Thursday, August 30, 2007

Should You Trade The Forex Market Or The Futures Exchange?

Back in the nineteenth century farmers started selling contracts to deliver their produce at a fixed price at some specified future date in an effort to stabilize the supply and demand of agricultural products out of season. At this point the futures market was effectively born.

Today the futures market extends far beyond agricultural products and includes many different items from manufactured goods to currencies and treasury bonds, but the principal remains the same. One essential difference however lies in the fact that for many futures traders there is no intention to actually purchase the goods in question or to take delivery and it is the futures contract itself that is the trading instrument.

As an example of how futures trading works let's assume that a baker enters into a contract with a farmer to supply 100 tons of wheat at $50 a ton on a specified date. This contract need not necessarily require the baker to purchase the wheat specified in the contract but gives him the option to do so if he so chooses. Now, Futures accounts are settled at the end of each trading day and so, if after entering into the contract, the market price of wheat on a particular day is $40 a ton the farmer's trading account will be credited with $1000 ($50 - $40 X 100) and the baker's account will be credited with the same amount.

Final settlement of the account and delivery of the wheat will then take place on the agreed date and, for the sake of argument, we'll assume that the price of wheat is still $40 a ton at this point. The farmer will now have $1000 in his trading account and the baker will need to pay his account the $1000 that it is down. So how did both parties do?

The baker has lost $1000 on his futures contract but is able to buy wheat on the open market now at just $40 a ton rather than the $50 he anticipated and so his loss on the contracted is balanced by his ability to buy cheaply on the open market. In effect he has protected himself against having to pay more than $50 a ton but has in essence lost because the market price has fallen.

The farmer on the other hand has made $1000 on his futures contract but, because the market has fallen, he can now only sell his wheat for $40 a ton. Once again the difference between the two is balanced and, by entering into the contract he has effectively gained the $1000 he would otherwise have lost on the open market.

In many cases speculators will enter the market and will buy and sell futures contracts. For example, if they expect prices to rise they will purchase the contract from the buyer (known as buying long) and, if they expect the price to fall, they will purchase the contract from the seller (known as buying short).

The Forex, or foreign exchange, market is similar in many ways to the futures market but has several important advantages.

The Forex is the largest financial market in the world and is a giant when set alongside the futures market. This makes the Forex market very much more "liquid" and provided many more trading opportunities for both buyers and seller.

The Forex market is also open 24 hours a day, 5 days a week, while most futures exchanges are open for only 7 hours a day on Monday to Friday.

Forex transactions are commission-free, while brokers will charge both commission and brokerage fees on futures contracts.

Forex transactions are executed almost immediately because of the high volume of trading and there is usually little difference between a quoted price and that actually paid on the transaction. In futures trading quoted prices will often reflect the last price paid on a similar trade and there can be a marked difference between the quoted price and the actual price paid.

Finally, the Forex market has a number of in-built safeguards which mean that trading on the Forex carries less risk than trading on the futures exchange.

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