Be wary of some of the promises made about the ’spot’ forex market...it’s mostly unregulated, and not for new traders.
Being the trader-trainer in the futures and forex classes at Online Trading Academy, 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 markets, and discuss how we deal with these markets.
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.
Click to Enlarge
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 timeframe. 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.
NEXT: Core Components of Cash (Spot) Forex
|pagebreak|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.
Lightly 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 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 spot forex brokers don’t charge commission. Instead they 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 or 3 pips but can easily go as wide as 5 to 10 pips at times.
At $10 a pip for most, this can mean that you are paying $20 to $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 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:
A Central 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.
Hopefully I’ve given you a few things to consider when deciding if you will trade currency via the spot market or the futures market.
Sam Seiden is an instructor at Online Trading Academy.
