An explanation of Forex and futures as asset classes, their differences and similarities, and the best ways to trade them.
Forex and futures are two asset classes with some overlap – Forex can be traded as a future, but while Forex is the exchange of one currency for another, futures are available in a wide range of asset classes, from currency pairs to commodities to equity indices, allowing the trader a widely diversified strategy. Forex trading, on the other hand, truly only allows geographical and not sectoral diversification, although some currencies can be used as proxies for certain commodities.
Read on to learn more about Forex and futures as asset classes, how they work, their similarities, differences, and pros and cons, as well as the best ways to trade them.
What is Forex Trading?
Forex is short for “foreign exchange”. Forex trading is the exchange of one currency for another. Forex trading can be undertaken for commercial purposes; for example, an American business operating in Japan may need to exchange US Dollar for Japanese Yen or vice versa. However, most Forex trading is for pure speculation. Here, Forex traders try to exchange one currency for another, then exchange back at a more favourable rate later while pocketing the monetary profit from the transaction.
Forex is the world’s largest and most liquid market and is open 24 hours per day on weekdays, even to retail traders or investors. Forex trading is often done with leverage. The Forex market is a decentralized global marketplace dominated by a few major banks. Forex is quoted in currency pairs, showing the rate at which one currency may be exchanged for another, for example, EUR/USD.
Forex is traded as many different financial instruments:
- Spot Forex – this is the simplest form. It is the direct exchange of units of one currency for another.
- Currency Futures – Forex futures are available for many currency pairs. Futures are technically a contract providing for the exchange of an asset at a specified future date, but in practice, the actual exchange is rarely made.
- Forex CFDs – most retail Forex brokers offer CFDs on Forex, which practically mirror price movements in spot Forex. CFDs are technically derivatives but usually are essentially the same as trading spot Forex.
- Forex Options – options are written on the future prices of Forex currency pairs. Writing or buying options can be a way to profit from Forex price movements while effectively limiting risk to a predefined maximum.
- Currency ETFs – there are ETFs which own one currency against a basket of its major counterparty currencies, which can be used as a Forex investment or trading vehicle.
Forex traders typically use technical analysis to decide when and what to trade, and sometimes fundamental analysis too, which looks at factors like economic indicators, geopolitical events, and market sentiment to make decisions on likely currency movements.
What is Futures Trading?
Futures are financial derivatives where participants contract to buy or sell assets, commodities, or financial instruments at a predetermined price and date in the future.
A key feature of futures trading is the obligation to fulfil the contract on the specified future date, although traders almost always close out the trade before this happens.
Futures trading is typically conducted by commercial hedgers, seeking to offset their risk of price fluctuations in the underlying asset, and speculators, who are just trying to make a profit by being on the right side of price movements in the futures contracts.
Futures are traded on exchanges as standardized contracts, unlike spot Forex. They are available for many different asset classes, including equity indices, commodities, currency pairs, and even Bitcoin. This can make futures trading an excellent choice for anyone wishing to implement a diversified trading strategy.
In practice, futures can be traded with high leverage if required, as margin requirements for futures contracts, which are set by exchanges as well as by brokers and regulators, are quite low.
Futures traders, like Forex traders, tend to rely mostly upon technical analysis to make trading decisions, although fundamental analysis is used more widely across all asset classes compared to Forex, so fundamental analysis is typically used to a larger extent in futures trading.
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Spot Trading vs Futures
I noted above that Forex can be traded either as spot Forex or as Forex (currency) futures. This is a comparison which can be made, as well as the general comparison between Forex and non-currency futures as different asset classes. I want to say a few words comparing these two different ways of trading Forex, showing similarities, differences, and the comparative benefits and risks of trading Forex and trading futures.
Spot Forex
- No Central Exchange (Over the Counter market):This means thatthe market you are trading is the market your broker is making for you. This has led to manipulation issues in the past, but nowadays, FX brokers have become very competitive with their pricing engines and execution policies. Reputational risk is very important for Forex brokers, so their practices are generally less "shady" than in the past.
- Regulation issues:the spot Forex market is being regulated more and more. While the market is not directly regulated, the FX brokers that deserve credit are all regulated by the major bodies worldwide (NFA, SEC, CFTC, FCA, CONSOB, ETC.), and thus the client is somewhat protected. Also, client money is often put in segregated accounts, so in case your broker goes bust, your funds are protected.
-Broker May Act as Principal:most Forex brokers do not charge any commissions. Instead, they get paid by the “spread." But often, they will act as principals, taking the other side of your trade. This means that your goals and their goals may not be in alignment as you are essentially trading against each other.This does not mean Forex brokers are trading against you or trying to hunt your stops. This simply means that your losses are their profits, and vice versa. Since most aspiring traders lose money, brokers are interested in acting as principals.
