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Futures on Currencies

Futures on Currencies

Another commonly traded asset class with futures is currencies.  Global currencies have long been used as the basis for investing, as a result of the interplay between different currencies and the fluctuations in value against other international currencies as a result of economic developments.  Low interest rates might lead to a weaker currency against the competition, whereas a forecast rise in interest rates might spell an attractive investment opportunity for the currency speculator.  Indeed, currency trading also plays a particularly important role in central government financing, with most developed economies investing heavily in other currencies to hedge against their own economic shortcomings.

But the vast majority of currency trading is handled through the forex, rather than futures markets.  The forex markets are renowned for their leverage, and have given birth to more than their fair share of currency millionaires.  In spite of that, futures can pose a number of key advantages over trading directly on the forex exchanges, namely in terms of the cost-savings implications and the enhanced leverage options currency futures afford.

The primary reason traders take futures positions on currencies is to allow longer-term speculation on currency prices.  Forex trading is ideal for the day trader, looking to enter and exit positions in quick succession to bank a profit over the trading day.  But for those looking to speculate on a currency price three months, six months or even twelve months down the line, the financing costs with forex trading quickly become prohibitive.

Additionally, futures build in a comfort zone for a dip in pricing in between the date of purchase and the date of expiry.  A currency price can behave however it likes, so long as by the expiry date it has surpassed the price locked in on the day of purchase.  With straightforward forex trading, this isn’t necessarily an option, particularly as the costs of financing the leverage portion begin to bite.

If a trader takes a long position on the US dollar, it is possible to leverage through both forex trading and futures.  The key difference, however, lies in the nature of the transaction.  Even leveraged positions in forex actually acquire currency, whereas futures trading gives the trader the right to only the obligation in currency.  This means that while intermediate negative performance can be enough to wipe out the value of a leveraged forex position, it will not impact on the long-term value of the trade in futures, so long as the currency price recovers in time to meet the expiry date of the futures contract.

For example, envisage a trader investing his capital fund of $100 in pound sterling.  Assuming both the forex and futures transactions afford a leverage of 50:1, forex trading would notionally acquire $5000 worth of pounds sterling to play with, while the futures transaction would acquire $5000 worth of rights to buy pounds sterling.  This effectively means that the leverage on the futures trade is significantly amplified compared to the forex trade, in addition to allowing the long-term speculation on currency price over the lifespan of the futures contract.  The futures contract can either be closed at any profitable time, or executed on maturity to deliver an enhanced return for the currency trader.

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