With the U.S. dollar in the doldrums, more and more traders are getting fired up about forex and currency futures. However, there are numerous questions to answer before venturing into either of these red-hot markets. When deciding between currency futures or cash forex trading, you must consider several factors or risk getting burned.
Forex trading is done over the counter (OTC), while currency futures are traded on an exchange with central counter party clearing. Currency futures offer an advantage to “the little guy” in terms of price competition.
“In the OTC market there are multiple filters that [don’t] allow a lot of the smaller customers to deal directly on the same prices as the big institutional customers,” says Derek Sammann, managing director of foreign exchange products at CME Group. “A central counter party takes the whole credit issue away from the equation and allows the smallest retail trader to match up with a [large institution] because all the counterparty trades are matched up with a central clearing house.” He adds that in the wake of the subprime crisis, currency futures trading has an advantage because “stripping out the credit risk element levels the playing field for all the players in the field and you know no matter how small you are in the market, you have access to the same prices as the biggest institutional players in the space.”
However, the OTC element of forex has its advantages. Alex Weinrich, sales trader at Saxo Bank, says that since OTC forex allows you to select the specific size you trade, it’s a pretty big advantage for hedging. “If you’re a business and you have $683,000 in [Canadian dollar exposure], for example, you can make a trade for $683,000. You don’t have to make a $1 million trade or a $500,000 trade like you would in a futures contract.”
When it comes to trade size, CME Group gears its products to both the retail and institutional investor. “By providing contract sizes that appeal to both the retail as well as the institutional market, we make sure that the guys most deep into the institutional space are equally incentivized to trade our contracts, which means retail traders know that they’re going to get the real price from the real market makers, from the real institutional flow, and that’s a really important piece of the puzzle,” Sammann says.
One of the cash forex market’s biggest advantages, the 24-hour market, is not so great, as currency futures now trade mainly on an electronic platform and for 23.5 hours a day.
If you decide to trade forex, after a bit of research (see “Picking a pair”) deciding what pair or pairs to trade is relatively simple. It is important to know the unique attributes of each pair and its volatility. “There are some pairs I would tell people to avoid. The pound-yen tends to be really volatile, so I would say to stay away from that if you’re a beginning trader. Pick a pair that interests you and research the behavior of that pair,” says Marilyn McDonald of Interbank FX.
Beginners should avoid cross pairs and stick to the most common and liquid currencies. When you know how a pair behaves over time, you can determine whether or not it’s right for you. Research is an essential element for investing in currency futures as well. The CME Group and numerous forex platforms offer educational forex articles and list quotes on currency futures and forex options.
On the surface, forex trading may appear cheaper than currency futures, but it is often more expensive, particularly for retail platforms and less liquid pairs. “When you trade forex, generally the only cost you have is the spread…which is typically pretty tight, about 2-3 pips,” Weinrich says. However, retail platforms offering smaller minimum lot sizes can charge up to seven pips. Pips are the smallest movement a currency pair can make (see “Pip my ride”). With forex, “the barriers to entry are very low. You can get into a retail account for about $250. It’s easy to capitalize on small movements in the currency market,” McDonald says.
Note, however, that the hidden charges in forex trades can make them more costly than currency futures. “There are a lot of hidden charges” with retail OTC brokerages, Sammann says. “When people come to the exchanges, they know exactly what the price is…and they know exactly what they’re paying. They pay a fixed price per contract – you can’t get any more transparent than that. When you deal on some of these opaque OTC FX platforms, you will not always get access to the real price, nor will you always get a competitive price.”
Weinrich says currency futures trades have a greater risk of slippage. “Not that there isn’t slippage in the forex market, because there is, but it’s usually limited.” He adds that if you’re trading forex, you should ask your provider for a list of their liquidity providers. “If they won’t tell you, which many won’t…they could at least say [how many they have], and that’s a good indication of how liquid they’re going to be,” he says. The more liquidity providers they have, “the more prices [they] can offer for their clients to trade on.”
Sammann notes that market participants dealing at CME Group “are operating in the deepest central liquidity pools available to retail FX traders. If you compare this daily turnover to some of the smaller retail OTC FX platforms, which typically see far smaller volumes, you can quickly conclude that the retail trader will always benefit from operating in the largest and deepest liquidity pool available to them.”
