Using Currency Futures Contracts
Rather than hedging, currency traders often use futures contracts to speculate on price movement and there are many advantages of using futures over the spot market. The first is price transparency and efficiency. Because the exchanges bring all buyers and sellers together in one centralized meeting place, there is an efficient discovery process since all prices are disseminated worldwide through major vending services such as Bloomberg, Reuters, and the GLOBEX system at the Chicago Mercantile Exchange (CME).
A second advantage is that the exchanges use clearing firms eliminating counterparty credit risk. The clearing firm acts as the buyer to every seller and the seller to every buyer so there is no need to worry about the creditworthiness of the counterparty. In fact, at the CME, there has never been a single default in their 108-year history. On the other hand, the over-the-counter market (OTC) relies on credit limits of the counter parties. The individual banks must have sufficient levels of capital to cover the forward exchange transaction risk.
Third, futures provide accessibility for all types of market participants. The Chicago Mercantile Exchange (CME) launched financial futures in the early 1970s. It was then that several commodity traders felt that major moves were about to occur in the currency markets but had no access to the inter-bank markets. These traders established the International Monetary Market (IMM), which is now a division of the CME.
Because of this, individual investors, small businesses, and professional money managers can buy or sell currencies. The futures markets also allow for a more efficient options market, which we’ll talk about later in the course. The reason for this is that the exchanges can line up the expiration dates for the options and futures contracts to make hedging much easier. Let’s now take a look at how to trade a currency futures contract.
Opening an Account
The first step you must take to trade a futures contract is to open an account. It’s also important to check with your broker which types of futures contracts they trade because it is possible that they do not trade currency futures contracts even though they may offer other futures contracts. As with most brokers, you will have to deposit some minimum amount in order to open the account but these amounts are relatively small; many brokers allow $2,000 to get started.
Trading Currency Futures
Once you have an account opened, you are free to trade currency futures contracts. If you buy and sell futures contracts in search of profits then you are acting as a speculator. The only difference in this role from the hedger is that you have no risk prior to the trade but end up with risk after the trade. The hedger, on the other hand, has risk prior to the trade but removes it through the use of the futures contract. Consequently, the hedger does not profit from a futures position when the underlying asset rises or falls. The futures contract just acts as a hedge and offsets any gains or losses. The speculator, on the other hand, will profit on a long futures contract from a rise in the underlying (and will lose if it falls).
For the speculator, the mechanics of buying and selling a futures contract are very similar to stock. If you buy the futures contract, you want the price to move higher.
Let’s keep with our previous example and assume you are bullish on the Japanese Yen against the U.S. Dollar. Rather than buy the yen and sell the dollar in the spot market you could just buy the Japanese Yen contract, which is traded through the CME. As we stated earlier in the hedging example, the Japanese Yen contract controls 12,500,000 yen but the CME does offer many “e-mini” contracts, which are half the size. Because many of you are trading currencies for the first time and will naturally be concerned with the large contract sizes, we’re going to assume the purchase of the E-mini Japanese Yen contract for this example. If you buy the Japanese Yen contract, you’re really buying the JPY/USD currency pair; that is, you are long Japanese Yen and short U.S. Dollars.
For the E-mini Japanese Yen futures contract, there are six months to choose from at any given time on the “March” quarterly cycle. The “March” cycle means that the third month of each quarter (March, June, September, December) will be trading. (Because March is the third month of the first quarter, the March cycle contains only the third months of each quarter.) For the full-sized contract, there will be six different months trading, which are also on the March cycle.
Contract Symbols
Each futures contract has a unique identifying symbol just as for stocks. For futures contracts, the letters H, M, U, Z are used to represent the months of March, June, September, and December respectively. The symbol for the E-mini Japanese Yen contract is “J7” with two more identifiers attached. The first is the month code and the second is the last digit of the current year. For instance, the symbol J7H6 represents the March 2006 E-mini Japanese Yen contract. The “J7” tells us it is the E-mini Japanese Yen contract, H represents the month of March while “6” represents 2006. Your broker will supply the symbols for you so there’s no need to memorize how they are constructed. However, it’s nice to understand the basic idea behind their construction so that you can potentially avoid any errors.
Margin Deposit
When you buy or sell a futures contract, you must deposit a relatively small amount of money usually ranging from 2 to 20 percent of the value of the contract. This is called the performance bond, which is similar to margin for stocks. It is considered a “good faith” deposit that provides the exchange with some security that you can sustain some of the market swings. It is important to remember that these percentages represent minimums and that means that your broker may require higher amounts. Brokers are free to make any requirement stricter than the exchange (but they cannot relax any requirement). Performance bond requirements will change as the price of a contract changes.
