The foreign exchange markets, or forex, stand alone as the largest and most liquid markets in the world with trillions being traded daily (see "Up, up and away," below). Open 24 hours a day, five days a week, this asset class is available to everyone from national banks and international corporations to the individual day trader. Like most asset classes, there are a number of ways for the individual trader to access it. Here, we will examine the various methods of participating in them.
Foreign exchange consists of trading one country’s currency for that of another’s to hedge exposure to a specific currency risk or to profit from movement in exchange rates. Most popular are pairs trading a particular currency versus the U.S. dollar but you can trade virtually any currency against another. Forex trades that do not include the U.S. dollar are referred to as crosspairs. (For a guide to beginning forex trading, see "Getting started in forex," April 2009).
Because currencies are always traded in pairs, traders simultaneously sell one currency and buy another. Doing so, they hope the value of the currency they purchased will increase in relation to the other side of the pair at which time they close the trade to lock in profits.
Currencies typically trade in lots of 100,000 units, which is also the standard size of most currency futures contracts, but mini futures and forex are offered in units of 10,000 and smaller.
To make these markets accessible, traders can use leverage based on their initial margin deposit. While it depends on the broker and the product, traders can often leverage their initial deposit anywhere from 10 to 250 times. (Currently, domestic leverage requirements, per the National Futures Association, are 100:1. The Commodity Futures Trading Commission (CFTC) had proposed 10:1 leverage and will put out final rules in mid-October.) For example, a $1,000 initial margin deposit could be leveraged to control $100,000 where a change in a couple pips could result in a large percentage profit or loss.
There are a number of ways a trader can participate in this asset class. The four most common ways are the spot, or cash market, currency futures, currency options and currency exchange traded funds (ETFs).
The spot currency market is the most basic way to trade currencies. Here, a broker supplies the trader with software that displays the current spread for a specific currency pair (see "How to trade forex cross pairs," April 2010). Typically, this occurs in currency lots of 100,000 of the base currency. As such, many brokers require a minimum initial deposit of $2,500 to begin trading.
Trades in the spot market normally have a two-day expiration, after which traders either have to accept delivery of the currency or roll over the contract. By rolling over the contract, the trader is accepting a similar one for the next expiration, but that rollover may include carry charges or interest. Of course, the day trader who does not hold positions overnight does not need to worry about rollover.
Often, brokers will advertise no commission for spot forex trading, but trading always has a cost. Brokers work as market makers, continually providing a bid-ask spread to their customers. Brokers either profit from a commission (futures) or through the spread. Usually this spread will be tighter for highly liquid pairs such as the EUR/USD (see "It’s all in the family," below) and wider for less liquid pairs. This provides one of the largest challenges for traders because they have to cover the spread before they can even begin to make money on the trade. Deals in the spot market are private deals between the broker and trader, and as such the quoted bid-ask spread may vary from broker to broker. Consequently, traders will want to check out as many brokers as possible to determine which have the tightest spreads.
While the spot market is similar to a futures market, it is not regulated as one. Therefore, it is the trader’s job to find a broker they want to work with. "[The spot market] is the purest form, the most liquid market and that’s where you’re prone to see the most activity. That’s where you’re going to see the narrowest spreads throughout the day and the greatest liquidity," Andrew Wilkinson, senior market analyst at Interactive Brokers LLC, says.
Over the years regulation of the retail spot forex market has been hazy. However, that has been clarified further in the Dodd-Frank law and now all retail forex trading will be regulated, most likely under the supervision of the CFTC, but that depends on how you access the market.
Currency futures were launched in 1972 by the Chicago Mercantile Exchange (CME) after the U.S. abandoned the gold standard and decided to allow world currency exchange rates to float. A number of similarities exist with the spot market, although there are key differences.
In trading a currency future, traders are buying and selling standardized contracts. For example, the standard contract size for the EUR/USD is €125,000, although different contract sizes are available for this and other major currency pairs which include E-mini and E-micro contracts. These standardized contracts are traded with set expiration dates on a quarterly cycle.
One of the biggest differences between the spot and futures market is that in the futures market everyone sees the exact same quotes. It does not matter if the trader is a day trader at home or a trader at a multinational bank; everyone sees the exact same price.
