Futures vs Forex - what is better to trade?
Most people that start trading today do so trading Forex. Forex is dominant in marketing, especially outside the USA. When one is running a trading floor, most applicants will have done some forex trading. Mostly because forex is cheap – a hundred USD can open an account to trade micro-lots.
Futures – standardized contracts for future delivery
Traditionally, high leverage trading for the private investor was done using Futures. And it was done on the US markets that al belong today to the CME group, like the Chicago Mercantile Exchange, the Chicago Board of Trade and their New York equivalents. Equivalent markets exist in London with the LIFFE (the London International Financial Futures and Options Exchange) which was established in 1982.
In futures markets, participant’s trade standardized contracts about a delivery to a future date. For example I can sell EURO (vs USD) for a delivery in September 2015. Many modern contracts are cash settles – so I never deliver the EURO and get the USD, instead I pay a loss or earn a profit based on the price change.
Contract delivery dates are standardized (but can vary by contract – crude oil in New York for example has monthly contracts and is physically settled. This means I may end up as a buyer of oil with the oil in the warehouse at my disposal – unless I am exiting my contractual obligations with an offsetting contract early enough.
The standardized contract system has positive and negative sides. All trades of all participants are always with the exchange. The exchange guarantees the obligations are met. Contracts can be excited by opening a counter position. Standardized contracts and the central exchange mean that options can exist (and do for most contracts) and there is an official price feed and a documented reliable order matching mechanism. It also means futures trading is generally highly regulated – in the USE the CFTC, the “Commodity Futures Trading Commission” is tasked with regulating the market. A critical failure of market participants is rare – there is only one case where customer funds got mishandled on a critically large scale, and that Peregrine Financial in 2013 and highly criminal – sending false account statements to the CFTC for years and running the operation effectively as a scam.
Instead of paying the obligations entered by contracts, traders must provide guarantee money (the so called margin) that can be used to pay their losses. The margin is generally low, though it depends on the contract volatility and whether a position is kept open between sessions. Day trading margin can be a lot lower than regular margin – often by a factor of more than 10. This allows highly leveraged trading. There is no daily charge – but the prices of a futures contract have an offset to the cash prices that slowly disappears as the delivery date approaches.
Forex – once for banks, now for everyone
Forex trading is based on the interbank currency trading done by banks for many years. It is classical “over the counter” in that the different parties do contracts with each other and there is no central clearing place. A trader asking to sell EURO (vs USD) will call different participants and get the best price he can. Typically contracts are standardized and a Lot was a size of 1 million base currency (mostly USD vs. something else).
Today, Forex is the area of many brokers which work together with various liquidity providers (the banks) and combine their offers into a data feed. Still, every broker can in theory have different providers, so a data fed from one broker is not official and can be different than the feed from another broker. Many – shady –brokers in the past also manipulated the price feed to “run stops” of their customers. Outright fraud in the eyes of many.
The standard lot size today is 100.000 base currency units, but mini lots (10.000) and micro lots (1000 base currency units) are available through retail brokers. There is no forward delivery, the purchase is done cash – so a lot transaction of our example means an account level of -100.000 EURO and + whatever USD was purchased. The credit costs interest rate every day (at the cut-off point once per day) while the positive assets collect interest – both combined are a carry charge that can be positive (the trader gets paid, a so called carry-trade) or negative (if the sold side incurs higher interest rate than the purchased side gets). Typically a cash guarantee for losses has to be provided – a leverage factor of 100 or more is often possible.
Traditionally Forex trades are “no commission” (instead the broker changes the bid and ask a little) though professional level brokers allow “real prices + commission” accounts today. Forex also does not mean only currencies anymore – there are various CFD (Contract for Difference) that are available at least for precious metals and often also for major indices.
Practical differences between futures and forex
For a trader there are some interesting differences between those two instruments. While similar in principle, these differences can push a trader to one or the other depending on his strategies.
In size, Forex has a distinct advantage over futures. The standardized contracts of futures mean that positions have to be opened with a very coarse granularity. Not only does one need enough capital to trade a full contract, when risk management asks for 2.3 contracts to be traded – the position can be either 2 or 3 contracts. Forex allows traders that do not routinely trade 20 contracts to instead trade for example 23 mini-lots (instead of 2 or 3 full lots) which makes hitting the optimal risk size a lot easier.
Forex also has an advantage in flexibility. The typical session close is 15 minutes (similar to Futures these days). This is normally a manageable risk. Contrary to futures, though, holding a position through this session pause incurs a carry charge – but not a higher margin. This means a day trader can effectively keep a position open from Monday to Friday (only closing it to avoid the weekend risk). The futures trader incurs significant margin requirements for this.
On the other side, the futures market is better regulated. This means a reliable and guaranteed price feed, an order book (not available from most futures brokers). It means the availability of options and it means that there is no counterparty risk because the exchange is the contract partner for all position opened.
How does a trader decide between Futures and Forex?
This is a good question, and one that every trader has to answer himself. Trade-Robots.com is coming from a futures background going 25 years back. Until this year we never seriously considered forex. This, though, is not logical – forex has many advantages and we will now move towards enabling it. Why? Because we love micro-lots – and the ability to test strategies against a real broker and the real market with low funds to test whether they work. We do not like the missing centrepiece that an exchange provides, we do not like the fact that we cannot see the order book. But the high liquidity and the ability to trader from Monday to Friday without higher margins and the variable lot size really make a difference for us. They should for most traders. And so the question “Futures vs. Forex” runs down to “use both, and use the advantages each market offers”.