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03 September 2011

There is quite different story with the futures market

Pipruit: Commander, once you’ve said that futures market is also exchange traded, so maybe we should skip this part, because I expect nothing really new from this comparison, unlike stocks vs. FOREX…
Commander in Pips: You think you’re very smart, eh? Although you’ve noted correctly about “Exchange traded”, indeed, futures and stock markets have a lot of common qualities. But at the same time, futures market has some extremely important differences that make currency futures more attractive than spot FOREX for many traders.

Pipruit: Hm, and what are they?
Commander in Pips: For example, you can trade currencies on futures market…but in the beginning, I will point qualities that are common for futures market as for stock market without many details, because we’ve talked about them already in previous part of this chapter.

First of all we will talk about currency futures and not about overall futures market. What is common between futures and stock markets?

1. Both are exchange traded markets. This leads to additional fees and presenting of middlemen – brokerage firms, because places in the Trading Pit on the exchange to trade futures are also very expensive.

2. Both markets are highly regulated by government authorities and exchange itself. The SEC is watching over the stock market and the NFA (National Futures Association) watches over the futures markets. It means that both of these markets are safer than FOREX market in terms of government monitoring. Particularly, the NFA assures that market participants and, more specifically, solicitors such as brokerage firms, brokers, and commodity trading advisors are conducting business in an honest and candid manner. But it’s worthy to say here, that now many US FX brokers are becoming a member of NFA both to attract clients and to comply with new regulations. This is a positive sign. Most of these are well-known brokers with fairly good reputations.

3. As with stock brokers, futures brokers have the same quotes, because all quotes come from exchange and are fixed there. This is a big advantage, because you definitely know what price was valid at a definite period of time. You can track it up to the tick. The FOREX market can’t offer that.

4. Both markets use segregated accounts for client’s assets. We’ve talked about it in a previous chapter. This makes client’s assets safer.

5. Lot or contract sizes are strictly determined by the exchange. These can’t be changed by participants.

And now we will turn to particular qualities of futures market and its differences from FOREX.


MYTH #1 FOREX market is greatly more liquid than futures market…

True

Yes, we’ve talked about it already. Approximately $1.5 Trillion on spot FOREX market versus $100 Billion of average daily trading volume of FX futures on Chicago Mercantile Exchange (CME) in 2009.

But

MYTH #2 … that’s why FOREX has higher price certainty and orders execution than futures market.

False


The major question here is as follows: does this liquidity really lead to faster and sharper execution of your orders? Not quite. I give you just an example that could really happen on the FOREX market, especially if you trade large volumes. It not necessary will happen, but it could. When using the CME electronic futures contracts, price doesn’t have to “trade through your limit order” for you to get a fill—you simply get filled as price trades at your order level. And what about spot FOREX brokers, what they really could do to your order? They can fill you, in fact, at any quote that is suitable for them. Why? Because the FOREX market does not have the central place, where all orders are moved to by market participants, and you can’t prove that this is not “market” price, when you get filled with 30 pips slippage, for example. Although this is very rare if you use a good broker, it still could become a reality, just because of the structure of the FOREX market. That’s not what happens when you trade the CME electronic currency futures. All bids and offers are placed in one market and you have direct access to all the bids and offers. Where your order gets filled depends on what orders are available, not upon whether someone else wants or does not want to fill your order. On spot FOREX rather, your broker (for example some small bank or little brokerage firm) could decide not to fill your stop loss order, just because it has not received quotes from its own counterparty (larger bank) and so on. When the quotes come in, the market could be far away from the stop price and you will be filled with slippage. This is not a typical situation for small accounts, but the structure of the FOREX market does not exclude that. And you should know that this, in fact, is possible.

MYTH #3 FOREX market is 24/7 and futures market is not.

False (mostly)

Futures market has GLOBEX electronic session that has a break for trading with just 1 hour per day. So, the futures market is really a 23-hour market.

MYTH #4 FOREX has guaranteed limited risk that couldn’t be exceeded and futures market does not

False

I think that the futures market even safer from this point of view than spot FOREX. The point is that in the futures market you should transfer to your trading account so-called initial margin. It will be different for different currency pairs. This is a minimum amount of money that is demanded by the exchange for opening positions with 1 lot. Its value is calculated by the exchange and varies with the market’s volatility. Also there is maintenance margin that exists. This is an absolute minimum asset value per 1 contract. When your current loss on an open trade reduces the initial margin to the value of the maintenance margin your position will be closed by the exchange itself. For example, if the initial margin for a full contract ($125,000) on EUR/USD is $4320 per contract, the maintenance margin would be about -$3200. So, if you initially transferred only just the initial margin to your trading account, then, your position will be forcibly closed by the exchange when your current loss on position will be: 4320-3200 = $1120. So, you can never lose more, than the initially transferred money.

On FOREX there is a look-alike system that exists, that also driven electronically. But the controller of this system is not an exchange but your FX broker itself. This offers a lesser level of safety. ner here


MYTH #5 Short selling on FOREX is simpler than on futures market.

False

Futures contracts, in fact, are just agreements between two counterparties to make a deal in the future. And in every deal there is always present those who want to buy and those who want to sell. It means, that futures trades act as the same as a spot FOREX trade. Each could be fulfilled at once you have counterparty. Because both of them assume simultaneous buying of one currency and selling of the other one, there are generally no rules about shorting in currency futures.

Of cause exchange traded markets always have greater regulation and sometimes an exchange can stop trading or forbid some operations for some time.

