Futures trading foreign exchange skills, analysis from the perspective of Xingye

To the surprise of many, currency futures have long been the only trading tool available to individual foreign exchange traders until 1996, when the spread of computers and the Internet prompted spot retail salesbrokerBegan offering spot foreign exchange trading. Forex futures were first conceived in 1971 by Milton Friedman, an economist at the University of Chicago and a strong proponent of floating exchange rates. When the dollar switched to floating exchange rates in 1973, Friedman had an exchange with Leo Melamed, chairperson of the Chicago Mercantile Exchange, who then hired Friedman as a consultant to design a new foreign exchange futures market. Friedman's autobiography, Escape to Futures, is a book worth recommending.

How did retail spot foreign exchange gain room for growth?

Before we get into the specifics of how FX futures work, we need to think about why retail spot FX brokers have been able to get a head start in a market that has been around for 25 years. The answer may come as a slight surprise - namely the slow response of the CME. The emerging retail brokers have an attractive selling point of "trading with large institutions", as well as a much-demanded feature: the CME contract size is 100,000 units of foreign currency (62,500 sterling contracts), so the dollar amount required is higher. The initial margin for trading such contracts is around $1,500. However, retail brokers accurately perceive that individual traders prefer smaller contract sizes and lower initial margins. But the CME did not introduce mini contracts until the 21st century.

In addition, during the 1996 period, the Chicago Futures System was mainly focused on the daytime trading hours between 7:20 and 14:00 Central Standard Time. Outside of this period, there were many restrictions on trading through the electronic market Globex. Before 1999, brokers did not really "make markets" (i.e. provide liquidity). However, spot brokers were able to advertise "trading 24 hours a day", which naturally appealed to individual traders who needed to work during the day or were otherwise limited by time. The Chicago Mercantile Exchange has also lost out to emerging spot retail brokers because its website design is too complex and information is difficult to obtain. For example, the minimum initial margin or even the dollar amount of mini contracts is not easy to find. Therefore, it is not surprising that individual traders still prefer spot retail brokers, despite their shortcomings.

This is regrettable because futures offer individual traders advantages over the spot market in many ways.

quotation practice

First, futures are quoted in US dollars, a standard established before 1979, when the International Association of Foreign Exchange Dealers adopted the euro quoting convention. For futures, each currency is quoted at its cost price in US dollars, so the value of a tick (minimum unit of price change) is fixed. Quick mental arithmetic comes in handy when you know that a tick is worth $10 for the Canadian and Australian dollars, $10 for the British pound, and $12.50 for other currencies. Everyone can easily calculate 10 or 20 times the value of a fixed tick, but in spot trading, this calculation is not simple.

The myth of no transaction costs

Secondly, when trading futures, you can definitely know the exact commission cost for each direction in a two-way trade. Nowadays, the commission for trading in each direction has been gradually reduced from $50 to less than $10. If a retail broker claims commission-free spot trades, this is often a ruse used for the sake of PR publicity. For example, if you execute 500 futures trades a year and pay $20 commission for each two-way trade, then the total commission cost is $10,000. Who wouldn't want to save that $10,000?

But retail brokers are clearly misleading by implying that commission-free equals zero transaction costs. In fact, spot platforms serving retail clients replace transaction fees with 1-2 pip spreads. If you pay 2 pip spreads per trade and execute 500 trades per year, your annual costs will be the same $10,000.

liquidity

Another advantage of the spot market hype is its much-talked-about sheer liquidity - reaching $5 trillion per day. However, we still have to face the reality: how much liquidity do you really need for your trading? The average futures trading volume is around 50,000 to 100,000 contracts per day, while the total futures and options trading volume is around 1,000,000 contracts per day. On November 15, 2016, open positions (i.e. unpositioned squaring positions) in CME FX futures reached 2,800,000 contracts. In fact, the futures market provides ample liquidity for the average trader.

Do you really deal with large institutions? Please face the reality

Regarding "trading with large institutions", let's examine whether the claims in the spot brokerage industry are true and credible. First, is your trading environment really comparable to Citibank, Deutsche Bank, Barclays, and other influential foreign exchange institutions?

The answer is, no. When Citibank trades with Deutsche Bank, the euro-dollar, dollar-Swiss franc, and dollar-yen dollar amounts are traded at $5,000,000. The size problem is like when you go to buy twelve plastic buckets, the wholesaler will definitely give you a different price than Walmart, which can order 12,000,000 pieces. Small retail traders don't trade enough volume to do business with Citibank, and it's not profitable to do so. When trading with another party, the bank offers a bid-ask spread (and captures the gains they get by opening a position early), so on a minimum basis, you need to invest millions of dollars per trade to make enough profit to offset the expensive operating expenses of the trading room. For example, if the bid-ask spread on a EUR/USD trade is 1 pip (0.0001), the bank can earn $500. The same 1 pip spread on your $100,000 trade will only generate a profit of $10. This is the main reason why Citibank has been slow to set up a retail spot foreign exchange brokerage system.

