Understanding how Futures work:
In the simplest language possible, Futures are contracts to sell/buy a commodity (in this case it will be a currency) at a set date at a set price.
What is achieved through this practice?
The reason why this is such a well-established practice is that it provides security to both sides. The key point here is the set price. This means that whatever changes take place in the spot prices of the currency, usually that particular contract will still hold its value.
For example, if a trader enters into a contract with another trader and agrees to sell USD at the rate 1.35 against XYZ currency and the contract expiry date is set for 6 months later, no matter what the value of USD is at the time of expiration the trader will sell the set amount of USD at 1.35.
The motivation behind entering this deal from the point of view of the seller is the assurance that any price falls won’t affect them, and that from the buyer’s point of view is that any price hikes won’t affect them.
This is how futures work for those looking to hedge and close all doors to any major risk. There is another type of trading that takes place with futures and we will get to it in a bit.
Do spot prices affect futures at all?
Yes, the rise and fall of spot rates will affect the futures rates if the change is seen as being a substantial one.
The contracts that are already open and working will not be affected. However, new rates for futures will be set based on the current spot price.
Second purpose behind buying/selling futures: Speculation
Even though a contract itself is very solid if the two parties enter into the agreement with the intention of seeing it through, it doesn’t always have to be such a long term commitment.
Speculators buy and sell futures like others trade currency lots. As we said before, futures’ rates are affected by fluctuation in spot rates if the spot rate change is signaling a major shift in the currency value. This will manifest in new contracts for that currency pair.
This means that there is a chance for speculation and to buy and sell contracts without any intention of buying or selling the currency promised in the contract.
For example, a speculator will buy a futures contract for EUR/USD at 1.15. Their hope is that the value of this pair will go up. Once it does, they will sell those contracts at a higher price. Sellers will adopt the opposite course of action.
How are Speculators different from Hedgers?
In the futures trade, hedgers enter because they want to guard their trades against risk. Speculators, on the other hand, jump head first into risk.
Of course, speculators will conduct their due research but it’s like day trading. Things can take any direction they want and you can never really be fully prepared because the market has a way of surprising traders.
Futures can serve two purposes: risk management and speculation.
Hedgers use them to secure their future transactions of a currency. Commercial companies and investors are the two common participants of using futures for hedging.
On the other hand, speculators buy and sell futures depending on the current market values of those currency pairs. They do the opposite of a hedge as they expose themselves to risk. Speculators will not actually deliver the currency promised in the contract to the original trader they did business with because that wasn’t the intention behind the participation at all. They only buy or sell contracts initially to move them along and make a profit from those transactions.