The global foreign exchange market accounts for over $5 trillion U.S. dollars worth of average daily trading volume, making it the largest market in the world. Within this market, there is a growing class of derivative securities: forex futures. This article will define and describe these futures contracts and their popular applications, as well as present some analytical tools necessary to successfully negotiate a contract in the $112 billion dollar a day forex futures space.
What Are Forex Futures?
Forex futures are standardized futures contracts to buy or sell currency at a set date, time, and contract size. These contracts are traded at one of the numerous futures exchanges around the world. Unlike their forwards counter-parts, futures contracts are publicly traded, non-customizable (standardized in their specified contract size and settlement procedures) and guaranteed against credit losses by an intermediary known as a clearing house. (Related Derivatives: Futures vs. Forwards) The clearing house provides this guarantee through a process in which gains and losses accrued on a daily basis are converted into actual cash losses and credited or debited to the account holder. This process, known as mark-to-market, uses the average of the final few trades of the day to calculate a settlement price. This settlement price is then used to determine whether a gain or loss has been incurred in a futures account. In the time span between the previous day’s settlement and the current’s, the gains and losses are based on the last settlement value.
Futures clearing houses require a deposit from participants known as a margin. Unlike margin in the stock market, which is a loan from a broker to the client based on the value of their current portfolio, margin in the futures sense refers to the initial amount of money deposited to meet a minimum requirement. There is no borrowing involved, and this initial margin acts as a form of good-faith to ensure both parties involved in a trade will fulfill their side of the obligation. Furthermore, the futures initial margin requirement is typically lower than the margin required in a stock market. In fact, futures margins tend to be less than 10 percent or so of the futures price.
Should an account take on losses after daily mark-to-market, the holders of futures positions must ensure that they maintain their margin levels above a predesignated amount known as the maintenance margin. If accrued losses lower the balance of the account to below the maintenance margin requirement, the trader will be given a margin call (no relation to the movie) and must deposit the funds to bring the margin back up to the initial amount.
An example of margin requirements for each type of contract can be found on the Chicago Mercantile Exchange, or CME's website here (more on the CME, below).
Forex futures are traded at exchanges around the world, with the most popular being the Chicago Mercantile Exchange (CME) group, which features the highest volume of outstanding futures contracts. Forex, much like most futures contracts, can be traded in an open out-cry system via live traders on a pit floor or entirely through electronic means with a computer and access to the Internet. Currently, open-outcry is being phased out in Europe and replaced with electronic trading. As mentioned earlier, in terms of the sheer number of derivatives contracts traded, the CME group leads the pack with 3.16 billion contracts in total for 2013. The Intercontinental Exchange and Eurex follow behind at 2nd and 3rd places, respectively, at 2807.97 and 2190.55 billion contracts traded. The bulk of the FX futures contracts are traded through the CME group and its intermediaries.
Contracts Specifications and the Tick
Each futures contract has been standardized by the exchange, and has certain characteristics that may differentiate it from another contract. For instance, the CAD/USD futures are physically delivered on settlement date, standardized by size to 100,000 Canadian dollars, and trades for twenty months based around the March quarterly cycle (i.e., March, June, September, and December). Of utmost interest to traders, however, would be the minimum price fluctuation, also known as the tick. A tick is unique to each contract, and it is imperative that the trader understands its properties. For the CAD/USD contract, the tick or the minimum price movement up or down is $.0001 per Canadian dollar increments. With a contract standardized at 100,000 Canadian dollars, this translate to a $10 move each way. That means if the Canadian dollar appreciates from .78700 USD to .78750 USD, a short seller would have lost 5 ticks or $50 per contract.
In contrast to the CAD/USD futures, the CHF/USD contract has a contract size of 125,000 Swiss francs, and the tick in this case is $.0001 per Swiss franc increments or $12.50/contract.
The futures markets also feature mini-contracts at half the standard of the regular contract and the E-Minis, which are 1/10th the size of their regular counterparts. E-minis are ideal for new traders of their increased liquidity and accessibility due to the lower margin requirements. The contracts trade 23 hours a day, Monday to Friday, around the world.
Types of Uses: Hedging
Forex futures are used extensively for both hedging and speculating activity. Let's briefly examine an example of using FX futures to mitigate currency risk.
- An American company doing business in Europe is expecting to receive a payment of €1,000,000 for services rendered, in five months’ time. For the sake of the example, imagine that the prevailing spot EUR/USD rate is currently at $1.04. Fearing further deterioration of the euro against the dollar, the company can hedge this upcoming payment by selling 8 euro futures contracts, each containing €125,000, expiring in five months at $1.06 dollars per euro. Over the course of the next five months, as the euro depreciates further against the dollar, the company’s account is credited daily by the clearinghouse. After the time has elapsed and the euro has fallen to $1.03, the fund has realized gains of $3750 per shorted contract, calculated by 300 ticks (at a minimum price move per tick at $.0001) and a multiplier of $12.50 per contract. With 8 contracts sold, the firm realizes total gains of $30,000, before accounting for clearing fees and commissions.