Instead of making money through the bid-ask spread, futures brokers charge commissions above the exchange and clearing fees. These fees range from $1.60 a trade for a standard contract to just $.16 for an E-micro contract. Futures typically have a one-tick spread during active trading hours.
Unlike the spot market, futures contracts are cleared by a central counterparty, which eliminates counterparty risk. The clearinghouse acts as the counterparty to every trade so there is no need to worry about the creditworthiness of whoever is on the other side.
While currency futures have grown exponentially since the onset of electronic trading, the spot market is still the most traded. "[Currency futures are a] pretty liquid market, although the major complaint I have is that those markets can still exaggerate moves in the spot market. You don’t have the same sort of liquidity in the overnight futures markets as you do in the overnight spot markets," Wilkinson says.
While retail forex platforms are numerous and offer access to forex to all sizes of traders, there had been very little retail access to forex options until the Nasdaq OMX PHLX options exchange and the International Securities Exchange (ISE) began offering them a few years ago. CME Group has offered options on currency futures for a long time but they are based on the futures contract, so they are not a perfect hedge for the spot price.
"[Forex] options provide investors with an exchange-listed, centrally cleared alternative to the OTC currency market. With [forex] options, investors can gain exposure to rate movements in some of the most widely traded currencies and can apply the same trading and hedging strategies they use for equity and index options, including spreads with up to four legs. FX options can be traded directly from an options-brokerage account," a spokesperson for the ISE says.
Options can be a way for traders to limit their risk in a trade. For instance, if a trader believes the EUR/USD will move upwards, he may purchase a call at a premium so that if the rate hits the option strike price he can exercise it. If the currency instead moves against the trader, all that is lost is the premium. Forex options, such as at Nasdaq OMX PHLX and ISE, are exchange traded.
Options are a much more precise tool and allow traders to define how much risk they want to put on as well as allowing them to manage the risk in an underlying position without having to have a hard stop. While options on futures can serve this purpose, they are based on the futures and not the spot and currently cannot be held in the same account.
(For more on forex options, see "How to trade forex binary options," January 2010).
Currency exchange traded funds (ETFs) are a financial instrument that holds an asset and trades in relation to that underlying asset, but trade similar to an individual stock. While there are some more complicated ones with exposure to multiple currencies, many follow just a single currency pair (see "Forex Trader"). Currency ETFs offer investors in the stock market exposure to currencies. The biggest advantage to currency ETFs is that they allow investors to diversify their portfolios without opening another account.
Currency ETFs attract a diverse group of traders. "You’ve got hedge funds, pensions, endowments and risk advisors, so it really runs the gamut," Carl Resnick, managing director of exchange traded products at Rydex SGI, says. "The difference is how they’re using [currency ETFs], whether that is civic trading strategy, pure speculation, carry trade, hedging or an asset allocation strategy to diversify their portfolio."
Currency ETFs are regulated by the same rules that govern the stock market. Further, the fees for trading currency ETFs would be the same as making a stock trade.
"These are probably more for the medium and long-term investors wanting to play out a view rather than somebody who wants to get in and out of a trade in the span of two or three minutes," Wilkinson says. "The cost associated with the fund manager may make these profits more meaningful for the medium-term investor."
The price of ETFs that follow only a single currency, such as the CurrencyShares Euro Trust (FXE), is easy to calculate as it is usually 100 times the exchange rate. So, one share of FXE is $130 if the EUR/USD is trading at $1.3000.
There are ETFs that track baskets of currencies, are leveraged or represent a short position in a currency.
Look before you leap
Forex is the largest, most liquid market in the world and it is growing every day. While there are plenty of potential rewards, like any market, risks abound.
While retail forex brokers offer zero-fee trading, you are paying through the pip spread and depending on that spread, it can be more expensive than currency futures. Futures also have the benefit of segregation. Your futures account is segregated from your broker’s assets and is safe in case of bankruptcy. On the spot forex side, your funds can be treated as just another liability in case of a bankruptcy.
Spot forex markets tend to be more liquid than futures, especially when trading crosspairs and during overnight hours. They also offer the flexibility to trade any size rather than having a standard contract size.
Options can be used to reduce and define risk, but if used improperly, they can take on more risk or fail to produce the desired results if postions are not calibrated correctly.
ETFs have many benefits but do not always follow the underlying closely.
Currency markets are the most liquid markets in the world and there are more ways to access them than ever before. The challenge is in determining which product matches your needs.