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Jun 14, 2018

Foreign Currency Futures Explained

By:Sage Anderson


By now, you're probably aware there are six main categories of financial futures; including agricultural futures, metals futures, equity index futures, energy futures, interest rate futures, and foreign currency futures.

Today on the blog, we’re are focusing on foreign exchange (FX) futures, and providing an in-depth introduction to this dynamic niche of the global financial markets.

Before delving into the futures themselves, let's first take a brief look at the foreign exchange (FX) market as a whole. This is the spot market where currencies are exchanged for one another, and its massive size dwarfs every other financial market on earth (in terms of daily volume).

On any given day, governments, companies, and individuals exchange anywhere between $3-$5 trillion in foreign currency. Traditionally, this market is referred to as the "forex" market, or the "foreign exchange market," and is conducted completely over-the-counter (OTC) through brokers - there are no centralized exchanges.

Participants in the FX market range from a huge tech company in America converting US Dollars to Chinese Renminbi in order to pay a supplier, a large multinational selling Euros to hedge revenue from that region, or s Swiss tourist in Vietnam exchanging Francs for Dong so they can enjoy a bowl of local Pho.

Forex Futures and Forwards

Aside from the forex spot market, which was highlighted above, there are two other primary methods that traders usually access foreign currency exposure - futures and forwards.

Just as with stocks and related options, the spot market for foreign exchange represents the "underlying market" for FX futures and forwards. In the past, the futures market was extremely popular for hedging and speculating in the foreign exchange market.

While that remains true today, volumes in the spot market have also surged due to the advent of electronic trading and a large increase in the number of available brokers in the OTC market. However, significant demand remains for currency futures because multiple expiration periods are available - meaning long-term hedges or speculative plays can be locked in on a regulated exchange using margin.

Unlike the spot market, the futures and forwards markets do not deal in actual currencies. Rather, they deal in contracts that represent claims to certain types of currency, at a specific price per unit, with a fixed date of settlement.

The forwards market operates OTC, which means the two parties in the transaction set their own terms. Given that the forex spot market also operates OTC, that means the only market for foreign currency exposure on a regulated exchange is the FX futures market - an important distinction for this product.

FX futures, which are the focus of today's post, possess specific parameters - including the number of units being traded, delivery and settlement dates, and minimum price increments - none of which can be customized.

As with any futures contract, the futures exchange also acts as a counterpart for traders, providing clearance and settlement.

Reading Exchange Rates

The nomenclature in the field of foreign exchange may be unfamiliar to you, but we hope to remedy that in short order. In this section, we provide an overview of some important terms in the FX universe and outline how to interpret exchange rates.

At a high level, an exchange rate tells us how much it costs to exchange one currency for another. As currencies fluctuate in value, so too do the exchange rates between them.

Before we jump into interpreting exchange rates, it's important to keep in mind that liquidity plays an important role in the FX futures market, just like any other financial product we opt to trade.

It probably won't surprise you that the countries with the biggest economies (or the largest trading blocks) represent some of the most liquid foreign currencies. Some of these include the US Dollar (USD), the Australian Dollar (AUD), the Euro (EUR), the Canadian Dollar (CAD), the Swiss Franc (CHF), and the Japanese Yen (JPY).

Taking any two of the above currencies, we can now walk through the interpretation of a sample exchange rate - for instance, the US Dollar and Euro - which is actually one of the most liquid pairs in the entire FX universe.

Exchange rates are listed using the format "XYZ/ABC," and are interpreted to mean that the first currency listed is a single unit, while the exchange rate itself represents the amount of the second currency that is required to purchase a single unit of the first currency.

For example, the current USD/EUR exchange rate is approximately 0.8531, which means it takes roughly 0.8531 Euros to purchase a single US Dollar.

To calculate the reverse exchange rate, the amount of US Dollars that are required to purchase a single Euro, we simply take the number 1 and divide it by the exchange rate.

In this case, the EUR/USD exchange rate would be "1 divided by 0.8531," which is equal to about $1.1721. That means that it takes roughly $1.1721 dollars to purchase a single Euro.

An understanding of exchange rates is obviously critical whether you’re trading the FX spot market, or the FX futures market.

Using “Brexit” to Reinforce Exchange Rates

To reinforce the format and interpretation of an exchange rate, let's look at the British Pound (GBP) before and after "Brexit."

Specifically, let's examine the amount of USD required to purchase a single British Pound before Brexit, as compared to the amount of USD required to purchase a single British Pound after Brexit.

Because we want to know how many dollars it takes to purchase a single British Pound, that means GBP comes first in the equation, and USD follows second, as such: GBP/USD.

Looking back as far as 2008, we can see that the exchange rate for GBP/USD was as high as $1.95 in the summer of that year. That means nearly a decade ago it took roughly two full US Dollars to purchase a single British Pound.