If the American company in the example had not entered this trade and received euros at the spot rate, they would have had a loss of $10,000: $1.04 EUR/USD spot five months prior to futures expiry, and $1.03 spot at futures expiry translates to a loss of $10,000 per €1,000,000.
Types of Uses: Trading and Speculating
As with the equities market, the types of trading method is dependent upon the unique preferences of the individual when it comes to both techniques and time frames.
Day traders generally never hold positions overnight and can be in and out of a trade within a matter of minutes seeking to jump on an intraday swing. A day trader’s M.O. is centered around price and volume action with a heavy emphasis on technical analysis as opposed to fundamental factors. A forex futures day trader primarily employs the main technical indicators prevalent in the sport markets, such as, Fibonacci patterns, Bollinger Bands, MACD, oscillators, moving averages, trend lines chart patterns, and support and resistance areas. (To read more see Analyzing Chart Patterns: Intoduction)
Many, if not all the aspects of technical analysis for equities can be interchangeable with the futures market, and thus, trading between the two asset classes can be an easy transition for day traders.
Swing traders are traders who hold positions overnight, for up to a month in length. They generally employ technical analysis spanning a longer time frame (hourly to daily charts), as well as short-term macroeconomic factors.
Finally, there are the position traders who hold onto a position for multiple weeks to multiple years. For these individuals, technical analysis may take a back seat to macroeconomic factors. Position traders are not concerned with the day-to-day fluctuations on the contract prices, but are interested in the picture as a whole. As such, they may employ wider stop-losses and differing risk management principles than the swing or day trader.
Note however, these are generalized definitions and the differentiating characteristics of traders are not black and white. At times, day traders may employ fundamental analysis, such as when Federal Open Market Committee data is released. By the same token, position traders may employ technical analysis tools to set up entries, exits, and trailing stop losses. Furthermore, the time-frames utilized by traders are also quite subjective, and a day trader may hold a position overnight, while a swing trader may hold a position for many months at a time. Much like in the equities markets, the type of trading style is entirely subjective and varies from individual to individual.
Types of Analytical Tools
Similar to the equities market, traders of FX futures employ both technical and fundamental analysis. Technical analysis by nature, examines price and volume data, and subsequently, similar methodologies are prevalent across both the equities and the futures markets. However, the biggest analytical contrast between the FX trader and say, a stock trader, will be in the way they employ fundamental analysis. Fundamental analysis in the stock market may emphasize scrutinizing the accounting statements of a firm, management discussion and analysis, efficiency analysis, ratio analysis and industry analysis. Depending upon the analyst, broader macroeconomic principles may take a backseat to company specific characteristics. However, traders of FX futures (and FX in general), must be absolutely familiar with macroeconomic principles and forecasting techniques.
The budding FX futures trader must understand the plethora of factors that can affect a country’s currency, such as, the causes and effects of inflation/deflation, as well as the counter measures available to a country’s central bank, and interest rate differentials. The trader must understand the principle determinants of business cycles within a country, and be able to analyze economic indicators, including (though not limited to), yield curves, GDP, CPI, housing, employment and consumer confidence data. Furthermore, the trader must be able to analyze macroeconomics accounting principles, such as a central bank’s level of reserves, current/ capital account surpluses and deficits, as well as study the causes and outcomes of speculative attacks on currency, for example, the Bank of England, Mexican and Thai currency debacles make for interesting case studies.
Finally, the trader must also be familiar with the effects of geopolitical turmoil on a country’s currency, such as the conflict in Crimea and the subsequent sanctions lobbied against Russia, as well as the effects of commodity prices on what is called commodity dollars. For example, both the Canadian and Australian dollar are susceptible to movements in the prices of commodities- namely those associated with energy. If a trader feels that oil will experience further declines, they may short CAD futures, or take on a long bet in the hopes of an oil rebound. Again, fundamental analysis for FX futures always concerns itself with the broader view of the world and the general relation of the markets.
A Brief Example
Lets assume that after checking the technicals, and the volatility surrounding Greece's future in the eurozone, a trader takes a bearish position on the EUR/USD and decides to short the euro June 2015 contract. He shorts the June contract at $1.086, hoping that it the euro will depreciate to at least where near-term support lies prior to expiration (around $1.07260).
With a contract size of 125,000 euros, he stands to gain 134 ticks, or $1675 if his trade is successful ((1.0860 - 1.07260) x 125000). At a maintenance margin requirement of $3100 USD x 1.10 (CME rules require 110 percent of maintenance margin requirement for speculative trades), his initial margin would be $3410. Taking his profit of $1675 and dividing by the margin of $3410, gives him a leveraged return of 49 percent.
The Bottom Line
Trading forex futures, much like any speculative activity, is risky in nature. The trader must at least have a passing knowledge of technical and macroeconomic analysis and understand a contract’s unique properties and exchange-related rules. Transparency, liquidity, and lower risk of default make forex futures attractive trading vessels. But the trader must respect the power of the margin in amplifying losses (as well as gains), conduct necessary due diligence, and have an adequate risk management plan prior to placing their first trade.