By Sam Seiden, Online Trading Academy Instructor*
Posted: Oct 8, 2010
Being a trader / trainer in futures and Forex classes, I get this question all the time. Because these two markets are constantly evolving, 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 them and discuss how I deal with these markets in my classes.
To begin with, both of these markets are where global currency values (exchange rates) are determined. These are fantastic markets because 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, in other words, the current value (exchange rate) at which the currency pair is trading right now. The "futures" market represents the perception of where that same currency pair will be trading on a specific date in the future. For example, if you had been trading the March 2009 Dollar / Yen back in 2008, the price would have represented the current perceived value of the future (March 2009) exchange rate.
For a trade some traders in my class took on the Euro / Dollar in 2008, two charts showed the same opportunity on the same day in the same time frame. The only difference was that one of the charts was of the Euro futures and the other was of the Euro Spot. It was a buying opportunity on a pullback in price to a pre-determined demand zone.
Although the charts and the trading opportunity looked almost identical, an understanding of how these two markets differ would help you to see which one was really the better opportunity. Before trading either of these markets, you must know certain facts about them, the 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 manipulation at times. There is a reason you hardly see volume in Spot Forex. It is because the real volume is very different from the "trillion dollar" volume you read about in all the marketing. The volume in this market is specific to the volume of order flow from a specific broker, depending on how many accounts the broker has and the size of those accounts.
Little Regulation
Slowly, but surely, the Spot Forex market is being regulated. However, it is still one of the least regulated markets around, which really can lead to manipulation and risk. Most importantly, if you run into a problem with your account, you really have little to no recourse because there is no one body that 100 percent regulates the Forex markets the way there is with other markets.
Brokers Trade against Clients
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 are on the other side of your trade. This means that your goals and their goals cannot be in alignment because you are 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 a few years ago). 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"รข€¦If you believe that, I have some beautiful land in the desert to sell you 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. 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 -- 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.
Huge Leverage
In Spot Forex, 400:1 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.
Big Trends
The Forex market experiences large moves almost daily. There is always a currency pair trending strongly, which means very frequent trading opportunities.
Forex Futures
One Central Market, the CME The Chicago Mercantile Exchange (CME) is the home of 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.
Lots of Regulation -- the SEC and NFA
The CME actually has double regulation. It is a futures exchange, so it is under the watchful eye of the NFA and the SEC. The CME is also a publicly traded company, so it has another level of regulation that comes with that.
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 order-matching system much like the NASDAQ for stocks. There is no broker on the other side of your trade. Instead, when you buy, your order is matched with a seller like you, not a broker. This leads to a very fair and free market.
Trading Times and Markets
People are trading the Spot market at all hours of the day and night; this is not so with Forex futures. The higher-volume time to trade is the U.S. day session, from early in the morning until approximately 2:00 p.m. CT. Outside those times, a substantial drop-off in volume occurs, especially overnight.
Also, although the CME has most of the Forex pairs that the Spot market has available, at this time, there is not enough volume to trade any Forex pairs outside the majors against the dollar. For example, trading the Dollar / Pound futures during the day in the U.S. is fine. Trading that market or almost any other during the U.S. night session may not be a good idea because there is so little volume.
Lots of game playing can go on in the Spot Forex market with certain brokers. Remember: They are market makers for the most part. Here is an email message from one of my students:
Sam,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 he robbed the bank.
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,
R
Given the pros and cons of these two gateways to trading global currency markets, what do we do? Here is exactly how I treat these fine markets in my Forex class.
Because the broker is on the other side of your trade in Spot, it is not a good idea to try to 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 right away because of the spreads created by the brokers; 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 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 the broker can move the market a bit and try to stop you out, the broker can't move the market too far away from the real market, or he runs the risk of losing big.
Another important point to remember with the Euro buy setup is that, when we buy at demand, we are forcing the broker to sell at demand, and the broker certainly doesn't want to do that. This is why the broker widens 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 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, quality opportunities are.
So, what about short-term trading in Forex? This is where the Forex futures come in. Although you can certainly trade the Forex futures longer term (and should), you can easily trade the Forex futures in the short term because the broker is NOT on the other side of your trade.
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.
Here are some, but not all, of the many Forex markets I trade each day with my students.
Some Popular Currency Markets
U.S. Dollar versus: Japanese Yen
Australian Dollar
British Pound
Euro
Canadian Dollar
Swiss Franc
And more...
Non-U.S. 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:
- Understanding how the Forex futures and Spot Forex markets work
- 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
*Reprinted (and modified) with permission from Online Trading Academy (www.onlinetradingacademy.com). Sam Seiden can be reached at sseiden@tradingacademy.com.
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