MYTH #6 FOREX offers higher leverage than futures market
MYTH #7 FOREX demands greatly lower start-up assets than futures market


Partially True

We’ve already discussed, that you can start trading spot FOREX even with only $5, although we do not recommend it due some reasons that we will discuss later. Obviously is that you couldn’t trade 1 lot with just $5. So it is on futures – to trade 1 lot you need at least an initial margin about 4300-4500$. But currently the CME has launched mini-contracts and micro contracts for mostly traded major pairs. A mini contract is 0.5 lot and a micro contract is 0.1 lot. A micro contract demands just 432$ as initial margin to start trading. This is 30:1 leverage, because the notional value of EUR/USD micro contract on CME is 12,500$. The usual leverage on FOREX is 100:1, but for successful trading you should not use it totally due to market volatility and money management strategy. Large FX brokers offer lower leverage 40:1 or even 20:1. So, as you can see, the difference Futures with spot FOREX is not so great. The new rules for US forex brokers bring the leverage between these two markets even closer.

MYTH #8 The Futures market is a bit more difficult to trade due to contract time of expiration schedule and delivery risk

True
Each currency pair trade as futures contract and this contract has predetermined day of expiration and/or delivery. So, if you do not intend to make a real delivery of currency, you should make a roll-over – close your position in current contract that is near to expiration and open it in the next period contract. You will know this date far ahead of time, because the exchange has definite rules when different contracts will expire or can be executed for delivery. If you do not want to dig around for all this stuff, the exchange also publish a schedule for the last trading days of each contract. All you need to do is just look in it and make a roll-over. In fact this is much simpler than it looks at first glance.

MYTH #9 The futures market has less available currency pairs to trade and some exotic pairs have a limited liquidity

Partially True

Well, currently CME (Chicago mercantile exchange) has about 40 pairs to trade. These include crosses, exotic pairs and of course 10-12 major pairs. May be some spot FOREX brokers can offer you more exotic pairs. But taking into account the fact that the most part of trades are made with major pairs, this difference looks insignificant.

MYTH #10 The counterparty of all trades at futures market is exchange itself

True


Exchange is a counterparty of all trades on futures market. It’s a guarantor of fulfillment of all obligations at every trade. It means that the exchange finds the counterparty that want to sell and buy from them – simultaneously it finds the party, who wants to buy and sell to them. This is made electronically and simultaneously, so that exchange does not have one-side positions. But this is a great advantage to traders, because the counterparty of all trades on the exchange is the exchange itself. And this fact guarantees fulfillment of obligations on your trade. Furthermore, if you take into consideration the fact that both – the seller and the buyer have initial margins for their trade, you should understand that trade on exchange is many times safer than on the spot FOREX market.


MYTH #11 The Futures market has greater fees than FOREX, so to trade futures is more expensive

False

Because, brokerage fees on the futures market much less than on the stock market. Let’s see – the Bid/Ask spread on CME EUR/USD futures just 1 point or 0.0001. As the value of 1 contract is $125,000, the spread value is $12.50 (=0.0001*125,000). I can say that broker fees for 1 trade that come to about $10 per contract is treated as high. The average fees on futures market $5 per contract. It means that buying and selling 1 contract (accomplish a full trade) will cost you $10 plus a 2 point spread (1 point during buy operation and 1 point during sell) that is $25 - all together $35. This is your total expenses on futures market. Ok, we can even assume the maximum expenses and take $10 per contract. In this case it will be $45.

Now let’s see what we have on FOREX. No fees, right. But spread is typically at least 2.5 points for 1 side of trade. It leads to 5 point on full trade or $50 for full lot on EUR/USD ($100,000). It’s even greater than max fees on futures market! Interesting, right?

But to be absolutely fair, I have to say that brokerage fees do not depend on the size of contract. If you trade micro contract that is 0.1 of normal one – the fee remains the same – $5 per contract. It means that futures market trading costs become less expensive when you trade big volumes, but a bit more expensive when you trade small volumes.

MYTH #12 You can’t see correct trading volume on FOREX or even the correct close price of the day.

True


Indeed how could you see trading volume, if FOREX market is decentralized market, and there is no center where all orders flow? You can see some trading volumes that are provided by your FX broker but this information will not give you the overall picture, because you can’t see the trading volume of other brokers. The situation isquite different on the futures market, because the exchange is the one place where all orders flow and it shows the real trading volume on the whole market.

The same situation is with daily close price. The FX market is 24/7 so it doesn’t have daily close. In fact the daily close price that you see depends on your FX broker and where is it situated. In the UK there will be one price, in Japan there will be another one, since they end the day at different times. On futures market every electronic GLOBEX session has a break for 1 hour. Besides, there is a Settlement (or Pit) trading session that exists and you can choose what quotes you would like to look at. This fact allows you to make correct technical analysis of the market. On FOREX it will be tricky due to the indefinite daily close price.
Pipruit: Wow, say, the futures market looks attractive and different from stock market too, but still more expensive to start trading with. What should we do, sir?
Commander in Pips: Well, personally, I like the futures market. Yes it has its own difficulties compared to spot FOREX, but it also has a great advantage – higher safety and relatively low trading expenses. If you like to trade currencies – you may trade on spot market first, but when you’ll get solid profit and your assets are becoming greater, I think that the best way to continue trading is to shift into currency futures. That’s my conclusion on the comparison of these two markets.
Pipruit: If I understand right, you mean that futures are preferable for trading than spot FOREX. Futures’ trading is cheaper and safer. Besides, answers on MYTH#1 and MYTH#3 tell us that liquidity itself can not really guarantee better orders and trade execution due to the different trading system and market structure of spot FOREX (Over-the-counter market) and Futures (exchange traded market). But it is difficult to start with futures directly, because it demands much larger start-up capital although it still provides you with solid leverage.
Commander in Pips: Yes, you’re absolutely right!

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