FX traders use futures contracts for a variety of reasons. When trading currencies on an exchange, the first speculators to take positions are called “floor traders.” They will often hedge their positions with future contracts. It is done because they can always lock in their current profit before closing out their work.
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Buying a call option on gold
The simplest example is when an investor buys a call option on gold at $1,200/ounce. If two weeks go by and gold has stayed around $1,200, they might sell their call option for $10/ounce to lock in some profit before it expires. But if gold rises to $1,300/ounce during that period, the trader may choose to hold onto the option until it expires. If that happens, they will have made $100/ounce on their choice, minus commissions and fees.
Capture anticipated market moves.
Another reason traders use futures contracts is to capture an anticipated market move before it occurs. For example, there are many times when a currency pair has broken through a significant technical level (like breaking the 200-day moving average). It would be possible for someone at this point to buy the currency pair immediately.
But what if the pair plummets another 50 pips right after buying? Traders often don’t want to go through that extra stress until they know where prices will end up in the short term. So instead, they might choose to buy at that moment but offset their risk by selling or “going short” a futures contract.
In the example, say you have a few friends who have been anticipating an economic number’s release in the next hour or so. You decide to join them and buy euros when they do. But what if market volatility causes prices to drop another 100 pips right after buying? Instead of going through that stress, your friend might choose to offset their risk by selling a futures contract instead.
When prices come back up, he can close out that position and keep any gains. However, suppose the price goes down again. In that case, he will be losing money on both parts – the 150 pip loss from purchasing euros now, plus the 50 pip loss having sold a future earlier – but overall, he’s still in the same position (buying Euros) that he was before(click here for a more in-depth explanation).
Shorting futures
Someone shorting futures contracts does not have to do with the underlying asset style. All you need to know is that this person has sold something which they do not own at this point. For example, if tomorrow Apple announces record profits for the last quarter, should you buy its stocks? What would happen if everyone decided to buy Apple shares today and the price went up by 10% – overnight? You can’t sell what you don’t have.
This kind of scenario happens all the time when dealing with futures contracts. When market volatility causes prices to go down, someone might decide to “go short” and sell a futures contract. It might be bearish on the underlying asset (indicated by them currently having no shares). Or it could even be someone who owns plenty of claims, but they want to make sure that they can buy back those shares at a lower price before the expiration date.
Differences between future and forward contract
As you already know, futures contracts are similar to forward contracts in some ways, but there are also very distinct differences between them. The first main difference between futures and forwards is that futures can be bought or sold on an exchange, whereas forward contracts do not have this option.
It does not mean that all futures need to be traded on an exchange, and all forwards do not need to either – just because businesses exist does not mean that everyone will choose to use them. For example, giant corporations might prefer to negotiate directly with each other and agree on a price for their products without the hassle of going through an exchange.
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