There are many ways to trade the currency market, also known as the foreign exchange or forex market.
Traders may engage in:
- Trading spot forex (with instant delivery or delivery up to two trading days)
- Currency futures (where the exchange rate is determined at the time of signing the contract and where delivery takes place at a specific date in the future)
- Trading currency options, swaps, and forward contracts
Here, we’ll take a look at the differences, advantages, and disadvantages of trading spot forex vs futures.
What is Forex?
Forex, short for the foreign exchange market, is the marketplace for the world’s currencies. In terms of daily trading volume, the forex market is the largest financial market in the world, according to the Bank for International Settlements it has an estimated turnover of a whopping $5 trillion.
Forex traders trade on currencies, just like stock traders trade on stocks. They buy currencies that they think will rise in value, and they sell currencies that could fall in value, making a profit on the difference between the buying and selling price.
There are eight major currencies in the forex market:
- US dollar
- Canadian dollar
- British pound
- Swiss franc
- Japanese yen
- Australian dollar
- New Zealand dollar
Some analysts also include the Swedish and Norwegian krona as major currencies, calling all ten currencies the G10 currencies.
When trading forex, it’s important to note that all currencies are quoted in pairs, such as EUR/USD (euro vs US dollar), GBP/USD (British pound vs US dollar), and NZD/CHF (New Zealand dollar vs Swiss franc).
The exchange rate of a currency pair tells the price of the base currency (the first currency in a pair) in terms of the counter currency (the second currency in the pair). For example, if EUR/USD is trading at 1.20, this means that one euro costs $1.20, or that it takes $1.20 to buy one euro.
Currency pairs can be grouped into major pairs, minor pairs, and exotics. Major pairs are pairs that include the US dollar as either the base currency or the counter currency, and one of the remaining seven major currencies, such as EUR/USD, GBP/USD, and USD/JPY.
Minor currency pairs include two major currencies except for the US dollar. For example, minor pairs would be GBP/CAD, CAD/CHF, and EUR/JPY.
Finally, exotic pairs include currencies that are not heavily traded and that are not as liquid as major currencies, such as the Turkish lira, Mexican peso, or Russian ruble.
Since traders who trade on forex usually buy or sell a currency pair at the current market rate using instant execution, there is a major difference between trading forex and futures contracts on currencies. For the sake of this article, we’ll refer to currency trading at the current market rate as spot forex.
What are Futures?
Currency futures are another way traders can trade the world’s currencies. In general, futures are derivative contracts that derive their value from the underlying asset, which can be anything from stocks and food, to oil, gold, and currencies. Futures oblige both the buyer and the seller to complete the transaction at the contract’s expiration date.
However, most futures contracts change hands before the actual expiration date, as their price fluctuates depending on the price of the underlying asset they’re following. This means that futures contracts are predominantly used to speculate on future price movements.
Currency futures are priced in US dollars per unit of the foreign currency in question. Futures are traded on centralized exchanges, such as the Chicago Mercantile Exchange, that offers currency futures in major currencies, minors, and some emerging market currencies.
Pros of Forex Trading
The forex market is the most liquid financial market in the world, with an average daily turnover of around $5 trillion, according to BIS. The enormous liquidity of the market makes it very hard to influence prices, even by large market participants like hedge funds or banks.
Due to the high liquidity of spot forex, traders can also enjoy low trading costs and tight spreads most of the time, especially during the most active trading hours (the NY-London sessions overlap.)
The spot forex market is open 24 hours a day, five days a week. The market opens at 5:00 pm EST on Sunday, when the Australian market opens in Sydney. Two hours later, at 7:00 pm EST, markets open in Tokyo, Japan, followed by London at 3:00 am EST. The US markets open at 8:00 am EST and close at 4:00 pm EST, which is when the trading day begins again in Australia.
While the futures market can also be traded overnight, the liquidity is still quite thin during those hours compared to the spot forex market. Check out our guide on the best time of day to trade.
Unlike the currency futures market, spot forex doesn’t have an expiration date. Currency futures come with an expiration date, so you have to not only anticipate the trend of a currency in the coming weeks or months, but also the time when the trend might end. When trading spot forex, you can simply close your open position whenever you want, be it in the first few seconds, after days, or even months.
Cons of Forex Trading
Lack of transparency
As a decentralized market, the main drawback of trading spot forex is the lack of transparency. Whereas trading in currency futures is cleared through a centralized exchange, like the Chicago Mercantile Exchange, trading in spot forex only involves two parties to perform a transaction, a buyer and seller who agree at the current market price.
Pros of Futures Trading
When trading futures on currencies, all trading costs are clear and known from the beginning. On the other hand, when trading spot forex, spreads can often change depending on the underlying market conditions, and traders can also incur interest charges if they hold their positions overnight.
There are no overnight costs associated with futures trading, which is a major advantage of trading futures vs forex. However, bear in mind that certain currency pairs also involve interest payments when trading spot forex, depending on the interest rates of each currency.
Accurate trading volume
Another major advantage of trading futures vs forex is that the futures market comes with accurate data on trading volume. Trading volume is an important indicator in the markets and can provide valuable clues when making a trading decision.
Cons of Futures Trading
A major disadvantage of the futures market when compared to the spot forex market is liquidity and trading hours. The forex market is the most liquid financial market in the world, with trillions worth of currency exchanging hand on a daily basis. On the other side, compare this with the average daily trading volume of currency futures of around $40 billion.
The forex market is also open 24 hours a day, allowing traders to open, manage, and close their trades around the clock. While the overnight market in currency futures is available and improving, it’s still far less liquid than spot forex.
Should You Trade Forex or Futures?
So what should you trade, spot forex or futures? Let’s cover the main differences once again: In spot forex, currencies are exchanged immediately after placing a trade, or at most two trading days thereafter since it takes around 2 days to transfer funds between banks. In spot forex, the exchange rate is determined at the moment a deal takes place.
In the futures market, the exchange rate is determined when the futures contract is signed and the delivery of the currencies takes place at a pre-specified delivery date, usually in the distant future.
Since futures contracts have expiration dates, they’re more suitable for sophisticated investors or market participants who want to hedge their exposure in a foreign currency. Most retail forex traders will therefore benefit more when trading the spot forex market, given the tight spreads and the fast execution speeds offered by retail brokers.
Credit: My Trading Skills