Monday, April 20, 2009

What's the Better Currency Trade: Forex Futures or Spot FX?

From Learning Markets.

There are a lot of marketing materials out there explaining why the spot market is so much better and cheaper than the currency futures market, but how much of it is fact and how much is hype?

What are the real differences between these two closely related markets? Is it really cheaper to trade spot forex? Aren’t there also advantages to trading futures? This is an important topic because so many of the differences are related to trading costs, which is often a neglected subject among new and experienced traders.

Let’s begin by analyzing the major attributes of each market -- futures and spot. Doing so will help us determine if either market really has an advantage.

24-Hour Market -- Advantage: Neither

Some spot forex advertising makes it seem like the only place you can trade 24/7 is in the spot forex market. That is not actually true. Both currency futures and spot forex effectively trade 23-24 hours a day, five days per week. The market is essentially closed from Friday afternoon through Sunday afternoon if you are in North America.

Spread -- Advantage: Currency Futures

The spread in the currency futures market is not fixed. Depending on the liquidity of the market at the time, the spread can be one pip or less, and an effective limit order may cut the spread to nothing. In the spot forex market, you can have a variable spread like this, which may widen with market conditions or a fixed spread, which does not change but is usually wider (2-3 pips on the majors) on average than a variable spread.

It is important to note that some spot dealers offer spreads on some pairs that are below one pip, but that is not the case for all pairs they offer. On average, the spread in the futures market is narrower across the majors and major crosses than the spot market because the futures market has more liquidity and price competition than an individual dealer.

Commissions -- Advantage: Spot Forex

Spot forex dealers do not usually charge commissions. The spread is where they make their money, which is one reason it is a little wider on average than the currency futures market. However, let’s put this in perspective.

A quick survey of good futures brokers put the average commission costs at $3.15 per side. That means an entry and exit (round trip) would cost $6.30 per contract or 6/10ths of a pip. Once commissions are added to the spread cost above, the advantages between currency futures versus spot forex become much closer to neutral.

Flexibility -- Advantage: Spot Forex

Spot forex dealers are extremely flexible on lot sizes. This is great since a full 100,000 unit lot may be too large for many new traders. Some dealers will slice the lot sizes anywhere from 10,000 to 1,000 units. The currency futures market generally has two lot sizes.

A full-size contract is usually a little larger than the 100,000 unit lot in the spot market. A mini contract, which is only available on some pairs, is usually about one half the size of a full-size contract. Larger lot sizes can make money management in a small account extremely difficult and may be the only clear advantage spot forex has over the currency futures market.

Roll Over Interest vs. Carrying Charges -- Advantage: Currency Futures

Because one of the ways a forex dealer makes money is by trimming the interest payment or increasing the interest charge on a particular pair, this premium tends to be a little higher in the futures contract. However, the cost or benefit of this interest is integrated into the price of the futures contract itself, which makes it harder to see at first glance.

Here’s how it works. Imagine that you are 45 days away from the GBP/USD futures contract expiring. That contract’s current price is 1.9811 but the spot price is 1.9866. This difference (also known as the cost of carry) is created by the value of the interest that will accrue between now and expiration. By the time this contract expires, in 45 days, the futures price will equal the current spot price exactly. That means that if prices were held steady you would make the equivalent of 55 pips as the futures price came up to meet the spot price. By contrast, the highest rollover rate we could find from a forex dealer on the GBP/USD would pay the equivalent of 38 pips in interest premium during the same 45 day period. Similarly, the charges for being on the non-interest paying side of the transaction is less in the futures market than with a spot forex dealer.

Transparency -- Advantage: Currency Futures

Currency futures are exchange traded, which means that you can see order flow, volume, open interest and outstanding orders. Forex dealers do not share that information, and because the market is so distributed, information available from any one dealer is probably not comprehensive enough to give a clear picture of what is happening in the market as a whole. $83 billion worth of currency futures trade on the CME exchange every day alone. The largest retail forex dealer in the market trades $11 billion a day in total notional value.

Which is Right for You?

The fact that forex dealers will split up a lot into very small slices makes the spot forex market the hands-down winner for small traders.

Larger retail traders should seriously consider the futures market as an alternative to the spot forex market. Trading costs are nearly identical, the exchange is more transparent, the product breadth is equivalent and interest is better.

Every trader should realize that trading cost differences are not just limited to whether or not you are paying commissions. Trading costs include average spread, commissions and interest premiums or charges. When looked at together, these two markets look a lot more similar than you may have thought.

Good investing, Kingsley.

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