Many who become interested in Foreign exchange trading wonder what the crucial differences between Spot Forex and currency futures are. While both forms of trading involve making decisions regarding the future prospects of global currencies there are a number of subtle differences traders should take note of before deciding which product is suitable for them.
Future Contract (Forward Contract)
A futures contract is a legally binding contract that obligates the two parties involved in a deal to trade a specified amount of a currency pairing at pre-determined price at some point in the future. A Seller of a contract will profit if the currency pairing is trading below the pre-determined price in the spot market at the time of expiry. A buyer of a contract will profit if the currency pairing is trading above the pre-determined price in the spot market at the time of expiry. The futures markets are dominated by multi-nationals companies who need to hedge their Foreign exchange risk and by large speculative traders who enter into the markets with the goal of turning a profit. A number of smaller speculative traders do trade currency futures however these traders make up a small percentage of the total market volume.
Spot Forex differs as the underlying currencies involved in a deal are exchanged immediately when a trade is successfully placed. Rather than waiting for the expiry date a trader will typical Buy or Sell a specific amount of a currency pairing immediately. This allows for traders to immediately profit off any fluctuation in currency prices. Whenever someone goes to change up one currency into another currency they are participating in the spot market. In addition to Foreign exchange, precious metals tend to be traded as a spot instrument.
You should now see that the main difference between Spot Forex and Currency Futures is when the price is determined and when the exchange of physical currencies actually takes place. When trading currency futures the price is determined when the deal is made while the exchange takes place at pre-determined delivery date. This delivery date can be many months in the future. When trading Spot Foreign exchange the price is determined at the time of the trade with the exchange of currencies occurring immediately. It is important to note that the majority of futures contracts are closed out before the time of delivery.
Benefits of Spot Forex
- Highly Liquid Markets: The Spot Forex markets are highly liquid it is estimated that $1.5 trillion dollars of currencies are traded every single day. The global futures market is tiny in comparison with around $30 billion dollars being traded a day. The fact that the Spot FX market is extremely liquid means that traders can enter and exit positions with limited slippage bar extremely volatile market conditions.
- Open 24 Hours a Day: As the Spot Forex market is an interbank market during the working week the Foreign exchange markets are open 24 hours a day. This makes Spot FX very popular with part time traders who are able to trade around their existing commitments.
- Significant Leverage: Many Foreign exchange brokers allow their traders to take advantage of significant amounts of leverage. This allows traders to take on large positions with limited initial capital. This allows traders to maximize their profits; however leverage is a double edged sword and can also work against a trader. So whether one should see significant leverage as a advantage or hindrance is debatable.
- No or Minimal Commissions: The majority of Forex brokerages do not charge their clients commissions. Instead they widen the spread to make a profit for themselves. This means that there are no hidden charges which end up eating into your profits. When a brokerage does in fact charge commission traders receive the actual interbank rate, making the Spot Forex market easily accessible for retail traders.
- Price Certainty: In general when trading Spot Forex you will receive rapid execution with limited slippage. Though during periods of significant volatility you may experience increased slippage and slower execution. When placing a futures trade your trade may not be filled at the price listed by your futures broker. As the futures markets are less liquid the difference between the price quoted and the price your order is filled at can be quite significant.
> View our selection for the best spot forex trading brokerages
Benefits of Currency Futures
- Centralized Exchanges: Currency futures are traded through centralized and heavily regulated exchanges. While the bulk of futures contracts are traded on the Chicago Mercantile exchange (CME) there are a number of international exchanges that cater to those looking to trade currency futures. In addition to the CME traders can trade currency futures on the Euronext.liffe, the Tokyo Financial Exchange and the Intercontinental Exchange.
- Transparent Volume: The fact that currency futures are traded through a number of exchanges means that volume is transparent and open to for anyone to see. This is not the case with Spot Forex where traders can never get a complete picture of trading volume and open interest, due to the fact that Spot Forex is largely an interbank market.
- Regulation: The major future exchanges are based in jurisdictions with significant financial regulation in place. This means the futures markets themselves are heavily regulated and in the US the futures markets are governed by both the SEC and CTFC. While the state of Spot Forex regulation has improved in recent years there are many jurisdictions in which the Spot Forex market is not regulated or with a particularly light touch. This has led to a number of scare stories that have put individuals off trading the Spot markets.
- No Conflict of Interest: Currency futures are traded on regulated exchanges meaning there is no conflict of interest. Your orders are matched against others using the exchange to trade the futures market. While many Spot Forex brokerages operate without a Dealing Desk, there are still many brokerages that still operate using a dealing desk model. When a brokerage operates a dealing desk your losses can equal the dealing desks profit. This has led to many to speculate that their brokerage is manipulating price feeds or engage in other unacceptable behaviour to make a quick profit.
> Try World First’s Currency options for risk management or read more about money transfer services
Both Spot Forex and Currency Futures have their own pros and cons. Those who favour currency futures as a trading instrument tend to place significant emphasis on transparency and regulation. While those singing the praises of Spot FX tend to concentrate on the liquidity and leverage. It should be noted that the Spot Forex is more accessible to the average retail trader and accessing the currency futures market can certainly be a challenge. The fact that the Spot Forex market can be so easily accessed partly explains the rapid growth that the retail spot market has experienced in recent years. Both forms of trading involve significant amounts of risk and those unsure whether trading is for them should seek the advice of an independent financial adviser. View our corporate foreign exchange comparison for more.