As with the layaway plan, you’re not paying the contract price in full and that is what creates the leverage of a futures contract, which we’ll talk more about as we go along. For now, just realize that the performance bond does not in any way represent the total amount that you could lose on the investment. If your prediction is wrong and the yen falls against the dollar then you may have to send more money to the broker.
For the E-mini Japanese Yen contract, the exchange requirement is $1,875 to enter the position. This amount applies whether you are buying or selling the contract. Because of this, it is sometimes referred to as the initial margin and we will assume this value for the example. Your broker will automatically “debit” this amount from your account but remember that this is not a payment for an asset. It is just a good faith deposit towards the futures contract.
So when they debit the account they are really just separating it from other funds so that you don’t use them again or try to withdraw them. As with any minimum, there is nothing that says you cannot deposit more. Additional money deposited to the account will reduce your leverage but it will also reduce the severity of the price swings and the frequency of maintenance calls. To make the example easier to follow though, we’re going to assume that you deposit exactly $1,875 to the account.
The contract trades through GLOBEX (automated trading) around the clock with the exception of 4:00pm to 5:00pm CST. The last trading day for all contracts is the second business day before the third Wednesday. While that sounds confusing, your broker will show the number of remaining days on that contract.
At the time of this writing, the June 06 contract had 60 days remaining until expiration and was trading for 8514, which you now know means that you’re paying $.008514 per yen. Let’s assume this is the price where you buy one contract. Remember, this is really the price that you’re agreeing to pay for yen in 60 days; you haven’t really paid for anything yet. But that agreed upon price sticks with you though the entire trade.
Since there are 6,250,000 yen in the contract then the total value is 6,250,000 * $.008514 = $53,212.50. If you must deposit a performance bond of $1,875 then you are, in essence, controlling $53,212.50 worth of goods (currency) for $1,875, which represents a deposit requirement of $1,875/$53,212.50 = 3.5%. If you purchased two contracts, your initial margin would double to $1,875 * 2 = $3,750 and so forth.
We previously mentioned in the above example that when you "pay 8514" for this contract, that is just the agreed upon price for the basket of yen 60 days into the future. You do not pay 8514 per yen now. So why must you pay anything? The reason is that, due to the extreme leverage (controlling a lot of shares for only a little money down), losses can quickly mount. To keep the rock-solid credit worthiness of the futures markets, the exchanges credit your account with any gains and debit your account for any losses on a daily basis. This is done at the end of the first day you enter the trade and at the close of each trading day thereafter. This process, as mentioned before, is called marking-to-market – the account is being marked to the market price of the underlying asset.
For instance, assume that you bought one contract for 8514 and the yen closes at 8524 (up 10 pips) at the end of the day. Because it closed higher, it is therefore a gain to you of .008524 - .008514 = .000010. On a contract of this size, that’s a value of 6,250,000 * .000010 = $62.50. Your account would therefore be credited with $62.50 cash, which is free and clear and yours to do with whatever you’d like. If you had purchased two contracts, the credit would be twice as large; three contracts would be three times as large and so forth.
You can withdraw this credit immediately or buy other assets through your broker if you’d like. Where did the money come from? It came from someone’s account that was short the contract. Their account was debited $62.50 and credited to your account. Your account is now worth $1,875 + $62.50 = $1,937.50. Remember that futures contracts are a zero-sum game and that all losses must equal all gains. Even though this $62.50 credit is available for withdrawal, it’s usually best to leave the money in your account until the position is closed in case you get debited on another day; these credits provide a nice cushion to your account.
As we said earlier, the initial margin deposit does not represent the maximum you could lose. Consequently, the brokerage firms require you to keep sufficient funds in the account to guard against losses. The exchanges allow for minor fluctuations and will allow your account to lose some value before requiring you to bring in more money. That level is called maintenance margin and, if reached, you will be required to bring your account back up to the initial margin levels.
The maintenance margin levels vary but are typically about 20% to 25% below the initial margin levels. For the E-mini Japanese Yen contract at this time the maintenance margin is $1,500, which is exactly 20% below the $1,875 initial margin level. If your account value ever falls below $1,500, you will be required to send in money to bring it back up to the $1,875 minimum level.
