Using Futures to Trade Spot Forex

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At Jarratt Davis, our team of traders and analysts incorporate intermarket analysis on a daily basis in order to guide our trading decisions. By looking at fixed income, equities and commodities prices we are better able to view the larger macro picture, and therefore make accurate calculations with regards to currencies. One of the most crucial instruments used to gauge direction are futures contracts.

Futures markets can be used to provide reliable predictions about various spot markets; from the price of milk due to be delivered in three months to probabilities regarding the path of the Federal funds rate, futures tell a story. Insights from futures prices can aid evaluations about currency direction, but this will always depend upon the relationship between the underlying asset of the futures contract and the specific currency – as each currency has its own unique correlation to other asset classes.

History of Futures

Futures and forwards were originally designed for hedging risk. For example, a wheat farmer will not know ahead of time whether he will have a high yielding season, as it will be contingent on rainfall.

If there is a drought, then the price of wheat will be high and supply will be low. Conversely, if there is a good year then supply will be high and prices will be low. In the first situation, the consumers of the wheat lose by paying more, in the second situation the producers lose because they have to reduce their prices to remain competitive. To eradicate this uncertainty, the farmer would agree with a wholesaler ahead of the season a fixed price that they will trade wheat for, regardless of the production quantity. This allows both the farmer and the wholesaler the ability to forecast their future income or outgoings with certainty and make better financial arrangements for their respective businesses. With the price locked in, they can concentrate on their core business rather than attempting to forecast future prices. Situations like this gave birth to forward contracts, which were the predecessor of futures contracts.

What are futures?

A futures contract is a standardised forward contract, both of which involve a party agreeing to buy or sell a specific quantity of an underlying asset for a specific price with delivery and payment due at a specific date in the future. A futures contract differs from a forward contract by having an intermediary as the central exchange and by having standardised contract sizes which serve to promote liquidity in the secondary market.

A futures contract is a derivative product which is entered into through a futures exchanges. The futures exchange acts as a marketplace between buyers and sellers. The exchange assumes the counterparty risk of each trader by ensuring they hold sufficient amounts on margin in their margin account. For traders of the foreign exchange market, the central exchange is also useful because it records transactions and positioning. This feature is not present in the spot forex market, which is an over-the-counter market, rather than a centralised exchange. Traders at Jarratt Davis regularly use currency futures information as a proxy to gauge overall positioning the in the spot forex market.

Currency Futures to Determine Positioning

Currency futures can be used by exporters and importers to remove the risk of fluctuations in the exchange rate. This allows the business to concentrate on its core operations rather than spend time and resources forecasting FX moves. Once a price is locked in for delivery or payment of foreign currency on a future date, the involved business can then account with certainty for its future inflows and outflows, regardless of currency moves. This allows the business to make better-informed financial decisions compared to if there was uncertainty about future inflows or outflows.

The US Commodities Futures Trading Commission publishes a weekly report called the Commitments of Traders which shows positioning in futures markets. By accessing the ‘Short Format’ report for ‘Futures Only’ in the Chicago Mercantile Exchange, FX traders can assess how the market is positioned in certain currencies. The report shows ‘Commercial’ and ‘Non-commercial’ interest. The commercial contracts refers to hedgers, such as multi-national exporters of commodities who have taken out futures contract to hedge their exchange rate risk. The non-commercial interest refers to speculative positions and this is the information which is valuable to professional forex traders. For example if non-commercial interest for EUR is 80,000 contracts long and 250,000 contracts short then it shows there are over three times as many short contacts than long contracts. This not only provides a snapshot of how the market is viewing the euro but can also be suggestive of reversals. Once a market gets saturated with either long or short positions then chances increase that eventually those positions will be liquidated, as there are less participants available to add to those positions. When such a liquidation occurs, the market direction reverses. This is why caution should be taken when entering positions in an already heavily long or short market; heavily one-sided positioning can eventually cause a squeeze on the currency. The COT table also shows the change from the prior week. If EUR short contracts changed -8,000 and long contracts changed 1,500 then it suggests traders are rebalancing the heavily short market. This is very useful to know if, as a FX trader, you are considering shorting an already short market – it may be best to wait for a reduction in extreme positioning first – this would manifest in the chart as a medium-term pullback.

Futures Pricing

When analysing or discussing futures, it is crucial to understand and appreciate the difference between three separate components: the delivery price, the futures price and the value of the futures contract. The delivery price is simply the price locked in for delivery at a specific future date, this price does not change. The futures price is the price today of the futures contract. When the futures contract is first entered into, the futures price equals the delivery price, which means the value of the contract is zero. However as time passes, the futures price changes due to fluctuations in the price of the underlying asset, causing the value of the futures contract to become negative or positive. The underlying spot price fluctuates due to factors of supply and demand.

