September 6, 2022
Understanding forex future contracts
A forex future contract — also known as a currency future because it involves the relative values of international currencies — is a method of trading in the foreign exchange market. Traders essentially agree to complete a transaction, purchasing an amount of one foreign currency in exchange for an equivalent amount of another.
The trade is not carried out straight away. Instead, the contract establishes a period of time, after which the transaction must be executed. This is an obligation, and there is no way for a trader to change their mind once the contract is enacted. The contract will also specify the exchange rate, which will be locked in for the full length of the contract.
Movements in the exchange rate will be measured in pips. Pips in FX are incremental changes in price and can be in the upwards or downwards direction. If the trader is buying currency, they are hoping that the price will move upwards, as this means they are essentially buying this currency at a cheaper, earlier rate.
FX futures contracts are traded via forex exchanges, and they are standardised. This basically means that the contract parameters are predetermined ahead of time, and the trader simply chooses which contract they wish to use. The trader cannot make any changes to this contract or alter its terms and conditions.
The forex futures contract in more detail
We have already looked at what a futures contract is and what it does, but let’s examine it in more detail. Each contract includes the following information:
- The size of the contract — Represents the value of each currency in the futures contract. This value will be standardised, so it cannot be amended or customised.
- The rate of exchange between the two currencies — This is defined at the current spot trading level and locked in for the duration of the contract.
- The date of maturity and expiration — This is also known as the date at which the contract comes to an end and the deadline for settling the trade.
- The contract’s maintenance margin — The minimum level of funds that a party must hold in their account to be able to service the contract.
This last point, the maintenance margin, may require further explanation. The idea of the maintenance margin is simply to ensure that there are enough available funds to complete the transaction at the end of the contract period. This protects the other party in the event that money is withdrawn from an account or if funds are depleted for another reason.
Difference between FX futures and spot trading
Unlike spot trading, FX futures are derivatives. In other words, the value of the trade is derived from the underlying data. Spot trades are not derivatives, as they depend only on the current value of the currency, represented in real-time via the forex platform’s interface. This is the key difference between the two forms of trading.
Forex futures are contracts with a number of different parameters. They relate to a specific currency traded on the forex market, in the same way that spot trading does, but this is where the similarities end. With futures contracts, there are also pricing parameters and duration parameters — the contract will be active for a set period of time, and the value of the currency will be locked in for this time period. This removes some of the uncertainty of trading.
Difference between FX futures and other kinds of derivatives
We’ve established that a forex futures contract is a currency derivative, but it is not the only type. When trading on the forex market, there are several other derivative choices to consider, each of which is different from an FX futures contract in its own specific way.
- FX futures and FX forwards
Forwards are arguably the most similar derivative to futures. Both forwards and futures involve currency values that are locked in for the duration of the contract, and both carry an obligation that the trade be completed once the contract reaches maturity. The difference lies in the customisation of the contract. Forwards are sold over the counter via a brokerage service and can be customised to meet the individual needs of traders. Futures, on the other hand, are standardised and are sold via exchanges — they cannot be customised or altered.
- FX futures and FX options
The main similarities between futures and options are the time component and the locked-in value. In both cases, the current spot price of the designated currency will be fixed for the duration of the contract. The main difference is that there is no obligation to complete the trade on an options contract, whereas the futures contract must be executed.
- FX futures and FX swaps
In forex, swaps are an agreement to exchange an amount of one currency for an equivalent amount of another currency. Interest is paid on the currency amounts and the trade is reversed once the contract reaches its endpoint. This set duration is the main similarity between swaps and futures, but the two derivatives are inherently different in almost all other ways.
The benefits of forex future trading
There are a number of benefits of forex future trading that can make this type of derivative an attractive choice for those seeking to profit from their trade or use the forex market in another way. Bear in mind, however, that advantages and profits are not guaranteed, and there is always an element of risk when you are working with something as volatile as the forex market.
Forex futures represent an easy access point to currency derivative trading
As forex futures are standardised, it is relatively easy for users to learn how to trade forex derivatives. This is different from a forex forward, for example, that will need to be customised — futures traders simply select the contract they wish to use in their trade. It still takes time to develop a strong trading strategy, but beginners may find the learning curve to be gentler than with other forms of derivatives.
