Trading a stock is very straight forward.
Buying it means becoming the owner of a stock that will rest in your bank account until you sell it. Legally, it will become part of your possessions, and it will be inherited by your loved ones one day in the (hopefully) very distant future, if you still have it.
You own a stock just as you own any physical object.
With currencies, everything becomes more complicated. Even if a broker tries to make things easy for their clients, the underlying mechanics of forex trading are not intuitive. In fact, if you buy a 1 EUR/USD lot, what you now possess is not immediately defined. Is it EUR or USD? Or is it something called EURUSD?
Let’s start from the beginning.
The simplest form of spot forex trading is when you go to a money changer and make a transaction for a foreign currency. The transaction takes place immediately based on the current market price.
As a speculator, the mechanism you would rely on won’t be the same as when you need to change money to go on holiday. I am going to explain the two most common—but not unique ways—you can speculate on currencies.
SPOT FOREX TRADING
Spot forex trading was initially developed by banks to satisfy the needs of big corporations who make money from the spread of express transactions. Overtime, spot forex trading was made available to everyone.
In this article, I will discuss spot forex trading in the case of brokers for retail investors. I won’t be referring to issue of spot forex trading in the interbank market, where big banks exchange currencies among themselves.
The most common and accessible way to trade currencies is using a forex broker.
In this scenario, a trader makes a deposit and can participate in the spot forex market using leverage that changes depending on the broker’s local regulations and nationality.
The broker, in this case, can link the trader to the interbank market, which is the place where most of the big transactions take place. Alternatively, the broker can act as a counter party—essentially behaving like a betting agency.
There are many types of forex brokers, and they vary significantly depending on where they are regulated. Therefore, it is not easy to explain in just one blog post how they differ. But it is will something I will discuss in a future article.
Granularity: you can choose how big you want your position to be. You can even trade lots as small as 1000EUR in the case of an EUR/USD pair.
Platforms are very user-friendly.
No costs for data and spot forex data are free in the case of futures. For example, you might spend thousands of USD a year just to have real-time, high-quality prices.
It is possible to start with very small account, even just a few hundred dollars.
It is unregulated, meaning the market does not have any regulation that protects market integrity, as is the case in the stock or futures market.
For example, there is nothing like the uptick rule or price limits.
IT is a futures contract to exchange one currency for another at a specified date in the future at a price that is fixed.
In the case of futures, listed on the CME (Chicago mercantile exchange), the price of a future is in US dollars. This means that you can only speculate on currency pairs where one is USD.
In practical terms, futures with the nearest expiration and spot forex can be treated as very similar things. The only difference is the interest rate difference between the two currencies.
For example, the price of EUR/USD at this moment trades at 1.1254, while spot trades at 1.12. But they are perfectly correlated. Therefore, movements are always of the same magnitude in the same direction.
The specification of each contract are known a priori. For example, the EUR/USD future is the value in dollars of 125,000 EUR. In the case of spot forex, every broker instead gives the trader greater flexibility to choose the size of the bet.
Regulated: every trader must obey to regulations of the CME market to ensure there is great transparency. The rules are the same for everyone, whether you are in position with 1:1 contract or 1000.
There is no conflict of interest; the broker cannot be on the other side of the client.
Everything runs “smoothly” and orders do not get rejected. There is transparency in prices, brokers’ platforms do not freeze when volatility is high, etc.
CME it is a very professional place where to operate.
Data are expensive; a few hundred dollars a year is the minimum one can expect to spend for high-quality data.
Sizes are greater and there is no granularity; hence positions can only be integer multiples of 1 contract.
Large accounts are necessary. With less than 10,000 USD, a futures account won’t last long in the event of a consecutive sequence of losses.
Only currencies against dollars are traded, which is a big limitation.
It is possible to build synthetic positions and replicate many currencies pairs by combining more positions in currency futures, but it is quite an unpractical solution.
There is no “best” solution. Spot forex and currency futures, from a trading point of view, both make sense and serve different purposes.
In the case of small money, even opening an account with a futures broker would be problematic, so a forex broker would be the only choice.
If the trader has a strategy that needs a sophisticated scaling in and out, futures won’t offer the required granularity. You cannot buy 0.2 contracts per time until you have 1.
If trading exotic currency pairs is your daily life, then there is not much for you to trade in the futures market.
In the case of large accounts, focus mainly on currencies against dollars since the futures market offers the transparency, smoothness and professionality that would satisfy you even if your account is more than hundreds of millions.
Warning: There is a risk of loss in trading. It is the nature of commodity and securities trading that where there is the opportunity for profit, there is also the risk of loss. Commodity trading involves a certain degree of risk, and may not be suitable for all investors. Derivative transactions, including futures and forex, are complex and carry the risk of substantial losses. Past performance is not necessarily indicative of future results. Please read additional risk matters on our web site www.londontradinginstitute.com
It is important you understand all the risks involved with trading, and you should only trade with risk capital. This communication is intended for the sole use of the intended recipient and is for informational purposes only. It is not intended as investment advice, or an offer or solicitation for the purchase or sale of any financial instrument.