So, how does a retail spot broker work? The answer is simple. As mentioned above, they don't give you the real spot price, but charge an extra one or two or three pips on top of the real price. For example, the AUD in the "real" spot market is trading at 7952-0.7954. The sync that appears on the retail broker's quote page is 7951-0.7955, which is widened by 2 pips. Alternatively, if the retail broker thinks the price will fall, he may adjust the quote to 7948-0.7952; if he thinks the price will rise, he may adjust the quote to 7954-0.7958. This of course requires a lot of skill to adjust the price, but this only applies when the broker expects its earnings to be higher than the paltry $10 earned through your exchange.

Other techniques to improve profitability include "bundling" a group of trades at or near the same price in order to write off those costs in the market at a relatively better price all at once. Or, if the broker thinks it can get a handle on the recent market movement, that movement may not write off your trade at all. In other words, it sells you $10,000 worth of AUD but never exits, but instead executes a trade in the other direction (buying AUD from the other side). If you set a stop loss close and the trade moves against you, you will leave the market at a loss. Brokers don't need to take any action because they have a two-point advantage to begin with.

What if you pay a 4-point spread? 4 points is $40, which is about twice the commission paid directly to the futures broker. And it doesn't stop there. The further you are from the real wholesalers and market-making banks, the more points you see added to the price.

Some brokers do give you spot prices that are the same as those on the "professional" trading quote screen, but it is important to note that these prices have already been marked up by large banks. From the perspective of a true professional trading bank, any retail broker is not a peer counterparty. It is just a client, not a like-minded market maker, and will therefore be marked up.

The main difference between the real spot market and a retail broker is that the main players in the real spot market are market makers. Being a market maker means you need to always provide your counterparty with a bid and ask price. It couldn't be easier. Even if you are GM, Sony or IBM, you still have to pay a markup to the trading bank on top of your forex trades because the trading bank is a market maker and you are not. There is a lot of risk involved in being a market maker. You don't know which direction your counterparty will choose until you give a two-way quote. When you want to sell, he probably wants to sell too. The last thing you want is for someone to force you to buy an underlying that is falling. But that's how a market maker works. Market making generates active traders and a large amount of capital flows.

Understanding this aspect of the market structure is very important because futures markets are based on establishing an equal trading environment. In futures markets, every seller has a corresponding buyer. You understand that price is the true market price because if you buy, there must be a party selling. Futures brokers can indeed add an extra point (and only one) to the exchange's own market makers, but this does not eliminate the main difference between spot and futures. In futures markets, the broker's role is that of the middleman and there is no conflict of interest with the trading outcome. In the spot market, large players have a close interest in the trading outcome because they also hold positions (even if only for a nanosecond). If a spot retail broker does not immediately hedge the buy with a sell order, then the broker also has an interest in the outcome of the trade.

For experienced traders in the spot or futures markets, it bothers spot retail brokers if they claim that small traders can trade under the same conditions as large players. Spot markets have layers, while retail traders sit at the bottom. With some experience, traders will find this claim to be patently false - it is just a form of market hype. Note that US spot retail brokers are regulated by the Commodity Futures Trading Commission, which does not allow the use of exaggerated marketing language. Clearly, the CFTC does not mind the claim that retail traders have the same trading conditions as large traders.

Carry Cost

If we accept that spot brokers' claims about "trading with a professional" and access to endless liquidity are innocuous hyperbole, experienced traders also object to the view that most spot retail brokers believe that trading and making money is simple (because of leverage). In an interview, Mr. Melamed mentioned that the claim that foreign exchange trading can make you rich easily is factually and morally wrong.

Futures traders won't lie to you that trading is easy. The institutions that run expensive Forex seminars are often promoting methods without substance; the seminars don't even teach proper trading rules. But above all, it's irresponsible to claim that trading is easy.

Melamed agrees that the futures price you see is the real price, because if you are a buyer, there must be a seller on the other side of the trade, and vice versa. And each side gets the same price. Except for one pip charged by Globex market makers, when a trader executes a trade, the largest hedge fund gets the same price for each $1 million trade.

However, Mr. Melamed also points to another real cost of spot trading - the much-watched cost of overnight interest, which must be calculated and added on a day-by-day basis in the spot market, but which is already built into futures contracts. The old saying goes that futures traders get a consistent price. But that may not be the case with spot contracts.

Here's how it works: Spot trades settle in two trading days. When you buy on Monday, if you do deliver the contract, you must pay in one currency and receive payment in the other on Wednesday. When you want to extend your position beyond the closing date, you pay a fee. This is not a well-known fee. Brokers have a lot of freedom to allocate costs to you.

In contrast, the delivery date of a futures contract is set in the future, usually starting after three months to date, and shortened to two days when the contract expires. Futures are primarily designed for hedgers and speculators, as the designers clearly recognize that speculators will add much-needed liquidity. No extra overnight interest is charged for holding a position beyond the delivery date, as the contract has been designed for a longer holding period. When a futures contract is a new contract (i.e. enters the "spot month" that is the main focus), it has a three-month operating period. For example, you hold US dollars and use them to buy Australian dollars. In theory, you are earning interest through US dollars, and someone who holds your Australian dollars before the delivery date is earning interest through Australian dollars. If the March interest rate of the US dollar is 3% and the equivalent rate of the Australian dollar is 5%, the difference between the two interest rates is exactly 2%. Since the holder of Australian dollars wants to maintain interest rate gains, he is willing to sell you three-month Australian dollars at the spot price minus a 2% discount.

