From the September 01, 2011 issue of Futures Magazine • Subscribe!

Dueling markets: Forex futures vs. spot forex

Spot forex is better By Michael Boutros

When considering which market to actively trade, investors have a host of options from which to choose. As it pertains to the forex market, both futures and spot have their benefits for traders attempting to tap into the estimated $3.98 trillion daily FX volume. Closer examinations of the two options reveal benefits and flexibility for long/short-term, intra-day traders in the spot FX market.

Spot FX provides traders with highly leveraged accounts that allow them to trade multiple times their account size. While this obviously can work against the trader, leverage allows the average investor to effectively trade standard-sized lots while holding just a fraction the actual value traded. Whereas a typical FX brokerage will require the trader to hold just 2% of the value of the contract, futures traders must hold the CME Group's (or other FX futures exchanges') required margin, which on a standard lot of EUR/USD would be more than $5,000. Comparatively, the margin required to hold one standard-lot of euro in the spot market would be approximately $2,800. Smaller contracts make it more appealing for new traders as the margin required for a single micro-lot can be as low as $20.

Flexibility

Everyone trades differently. Whether a person is an active scalper or a longer-term fundamental trader, trading the proper size position becomes key when implementing various trading strategies. Spot FX brokerages allow for much more flexibility as many now offer mini-lots and even micro-lots to smaller traders looking to participate in FX markets. The flexibility to trade various sized contracts also inherently gives investors more versatility with regard to their strategy and how much risk they would want to take on. The availability to trade smaller lots means an investor can participate in the market with less capital at risk while still being able to take advantage of intra-day market volatility.

While spot FX markets are open virtually 24 hours during the week, futures markets are closed one hour each day. Although markets are usually at their quietest during the break, it does mean traders will not be able to open/close positions or react to any unforeseen market moves. Once the futures market comes back online, there also may be gaps and/or slippage on orders as market liquidity spikes suddenly.

An important aspect of trading any market is transaction costs. While futures traders often are hitting the bid or lifting the offer and are charged a commission and clearing and exchange fees on every trade, spot FX traders usually pay only the spread. Spreads can widen dramatically under illiquid conditions that tend to happen more often in the futures market.

Duration of the trade is another key aspect to consider when choosing the correct market. Execution is the single most important factor that can affect a trader's performance directly. Spot FX brokerages have fast and accurate execution, especially in light of the new ECNs (electronic communication network) now offered by various brokerages that match buyers and sellers at lightning speed. Although futures markets may provide traders more transparency in this regard, orders often can take a few seconds before confirmation of the trade is received by the trader as the order bounces from the broker to the exchange.

Rollovers are a process by which the settlement date of an open position is extended via the simultaneous closing and opening of a new value-dated contract. This process is needed because traders would be required to take delivery of the currency two days after transaction date. Another main function of rollovers is to take into account the different yields each currency offers. For example, if a trader is long a higher-yielding currency, he will receive a designated amount based on the interest rate differential of the counter-currency; whereas if a trader is long the lower-yielding currency in the pair, the position is charged on the rollover. In spot, this transition is seamless to the trader, and the exact amount of each roll is accessible on the trading platform or account history at the same time on every trading day. In the futures market, the value of the contract takes into account the differentials, and the actual exchange rate will reflect the diverging yields. It is not always as easy for a futures trader to identify the actual amount he is paying/gaining on a specific transaction, as the difference between the spot rate and futures rate dwindles as the futures contract reaches expiry.

Rollover

This leads us to yet another important point for longer-term traders. As a futures contract reaches expiry, liquidity on that particular contact starts to dry up, requiring the futures trader to roll his position (exiting his position in the expiring contract and establishing it in the next delivery month, usually with a calendar spread). Spot traders never experience this problem. Traders can hold the same position for hours, months, days or even years without having to jump into a new, more active contract. All the while, the rollovers are accessible and readily available with most reputable brokerages.

This highlights the final point. While futures traders will often argue the benefits of transparency in their respective market, a closer look reveals the importance of choosing the correct broker. While CME Group offers much more transparency for participants, does this really outweigh the other benefits? Choosing an FX brokerage should not be taken lightly and, with the proper research and due-diligence, traders can remain confident that they are doing business with the right firm. Some traders are not keen on having the broker trade against them, but there always is someone on the other side of a given trade; whether it is the broker or another trader is irrelevant. So long as the rates supplied are in line with broader markets, the counter-trader should be of no concern to a trader. More important is the reputation and track record of a broker. Most reputable FX brokerages are governed by a regulator that ensures fair business practices with clients. In the United States, this agency is the National Futures Association (NFA), while offshore brokerages are governed by their own respective agencies.

There are benefits for traders utilizing spot or futures FX. When deciding which market is best, you need to match your style of trading and risk tolerance to the platform that best serves you. For the average active trader looking to take advantage of market fluctuations with minimal transaction costs and ultra-flexibility with account and trade sizes, the spot market offers the most suitable trading environment.

Michael Boutros is currency analyst for DailyFX.com. He specializes in the FX markets. Contact him at mboutros@fxcm.com.

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