Since the late 90’s, retail currency trading has become one of the fastest growing sectors in the financial industry. This success has largely been due to online trading platforms that are increasingly making forex trading available to consumers.
Around the same time, another major market maker began offering online trading-Eurex. As the world’s largest futures and options exchanges, Eurex has also enjoyed significant and rapid growth and has increasingly made futures and commodities trading available to consumers.
There’s no question that these two developments are extremely significant in the financial retail sector, but are they connected in any way? This series will compare and contrast the two industries, exploring how the common elements in each provide insights into the other. In addition, it will explore ways in which the development and strategies of the forex trading industry might aid futures traders within Eurex and beyond.
Forex trading is based on the fact that currencies are constantly changing in value. Since the Nixon shocks in 1971, world currencies have had a floating exchange rate that emerges from the combination of economic growth, trade, central bank actions, and trader sentiments based on economic data. As a result, currencies can be traded and profit can be made on every change, much like traders of securities respond to changes on the stock market. Traders use currency pairs, which represent the value of one currency against another. Major examples might be the USD/EUR (dollar against the euro) or GBP/JPY (British pound against the yen). Profit is generally measured in pips-the unit at the fourth decimal point or 1/100th of one percent.
Similarities between futures and forex trading
The closest analogue to forex trading is not stocks but futures-contracts locking the price of various securities or commodities over time. This is evident in several ways:
First, both forex and futures traders can profit from upside or downside change. Of course, there is a way to do this in almost every market, but few markets make it so natural or easy. In both forex and futures markets, traders profit as easily from either direction of movement, as long as they can predict the change accurately.
This leads to a second feature in common: both markets capitalize entirely on predicting future changes. This may seem like a truism, since knowledge of the future is a core value in any market. But what makes forex and futures trading more distinctive in this way is that their value comes entirely on this basis. In other words, holders of underlying securities or commodities often make their purchases with the intent of owning the fundamental unit of value over time. For instance, an investor might hold stocks over the long-term with the expectation that the company’s value will go up. In contrast, most futures trading have no real interest in the fundamental value of the securities-only with predicting where they will go. Likewise, forex traders rarely hold currencies for their long-term performance. Rather, the value is in knowing and predicting the changes between currency pairs. Both markets focus not on the value of the traded assets but on information about how that value will change.
This fact leads to a third shared characteristic: both markets tend to focus on the short term. In the case of futures, this is a natural limitation. If a futures trader takes or makes delivery of the underlying asset, it obviously becomes a security instead of a futures contract. On the other extreme of the time horizon, most commodities have natural limitations on their contracts that limit how far predictions can be made. Forex trading does not have these natural limitations, but it does also tend to be a short-term market.
This short-term focus means that both markets are also heavily affected by news shocks and current events. Once again, this is something of a truism in any market, post-globalization. However, because the futures market trades on predictions and therefore on information, the effect of news shocks is only more magnified than with fundamental assets. Likewise, forex trading constantly measures the good fortunes of every country against its peers, and every international event sends shocks that resonate through every other currency pair.
Significant contrasts between forex and futures trading
However, there are several significant contrasts between forex trading and futures. The most significant is that forex trading depends on the most fundamental of economic values-money itself. By contrast, futures are derivative and rest on “higher-order” assets, such as securities and commodities.
Since forex trades on the fortunes of countries, it is only natural that it also has a much more international scope, with a focus on GDP, debt ratios, and international politics. Futures trading, on the other hand, might be concerned only about a security traded on one stock exchange, or specific commodities in a single country. While futures traders evaluate how the marketplace in one region views a single asset, forex traders evaluate how the world and international trading partners view other economies.
Another difference was also mentioned earlier – futures trading has an inherent time horizon with a constant view to future value. This is possible because it is a derivative financial instrument. Forex trading, on the other hand, is only concerned with the present, because it trades on fundamental assets.
Of course, there is a fascinating financial instrument where both of these markets meet – currency futures. Like other types of futures, these contracts establish a future price, but here it is a rate for exchanging currencies. With currency futures, all of the characteristics from forex and futures markets apply and traders can only be successful if they have a solid understanding of both. Some interest rate and inflation derivatives also relate to the forex market.
