Forex vs. Futures: Which one should I trade?
Like you, trading was an easy decision to make. I was compelled by the idea of the markets, of the vast amounts of information, and the potential to take hold of my financial future. I began reading everything I could about investing, about how to trade, and about the markets.
Maybe you’re in the same position I was years ago: You watch Mad Money, you spend hours on Yahoo! Finance, and you are digging into your 401k’s portfolio. You are in the exploration phase, gathering as much information as you can.
Eventually, all traders need to decide what they will trade and how they will trade. The list of tradable securities is long, and oftentimes beginners don’t recognize the choices they have:
In this article, we’re going to focus on a comparison of two of the larger and more popular instruments: forex and futures.
Introducing Forex and Futures
Forex. This stands for foreign exchange market, also known as FX, or currency market. This is where investors buy and sell currency pairs in an attempt to generate profit or hedge against loss. The market for currency is massive, with daily trades well over $5 trillion. Popular currency pairs include USD/CAD, GBP/JPY, EUR/AUD, and NZD/USD, among many others.
Futures. In comparison to forex, futures are an agreement to buy or sell a commodity at a fixed price at a future time. A futures contract specifies the price, duration, commodity, and other details of the agreement between buyer and seller. Popular commodities include crude oil, gold, wheat, cotton, and sugar, among many others. Currency pairs can also be traded through a futures contract, called a currency future.
To help you decide which security might be the best for your investment strategy, we will take a look at five elements of both forex and futures securities.
Leverage is first up. If you haven’t heard of leverage before, in a nutshell, this is the practice of borrowing money to increase the possible return on an investment. Leverage can be risky, as it can also amplify a losing trade. Both forex and futures trading allows for the use of leverage, although leverage is more common in currency trading.
- Forex – Yes
- Futures – Yes
When deciding on a trading strategy, you’ll want to carefully consider just how much commissions will eat into your trading profits. Often beginners don’t account for commission costs and watch as winning trades that net say, 3%, only garner 2% after the fees.
In the futures markets, commissions are charged on a per-contract basis. Furthermore, a brokerage may charge different fees depending on the contract.
Commissions function a little differently in the forex market. When you buy a currency pair, you pay the broker who sells to you at a higher price (the ask price) and buys from you at a lower price (the bid price). The commission is usually built into the spread in some manner and can be fixed or variable.
- Forex – Yes (usually part of the spread)
- Futures – Yes
This is a measure of how easy or difficult it is to buy or sell a particular security. A market that has many active buyers and sellers is said to be liquid. The opposite is an illiquid market, where buyers and sellers are not readily trading. The perfect trade can quickly turn south when a buyer fails to materialize.
The forex market is a massive market that is highly liquid. Currencies are moving rapidly day in and day out. On the other hand, the futures market is less liquid than forex. While some contracts may trade easily, other contracts might not move as fast.
- Forex – Very liquid
- Futures – Variable, depending on particular futures contract
Last up, we will consider the tax situation for both forex and futures. This is an important consideration, as your tax obligations will also factor heavily into how successful you are as a trader.
At the time of this writing, forex trades have no special tax status and are taxed as ordinary income. However, forex investments can be taxed at 60/40 if the underlying currencies are not delivered. Futures, on the other hand, are taxed at the 60/40 rule, which means that 60% are considered long-term gains and 40% are taxed at the ordinary income level.
- Forex – Ordinary income or 60/40
- Futures – 60/40 rule