Forex versus Futures - A Useful Guide

What is the difference between forex and futures trading?

Simply put, forex trading entails buying and selling currencies of different countries, while futures trading is a method that allows traders to trade on numerous financial markets, such as commodities, shares, forex, and indices.  

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What is forex trading?

Forex trading also referred to as FX or currency trading refers to the process of converting the currency of one country into another country’s currency. For example, ZAR (South African rand) to GBP (British pound, also called pound sterling). Express differently, currencies are traded in pairs, implying that when a trader is buying one currency, he or she is selling another currency at the same time. A currency pair comprises a base currency (appearing first in the currency pair) and a quote currency (appearing to the right of the base currency.) The price displayed in a currency pair indicates the amount of the quote currency required in order to buy one unit of the base currency. The seven most traded currency pairs in the forex market are:

1. EUR/USD (Euro/US dollar)
2. USD/JPY (US dollar/Japanese yen)
3. GBP/USD (British pound/US dollar)
4. AUD/USD (Australian dollar/US dollar)
5. USD/CAD (US dollar/Canadian dollar)
6. USD/CNY (US dollar/Chinese renminbi)
7. USD/CHF (US dollar/Swiss franc)

Currency pairs that do not comprise the US dollar are called cross currencies. For example, EUR/GBP (Euro/British pound) or AUD/NZD (Australian dollar/New Zealand dollar). The forex market, also called the currency market, is the largest financial market in the world, trading around 6,5 trillion US dollars daily. The forex market has no physical location. Currencies are traded on a decentralised market, referred to as an over-the-counter (OTC) market, via an electronic framework. The forex market is open somewhere in the world between 19:00 GMT on a Sunday and 17:00 GMT on a Friday. Nowadays, forex traders can open a forex trading account through a regulated forex broker (forex brokerage). Forex transactions are facilitated by forex brokers, with gains and losses being the responsibility of the traders.  

What is futures trading?

Futures are derivative trading instruments that are traded through contracts. Features of futures trading are, inter alia:

• An agreement between a buyer and seller in which the buyer consents to buy the underlying asset and the seller to sell the underlying asset before the expiry date of the agreement.
• The value of the contract is determined in terms of an estimated future price of the contract.
• Futures are traded on different financial markets (exchanges).
• All transactions related to futures trading are facilitated and cleared in a standardised manner.
• The value of futures is based on the value of another asset, called the underlying asset, allowing traders to trade in various asset classes, such as commodities, bonds, market indices, interest rates, and currencies.

 

Trading forex[1]

Basically, there are three ways to trade forex:

• Spot trading

Spot trading occurs when a currency is purchased or sold ‘on the spot’ in the spot forex market, also called the spot FX market. In the spot FX market, the physical exchange of a currency pair takes place simultaneously with the settlement of the price of the currency pair, or within a short period of time thereafter. Spot prices correspond with the underlying market and have no predetermined expiry date, commonly called expiry.  

• Option trading

A forex option, also referred to as a currency option, allows a forex trader the right, but not the obligation, to purchase or sell a specific currency at a specific price (exchange rate), referred to as the strike price, on or before predetermined expiry date. For this right, the buyer is obliged to pay a premium to the seller.  

• Futures (forwards) trading

When trading forex with futures, it is called forex forwards. A forex forwards contract is a legally binding agreement in which the involved parties are required to trade a specific currency pair at a predetermined price, indicated by the stated exchange rate, at a specified date in the future. Typically, the choice of a specific currency pair would depend on the currency a trader is expecting to strengthen against the other currency in the pair by the set date in the future. Futures are used in forex trading as a strategy to hedge against expected changes in the exchange rate. Usually, forex futures (forwards) are offered by forex brokers via contracts for difference (CFDs) trading, which is a method to trade on financial markets that do not require the purchasing and selling of an underlying asset. Leverage plays a key role in forex trading, enabling traders to trade with a substantial amount of money with a relatively small deposit, called the margin, initial margin, or margin account, in their trading accounts. A trader’s margin account is activated and managed by a forex broker. The amount kept by the broker in the margin account can vary, depending on the requirements of the broker and how large the trade size is. However, trading on leverage involves the risk to incur losses with the possibility of losing the initial deposit.  

