The spot foreign exchange (forex or FX) market is the world's largest market, with over US$1 trillion traded per day. One derivative of this market is the forex futures market, which is only one one-hundredth the size. This article examines the key differences between forex futures and traditional futures and looks at some strategies for speculating and hedging with this useful derivative.

SEE: Forex Tutorial

Forex Futures Vs. Traditional Futures
Both forex and traditional futures operate in the same basic manner: a contract is purchased to buy or sell a specific amount of an asset at a particular price on a predetermined date. There is, however, one key difference between the two: forex futures are not traded on a centralized exchange; rather, the deal flow is available through several different exchanges in the United States and abroad. The vast majority of forex futures are traded through the Chicago Mercantile Exchange (CME) and its partners (introducing brokers).

However, this is not to say that forex futures contracts are over-the-counter per se; the futures are still bound to a designated 'size per contract' and are offered only in whole numbers (unlike forward contracts). It is important to remember that all currency futures quotes are made against the U.S. dollar, unlike the spot forex market.

SEE: Futures Fundamentals

Here is an example of what a forex futures quote looks like:

Euro FX Futures on the CME
For any given futures contract, your broker should provide you with its specifications, such as the contract sizes, time increments, trading hours, pricing limits and other relevant information. Here is an example of what a specification sheet might look like:

102704_2.gif
Figure 2: Specification Sheet from CME.

Hedging Vs. Speculating
Hedging and speculating are the two primary ways in which forex derivatives are used. Hedgers use forex futures to reduce or eliminate risk by insulating themselves against any future price movements. Speculators, on the other hand, want to incur risk in order to make a profit. Now, let's take a more in-depth look at these two strategies.

Hedging
There are many reasons to use a hedging strategy in the forex futures market. One main purpose is to neutralize the effect of currency fluctuations on sales revenue. For example, if a business operating overseas wanted to know exactly how much revenue it will obtain (in U.S. dollars) from its European stores, it could purchase a futures contract in the amount of its projected net sales to eliminate currency fluctuations.

SEE: Spotting A Forex Scam

When hedging, traders must often choose between futures and another derivative known as a forward. There are several differences between these two instruments, the most notable of which are these:

• Forwards allow the trader more flexibility in choosing contract sizes and setting dates. This allows you to tailor the contracts to your needs instead of using a set contract size (futures).

• The cash that's backing a forward is not due until the expiration of the contract, whereas the cash behind futures is calculated daily, and the buyer and seller are held liable for daily cash settlements. By using futures, you have the ability to re-evaluate your position as often as you like. With forwards, you must wait until the contract expires.

SEE: Forex Walkthrough

Speculating
Speculating is by nature profit-driven. In the forex market, futures and spot forex are not all that different. So why exactly would you want to participate in the futures market instead of the spot market? Well, there are several arguments for and against trading in the futures market:

Advantages
• Lower spreads (two to three).
• Lower transaction costs (as low as $5 per contract).
• More leverage (often $500+ per contract).

Disadvantages
• Often requires a higher amount of capital ($100,000 lots).
• Limited to the exchange's session times.
National Futures Association fees may apply.

The strategies employed for speculating are similar to those used in spot markets. The most widely used strategies are based on common forms of technical chart analysis since these markets tend to trend well. These include Fibonacci studies, Gann studies, pivot points and other similar techniques. Alternately, some speculators use more advanced strategies, such as arbitrage.

The Bottom Line
As we can see, forex futures operate similarly to traditional stock and commodity futures. There are many advantages to using forex futures for hedging as well as speculating. The distinguishing feature is that the futures are not traded on a centralized exchange. Forex futures can be used to hedge against currency fluctuations, but some traders use these instruments in pursuit of profit, just as they would use futures on the spot market.

SEE: 10 Forex Misconceptions

Related Articles
  1. Options & Futures

    A Primer On The Forex Market

    Moving from equities to currencies requires you to adjust how you interpret quotes, margin, spreads and rollovers.
  2. Active Trading

    9 Misconceptions About Managed Futures

    Managed futures are not all they're worked up to be. Learn why they are not a good option for investors.
  3. Active Trading

    Take A Tour Of The Futures Trading Pit

    Discover why controlled chaos can mean an exciting investment experience for you.
  4. Options & Futures

    Options Risk Graphs: Visualizing Profit Potential

    With a single diagram, you can see how price, time and volatility affect potential gains.
  5. Options & Futures

    The National Futures Association As Market Watchdog

    As the overseer of the commodities and futures industry, the NFA helps to protect investors from fraudulent futures activities.
  6. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  7. Mutual Funds & ETFs

    ETF Analysis: WisdomTree Bloomberg US Dllr Bullish

    Explore an analysis of information on the WisdomTree Bloomberg U.S. Dollar Bullish Fund, a currency ETF that tracks the overall performance of the U.S. dollar.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI South Africa

    Learn more about the iShares MSCI South Africa fund, which is an NYSE-listed exchange-traded fund offered and managed by BlackRock.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI EAFE Small-Cap

    Read an in-depth analysis of the iShares MSCI EAFE Small-Cap Fund, a well-managed exchange-traded fund that tracks small-cap international stocks.
  10. Mutual Funds & ETFs

    ETF Analysis: Vanguard Global ex-US Real Estate

    Take an in-depth look at the Vanguard Global ex-U.S. Real Estate ETF, an international property fund tilted toward Asian markets.
RELATED TERMS
  1. Derivative

    A security with a price that is dependent upon or derived from ...
  2. Brazil, Russia, India And China ...

    An acronym for the economies of Brazil, Russia, India and China ...
  3. Optimal Currency Area

    The geographic area in which a single currency would create the ...
  4. European Sovereign Debt Crisis

    A period of time in which several European countries faced the ...
  5. Transfer Risk

    The risk that a local currency cannot be converted into the currency ...
  6. Inverse Transaction

    A transaction that can cancel out a forward contract that has ...
RELATED FAQS
  1. How can I trade in foreign futures?

    Trading in foreign futures takes place much like trading in domestic futures, except that transactions occur on specifically ... Read Full Answer >>
  2. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
  3. Is there a difference between financial spread betting and arbitrage?

    Financial spread betting is a type of speculation that involves a highly leveraged derivative product, whereas arbitrage ... Read Full Answer >>
  4. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  5. Why do companies enter into futures contracts?

    Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>
  6. What does a futures contract cost?

    The value of a futures contract is derived from the cash value of the underlying asset. While a futures contract may have ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!