The value of a futures contract today is the difference between the delivery price and the futures price today. (after discounting the time value of money at the risk-free rate between now and the delivery date)

Changes in supply and demand factors influence the spot price of an asset today. And those same factors influence expectations about the future spot prices, which in turn causes market participants to either buy or sell certain futures contracts that have specified delivery prices. If the future spot price of an asset is expected to be below the delivery price of the futures contract, then traders will want to short those contracts in anticipation of profiting at or before the delivery date. Holders of short futures contracts will gain the difference in price between the underlying asset and the delivery price. If the asset’s price is below the delivery price then traders holding short contracts will profit. Net shorting contracts will put downwards pressure on the futures price causing it to move towards the expected future spot price, and upon delivery date converge. The two prices must converge all there will be an arbitrage opportunity. The value of a short futures position increases as the price of the underlying moves lower.

If on the other hand the future spot price is expected to be above the delivery price then traders will want to long those contracts so they can profit from buying at the lower delivery price and selling at the higher spot price on the delivery date, or simply closing out the position and profiting on the difference, as is the convenience of futures over individually-tailored forwards which often require physical delivery. Demand for long positions puts upwards pressure on the futures prices and moves it towards the expected future spot price where it will converge by delivery date. The value of a long futures position increases as the price of the underlying asset moves higher.

As time approaches the delivery date, the delivery price and the sport price of the underlying asset must converge. This occurs by traders continually identifying any arbitrage opportunities and profiting from them. This serves to equalise any mispricing. It is this mechanism of arbitrage which keeps today’s futures price correctly aligned with the expected future spot price.

The determination of the futures price at the beginning of the contract’s life will vary depending on the type of underlying asset. Some examples are an investment asset paying no income, an investment asset paying known income, an investment asset paying known yield, an investment asset with storage costs, or a consumption asset such as oil or dairy products, which usually also includes storage costs.

Interest Rate Futures to Gauge Direction in FX

Interest rate futures provide insight about what bond traders are anticipating regarding changes in interest rates. If interest rate futures are pricing a high probability of an interest rate increase, then a currency will strengthen. If they are pricing a high probability of a cut then the currency will weaken.

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The ASX 30-Day Interbank Cash Rate Futures are used to calculate probabilities for changes in the Official Cash Rate set by the RBA. Similarly the 30-Day Federal Funds Rate Futures provides probabilities about future changes to the key interest rate set by the United States Federal Reserve Bank. Both these futures price are available as free indicators online and are crucial for assessing market expectations about interest rates for the respective economy.

Commodity Futures and the Commodity-linked Currencies

Other ways futures can be used to trade forex is with commodity futures. Certain currencies have strong correlations with specific commodities. The prime examples of this are the commodity currencies – the Australian, New Zealand and Canadian dollars.

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For the Australian economy, the most relevant commodities are the industrial metals. Given Australia’s close trading links with China, the economy is highly sensitive to Chinese growth. Industrial development in large economies such as China requires immense quantities of minerals or base metals such as copper, aluminium, nickel and of course, Australia’s largest mineral export, iron ore, which is used to make steel. Iron ore futures can be monitored through CME Group Iron Ore 62% Fe, CFR China (TSI) Futures or Dalian Iron Ore Futures. Drops in the iron ore futures will put pressure on the AUD as lower expected future prices will reduce the country’s export income.

The Australian dollar’s strong positive correlation with minerals and metals means that futures markets such as iron ore, copper, aluminium and nickel as well as the precious metals gold and silver, should be closely monitored before and during trades on the AUD.

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The New Zealand economy is most correlated with dairy prices, with diary making up seven per cent of the country’s gross domestic product. New Zealand Exchange (NZX) Global Dairy Futures market shows quotes for Whole Milk Powder, Skim Milk Powder, Butter, Anhydrous Milk Fat and Butter. By analysing the trend in prices for future delivery, an educated estimate can me made about the future spot price. This in turn can help inform a trade on the New Zealand dollar and help to predict the outcome of the fortnightly Global Dairy Trade price index and Milk Powder auction – which more often than not affects the Kiwi.

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The Canadian dollar is highly correlated with the price of crude oil because crude is one the country’s main exports. There are two major blends which serve as benchmarks for crude prices; West Texas Intermediate which is mainly traded in North America and Brent crude from the North Sea. Due to proximity, movements in WTI are watched closely for effects on the Canadian economy; a fall in WTI will reduce Canada’s GDP. WTI futures contracts can provide insight about the market’s expectations regarding future price of the commodity and therefore export revenue for Canada, which in turn can provide a rough indication of whether the market is bullish or bearish on the CAD.

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Application

Each currency has its own specific characteristics and unique correlations with other asset classes. It is important to be familiar with these relationships and always monitor the relevant asset’s futures prices before entering a position in the currency markets. For example, it would be inadvisable to buy the Canadian dollar if West Texas Intermediate crude futures are sliding lower. For the risk currencies – EUR, JPY and CHF – equity index futures should be used to gauge sentiment. While for the commodity currencies, various commodity futures.

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Our team of professional FX traders and analysts at Jarratt Davis is well aware that to improve trading performance, a trader must glean as much relevant information as possible, and intermarket analysis using futures prices is therefore an integral aspect of any successful macro trader’s toolkit.

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