Forex Futures - Definition
Forex Futures are futures contracts that trade a given amount of currency at a predetermined price on a predetermined future date.
Forex Futures - Content
:: What Are Forex Futures?
:: Difference Between Trading Forex Futures and Spot Forex?
:: When Does Forex Futures Trade?
:: Why Trade Forex Futures?
:: How To Get Started Trading Forex Futures?
:: Benefits Of Trading Forex Futures
:: Risks of Forex Futures
:: Brief History of Forex Futures
What Are Forex Futures?
Forex Futures, short for Foreign Exchange Futures or also known as Currency Futures, are futures contracts with currency as its underlying asset. Since it is cash that Forex Futures are dealing with, it is an interesting futures contract that delivers cash no matter if it is labelled "Physically Settled" or "Cash Settled". In a physically settled Forex Futures contract, futures traders that are long receive the amount of currency covered by the contract upon final settlement while in cash settled futures futures contracts only the profit on the contract is delivered in cash. Forex Futures are one of the most important financial futures in the world today as it literally created the global currency market we see today. Forex Futures are the first form of financial futures to be created in the world and is now a global 24/7 market that trades currencies around the world with leverage everyday of the week, every hour of the day, making the Forex Futures market the single biggest market in the world.
Forex Futures cover what are known as "Currency Pairs". Currencies derive their value from other currencies since they are traded against one another. This makes each traded pair of currencies a product on its own. For instance, the EUR/USD pair is a product on its own with the value of the Euro priced against the US Dollar. Forex Futures have as their underlying asset such currency pairs and allows investors to speculate on changes in the value of the currency pair with leverage, to hedge against currency exposure risks or even to obtain arbitrage profit from any mispricings.
Difference Between Trading Forex Futures and Spot Forex?
Spot forex refers to the trading of the physical currencies directly while Forex Futures are futures contracts written on these currencies for trading some time in the future while still participating in all its price movements using only a fraction of what it could have been trading spot forex. When you go to the bank to "exchange" your local currency into a foreign currency in anticipation of an appreciation in value of that foreign currency is trading in spot forex. The main difference between that and trading forex futures is that in forex futures, all you need is a fraction of that money you used towards buying those foreign currencies and you won't have to keep any of those foreign currencies while still participating in all of the price movements of that foreign currency with LEVERAGE. You only buy in those foreign currencies upon expiration of the forex futures contract and only if you wish to, if you don't, you simply offset your forex futures position and take profit. You don't even have to ever own the foreign currencies to profit from them through Forex Futures unlike in spot forex trading.
When Does Forex Futures Trade?
Forex futures trade around the clock, 24 hours a day, 7 days a week. It is a decentralized non-stop market that trades around the world in a baton-relay style starting from Sydney, Australia and follows the sun all through to New York, beginning on Sunday at 5pm EST all through 5pm EST on Friday. This decentralized, 24 hours market, made it possible for anyone in any time zone to trade forex futures at anytime they wish and is useful for futures traders who has a full time job and can only traded during after-office hours.
Why Trade Forex Futures?
There are two main reasons why Forex Futures are being traded; Leveraged Speculation and Hedging.
Leveraged speculation means attempting to profit from a directional move in the underlying currency pair by being long on Forex Futures when you expect the value of the currency pair to appreciate and being short when you expect the value to depreciate. Due to the leveraged nature of futures trading, you could easily end up with a profit of 1% or more on moves as small as 0.1%, depending on the amount of leverage granted by the Forex Futures contract.
Forex Futures Trading Example:
Assuming EUR futures (Forex futures contracts on the EUR/USD currency pair) are trading at $1.4 today. Assuming you are bearish on the Euro, you decided to go short on its June contracts trading at $1.41 with contract size of $125,000 and a tick size of $0.0001. Initial margin requirement for this contract is about $440. Assuming EUR drops and the price of the contract drops to $1.395, you make:
$1.4 - $1.395 = $0.005
$0.005 x $125,000 = $625
$625 / $440 = 142% profit
The EUR/USD pair dropped by only 0.3% but you make 142% profit by speculating through the EUR Forex Futures. That's speculating with leverage.
Hedging against currency exchange risk is one of the most important functions of the Forex Futures market. International corporations operating across many different currency zones need to be able to hedge against currency price fluctuation in order to ensure a steady and predictable international revenue as a disfavor currency dip could actually wipe out all the profit made in that country for an international corporation. Hedging against forex risk is also important for companies purchasing big ticket items from overseas suppliers in foreign currency as any sudden increase in value of the foriegn currency can increase costs tremendously in the local currency, potentially eliminating any economic benefits such a purchase could bring. Such companies include companies that import machineries or cars in the currency of the producing country.