-Counterparty Risk: you must make sure you know exactly where your funds are being held. Are they being held at a large bank in a segregated account or some account that the broker has rights to? Again, reputable brokers regulated with the FCA, NFA, CONSOB, etc., must follow best practices to keep client money safe. With that said, counterparty risk is real, and it is always a good practice to deposit only a part of your risk capital with your broker.
- No Commissions:most Forex brokers do not charge commissions. Instead, they take the best bid and best offer from their interbank counterparties and add a markup.
- Big Leverage:in spot Forex, 100:1leverageis not uncommon if you are resident outside the G7 nations. This means you can open an account with as little as $100 dollars and begin trading. This means that trading through a Forex broker is cheaper. However, while it is great to be able to use so little margin for trading (making it “cheap” to trade FX), keep in mind that leverage can work against you as well.
Futures
- Single Central Exchange(CME or another major exchange): theChicago Mercantile Exchange (CME)is the home of Forex futures. The CME is one of the largest exchanges in the world and is very well capitalized. Some of the largest banks use the CME Forex futures to hedge currency risk.
- Transparent Volume:because there is a central exchange,we can see trading volume and open interest easily, and everyone has access to it.
- Well Regulated (SEC, NFA):the CME has double regulation. They are a Futures exchange, so they are under the watchful eye of the NFA and the SEC. They are also a publicly traded company, so they have another level of regulation that comes with that structure.
- Trades Matched on Globex:as with other Futures markets, Futures are traded in the trading pit but also on the Globex system. The Globex system is an electronic order matching system, much like NASDAQ for stocks. There is no broker on the other side of your trade. Instead, when you buy, your order is matched up with a seller like you, not a broker. So, conflicts of interest are reduced.
Forex vs Futures - How to Trade?
Trading Forex, whether by using currency futures, Forex CFDs, or other Forex instruments, will be done using the same strategies. The question here, as to how to trade Forex and futures differently, is really the question of the best ways to trade Forex and other asset classes which are represented by futures.
Both Forex and futures can be traded using technical or fundamental analysis. However, Forex is typically more driven by technical analysis and by levels of support or resistance, which often represent barrier options defended or attacked by major banks which are holding positions.
This means that for Forex traders, identifying areas of likely support and resistance and waiting for reversals at these areas will probably be the best trading strategy. Trading Forex with fundamental analysis will mostly involve looking at comparative interest rates and whether relevant central banks are loosening or tightening their monetary policies. Some of the best long-term Forex trades will be long of currencies with higher interest rates and tightening central banks and short of currencies with lower interest rates and loosening central banks.
In futures trading in non-Forex asset classes, trend and momentum trading are likely to dominate the trading strategies used. There are many trend-following funds using diversified managed futures strategies relying upon long-term breakouts for entries and trailing stops for exits. These funds have good track records and use surprisingly simple trend-following strategies.
In trading futures on equity indices, the general long bias in equity markets might be respected, as well as fundamental analysis of the economic outlook of the geographical equity index which is traded.
In trading commodities futures, there is also a historical long bias which could be factored in, with bullish momentum after long-term breakouts usually worth noting. Supply and demand analysis can also be useful in deciding which commodities to trade and in which direction.
Bottom Line
The conclusion to the spot Forex vs Futures debate is quite simple. Spot Forex is more accessible, and the low deposit entry barrier makes it easy to trade. However, it takes a lot more due diligence on the trader's part to find areputable Forex brokerthat will keep his funds safe and answer the phone in the event of a black swan.
With Futures, there is hardly any due diligence to be done. However,the trading capital necessary to trade Futures is more than for spot.Also, you must find out what type of fees your Futures broker will apply on top of the regulated exchanges' fees. So,Futures are potentially more expensive to trade: you are paying for standardization and zero conflicts of interest. However, the increased diversification of the futures universe can make it more rewarding to trade than sticking to only Forex.
FAQs
What is better, futures or Forex?
For the average retail trader, trading Forex is probably the way to go. It is more accessible, and there are regulated brokers to trade with. For sophisticated investors with more capital, Futures are probably the better choice.
Which is more profitable: futures or Forex?
As we have seen in this article, the front-month Futures contract is an exact replica of the Forex market prices. The key to profitability is not the instrument (Forex or Futures); it is your strategy and discipline.
Why is Forex a bad idea?
Forex is not really a bad idea. It is an over-the-counter market that has been functioning well for 50 years. You just need to make sure you are trading with a reputable broker.
Is Forex trading the future?
Forex trading will always be around because international corporations need to use the Forex market to hedge currency risk.
Why trade futures over Forex?
The main advantages of trading currency futures over spot Forex are the absence of any overnight swap fees and more favourable tax treatment under some countries' tax laws. Despite the lack of overnight swap fees, currency futures have some swap effectively priced in, but it is usually more favourable than what you will get trading spot Forex.
You might also be interested in reading the below articles:
- Which Forex Pairs Range the Most?
- Which Forex Pairs Trend the Most
- Forex Trading Industry Statistics and Facts
- How to Count Pips on GBP/JPY
- Which Forex Pairs Move the Most?
