Spot forex vs forex futures?

Being the trader/trainer in the Extended Learning Track (XLT) Futures and Forex classes, I get this question all the time. Due to the ongoing evolution of these two markets, the answer is not as simple as you may think. In this piece, I will discuss what these markets are, identify the advantages and disadvantages of each of these two markets, and discuss how we deal with these markets in the XLT.

To begin with, both of these markets are where global currency values (exchange rates) are determined. These are fantastic markets as they are always moving and the moves and trends are larger than you will find in any other set of markets. The "spot" market is the cash market which means the current value (exchange rate) of where the currency pair is trading at right now. The "futures" market represents the perception of where that same currency pair will be trading at on a specific date in the future. For example, if you are trading the September 2011 Dollar / Yen, the price represents today's perceived value of the future (September 2011) exchange rate.

Here is a trade some traders in the XLT took a while back in the Euro/Dollar. Both charts show the same opportunity on the same day in the same time frame. The only difference is that the chart on the left is the Euro Futures and the chart on the right is the Euro Spot. This was a buying opportunity on a pullback in price to a pre-determined demand zone. While the charts and this trading opportunity look almost identical, understand that these two markets have some differences that the average person may not be aware of. Let's first discuss the Spot market and its pros and cons.

Cash (Spot) Forex

• No Central Exchange

This means that the market you're trading is the market your broker is making for you. This can lead to some minor manipulation at times. There is a reason you hardly see volume in Spot Forex. It is because the real volume is very different than the "trillion dollar" volume you read about in all the marketing.

• Non–Regulated

Slowly but surely, the Spot Forex market is being regulated more and more. It is still one of the least regulated markets around which really can lead to manipulation and risk for average retail clients. Most importantly, if you run into a problem with your account, you really have little to no recourse as there is no regulating body that 100% regulates the Forex markets as much as other markets.

• Broker May Trade Against Client

Most but not all Forex brokers don't charge any commissions or fees. Instead, they get paid on the "spread." What they do is constantly make a spread that ensures they will profit from your trades. When you push the button to buy or sell, they or a partner are typically on the other side of your trade. This means that your goals and their goals may not be in alignment as you are essentially trading against each other.

• Counterparty Risk

When you are trading a semi-non-regulated market, you have to make sure you know exactly where your account is actually being held. Is it being held at a large bank or some account that the broker has rights to? There have been some disaster stories such as Refco not long ago and others that come to mind. Make sure you know where your account is being held and how safe it is.

• No Commissions

You will see marketing for the Spot Forex market that suggests "free trading"... If you believe that, I have some beautiful land in the desert for sale with a huge lake in the backyard and plenty of green grass, trust me... Anyway, most but not all Spot Forex brokers don't charge commission, they instead widen the spread in the real market, offer that artificially wide spread to you and get paid on the spread. Typically, a spread in a major pair might be 2-3 pips but can easily go as wide as 5–10 pips at times. At $10 a pip for most, this can mean that you are paying $20 - $30 to get into the trade. At that rate, commissions would be very cheap so don't be fooled when you see the "no commission" trading marketing material.

• Big Leverage

In Spot Forex, 200:1 leverage is not uncommon. You can open an account with as little as $500 dollars and begin trading. That is not ideal, but it can be done. Don't forget, leverage can work for you and against you, so be careful and don't abuse it.

• Large Trends

The Forex market experiences large moves almost daily. There is always a currency pair trending strongly which means very frequent trading opportunity.

Forex Futures

• One Central Exchange (CME or another major exchange)

The Chicago Mercantile Exchange (CME) is the home of the Forex Futures. The CME is one of the largest exchanges in the world and is very well capitalized. Some of the largest Banks use the CME Forex Futures to hedge currency risk. I actually began my trading career on the Currency floor of the CME and understand the power of a central exchange.

• Transparent Volume

Because there is a central exchange, we can see trading volume and open interest easily and everyone has access to it.

• Very Regulated (SEC, NFA)

The CME actually has double regulation. They are a futures exchange so they are under the watchful eye of the NFA and the SEC. They are also a publicly traded company so they have another level of regulation that comes with that structure.

• Trades Matched on the Globex system

As with other Futures markets, the Forex Futures are traded in the trading pit but also on the Globex system. The Globex system is an electronic order matching system much like NASDAQ for stocks. There is no broker on the other side of your trade. Instead, when you buy, your order is matched up with a seller like you, not a broker. This leads to a more balanced and free market for the retail trader.

Much more information on Forex Futures can be found on the CME website, at our Online Trading Academy website, or by emailing me. The CME is: www.cmegroup.com.

Lots of game playing can go on in the Spot Forex market with certain brokers. Remember, many are market makers for the most part. Here is an email from a student that I unfortunately receive too often:

Sam,

I took the eurgbp trade today. I got stopped out even though price never hit my stop! I have an inquiry in with the broker. Anyway, I'm attaching my trade.

Thanks,

Ryan

Yes, this can happen so you need to be careful. As you can see, this trader took up his complaint with the broker. This, my friends, is like asking the bank robber if they robbed the bank.

Given the pros and cons of these two gateways to trading global currency markets, what do we do? Here is exactly how we treat these fine markets in the Extended Learning Track (XLT) Forex class. Because the broker is on the other side of your trade in Spot, it is not a good idea to try and risk 5 pips to make 15. Especially if you put your stop loss order in the market for this trade. More often than not, you will get stopped out of this trade quickly because of the spreads created by the broker; this is easy money for them. Instead, when trading the Spot market, we never go down lower than a 15-minute chart. This forces us to find demand (support) and supply (resistance) levels that provide opportunities for us to risk 15 pips or so to make 50 or more. Most of our Spot Forex trading opportunities in the Forex XLT have us risking 15 – 25 pips to make at least 100 or much more. This accomplishes two things. First, it helps solve the problem of getting stopped out by the broker who controls the spread. While they can move the market a bit and try to stop you out, they can't move their market too far away from the real market or they run the risk of losing big.

Another important point to remember with the Euro buy setup from the XLT above is that when we (Online Trading Academy traders) buy at demand, we are forcing the broker to sell at demand and they certainly don't want to do that. This is why they widen the spread so much at the significant demand and supply levels. Second, by staying away from the very micro time frames and only using the 15-minute chart or higher, we are now able to take advantage of the huge moves that happen in the market almost on a daily basis. Even if the brokers were not an issue, you are still better off trading the Forex markets for the larger moves because this is where the large and quality opportunities are.

So, what about short-term trading in Forex? This is where the Forex Futures come in. While you can certainly trade the Forex Futures longer term and should, you can easily trade the Forex Futures short-term without the big risk of manipulation. Remember, you are trading on the Globex system which is an electronic order matching system. If you want to trade the Euro on a 2 minute chart, go ahead, just make sure you use the Forex Futures for this and not the Spot.Below are some but not all of the many Forex markets we trade each day in the Extended Learning Track (XLT) - Forex class.

Some popular currency markets

US Dollar vs:

Japanese Yen

Australian Dollar

British Pound

Euro

Canadian Dollar

Swiss Franc

And more...

Non US Dollar Related Markets:

Japanese Yen/Australian Dollar

Euro/British Pound

Euro/Japanese Yen

Euro/Swiss Franc

British Pound/Japanese Yen

Swiss Franc/Japanese Yen

And many more...

The key to success when trading these markets comes down to two things:

1. Understanding how the Forex Futures and Spot Forex markets work.

2. The ability to objectively quantify bank / institution demand and supply on a price chart, what a supply and demand imbalance looks like and how to take advantage of that opportunity with objective and mechanical rules.