FOREIGN EXCHANGE-THE FASTEST-GROWING MARKET OF OUR TIME

FOREIGN EXCHANGE-

THE FASTEST-GROWING MARKET OF OUR TIME

DIFFERENT WAYS TO TRADE FX

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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.