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FX, Currency Futures: Making Sense of Market Choices
You may have heard the terms foreign exchange, forex, fx, and
currencies used interchangeably. While all these terms essentially refer
to the same thing—trading a nation’s currency rate against another’s—there
are different types of markets available for traders wishing to hedge or
speculate. Some are regulated, some are not, and all offer unique
characteristics depending on your individual strategy and risk tolerance.
I’ll go over some of the basics first, and why you might consider one over
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Foreign Exchange Basics
investment managers, corporations and private investors trade foreign
exchange (forex) markets to manage the risks and capture potential
opportunities associated with currency rate fluctuations.
a nation’s currency doesn’t occur in a vacuum; you don’t actually trade
one currency but a pair based on its relationship to another currency A
number of factors go into determining the “strength” or “weakness” of a
currency vs. another, but it usually comes down to comparing one nation's
economy to another's. Generally, expanding economies have stronger
currencies while recessionary economies have weaker currencies.
Fundamentals influencing a currency’s value include the nation’s gross
domestic product (GDP) as well as the trade balance between countries,
interest rates, and other macroeconomic factors.
There are several types of financial
instruments commonly used for currency
Spot: A spot transaction is a two-day
delivery transaction. This trade represents a “direct exchange” between
two currencies, has the shortest time frame, involves cash rather than a
contract; and interest is not included in the agreed-upon transaction
Spot transactions were developed for actual cash deliveries, but each day,
they can be closed and reopened the same day to postpone the delivery date
Forward transaction: In this
transaction, money does not actually change hands until an agreed upon
future date. A buyer and seller agree on an exchange rate for any date in
the future, and the transaction occurs on that date, regardless of what
the market rates are then. The duration of the trade can be a few days,
months or years.
Futures: Foreign currency futures
are forward transactions with standard contract sizes and maturity dates —
for example, 500,000 British pounds for next December at an agreed rate.
Futures are standardized and are usually traded on an exchange created for
this purpose. The average contract length is roughly three months. Futures
contracts are usually inclusive of any interest
Swap: The most common type of forward
transaction is the currency swap. In a swap, two parties exchange
currencies for a certain length of time and agree to reverse the
transaction at a later date. These are not standardized contracts and are
not traded through an exchange.
Options: A foreign
exchange option (commonly shortened to just FX option) is a derivative
where the owner has the right but not the obligation to exchange money
denominated in one currency into another currency at a pre-agreed exchange
rate on a specified date.
As a trader, you have a variety of ways to
participate in trading global foreign exchange. There are three main
markets you can choose, with different characteristics—cash forex,
currency futures, and the newest, spot equivalent
Cash Forex. The cash forex market
provides a mechanism for transferring funds globally, and determining the
currency exchange rate. Trading occurs primarily between large banks,
central banks, speculators, multinational corporations, governments, and
other financial institutions. Individual traders can participate in cash
forex trading via a broker or bank. This market is typically called an
“over-the-counter” (OTC) market, as there is direct negotiation between
parties without a central exchange or centralized clearing. The parties
involved take on the risk, and they may or may not be creditworthy. As the
market is made up of interconnected participants, there may not be unified
rate for a particular currency at any given time. And, there are different
levels of access, and pricing. The inter-bank market is at the top of the
ladder, made up of the world’s largest investment banks. The tightest
bid/ask spreads are generally within this tier. The retail cash forex
market is only loosely regulated, so individual traders wishing to
participate should be cautious.
CME Group is the leader for currency futures trading in the United States.
Currency pairs are also available at ICE Futures U.S. You can trade a
variety of foreign exchange futures contracts in a fully regulated and
transparent marketplace, with pricing based on a nation’s respective
currency value vs. the U.S. dollar, or another currency. For example, you
can trade futures on the Australian dollar vs. the Canadian dollar, or
British pound vs. the Japanese yen. Unlike the cash forex market,
institutional and retail traders alike have access to the same prices, the
same pool of liquidity, and a central clearing mechanism to eliminate
counterparty risk. CME Group offers 41 individual FX futures and 31
options products, covering major currency pairs as well as an array of
emerging market currencies.
Individuals wishing to participate in foreign
exchange trading now have a new choice that blends the characteristics of
the cash futures market with the futures market. These products offer a
level playing field for participants of any size with no hidden
costs—unlike cash forex. Spot equivalent futures, traded at the U.S.
Futures Exchange, replicate spot markets on a regulated, exchange
environment backed by a clearinghouse. USFE’s spot equivalent futures
automatically allocate the cost-of-carry in holding a spot position
overnight via an end-of-day cash payment, making an SEF position
economically similar to a spot position. This differs from traditional FX
futures contracts, which have quarterly expiries and include cost-of-carry
basis in the price of the contracts. Six currency pairs are currently
available for trading electronically 23 hours a day. Most common futures
order types are supported, including stops Learn more at www.usfe.com.
I feel the Spot Equivalent Futures contracts listed exclusively on the
USFE provide currency traders a smooth transition into the futures
markets. Cash currency traders often have difficulty adapting to the
quotation system used on other FX futures contracts. The USFE contracts
are quoted as spot prices. Because all the major seven currency contracts
are traded in this format, one can use either outrights against the US.
dollar, or trade crosses by executing spread orders. Spread orders allow a
trader to eliminate the U.S. dollar from the equation and trade the
relative value of the cross pair.
Many traders ask what benefits they would receive by trading these
contracts as spreads rather than staying in the OTC cash forex market The
major benefit is the fact that futures contracts are regulated. Customer
accounts are segregated, and no customer has ever lost money due to
company default. There have been many instances of improprieties by FX
firms. The OTC market is unregulated and not subject to the strict law the
Commodity Futures Trading Commission imposes on futures brokerage
Another benefit to traders is the fact that you can hedge your currency
risk by using other futures products. Position enhancement techniques can
be held in one futures account, making it much simpler to track the
performance of each position and accounts as a whole.
As currency markets continue to gain in popularity, I believe traders
will turn to regulated markets for the ease of execution, the secure
nature of futures markets, and the ease of transition. Lind-Waldock
believes in the security of regulated exchange trading and is the leader
in futures brokerage for individual investors. Feel free to contact
me and I’d be happy to assist you with your forex futures trading and
tailor strategies specific to your individual needs.
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Favorite Movie: Good Will Hunting
Tim Evans is a
Senior Market Strategist with Lind Plus, Lind-Waldock's broker-assisted
division. He started his futures career as an independent trader, trading
for his own account for four years before joining Lind-Waldock. He has a
B.A. in economics from UNC-Chapel Hill and is currently pursuing his M.S.
in financial markets at the Illinois Institute of Technology. Tim uses a
combination of fundamental and technical analysis, and focuses primarily
on financials, currencies, and metals futures. He finds it important to
examine the relationships between multiple markets, looking for
convergence or divergence in the markets to give solid confirmation of a
trading strategy. He can be reached at 800-798-7671 or contacted via email
You can hear market commentary from Lind-Waldock market
strategists through our weekly Lind Plus Markets on the Move webinars, as
well as online seminars
on other topics of interest to traders.
trading involves substantial risk of loss and may not be suitable for all
investors. © 2007 MF Global Ltd. All Rights Reserved.
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