Fast forward to the wake of the Brexit, and we can see a much different paradigm between the Pound and the US Dollar. In early 2017, the GBP/USD exchange rate was as low as $1.21, meaning it took only $1.21 US Dollars to purchase a single British Pound.

As of today, the GBP has appreciated slightly against the Dollar, and the exchange rate currently sits around $1.35 - still well below the levels observed nearly a decade ago.

The GBP/USD example helps reinforce how imperative it is that traders understand the exact currency pair they are trading, and what direction they are betting on.

For example, a trader expecting the Pound to strengthen against the Dollar would purchase the GBP/USD exchange rate (/6B). An increase in the /6B exchange rate would mean that more Dollars are required to purchase a single Pound - meaning the Pound had appreciated against the Dollar. Alternatively, if the Dollar appreciates against the Pound, then the /6B would decline.

It's absolutely vital that traders understand the interpretation of an exchange rate prior to trading FX products, especially the ordering of the currencies in an exchange rate.  

This is important because by flipping the order of the two currencies, one is now dealing with a completely different relationship. For example, if we change the previous GBP/USD example to USD/GBP, that means we are now looking at how many Pounds are required to purchase one US Dollar.

In this latter case, a trader wishing to express the view that the Pound will appreciate against the Dollar would sell the exchange rate, instead of purchasing it. Because a decline in the USD/GBP exchange rate means fewer Pounds are required to purchase one US Dollar - an appreciation of the Pound versus the Dollar.

More Details on FX Futures

Now that we have a better understanding of foreign exchange rates, it's probably a lot easier to see how similar FX futures are to other segments of the futures market.

For example, a speculator in crude oil that is expecting the price to rise may decide to purchase a crude oil futures contract. The same might be said of a trader that expects the Euro to appreciate versus the Dollar, and decides to purchase the EUR/USD futures contract.

As stated earlier, futures contracts in currencies are standardized, meaning traders know up front the exact size of the contract, the minimum price increment, and the corresponding tick value.

Using the EUR/USD as an example, the minimum price increment is 0.0001, with a corresponding tick value of $12.50. That means every time there is at least a 0.0001 movement in the price of the exchange rate, the value of the contract will change by $12.50.

Now imagine that a trader decides to purchase one futures contract of the EUR/USD, which is trading $1.1721 (calculated in the previous section). That trader would be banking on appreciation in the value of the Euro, relative to the Dollar.

If things go as expected, and the exchange rate rises to $1.1722, the trader has made $12.50 in profit (per contract).

If the exchange rate instead rose to $1.1731 (an increase of 10 ticks), then the trader would make $125.00 in profit per contract ($12.50 x 10 ticks = $125.00).

If a trader wants to lock in profits or avoid further losses, an FX futures contract can be closed by deploying a trade that represents the opposite position from the original trade.

The graphic below depicts the contract specifications for some of the highest volume FX futures contracts, including the EUR/USD, GBP/USD, and the AUD/USD:

For the three contracts listed above, a decision to purchase or sell the associated future effectively represents a decision to purchase or sell the first listed currency - relative to the US Dollar.

For example, a long /6E contract benefits when the exchange rate rises, which equates to an appreciation in the Euro versus the Dollar. A decline in the exchange rate would mean that the Euro has depreciated against the Dollar, which in turn damages a long /6E position.

Parting Shots

Like other futures products, foreign exchange futures are used by various market participants for hedging and speculative purposes.

For example, a trader may take a long position in one currency, or deploy a pairs trade involving multiple currencies.

Traders looking to learn more about FX pairs may find a recent episode of Into The Deep worth a few moments of their time. On this episode, the hosts walk viewers through two different exchange rates - CAD/USD (/6C) and AUD/USD (/6A) - as well as the spread between the two over the last several months.

This episode can help traders better understand how FX futures traders evaluate potential pairs trades as well as the mechanics involved.

It should be noted that settlement in foreign currency futures operates much like other futures products. Traders have two choices when it comes to settling a foreign currency futures contract - offsetting the original position by deploying the opposite position, or by holding the contract through the maturity date.

In the case of the former, when an offsetting position is deployed to close the trade prior to maturity, the profit or loss is credited or debited from the trader's account. In the case of the latter (holding through maturity), the contract is cash-settled or physically delivered, depending on the specifics of the contract and the exchange.

The physical delivery of a foreign currency futures contract isn't a simple process, which is why the bulk of them are closed with an offsetting position prior to maturity. It's important that traders thoroughly understand the mechanics and risks involved with physical delivery (for any futures product) prior to trade deployment.

If you are new to FX futures, and want to learn more, we recommend reviewing the links below. Additional content focused on FX futures is also available through the “search” functionality on the tastytrade website:

If you have any outstanding questions about foreign currency futures, or the forex spot market, don’t hesitate to leave a message in the space below, or reach out directly to support@tastytrade.com.

We look forward to hearing from you!

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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