Spot forex trading has became very popular over the past few years. Everyday and everywhere, people are trading forex, or analysing currency price charts on their smartphones. What is previously inaccessible to the retail investors is now open to all.
One way for retail investors to profit from currency fluctuations is through spot forex trading. Another little known way is through currency futures trading.
Currency futures contracts are formal agreements for a specific amount of a currency in another base currency at an agreed price today. The agreements will lapse on a certain delivery date in the future. When the date of delivery or expiration date is reached, the amount of currency in the futures contract is exchanged at the currency exchange rate at that time, resulting in a profit or loss. In the spot forex market, the currency exchange is made on the spot and the investor could hold on to the currency bought or sold as long as they like.
One distinct difference is that currency futures contracts are traded on formal futures exchanges, such as Chicago Mercantile Exchange (CME). On the other hand, Forex trades are decentralized and can take place between two traders, but more often involving a trader and a broker. There is no central exchange where forex trades can be carried out centrally. While two private parties may come to a deal, the common practice is for the brokerage firm to take the other side of its clients' trades.
Hence, spot forex transactions are different from trading in currency futures in a subtle way based on their decentralization. There can be more than one price for spot forex trades and it varies from one forex broker to another. Currency futures transactions are cleared through centralized exchanges and everyone sees the same price.
Another difference that new currency traders might not be aware of is that the brokerage where they have their account may be acting as a market maker on their spot forex trades. In order to make money when the currencies are resold, the broker must maintain a spread: their asking price when the currencies are sold to their clients is higher than their bidding price when they buy back the currency. This is in addition to any fees on the spot forex trade, so that the brokerage has an incentive to charge buying customers as much as the market will bear and pay sellers as little as possible. Since futures trades take place on a centralized exchange, this conflict of interest does not arise.
The spot forex market is very difficult to regulate because of its global nature. It does not have a fixed physical location and not subjected to the regulatory restrictions of any country. One good thing is that this does not apply to forex brokers as some are located in the US. And, they have been fined for deceptive practices.
Currency futures contracts are traded on a physical exchange in a building on Wacker Drive in Chicago. This means that the US government, the state of Illinois and the Chicago Mercantile Exchange itself have some say in regulating the currency futures market, unlike the inconsistent environment found in spot forex trading.
Trading in currency futures is a great way to hedge investments or to speculate on exchange rates. Spot forex trades, while they may be a valuable tool to those who can understand and exploit, have a definite downside for the average currency trader. While many foreign currency exchange brokers are highly ethical, the potential for abuse does exist, and this makes currency futures a safer place to put their money in for the average investor.