If you prefer the formula, think of it as the principal plus interest in one currency should equal the principal plus interest in the other. Since both the interest rate and the spot exchange rate are specified, the only thing that can change is the discount or premium to the spot price used to balance the principal plus interest rate. In fact, forward contracts with the same delivery date in the professional market will also trade at a discount of 2% from the spot price. Arbitrageurs also ensure that the near-perfect equation between the forward market and the futures market is maintained. Consider why this is the case, because if it were not, high-interest-rate countries would be flooded with foreign currencies that investors can take away after three months through forward contracts, while reaping higher interest rate yields without taking on exchange rate risk.

Therefore, futures contracts have included "carry costs", meaning it includes interest rate differentials. The futures market has only four contracts per year, expiring in March, June, September and December. Carry costs are already included in the prices you see, so if you extend your contract by one day, you don't have to face the hassle of daily recalculation. Costs are fixed upfront.

If you buy a currency at a higher interest rate, the futures price is discounted. If you buy a currency at a lower interest rate, you earn a higher interest rate, so the other currency is sold at a premium to the spot price. Now we turn to the spot market. You execute a trade on Monday, but don't position squaring on Monday. You hold a position until Tuesday. You have to pay or earn a one-day interest rate difference. It sounds simple - just take a one-day interest rate difference. But in reality it's not simple. The cash or overnight interest markets are also specialty markets, and they can offer market makers rates you see in newspapers, such as the federal funds rate. Major dealers don't offer $100,000 worth of federal funds to non-bank customers for your trades. On the contrary, the interest rate received by the broker who executes the trade on your behalf has been marked up on the federal funds rate, or only for one week or other terms.

You don't know exactly what interest rate the broker is getting. Furthermore, you can't extrapolate from published interest rate data, because the interest rate each borrower/lender in the money market gets depends on the bank's specific credit rating for that broker. To make things even more complicated, one-day interest rates are not just one-seventh of a week's rate or one-thirtieth of a 30-day rate, or any other simple algorithm. In many cases, overnight interest rates are higher than one-week and one-month rates, respectively, to discourage exchange rate speculation. Whenforeign exchange marketWhen there is volatility, central banks such as the Swiss National Bank maintain or suddenly implement interest rates of this structure. In the late 1990s, hedge funds went bankrupt when Greek banks suddenly adopted 400% overnight interest rates. This does not happen often, but it does happen.

How do you know that the overnight interest charged on your account is real and fair? You have no way of knowing. They may or may not be real and fair. The key point is that the algorithm is not disclosed to traders; the futures market is not, everyone gets the same discount and premium, and we know it is real and fair because arbitrageurs in the spot/forward market ensure that futures prices are almost exactly the same as the futures foreign exchange market and the interest rate market.

This raises the final question. When a currency crisis occurs, the central bank suddenly implements punitive overnight carry costs, and the cash-strapped spot retail trader will be charged such huge carry fees that he will either pay them or liquidate his position. Futures traders are only affected by the price of the contract itself, without facing additional fees. Whether there is a crisis or not, futures contracts are a more transparent tool for speculators who extend the initial trading period. For traders who want to learn more about the skills of futures trading foreign exchange, they can refer to the relevant information provided by some professional platforms such as Industrial.

The last two key points

In the futures market, every broker and data provider has access to the same Open-Highest-Lowest-Closing data, and will receive the same Buy-Ask price for one day. In addition, most data providers and some brokers provide "Deal Time and Volume" information. This information lists the bid and ask prices for each minute of the futures market, as well as contract change times and change prices. This can be used not only for technical analysis, but also to check if your broker has mishandled your stop loss or target levels. For example, you set your stop loss at 30 points below the bid price, but your broker claims that the trade was executed at 40 points below the bid price. You can check the Hours and Volume table to confirm whether there is indeed a gap during the trading day that forces you to execute the trade at 40 points below the bid price. If there is no gap, you have reason to communicate with the broker; if the broker refuses to budge, you can report the broker to the National Futures Association and the Commodity Futures Trading Commission. To be exact, you can also report the broker's violations to the CFTC, but you cannot produce as strong evidence as the Hours and Volume report.

Finally, every futures trade is guaranteed by the exchange. If you work with a spot broker, you can at best be guaranteed against its capital base. But every futures trade is guaranteed; if your broker goes bankrupt, the exchange will step in to ensure that the trader completes the trade. When Refco went bankrupt in 2005, traders who held futures trading accounts found their accounts handed over to another broker, while their margin amounts were as safe as any open trade. But spot FX traders in Refco's spot brokerage business had nothing.

So, if futures have so many advantages over spot retail, why is its market size shrinking relatively? Because the starting threshold, leverage ratio and required capital of spot foreign exchange are more relaxed than that of the retail futures market.