These comparisons and contrasts are only introductory to a more challenging consideration – what insights can forex markets give to the futures market and how can futures traders gain successful strategies from their fellow forex traders? This is the subject of the next article.
Forex and futures markets are the perfect pair for comparison and contrast. Both developed simultaneously and in very similar ways, and yet they differ enough to provide fascinating insights for market makers and traders alike.
What lessons should the futures market learn from forex?
First, market makers should learn from the negative commercialization of the forex markets. Soon after online trading became available, many brokerages presented the forex market as the next opportunity to become rich instantly. This led to a flood of consumers who wanted to try their hand at forex trading, and with it came a flood of frauds and scams. The agency responsible for regulating forex markets in the US estimates that 26,000 people lost $460 million in forex frauds in only 6 years. This was duplicated in Europe-most conspicuously with the Finnish pyramid scheme, WinCapita. The result is a loss for all. Consumers felt cheated, and legitimate market makers lost public trust-even if they did nothing wrong. Market makers for futures and derivatives should be wary of the same possibility. The online availability of options and futures contracts on everything inflation to weather is positive. Growing competition between online exchanges is even more positive. But if the only way to draw consumers is to promise something that futures trading can’t deliver, the long-term cost will be high for all parties involved.
This doesn’t mean that market makes for futures should avoid advertising themselves. Part of the reason for the losses in forex relates to a second lesson: the central role of education for traders. One problem in the forex market is the number of consumers who try their hand at trading without understanding the fundamentals of the market or being concerned about risk management. They view the market much like gamblers view a casino. After suffering huge losses, they exit the market with the cynical assumption that the house always wins. “Third-wave” forex brokers have tried to forestall this problem by providing free education and by making their platforms more user friendly. This principle is simple enough-to have a productive and healthy market, there must be low barriers to entry but it also a constituency of well-informed, knowledgeable traders. The lesson from forex is that market makers must literally “make” their markets-both by providing a forum for trading, but also by helping traders understand and use that forum responsibly. Free online education is a minimum one-time investment with powerful, long-term results. Furthermore, this is an excellent way for exchanges to distinguish themselves while demonstrating a concern for the success of their clients.
To help customers further, most forex brokerages now offer simulated trading, where clients can practice trading without a risk of loss. Some futures exchanges have already implemented this tool, and in some cases it is available to consumers for free. Find a practice account with one of the best brokers.
One other way that futures trading developmentally lags behind forex is in software development. Since the advent of the iPhone and other smartphone platforms, most forex exchange has begun offering mobile trading. This is in addition to advanced trading platforms with significant charting and analysis tools. While futures platforms contain many of these tools, they are not generally as developed or easy to use.
Insights for futures traders
The forex market also offers several insights for futures traders. The first is fundamental and obvious – take advantage of whatever education you can find. Unfortunately, this is not as commonly available for futures trading as for forex, but helpful courses exist for both markets. Even if the investment is hefty, it will make a significant difference on the returns you get in trading. Of course, another way to get education and experience without additional cost is to use one of the free simulated trading packages that some exchanges offer.
A second insight is to stay focused on a select group of financial instruments. Skilled forex traders learn to resist the temptation of exotic currency pairs, focusing instead on a few currencies and mastering them. Traders in the futures markets only have other exotic financial instruments to understand and more choices to resist. Still, the traders who are successful in both markets limit themselves to fewer choices that they can personally master.
The final insight is obvious – if you plan to trade FX options, interest rate, or inflation derivatives, take the time to understand both markets first. Both markets are extremely complex and currency futures only combine these complexities. This may seem like a reason to avoid these instruments, but it actually represents an opportunity. Few traders take the time to learn these challenging instruments well, since most traders come to them from one or the other related markets. With a thorough education in both, most traders will fare quite well.
Both markets are developing
The forex and futures markets are still developing. Trading platforms will grow and change in significant ways over time. In some ways, options trading is developmentally behind the forex markets. To use a financial metaphor, forex trading expanded far too quickly and irresponsibly until it overheated. Market makers in futures and derivatives now have the opportunity to duplicate wise decisions while avoiding the pitfalls. If they can manage their exchanges and markets carefully, they, their clients, and the industry at large will be the beneficiaries.