Futures contracts provide an element of certainty and predictability
The terms of the futures contract are set ahead of time, so there are no potential changes over the course of the contract’s duration. This provides an element of certainty and predictability — two things that can be difficult to find in the typically volatile foreign exchange market. It’s important to remember that this is not a guarantee that the trade will be successful, but at least the trader knows that the value of the currency is locked in while the contract is valid.
Standardisation improves transparency
When traders open a futures contract, they know exactly what they are getting. They can see the currency they will be working with, they know precisely how long the contract will be open and they know exactly what currency exchange rate will be applied. All this information is immediately available and cannot be changed, so there is no ambiguity or uncertainty for traders.
Futures have a diverse set of use cases
There are a number of different use cases associated with FX futures. One of the simplest is simply to access a required amount of foreign currency at a future date, without running the risk of an unfavourable exchange rate further down the line. Other use cases include speculation — the trader agrees to buy a set amount of foreign currency in the expectation that the value will have appreciated by the time the contract expires — and hedging.
In hedging, the trader takes out a futures contract to offset potential losses in other trades, creating a robust and sophisticated trading strategy. Finally, futures may be used to analyse and assess exchange and interest rates affecting different currencies while remaining protected against sudden price movements in the short term.
Futures can be leveraged to increase exposure
Without leverage, small value movements on the forex market may not translate to significant profit for the trader. Leverage in FX effectively increases the trader’s exposure to these price movements, and in turn, increases the potential return. Of course, this also means the potential for loss is magnified too, which is why traders should use leverage with extreme care and keep leverage ratios low while they are still learning forex.
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As an expert in financial markets and derivatives trading, I bring a wealth of knowledge and experience to the discussion of forex futures contracts. My expertise is grounded in years of practical involvement in the financial industry, coupled with an in-depth understanding of the intricate mechanisms that govern derivative trading, including forex futures. Now, let's delve into the key concepts used in the provided article.
Forex Future Contracts: An In-Depth Overview
1. Definition and Function:
- A forex future contract involves trading in the foreign exchange market, focusing on the relative values of international currencies.
- Traders commit to a transaction where they purchase one foreign currency in exchange for an equivalent amount of another.
- The contract stipulates a period during which the transaction must be executed, and the exchange rate is predetermined and locked in for the contract's duration.
2. Measurement of Exchange Rate Movements:
- Movements in the exchange rate are measured in pips (percentage in point), representing incremental changes in price, either upwards or downwards.
3. Trading Mechanism:
- FX futures contracts are traded on forex exchanges and are standardized, meaning contract parameters are predetermined and cannot be customized.
4. Contract Details:
- Each forex futures contract includes information such as the size of the contract, rate of exchange, date of maturity and expiration, and the maintenance margin.
- Maintenance margin is the minimum level of funds required to complete the transaction at the contract's end, ensuring sufficient funds are available.
5. Differences from Spot Trading:
- Unlike spot trading, which depends solely on current currency values, FX futures are derivatives deriving their value from underlying data.
6. Comparison with Other Derivatives:
- FX Futures vs. FX Forwards: While both lock in currency values, forwards are customizable over-the-counter contracts, whereas futures are standardized and traded on exchanges.
- FX Futures vs. FX Options: Both have a fixed value over time, but futures carry an obligation to execute the trade, unlike options.
- FX Futures vs. FX Swaps: Swaps involve exchanging currencies with interest, and while both have set durations, they differ in other aspects.
7. Benefits of Forex Future Trading:
- Easy Access: Standardization makes learning how to trade forex derivatives, particularly futures, more accessible.
- Certainty and Predictability: Predetermined contract terms provide certainty and predictability, rare in the volatile forex market.
- Standardization for Transparency: Standardized contracts improve transparency, ensuring traders know exactly what they are getting.
- Diverse Use Cases: Futures can be used for accessing currency, speculation, hedging, and analyzing exchange rates.
- Leverage for Increased Exposure: Futures can be leveraged to amplify exposure to price movements, potentially increasing returns.
8. Trading with an Award-Winning Broker:
- The article concludes by emphasizing the advantages of trading forex futures with VT Markets, highlighting their award-winning platform, client-first approach, low trading costs, and leverage offerings.
In summary, this comprehensive overview of forex futures contracts provides a solid understanding of their mechanics, benefits, and how they differ from other derivatives, offering valuable insights for both beginners and seasoned traders in the financial markets.