In fact, hedging using forex futures is so important that real world international companies that has not done any foreign currency hedging has suffered tremendous economic losses. In 2009 alone, fortune100 companies worldwide has lost an estimated $20billion due to unhedged currency movements and Oracle suffered a lost of $0.05 per share in earnings due to unhedged currency movements as well. These go to show the tremendous importance of forex futures in today's global business environment.
Forex Futures Hedging Example:
Assuming a US company is buying a shipment of cars from Germany for 1,000,000 Euro to be delivered and settled in 3 months time. Assuming the exchange rate of EUR/USD is $1.4 upon signing of contract and the cost of the shipment in USD is $1,400,000. The US company wants to make sure it pays no more than USD$1,400,000 when it comes time to pay in 3 months time. The US company goes long EUR futures for 80 contracts of $125,000 per contract at $1.40. Assuming EUR rises to $1.45 in 3 months time.
Amount payable in USD = $1,4500,000
Loss in USD = $1,4500,000 - $1,400,000 = $500,000
Profit on EUR futures = $1.45 - $1.40 = $0.05 x 125,000 = $6,250 x 80 = $500,000
In this simplified example of forex futures hedging, the profit on the EUR futures completely offset the loss on the amount of USD payable for 1 million Euros, thereby saving the US company $500,000 in foreign exchange loss on the purchase.
There are also professional forex futures traders (typically institutions) who are in the forex futures market solely for arbitrage purpose with extremely complex computers and formulas running automated programs designed to seek out any slightest price discrepanies across multiple exchanges all over the globe. As the forex market is a huge and complex one, there are many ways to seek out arbitrage opportunities but such opportunities are typically available only to professional institutions which has access to the hardware and software needed for such complex global forex arbitrage trading.
How To Get Started Trading Forex Futures?
To get started with trading forex futures, you need to first of all have a comprehensive knowledge of the global currency market and then also have a comprehensive knowledge of how futures contracts work. Once you have those knowledge, you need to then choose one or just a few currency pairs to work on for a start and completely understand the behavior and trends of these currency pairs. After that, you would be set to open a forex trading account with any online forex trading brokers and then start to paper trade (or also known as "virtual trade") your methodology to make sure it works. After that, you would be all ready for real forex futures trading.
Benefits Of Trading Forex Futures
One of the biggest benefits of trading forex futures is the fact that it is a 24 hours a day, 7 days a week, global market. This allows traders to trade forex futures on their own free time, regardless of what time that may be. Apart from that, being able to hedge against foreign currency risk is definitely the main benefit of forex futures trading for companies and institutions.
Risks of Forex Futures
The single most significant risk of trading Forex Futures, as in the risks of futures trading for speculative purposes, is that fact that you can lose more than the money you initially started the trade with. If you are long a Forex Futures position and the currency move against you drastically in a single day, you could lose enough in one day to warrant a margin call and if you don't have enough money to fulfill the margin call, your position would not only be forcefully closed but you would also end up owing money to your broker. This is how many multi-billion dollar companies collasped overnight trading forex futures. One example of such a company is the Barings Bank which went bankrupt on forex futures trading. As such, careful risk management in terms of leverage and cash reserve needs to be planned out when trading Forex Futures.
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Brief History Of Forex Futures
Forex futures is the very first financial futures to ever be created. Prior to the creation of Forex Futures by the Chicago Mercantile Exchange (CME) in 1970, there were only futures contracts for physical commodities or Commodities Futures. Forex futures ushered in the era of Financial Futures which made hedging against financial risk possible. The first two years of Forex Futures trading isn't that popular since the Bretton Woods System was still in force and all currenies were pegged to the US dollar and the US dollar to gold, which left little to no room for any trading since exchange rates are relatively fixed. It was not until the Bretton Woods System collasped with the US abandonment of the Gold Standard did most currencies became free floating allowing the Forex Futures market to really take off. In fact, the creation of forex futures (which would be extremely important when currencies become free floating) just a couple of years prior to the collaspe of the Bretton Woods System probably signalled the imminent end of that system to the world back in those days. The CME established and chartered the International Monetary Market (IMM) in 1972 for the trading of 7 forex futures and since then, the forex futures market has been growing from strength to strength and is now one of the biggest and most important markets in today's global marketplace.