All traders must perform due diligence on cash forex firms because they do not face the same regulatory scrutiny of a regulated exchange. Currency futures are regulated by the Commodity Futures Trading Commission (CFTC), and all accounts are subject to futures style segregation. For example, some retail customers of the unregulated Refco forex platform lost nearly their entire accounts in the Refco bankruptcy, while customers of Refco futures accounts were protected under the segregation rules. Sammann says traders should “be on a regulated market where there is oversight of the business and where you know that there’s recourse if anything goes wrong. Many people like to deal in the opaque OTC markets precisely because they’re unregulated, and this is where you get room for maneuver for the unscrupulous firms to market to people because they’re not regulated. If you’re a retail investor, you have to [decide] where your funds will be safe.”
So if you decide to trade in the cash forex market, what due diligence do you need to perform? The National Futures Association’s Web site, www.nfa.futures.org/basicnet/ , offers a background search for forex firms that includes CFTC registration and NFA membership information and any actions taken against the firms. The CFTC’s $5 million minimum net capital requirement for Forex Dealer Members, which went into effect in December 2007, has helped weed out some of the undercapitalized firms. While retail forex firms are not subject to the same regulation as futures exchanges, they are required to register with the CFTC.
Remember that the forex market is risky, so don’t let your provider convince you that it isn’t. “If they tell you you can make money without mentioning risk in the same sentence, run. That’s a big red flag,” McDonald says. “People need to take a strong, objective look at any system [and ask], ‘does this suit my trading style?’” Also, don’t be in a rush. “This market has been here forever, and it’s not going anywhere. If anyone tells you that you have to trade today, or sign up today, you really don’t. Test as long as you want until you feel comfortable.” Despite the risks, she calls the forex market intense, highly-caffeinated, and most of all, fun. “The whole industry should be sponsored by Red Bull,” she says.
When deciding between currency futures and forex, Sammann says traders should consider the credit issue, noting that with currency futures “the smallest guy on the street has access to the same price that the biggest guy has because credit is stripped out of the dealing equation.” He also says currency futures have greater transparency than forex, and “the fair price and level playing field for everyone to access the same price in real time is absolutely key. In an exchange, we work on a FIFO model (first in, first out) – whoever’s first on the price has the highest priority. If a trader comes directly to an exchange, they have the same priority and the same level of information about the market as the biggest institutional players in the space.”
Retail traders are utilizing options more than ever and trading options on forex has gotten easier for retail traders as the Philadelphia Stock Exchange (PHLX) and International Securities Exchange (ISE) are listing options on forex. In the past, only institutional traders had access to forex options and while options on futures trade at the CME, they are still mainly pit traded and are not a perfect hedge for cash forex. CME offers options on futures, whereas currency options are held in a securities account. “All an investor has to do to get an options chain via their online securities account is to enter a ticker symbol like IBM, or XDE for the euro or XDB for the pound. You can’t do the same with any type of options on futures contract because each option on futures has a different symbol and moreover, you can’t see options-on-futures prices from a securities account,” says Dan Carrigan, vice president of new product development at PHLX.
“Forex options are extremely popular, particularly with retail customers. This demand is fueled by the continued headlines about the sinking dollar,” says Mark Longo of The Options Insider.com. He says while the most popular products are traditional options on currency futures, the forex options that can be placed in securities accounts offered by both PHLX and the ISE have enormous potential.
Longo expects retail interest in forex options to continue. “Many traders choose currency options over currency futures because they offer much more bang for the trading buck. You can build a position with much more leverage in currency options without investing as much capital. Leverage is important if you want to capitalize on the minute fluctuations that typically occur in the foreign currency market.”
Whether you decide to trade forex, currency futures, or FX options, discipline is essential. Beginning forex traders should develop a comprehensive plan, set reasonable goals, and stick to them. McDonald says, “It’s important to understand why you’re placing a trade. A successful trade doesn't mean you make money. A successful trade means you knew why you placed a trade and why you got out. You can make a ton of money and still have a crappy trade. If you teach yourself bad behavior, you’re never going to be successful long term. At the end of the day, it’s discipline that will make you a successful trader.”