FOREIGN EXCHANGE-THE FASTEST-GROWING MARKET OF OUR TIME
FOREIGN EXCHANGE-
THE FASTEST-GROWING MARKET OF OUR TIME
DIFFERENT WAYS TO TRADE FX
______________________________________________________________
Over the past few years, the FX market has evolved significantly. Many
products have been introduced as alternative ways to invest in or trade
currencies. Foreign exchange spot is the oldest of these markets and
represents the underlying for many of the new derivative products. Options, futures, and forwards are the next oldest, but forwards are generally
limited to a nonretail audience. An entire book can be dedicated to the differences between all of the new derivative products, but for the purpose of
this book, here are some basic descriptions as well as general advantages
and disadvantages (there may be many others that are not included in
this list).
Spot
The FX spot market is the largest market in the world with a daily turnover
of over $3 trillion.
Quoting Convention Spot forex is quoted in pairs. If the EUR/USD exchange rate is 1.50, for example, it means that every euro buys 1.5 U.S.
dollars. A one-pip move represents a change in the last decimal place, and
for the EUR/USD it is worth $10 on a 100K lot.
Advantage The biggest advantages of trading the spot market are its
simplicity, liquidity, tight spreads, and around-the-clock trading. There is
no expiration or time decay, and accounts can also be opened with very
small initial balances. Real-time charts, news, and research are provided
free by many brokers.
Disadvantage The biggest disadvantage of the spot market is the fact
that it is an over-the-counter market, meaning that spot is not exchange
traded. Usually customers deal directly with their FX broker, who sources
their price feed from the interbank market. Unfortunately, not all brokers
are regulated, though this is expected to change in the coming years.
Additional Comment A characteristic of the spot market that can be
looked at as both an advantage and a disadvantage is leverage, because
in the spot market leverage is very high. Some brokers offer as much as
400-to-1 leverage. Many people view the generous leverage in the FX spot
market as a benefit, but leverage is a double-edged sword, meaning that it
exacerbates losses as well as gains. Too much leverage is also the primary
reason why many traders have difficulties turning a profit. Traders have the
option to change their leverage, but they usually don’t.
Futures
FX futures were created by the Chicago Mercantile Exchange (CME) in
1972 and were the first financial futures contracts ever created. The daily
notional volume is approximately $60 billion.
Quoting Convention Futures contracts are standardized and are subject to physical delivery. The prices of futures contracts are all quoted in
terms of U.S. dollars per unit of other currency being traded. For example,
the quotes would be given in U.S. dollars per euro or per Japanese yen.
Each tick or point equals 0.0001. Each contract for the euro, for example,
involves trading the value of 125,000 euros.
Advantage The biggest advantage of trading futures is the fact that the
transactions are conducted over an exchange. The market is very liquid
and is well regulated. As the counterparty to every trade, CME Clearing
eliminates the risk of credit default by any single counterparty. Price and
transaction information is readily available, and the top five bids and offers
can be seen by electronic traders.
Disadvantage The contracts are standardized, which means that the
options are limited. Unless traders keep up with expiring contracts, they
are subject to physical delivery. Futures margins can be higher, which is
seen as a disadvantage by some traders, and account minimums are generally higher. Commissions and brokerage fees may also be higher.
Leverage is usually 5 to 1.
Options
There are many different ways to trade currency options. The Philadelphia
Stock Exchange, the International Securities Exchange (ISE), and the
Chicago Mercantile Exchange all offer options trading on currencies.
Quoting Convention With currency options, quoting conventions vary
depending on where the option is traded. At the Philadelphia Stock
Exchange, for example, euro currency options are quoted in terms of
U.S. dollars per unit of underlying currency, and each contract is worth
10,000 euros. The point value is $100 (i.e., one full Eurocent = currency
value × 100). At the International Securities Exchange, FX options have
underlying values expressed in foreign currency units per U.S. dollar that
are modified to create an indexlike underlying. For example, if the current exchange rate for USD/EUR is 0.7829, the underlying value for the
USD/EUR ISE FX option would be 78.29 (0.7829 × 100). This format is designed to help investors easily adapt the trading strategies they currently
use for equity and index options. One point is equal $100. The Chicago Mercantile Exchange, by contrast, offers options trading on futures contracts.
The trading unit is one CME futures contract (in euros, one contract =
125,000 euros), and the minimum tick size is 0.0001 per euro, which is the
equivalent point value of $12.50.
Advantage Like futures contracts, options are exchange traded. They
allow for limited risk because the premium is the predetermined maximum
loss. They also are inherently leveraged products, which may be attractive
to some traders.
Disadvantage The biggest disadvantage of trading FX options is the
time decay. Also, there are limited trading hours for some of the different
currency option products.
Exchange-Traded Funds
Exchange-traded funds (ETFs) are the newest entries into the FX world,
with Rydex Investments launching its first CurrencyShares in 2005. PowerShares have also entered the market, but only with DB U.S. Dollar Index
Bullish and Bearish funds. CurrencyShares are traded on the New York
Stock Exchange (NYSE) like any other exchange-listed security.
Quoting Convention CurrencyShares are traded like any stock or traditional exchange traded fund on the NYSE Arca. Shares are traded in
one or more blocks of 50,000 shares. A share in the CurrencyShares Euro
ETF for example is the equivalent of 100 Euros. PowerShares on the other
hand usually represent a basket of currencies. The shares are traded on the
American Stock Exchange (AMEX).
Advantage For many equity market traders, the biggest advantage of
trading Rydex’s CurrencyShares is their simplicity, because currencies are
traded in the same way as U.S. stocks and on the same exchange.
Disadvantage The biggest disadvantage is that the CurrencyShares are
available for trading only until 4:15 p.m., and trading does not restart until
the NYSE opens the next day. Because the market closes, exchange-traded
currency funds cater primarily to long-term traders. Also, since they are
traded on the NYSE, they are subject to standard stock commissions and
they have expense ratios.
Comments
Post a Comment