's important to remember that forex and futures trading each have unique attributes that can make them useful and profitable depending on traders' short- and long-term financial goals. No matter if you're a scalper, day trader, or swing trader, both markets are viable targets. Of course, it is important to first evaluate your location, resources, and expertise. In doing so, you'll be able to narrow down the types of assets that you are best suited to trade.
In reality, forex trading may be more accessible for beginning traders, because it requires a smaller amount of initial capital and a limited exposure to long-term risk. On the other hand, futures trading is a more complex undertaking that involves understanding an array of seemingly abstract factors. Items such as contract expiry and different margin requirements are a few that come to mind.
Nonetheless, the two types of financial trades can be used simultaneously to an advantage, especially by more experienced traders who have become familiarised with the characteristics of each.
FXCM Research Team
FXCM Research Team consists of a number of FXCM's Market and Product Specialists.
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