How to Trade FOREX Futures
A forex (foreign exchange) future is a standardized, transferable, exchange-traded contract that requires delivery of a currency at a specified price on a specified future date. The holder of a future has an obligation to buy or sell the currency. The risk to the holder is unlimited, and the risk to the seller is unlimited as well. Corporations and individuals use futures to hedge (as an insurance) against detrimental currency fluctuations. Futures are also used to speculate against movements in currency prices.
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Instructions
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Hedging Using Forex Futures
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1
Imagine that it is October and that you are the treasurer of a multinational company with many stores in Europe. You want to know exactly what revenues in U.S. dollars you will get from your European stores. You are worried that if the euro appreciates, your profit margin will be eroded.
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2
You check the current euro to U.S. dollar (EUR/USD) spot rate (current market rate) and see that it's 1.0900 dollars per 1 euro. Your anticipated revenues over the next three months are budgeted at 5 million euros. At today's EUR/USD spot rate of 1.0900, this is $5,450,000 in dollar revenues and your net profit will be 5 percent of these revenues.
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You calculate that if the EUR/USD spot rate depreciates to 1.0355 you will lose all your profit. (1.0900 times 0.05 = 0545pips), (1.0900 minus 0545 = 1.0355). A pip is 1/100th of 1 percent of a rate and is the fourth decimal place after the point in an exchange rate.
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4
You decide to hedge any potential currency fluctuations by doing a forex future. You ask your broker what the forecast for the euro is over the next three months and he tells you that he sees the euro depreciating against the dollar. You ask your broker for a quote for euro futures for December. Your broker quotes 1.0865 for December delivery of euros.
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5
You decide to sell 40 contracts of EUR/USD futures at 1.0875 (each contract is euro 125,000) to cover your anticipated revenue of 5 million euros (40 times 125,000 = 5,000,000). Your broker asks you for an initial margin of 3 percent and a maintenance margin of 2.5 percent.
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You calculate that the 40 contracts are worth $5,437,500 at the futures rate of 1.0875 (40 times 125,000 times 1.0875 = 5,437,500), which reduces your dollar revenues by just $12,500, or 0.2 percent (12,500/5,450,000 by 100 = 0.2 percent).
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You tell your broker to go ahead and sell 40 euro contracts and that you will deposit the 3 percent initial margin of $163,000 (5,437,500 times 0.03 = 163,000). Your broker reminds you that the EUR/USD futures rate for December will fluctuate daily and that you should always have at least 2.5 percent of the value of the contracts in your margin account. For example, if tomorrow the rate was 1.0873, the dollar value would be EUR 5,000,000 times 1.0873 = 5,436,500 times 0.025 = $135,912. This is a lesser amount than the balance in your margin account, so the margin account would be reduced by $27,085.
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Protected profits. Imagine that it is now December and it's time to settle the futures contract. You deliver the 40 EUR contracts and receive $5,437,500. You check the current spot rate and see that it is EUR/USD 1.0587. You calculate that if you had not done the futures contract and sold EUR 5,000,000 at spot you would have lost $144,000, almost half your anticipated profits (EUR 5,000,000 x $1.0587 = $5,293,500. $5,437,500 minus $5,293,500 = $144,000).
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Tips & Warnings
If you are new to trading foreign exchange it is advisable to seek professional advice on hedging strategies.
Currency futures are a zero-sum game and even seasoned sellers or the buyers of futures contracts can lose all their capital.
References
Resources
- Photo Credit keys to your future image by Keith Frith from Fotolia.com profit image by Jaroslaw Grudzinski from Fotolia.com
