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.