The currency futures market is a type of derivatives market. The term derivative is self-explanatory. Prices for the futures market instruments are derived from the spot price of the underlying security being traded. There are a number of futures contracts one can trade, and among them, currency futures are one of the popular instruments.
As the name suggests, the currency futures market consists of instruments whose price is derived from the spot Forex market. Therefore, you can trade currencies such as the euro, yen, British pound, etc., in the futures market.
One might wonder why there is a need to trade futures in currencies when there are already available and highly liquid spot Forex or spot currency markets. The answer to this comes from the fact that derivatives markets are usually used as a hedging tool.
For example, an exporter from Europe who is expecting payments in US dollars for delivering their products to the US can hedge this exposure by either going long or short in the futures market. This allows them to hedge the volatility in the currency markets.
There are many participants in the futures market and currency futures contracts are no exception either. Primarily, the main group that makes up the currency futures are the large institutions. These are basically banks, hedge funds, and other financial institutions that have to deal with currencies on a daily basis.
There are also significant participants such as merchants like exporters and importers and so on. But still, even these merchants who tend to perform transactions via banks eventually end up using the institutions.
Speculators make up a small part of the futures market. These speculators in the currency futures market tend to take advantage of the volatility that is present. Thus, currency futures speculators or day traders can go long or short on an intraday basis and reap profits.
Difference between currency futures and spot Forex
There are many significant differences between the futures and the spot market when it comes to currencies. The biggest difference is that currency futures are traded on an exchange, while the spot Forex market is traded over the counter.
One such popular exchange is the CME Group (Chicago Mercantile Exchange), which specialises in futures. Other futures exchanges include the Intercontinental Exchange, or ICE in London, and the Eurex exchange in Europe.
Currency futures derive their prices from the spot market values; whereas, the spot Forex prices are determined by market forces. Moreover, currency futures are standardised products, meaning that specific contract sizes can be bought and sold.
One of the advantages of trading currency futures is that transactions are done directly between buyers and sellers. This removes the risk faced by market makers. In the spot Forex market, you can often find that brokerages act as market makers, thus taking counter-positions against clients.
Another benefit of the currency futures market is that there is no counterparty risk. All over the counter (OTC) transactions always carry a counterparty risk because they are not centralised. When trading futures you are required to come up with the collateral and you also need to maintain a margin.
The prices in the futures market are marked to market on a daily basis. Thus, funds are added to or deducted from your account. This is where currency futures are greatly beneficial to speculators. Although counterparty default is very rare in the spot Forex market, the risk still exists.
With the futures contracts traded on an exchange which acts as a clearing house as well, futures traders do not face the risk of a default.
Futures contracts are well leveraged, thus making them more attractive for speculators to switch to trading currency futures than the spot market. Another difference with the currency futures market is that the contracts come with a quarterly expiration date.
Popular currency futures
The most popular currency futures are the US dollar, euro, yen, and British pound.
Besides the above, there are also a number of other contracts such as Swiss franc futures, Canadian dollar futures, and even South African rand futures if one wants to gain exposure or hedge with exotic currencies.
There are different types of futures contracts. For example, you will generally find euro futures contracts to be standard contracts, but you can also find E-mini or E-micro futures contracts for it.
The main difference between these three types of futures contracts is the contract size.
The standard euro futures contracts size is 125,000 EUR. This means that when you buy one standard contract, you gain exposure to 125,000 EUR in the contract. With a tick size of 0.00005, this means one tick is equal to 6.25 USD.
Thus, if the EURUSD pair moved from 1.2005 to 1.2010, which marks a 10-tick move, this will be equivalent to 62.50 USD when you trade a standard euro futures contract.
Similarly, when you trade E-micro euro futures contracts you are able to control 12,500 EUR. Here, the minimum tick size is 0.0001, or 1.25 USD. Thus, a 10-tick move will be equivalent to 12.50 USD.
Depending on the amount of capital you have, traders can choose between the larger or smaller contracts.
Each of the currency futures has its own symbol. For example, euro futures are called E6 contracts, while British pound futures are called B6 contracts. Every contract that is listed comes with an expiry month as well. Typically, the contract is rolled over in four months out of the year.
Settlement, delivery, and profits
Settlements in currency futures are based on the contract month that is being traded. As a general rule, currency futures expire in March, June, September, and December.
The futures contracts need to be rolled over to the next month's contracts in order to avoid delivery. However, even in case of delivery, the settlement is done financially, meaning that the funds are transferred.
The exchange rate at which the funds are transferred will be based on the prevailing spot rate of the currency. For most day traders, positions are closed before the last trading day. One week before the expiry time, traders can only close their positions and no new positions are allowed to be opened.
Around the same time, the next cycle contracts are opened. This enables traders to close their existing positions and open the next expiring contracts. Because the futures market is settled daily on a mark to market basis, the final transaction you see already reflects your market value.
Conclusion
Currency futures are a popular hedging tool for speculators and investors alike. They allow those with exposure to the underlying instruments to hedge against volatility. Speculators or day traders can in turn take advantage of the volatility in the currency markets in order to make a profit.
Although the currency market has higher volumes during US trading hours, they can be traded round the clock. For those who want to trade currencies, but on an exchange, the currency futures market is the place to be.