Let’s now assume that the contract is trading for 8520 the next day, which is down 4 pips. The account would now be debited 6,250,000 * .000004 = $25. If you were long two contracts, you’d be debited $50 and so on. Your account is now worth $1,937.50 - $25 = $1,912.50. The important concept to understand at this point is that it is the net change on the contract (yen price) that determines whether your account is debited or credited. In this example, the yen closed down from 8524 to 8520 and that represents a debit to every long account.
Many new traders think that this represents a gain since they are locked into a more favorable price of 8514 that they should be credited. However, that would be too good to be true because otherwise the contract price could bounce back and forth among many prices above your price and it would produce nothing but credits. Just understand that your account is always marked to market on a daily basis according to the change in closing prices. If the contract price rises (falls) from yesterday’s close then all long (short) positions will receive a credit at the expense of the short (long) positions.
Whether you have a profit or a loss facing you at any time, you can always close out the contract in the open market. Just as with stocks, if you are long the contract you can get out by selling it. If you are short the contract, you get out by purchasing the same contract back.
However, to understand how maintenance calls work, we’re going to assume that you continue holding onto the contract and that the yen, unfortunately, continues falling against the dollar. In our example, the last closing price was 8520 and we’re going to now assume that the yen takes a tumble to 8450, down 70 pips. The total that is subtracted from your account at this point is 6,250,000 * .000070 = $437.50.
Your account is now worth $1912.50 - $437.50 = $1,475 and has fallen below the maintenance level of $1,500. You are now required to bring your account value all the way back up to the initial level of $1,875 and that means you must send a check to your broker in the amount of $1,875 - $1,475 = $400. It’s important to understand that it is not the maintenance margin level of $1,500 that you must restore; it is the initial margin level of $1,875.
The deposit you make is called variation margin. Technically, this money is due immediately, which usually means that a check must be deposited with your broker by the close of business that day. Now you have a better appreciation why most traders leave any credits in their account alone. In addition, this underscores why you shouldn’t enter into a futures contract even if all you can afford to lose is the bare minimum required to initiate the futures contract.
Remember, that initial deposit does not represent the maximum amount you can lose as it does when you buy stocks, mutual funds, bonds, options, or most other assets you are probably used to dealing with. All it represents is a down payment of an expensive basket of currency. If the yen continues to fall against the dollar you could certainly lose more than the remaining $1,475 that’s in the account at this point.
In this example, the value of the yen has fallen from 8514 to 8450, which is a decrease of 0.75% while the account value has fallen from $1,875 to $1,475 for a total of 21.3%. This shows that tiny movements in the currency are greatly magnified in terms of dollars to your account whether up or down. This magnification of the return on your investment is known as leverage. The leverage stems from the fact that you were required to only pay for a fraction of the value of the contract ($1,875), while fully controlling the full value of the contract ($53,212.50), or 3.52%. This means that each percentage point change in the price of the yen will result in a 1/3.52 = 28.4% change in price. Therefore, a 0.75% change should result in a 0.75 * 28.4% = 21.3% change in account value.
Leverage can be your best friend or your worst nightmare. On one hand, it is the one variable that was the key to many great success stories in the market. On the other, it is the same variable that has destroyed many speculators and even major corporations. Nick Leeson destroyed the historic Baring's Bank by recklessly gambling in the futures market in an attempt to support some options positions that had already gone bad. If the leverage is great enough, even well capitalized banks cannot withstand the pressures.
Forward agreements, as we said earlier, are independent agreements between two people to buy and sell an asset for a fixed price in the future. In the case of forwards, profits and losses are not realized until that future date. If the previous example were a forward contract at a price of $8514, we would not realize the $400 loss until expiration. It would not matter how high or low the stock moves in the meantime. The only thing that matters to a forward contract is where it ends up at expiration. This is one of the big dangers of forward contracts, especially if the integrity of the other party is questionable. If the forward contract moves against them substantially, all of the losses are due at expiration and it is possible they default on the agreement.
Futures contracts, however, realize profits and losses daily through the process of marking-to-market. In effect, futures contracts are closed and rewritten at a new price each day. Forward contracts will not expose you to daily credits or debits. With futures contracts though, price swings will cause intermediate gains or losses. In our previous example, we assumed you purchased the yen contract for 8514 and that the yen closed up 10 pips to 8524. When your account was credited $62.50, that credit effectively closes out the original contract at 8514 and rewrites it at 8524.
