The difference between FX spot trading and futures trading is basically the timing of when the exchange takes place. In spot trading, transactions are made based on the current market prices – they are made “on the spot”. A very basic example would be me going to the bank and exchanging my pesos for dollars at whatever the rate was that day.
On the other hand, a futures contract is an agreement that takes place at two times – the present and the future. Say that again? Let me explain. In a futures contract, two parties, let’s say, Vlad and Odell, agree to trade a specified amount of a currency pair in the future, with the price being settled now. At the agreed upon date, Odell and Vlad will finish the transaction by exchanging currencies at the agreed upon price. They are binded to do so, whether or not the agreed upon price is higher or lower than the spot rate at that time.
The differences between the spot and futures markets do not just end at the settlement date. There are still some differences as to how and where trading takes place.
Futures are normally traded on exchanges (the Chicago Mercantile Exchange is an example of one) and are normally tied to the hours of exchange of where it is traded. This is different from the spot market, which is open from the Monday morning Asian session to the Friday afternoon US session. There do exist night markets but not many traders trade there because they present illiquidity and inaccessibility problems.
Because futures are traded in exchanges, there is more regulation as these exchanges are monitored by government agencies. On the other hand, spot trading dealers are not regulated. This is important because it has to do with how well a trader can see the market. Since not as many futures exchanges exist as compared to spot market dealers, more volume tends to be concentrated in fewer exchanges. For example, $83 billion worth of FX futures pass through the CME every day. With so many retail FX brokerages in the market, this tends to give a diluted picture of how the spot market is really doing.
In terms of position sizes, the futures market is less flexible than the spot market. Lot sizes of up to 1,000 to 100,000 can be traded in the spot market. The smaller lot sizes are made available because traditional 100,000 lot sizes may be too big for the average trader. Futures only come in two lot sizes – a full size lot and a half-size lot. Keep in mind that the full-size lot is a little bit bigger than the 100,000 lot in the spot market. This gives traders less options when it comes to position size.
Another difference comes in the way of how spot and futures brokers make money. Spot market brokers do not normally charge commissions – although they can, depending on whether they are a dealing desk or non-dealing desk broker. They normally compensate themselves through pip spreads between the bids and ask price. This too is variable, as the broker can either choose to have a fixed spread or a variable spread. On the other hand, futures brokers tend to charge commissions for each transaction. They also make use of pip spreads and other fees, like NFA (National Futures Association) commissions.
Based on these differences, it would seem that spot trading would be a more natural fit for the average trader. It provides more flexibility and accessibility, as it allows “small-time” traders to enter the market. The “24-hour market” and smaller lot sizes make it easier for the average-Joe to trade. On the other hand, the futures market could be great for big time traders and corporations. The futures market provides an opportunity to hedge, helping limit currency fluctuation risks. Also, they could partake in arbitrage and take advantage of differences in interest rates.
There of course, should be no limitations between which market a trader chooses to trade in. It comes down to the trader understanding the ins-and-outs of each market and to their own individual trading style.
Published At: Isnare.com
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