Trading futures

As already mentioned, futures are derivative financial contracts whose price is determined in terms of an estimated future value of a specific underlying asset. (Also refer to ‘Features of futures trading’ above under ‘What is futures trading?’)   There are different types of futures contracts that are based on different asset classes and utilised as underlying assets, such as:

• Currency futures, including major currencies like the euro, US dollar, and the British pound. (Also see ‘Futures (forwards) trading’ above under ‘Trading forex’).
• Commodity futures such as crude oil, and agricultural commodities like wheat and corn.
• Stock indices futures such as the Johannesburg Stock Exchange (JSE) index (South Africa) and the S&P 100 (USA).
• Precious metal futures such as gold and silver.

As with forex trading, leverage also plays a key role in futures trading. The amount in the margin account can vary depending on aspects such as the size of the futures contract, the terms and conditions of the broker, and the creditworthiness of the trader. Leverage in futures trading also involves the risk to suffer losses.  

Trading futures for speculation

A futures contract enables a trader to speculate on the future trend (upwards or downwards) of the price of an underlying asset. A trader generates a profit with a futures contract when the price of the underlying asset increases and is trading above the original contract price at expiration. Prior to the conclusion of the contract, the long position (buy trade) would be cancelled out with a short position (sell trade) for the same amount at the current price. Conversely, traders can take a sell (short) speculative position when they expect that the price of the underlying asset will drop. If the price does fall, a trader will execute an offsetting transaction, closing the short position. Also, the net difference will be settled when the futures contract expires. In this case, a profit will be generated when the price of the underlying asset is below the contract price. Contrarily, a loss occurs when the current price exceeds the contract price.  

Trading futures for hedging

Traders use futures to hedge an underlying asset’s price movement, aiming to prevent losses from potentially unfavourable changes in the price of the underlying asset. Simply put, hedging involves taking an offsetting position in an investment with the object to balance any profits and losses in the underlying asset that backs the futures contract. An offsetting position is executed by taking an equal opposite position on the futures market on the current futures position. Long hedging occurs when a hedger buys a futures contract, agreeing to buy a commodity at some date in the future. Futures contracts involved in hedging are rarely filled but are mostly offset before expiry. The profit made or loss incurred on such a transaction is settled with the current price. Short hedging takes place when producers of commodities sell their product using a futures contract for delivery at a time in the future. They hedge their price risk by selling a futures contract, which they offset at the expiry (maturity) date by purchasing an equal futures contract. The profit gained or loss incurred by offsetting the position is then settled with the spot market price, which is the actual price a producer has attained for selling his/her product.  

Summary of key differences between forex and futures

 

Advantages of forex trading

• The variety of three ways to trade, namely spot trading, options trading, and futures (referred to as forwards in forex) trading.
• The opportunity to open a trade position with large leverage, increasing the potential profit.
• Traders can take long and short positions.
• The availability of more than eighty currency pairs ensures consistent and optimal liquidity.

Although, notwithstanding the opportunity to trade with numerous currency pairs and the ability to trade with the world’s major, minor, and exotic currencies, the number of currency pairs offered by forex brokers averages about 50. Furthermore, only the top 8 to 12 currency pairs present optimal trading conditions.

• Extended trading hours.
• Forex trading is straightforward.
• The forex market is the largest global financial market which is not overly regulated.

 

Disadvantages of forex trading

• Periods of extreme volatility because of drastic price movements (upwards or downwards) of currencies because of the intervention of central banks and/or governments.
• Enhanced leverage enhances risk exposure that can lead to significant trading losses.
• As an over-the-counter (OTC) market, the forex market has no centralised authority or regulator.

 

Advantages of futures

• Opportunity to trade with a variety of asset classes.
• Trading takes place on numerous financial markets which are well regulated.
• Traders can go long or short when taking trading positions.
• Futures contracts allow traders (investors) to speculate on the price of an underlying asset.
• Producers of agricultural products and suppliers of commodities can hedge the price of their products or commodities as protection against adverse price fluctuations.
• A trading position can be opened with a deposit, allowing leverage to increase potential profits.

 

Disadvantages of futures

• The liquidity of futures contracts varies extremely from contract to contract.
• Limited leverage compared to forex.
• Leverage can magnify losses.
• Futures contracts entail complex specifications regarding expiry dates, quantities, and trading hours.
• Unexpected volatility makes futures markets unpredictable at times.
• Hedging may cause hedgers to miss out on favourable price movements.

  [1] This article does not intend to provide investment or trading advice regarding forex or futures trading. Its aim is solely informative.  

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