It’s a well-known fact the FX market is, by far, the largest globally, with several trillion traded daily. What many might not know is that forex is technically divided into different subsets.
For the average retail trader, much of their initial awareness of currencies is through spot trading, which makes up a large portion of foreign exchange overall. Other versions of forex, typically reserved for the larger sophisticated players, also include forwards, options, and swaps.
Futures form a significant segment of foreign exchange and are quite popular in trading circles for different reasons. This article will broadly outline the differences between the popular spot FX we are all used to and the futures contracts.
At their core, spot FX refers to the immediate execution of currencies, while futures deal with a future-dated delivery. Primarily, participants in the former market tend to be heavy speculators, with the instrument being designed favorably for both retail and institutional clients.
On the other hand, people who trade futures hedge more than they speculate. Futures generally favor larger players with substantial capital as this market has some restrictions not found in the spot market.
What is spot FX?
The market which the majority of people know is spot forex. By spot, traders buy or sell ‘on the spot’ or receive immediate delivery of the chosen position at the current exchange rate.
For instance, if a trader buys the USDJPY pair, the broker accepts and fulfills their order at the present market price. The client is free to hold the position indefinitely, provided they can maintain the required margin.
Traders aren’t locked into a contract as they would in the futures contracts and have free will to close the order at any point. Technically, the settlement of forex positions often occurs after two days, known as the T+2 settlement or sometimes T+1 settlement for one day.
This duration refers to the period in which funds are transferred between bank accounts. It is partially why most brokers rarely perform withdrawals for their clients quicker than this time.
The spot FX market is characterized mainly by a highly decentralized framework of distributed dealers or brokers, unlike futures that we trade purely through exchanges. Participants in spot forex trade for speculative reasons to make a profit.
What are futures in FX?
Futures are slightly trickier to understand than spot FX, but it should all make better sense by the end of this section. Ultimately, the spot and futures markets move in tandem with one another, with very tiny differences between the two.
A future is a derivative obligating a buyer or seller to trade an asset at a pre-established expiry date and price in the future. As was the case centuries ago, the purpose of the futures markets was for securing prices of commodities that were to be purchased and sold at a future date.
Ultimately, parties who use futures in forex for their original purpose tend to be massive financial institutions and companies with a large ‘inventory’ of one currency and look to hedge any exchange rate risks.
For instance, a US-based multinational corporation expecting millions of euros in a few months would sell euro futures with their US dollars. At this point, the company has too many US dollars that they might not need presently.
The purpose is to lock in the present exchange rate so that by the time they receive euros, the value of their US dollars would still be relatively the same. Of course, they forfeit any potential gains that may have been possible if the exchange rate was favorable to them.
Understanding the fundamental differences between spot and futures in FX
It’s important to note ordinary traders can still use futures for speculative purposes as most contracts rarely run till expiry. Similar to the spot version, investors make or lose money based on the exchange rate when they close their position. Also, this market is still leveraged, although far less than with spot forex.
The spot market continues to be largely speculation-driven and less about hedging. Though traders have the liberty to employ a myriad of hedging techniques with relative ease, we see the majority using spot FX to speculate.
Similarly, while futures have historically been about hedging institutional risks, advancements in trading platforms see a growing number of retail traders switching over to this market.
It all boils down to the different mechanics of both markets matching people’s preferences, skills, and experience.
Advantages and disadvantages between spot FX and futures FX
Experts consider the transparency and regulation of the futures markets as being far superior. On the transparency side, futures traders have special tools accessing real volume data routed through an order book (level 2 / depth of market) since this market is traded on a centralized exchange.
Observing the futures market for traders interested in order flow can provide them with an edge they can translate onto spot FX. It is one of the reasons why a tool like the Commitment of Traders report, based on currency futures from the Chicago Mercantile Exchange, is a popular indicator for understanding institutional positioning.
The volume feature is virtually absent with the spot market because of its decentralization. Hence, it is impossible to understand the true order flow of buyers and sellers other than looking at the client positioning of a particular broker, if at all provided.
This lack of transparency is one of the biggest criticisms of the spot market, leading to a lack of regulation. Not all facets of spot forex are entirely and correctly regulated, which is why many broker scams have and continue to occur.
As most futures are traded through a fully regulated exchange, these financial malpractices are significantly reduced or non-existent.
On the downside, futures present a much higher barrier to entry than spot forex. While more retail traders have recently switched over to the former, this market still has a greater minimum deposit, larger trade volume requirements, and far less leverage.
Hence, they have still maintained their historical tendency towards institutional investors with larger capital amounts. Moreover, the selection of currency pairs with futures is a little lower than its counterpart.
Final word
Does one gain any real edge trading one over the other between spot and futures FX? Many experts argue the futures markets provide some considerable advantages due to the transparency and regulation.
Despite these advantages, the spot market is still far more accessible for the average retail investor because of the high leverage and low capital requirements, despite continually facing regulatory issues.
