Foreign currency futures do not differ a great deal from the futures market familiar to those who follow the stock market. For the uninitiated, the futures market began with eighteenth century agricultural products. Farmers started to sell contracts promising to deliver their grains or vegetables sometime in the future at a price agreed upon when the contract was issued. These futures contracts helped to stabilize the market and even out the supply and demand.
Today, the futures market encompasses a lot more than just agricultural goods. Manufactured items, treasury bonds, and foreign currency futures are all part of the market. The market is not limited to just one country, but can apply to markets in virtually every country in the world.
Speculators in foreign currency futures generally do not expect to ever receive delivery of a purchase. Instead, it is the contract itself that is most often traded, and the value of that contract can change daily. They hope to earn a profit due to the liquidity of the market. If a price increase is expected, they will try to buy long. If a price decrease is expected, they will try to buy short.
Foreign currency futures are similar to options in that an agreement is made to make a purchase on a certain date and for a certain price. However, with options, the buyer is under no obligation to exercise his option. He can choose to forfeit his premium and refuse to exercise his option with no repercussions. With foreign currency futures, the contract requires completion of the transaction.
This is not to say that there will ultimately be a delivery to the buyer. Most foreign currency futures are settled. More often, the buyer’s position is sold to someone else. This is also the case for other types of futures contracts.
To understand how foreign currency futures, and other futures, work, consider the following example. Your Internet provider offers a reduced rate if you will commit to a one year contract. They offer you 12 months of service at a set price that will not increase should there be a price increase during the next year. This is a simplified example of a futures contract. You have agreed to pay a price in the future that is determined today for a service you will receive in the future.
In this example, as with foreign currency futures, you have some risk. If the Internet provider’s price goes down over the next year, the new pricing will not affect you. You have already agreed to a price. If, on the other hand, prices are increased, you have saved yourself some money.
Trading foreign currency futures is not for the faint hearted. There is always the possibility that you could lose money on your position. For this reason, most brokers recommend that retirement funds never be invested in foreign currency futures.
When trading foreign currency futures, it is important to know that the definition of a margin is quite different than in the stock exchange. In the stock market, margin is money that is borrowed in order to purchase stock. In futures, it is essentially a good faith deposit. If there are losses, the margin will be decreased as these losses occur.