If you are under contract to buy 6,250,000 yen for 8514 then that’s a total contract value of 6,250,000 * .008514 = $53,212.50. But if you are paid $62.50 then effectively you are able to pay $53,212.50 + $62.50 = $53,275. When we divide this number by the amount of yen in the contract, we find that your effective purchase price is $53,275/$6,250,000 = .008524, which is exactly the current price of the yen.
Table 3-8 shows an accounting of the debits and credits that would occur for a futures contract purchased for 8514 compared to a forward contract at the same price:
Table 3-8
Bear in mind that the contract is not actually rewritten or changed in any way. We’re just saying that this credit effectively rewrites the contract and brings all participants to the current price of the yen so that losses do not mount beyond to unmanageable levels. If you ever wish to truly close out the contract, you must do so in the open market with a reversing trade.
If the idea of marking to market is still unclear, think of the following analogy. Imagine that you are hired by a small, start-up company as a business consultant. You sign a contract to work every day for one year and, in return, they agree pay you $120,000 at the end of the year. Obviously, this deal has a lot of risk for you since new companies are highly likely to go bankrupt.
Rather than working the entire year and then collecting the entire check, you may ask for a monthly check of $10,000. Doing so reduces the risk that they default on your entire salary at the end of the year. After receiving your first check, you have effectively closed out the original $120,000 contract and rewrote it for $110,000. Even though a new contract was never actually drawn and signed, the $10,000 payment to you effectively does so. That’s really the idea behind marking to market. The daily payments back and forth reduce the risk to both the buyer and seller and ensure that one party does not accrue losses that threaten default.
Daily Price Limits
Even with marking to market, traders can get into large losses. To lessen the chances of that happening, many futures contracts have daily price limits. This simply means that the underlying assets are allowed to only move up or down a certain amount per day before trading must be suspended and no trading can take place outside these limits on that day.
Daily price limits are normally set by the exchanges and can, under certain circumstances, be modified. In the commodities market at the Chicago Board of Trade (CBOT), for example, corn futures are quoted in cents and quarter cents per bushel and have daily price limits of 20 cents per bushel with no limit for the spot month (current month contract). If corn closed at 2.20 per bushel yesterday, the highest it could trade today would be 2.40 and the lowest it could trade would be 2.00. If corn closes at 2.10 today, the new limits of 1.90 and 2.30 apply tomorrow.
Because each contract controls 5,000 bushels, the most you can gain or lose in a single day is 0.20 * 5,000 = $1,000. Most commodity futures contracts have daily price limits of some type and they vary in size based on volatility and size of the contract. Many futures contracts, however, do not have daily price limits especially with the financial contracts, such as bond or Fed funds futures.
If a contract trades at its upper limit, it is said to be limit up or locked limit up, emphasizing that trading is locked for the day. Likewise, if it reaches its lower limit, that contract is said to be limit down or locked limit down. The unnerving part about lock limit trading is that it can continue day after day, thus never allowing you a way out of the trade! So while the limits theoretically make it less risky, the reality is that you can still get stuck if a commodity decides to run away in price.
For example, suppose that a commodity is trading at its upper limit and you are short the contract and will have losses at the end of the day. You wish to buy back the contract (offsetting position) to get out. But if it is trading limit up then that signifies that people think the price of the commodity is going to move higher yet. Who do you suppose wants to sell? So while you may theoretically be able to buy or sell at or within the limits, the truth is you may not find someone to take the opposite side of the trade.
The important thing to know is that currency futures do not have daily price limits. So while most of your daily gains and losses are expected to be small, if you get on the wrong side of a trade where the stock makes a large move, the losses can become large – and fast. There are certainly pros and cons to limit trading and whether limit trading is overall good or bad for the markets is controversial. Incidentally, the minimum price fluctuation, called a tick size, will be one cent per share, or $1 per contract.
Delivery Process
If you wish to take delivery of the actual underlying currency then there is a process which allows you to do this. As we've said earlier, most futures contracts are used for hedging or speculation and just closed in the open market with an offsetting position so we’re not going to cover the details of taking delivery. If you wish to take delivery, the steps are fairly simple and your broker can lead you through them.
Just realize that you can take delivery of the underlying currency if you wish (with the exception of the Brazilian Real and the Russian Ruble, which are always cash settled.) At the same time, please understand, as we’ve stated before, that futures contracts are obligations unless you enter into a reversing trade. This means that if you do not wish to take delivery of the underlying currency then you must enter an offsetting position otherwise you will take delivery!