Forex Contracts Explained – What are Forex Contracts
If you are new to Forex trading, here are Forex contracts explained for all of you curious about how contracts work in the foreign currency market.
Forex Contracts Explained – The Delivery of Forex Exchange Contracts
To have Forex contracts explained in detail, let’s first see what the spot rate represents and its standard delivery time.
Forex trading contracts represent the agreement between the buyer and seller of currencies at a specific price or spot rate.
This rate is the price at which the currency pairs exchange takes place at the very moment the price is quoted. Spot rate stands for a prevailing foreign exchange rate on the Forex market.
The typical delivery time for spot rate is up to T+2 days.
However, it rarely occurs in Forex trading. Retail traders very often retain their trading positions for more than two days. In that case, brokers can reset their clients’ trades.
They open and reopen positions, and in that case, rollover fees are applied. Forward and futures allow taking long positions without paying overnight fees. Also, they are great for mitigating currency risks.
The Difference Between Forex Spot Prices and Futures
Futures prices differ from spot prices. Future rates are not based on the current market price but on potential future market prices. If investors hold a position in a spot currency, they can use futures contracts to hedge currency risks.
For determining the Forex futures profit, it’s best to use the currency profit calculator rather than bother with the complicated formulas. You can find the calculator on every Forex brokerage website.
Understanding Futures Contracts
A futures contract is a transaction negotiated between the two counterparties (the buyer and the seller) on an organized and regulated market called a “futures market.”
A forward contract represents a commitment to buy (for the buyer) or sell (for the seller) an underlying asset at a price set today, but for delivery and settlement at a future date.
The underlying asset can be a physical product (commodities), a financial instrument (stocks, bonds, interest rates, exchange rates), or even a stock index.
Forex Futures – Forex Exchange Derivative Contracts
Currency futures are the type of contract determining the price you can purchase on currency on a specific date in the future. These contracts are also known as derivatives.
They are less suitable for pairs with low volatility like EUR USD and major pairs composed of the Euro, US dollar, Australian dollar, and Japanese yen.
It’s, therefore, a smaller market used for exotic, high-risk, and minor pairs, usually for hedging purposes and speculations. When trading Forex futures, always bear in mind the liquidity of the financial instrument.
Currency Futures Contracts (derivatives) vs. Currency Forwards
Futures and forwards are financial derivative products that allow investors to buy and sell currency pairs on a given date and price. Although they are similar, some key elements differ.
Currency futures or derivatives are highly standardized transactions (with legally binding terms and conditions traded on a stock exchange). Future contracts include elements like purchase currency, contract amount, trade date, and maturity date. The investor keeps the product until the end of the holding period and cannot end the product early. Or he must pay an extra cost to end the contract early.
Currency forwards are also derivatives, but traded over-the-counter, negotiated privately, and specific to the needs of each investor. When it comes to forward contracts, they encompass the less traded, less liquid, and therefore overall riskier currencies.
Many retail traders prefer trading forward. These enable them to open positions over the long term without paying overnight fees.
When you are trading currencies, you practically always trade forwards. This means you aim to buy one currency hoping for another while selling another at a predetermined price. Moreover, you hope one will strengthen against another currency on a specific date in the future.
You can buy or sell Forex forward contracts. If you buy, you bet that the base currency will rise. And if you sell, you hope the quote currency will strengthen against the base currency.
Forex forward allows for speculating over a long haul without paying rollover fees.
The Futures Market General Mechanism
Initially designed for agricultural markets, the primary role of futures contracts is to minimize the risk of losses associated with fluctuations in the price of the asset to which they relate (“hedging” role).
The best way to explain the sense of futures is by sticking to the commodity market. The principle applies to other markets.
For example, a corn farmer who fears a fall in corn prices between now and harvest can sell corn futures contracts to secure their selling price in advance. Of course, he will pay more for his contracts as he asks for a high selling price so the downside forecasts are important.
Opposite the professionals of the underlying product are other operators who have different interests or expectations. They can be pure speculators, intervening in the hopes of profiting from a market movement.
They play a crucial role in the proper functioning of the markets. That’s because they promote liquidity, allowing the execution of large orders with minimal price fluctuations.
At all times, futures quotes, therefore, represent a consensus of opinions on the levels that the price of the underlying product will reach on a certain date.
Delivery or Unwinding of a Position
In a futures market, one can take a short position before buying. But delivery takes place later in the future.
As a guarantee of sales, it will be sufficient to obtain on the “physical market” the underlying product before the expiry date of the forward contract to deliver it.
Suppose you do not want to deliver the product in the end. In that case, it is imperative to “unwind” your sell position before maturity by following it by taking a buy position on the same derivatives contract.
Since derivatives are standardized (size, maturity), they are “fungible,” making it easy to buy back or sell them during their lifetime. In this case, the broker cancels the position and releases the investor from initial commitments.
In practice, few players maintain their position until the delivery on a futures market. They close their position before maturity. The sale followed by purchase or the purchase followed by a sale on the same underlying then results in a profit or a loss.
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