How the two markets operate
Currency futures are not functionally different from other futures. Like in any other futures contract, currency futures entitle forex buyers and sellers to trade specified currencies at predetermined prices at an agreed date in the future. Under such contracts, buyers may opt to either close their position and own the currency or wait to buy it at the spot market in the hope that prices will have reduced by then.
In case the buyer opts to wait to buy it in the spot market, they may either get it at a higher price or get it for cheaper. Futures present both buyers and sellers with an opportunity to lock in their currencies in good time and safeguard them against unforeseeable price movements in the future.
In contrast to futures, spot market forex transactions are executed and completed at the point of exchange, with the transfer of the currencies typically done within 48 hours. For futures to be profitable in their competition versus the spot market, their current prices are usually higher than spot prices.
The other key difference between futures contracts and spot forex is that spot market transactions involve exchanging the actual currencies being traded while futures do not guarantee that a transfer will take place.
Key features of the forex spot market
The markets do not have a central exchange platform: Due to the widely decentralized nature of the spot market, currency traders are hardly in the know as to the actual volume of the currency traded. This makes the spot market somewhat more unpredictable than futures.
They are not regulated: Unlike the futures contracts, spot FX markets are more liberalized. Therefore, there is always the risk of market manipulation.
This kind of manipulation may lead to the loss of money, especially by inexperienced traders. The risk is further compounded by the fact that traders who lose their money to unscrupulous entities have nowhere to turn to in the absence of a regulator.
Brokers at times antagonize their clients: Since spot markets typically offer no commissions to brokers, most of them have devised a way of profiting from spreads. Whenever you enter a position, either brokers or their proxies assume positions that will ensure that they get a cut from the spreads. This, therefore, puts these clients at a greater disadvantage when trading in the spot market, as compared to the futures markets.
No commissions: The majority of brokers in the spot market do not charge commissions. To make up for the lost money, they instead widen their spreads. This results in their clients taking a hit from their positions. Therefore, you may be several pips below or above the average going rate.
Spot markets have bigger leverage: This is one of the aspects of spot markets that some investors find attractive. From amounts as small as a few hundred dollars, you can get leverages that are comparatively higher than others. However, note that taking leverage also increases your potential losses.
- They are traded in centralized exchanges: Futures are traded at centralized exchanges like Cboe and EUREX. This makes it easier for not only individuals but also institutions to trade, because of the high liquidity and regulated environment.
- A known volume of trade: Due to the regulated and centralized nature of the futures markets, their trading volumes are open to traders. Therefore, they can make their moves from a better-informed position than in spot markets.
- They operate in a regulated environment: As highlighted above, futures are traded under regulatory authorities, whose rules they have to abide by. For example, Cboe is regulated by the Securities and Exchange Commission (SEC) and the National Futures Association (NFA).
- Futures have counterparty risk: While futures are technically contracts between buyers and sellers, there is always a risk that one of the parties involved in the trade may not show up when the futures maturity date comes.
To cushion against these risks, futures exchanges require traders to have maintenance margins and performance bonds:
- Performance bonds are a form of security that you deposit into your futures contract account to ensure that you can meet your contractual obligations.
- Maintenance margin is the minimum amount of money that you must maintain in your account for each of the trading positions you have opened.
Using this approach ensures that if the market moves against you, then your position will be covered by debiting the equivalent amount of money from your account. On the other hand, if you end up winning against the market, then your earnings will be credited to your account.
- Futures provide a cushion against spot market risks:
Due to the comparatively greater leverage offered by futures, traders can use a few contracts to cover larger positions taken in the spot market. Therefore, you can use futures as a cover in case you also opened riskier positions in the spot market.
Spot markets and futures can present traders with great opportunities to trade profitably. Whilst this type of contract serves the needs of large international corporations in the first place, forex traders can use them individually or use one to complement their portfolio of assets.