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.
Foreign Exchange – The Currency 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.
While foreign exchange trading has existed over the centuries, U.S. President Richard Nixon in 1972 inadvertently gave incentive to the development of more active foreign exchange trading around the globe when he took the U.S. off the gold standard. It was an action that, over time, encouraged many countries to float their currencies against the U.S. dollar.
Forex trading got a further boost in the late 1990s when individual, or "retail," forex traders got into the market on a larger scale than previously through opportunities offered by internet-based brokerages and trading.
Forex Trading: How Is It Done?
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.
Currencies are traded in pairs, meaning that if you are buying one, you are simultaneously selling another. 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). 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.
Forex is considered to be an individual class of assets that can be bought and sold directly, like equities, commodities and bonds. However, futures are a derivative trading instrument, meaning their value is based on the value of another asset known as the "underlying" asset.
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.
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.
The contracts come 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.
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.
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.
As with other types of underlying assets, futures can be used to trade forex.
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 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.
Forex and futures trading have unique attributes that can make each of them useful and profitable depending on traders' short- and long-term financial goals.
Forex trading may be more accessible for beginning traders, because it requires a smaller amount of initial capital and more limited exposure to long-term risk. In some cases, 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.
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