Inside The Futures World
Want to find out how the futures markets really work? DeCarley Trading senior analyst and broker Carley Garner responds to your questions about today’s futures markets. To submit a question, post your question at http://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.
FUTURES VS. FOREX
What are the advantages of trading currency futures as opposed to forex?
The popularity of foreign exchange (spot currency) trading has exploded, thanks to low margins, seemingly low transaction costs, and flashy trading platforms. However, there are a few things that you should consider before choosing forex over currency futures like those traded on the Chicago Mercantile Exchange (Cme):
Government regulation: The National Futures Association (Nfa), the Commodity Futures Trading Commission (Cftc), and the futures exchanges themselves all work together to create and enforce rules and regulations over industry participants. More specifically, each of these entities attempt to produce an environment in which solicitors such as brokerage firms, brokers, and commodity trading advisors are conducting business in an honest and candid manner.
The forex market, on the other hand, is global in nature and due to the lack of a physical trading floor or headquarters, regulation of operations doesn’t fall within any single jurisdiction. Although the Nfa and the Cftc have made strides in the right direction when it comes to enforcing compliance rules for those soliciting forex in the US, there are still operations abroad (and in some cases domestic) doing business without the necessary restrictions.
As a retail trader, I find it important to realize that forex clearing firms located in the US are currently required to register with the Nfa, leaving them subject to government regulation. However, Nfa registration, and thus regulation, is not necessarily required of those soliciting trading accounts, trading systems or signals, and software. Further, many forex salespeople are comfortable in exercising what they consider to be their right to freedom of speech, regardless of the credibility of the claims that they make. Of course, not all forex affiliates are in the business of misleading the public and not all futures industry participants are noble, but there is relatively more opportunity for wrongdoing in the world of forex than in others.
Forex dealing desk: There are primarily two types of forex brokers: market makers (dealing desks) and those that offer electronic communications network (Ecn) trading.
In the US, the practice of dealing desks is diminishing, but some popular forex brokerage firms are essentially making markets for their clients. In a nutshell, they are taking the opposite side of their clients’ trades. Their intention is to generate revenue by charging traders a fixed pip spread beyond what those directly trading through the interbank are paying. This is often referred to as a markup.
Those trading with a dealing desk are trading against the house. As you can imagine, this poses a conflict of interest in that they can see your stop and limit orders and possibly make money even as you lose it.
Those trading with an Ecn broker are provided access to the actual interbank market as opposed to a brokerage-created synthetic market. Ecns do not have fixed pip spreads; instead, it is determined by market liquidity.
Currency futures traders don’t have to worry about Ecns vs. dealing desks. They are all granted access to a centralized and regulated marketplace. Futures brokerage firms are forbidden from taking the other side of a customer’s trade.
Synthetic market: Unlike futures contracts that are traded in what are believed to be efficient and open markets, those trading forex through a brokerage firm with a dealing desk are trading a brokerage firm–created market. Buy and sell orders never actually reach the true forex market; instead, they are buying and selling at prices set and possibly manipulated by the dealing desk.
As far as I am aware, price manipulation such as stop-loss fishing has yet to be proven by a regulating body, but you must be conscious of the fact that the potential exists. Brokerage-driven price skews are not a risk while trading Cme currency futures.
Customer-segregated funds: Money on deposit with a futures brokerage firm is required by the Nfa to be held in what are known as customer funds in segregated accounts. This means that your funds are not comingled with the firm’s assets.
This is critical because assuming that the brokerage firm is in fact following the rules, if the firm becomes insolvent, then your money will still be safely in the bank. There is a minuscule chance that your brokerage firm is not upholding the regulations set forth regarding segregated accounts. In this case, your money would be at risk in the case of a brokerage firm bankruptcy. This is not a likely occurrence for a futures trader, but it is a constant worry to a forex trader.
Counterparty risk: For those trading currency futures, the Chicago Mercantile Exchange guarantees each transaction. This means that if your speculation was correct, you will walk away from the trade with your profit even if the person who took the other side of the trade fails to pay (they might have lost more money than they had on deposit).
Forex traders, on the other hand, are exposed to counterparty risk. As a forex trader, you might be trading against the dealing desk or it might be another participant in the actual interbank market, but either way, your profitable trades are dependent on their ability to pay up.
There are forex traders who have been extremely active for years and have yet to be affected by counterparty risk. Yet the risk exists and you should know about it. As always, there is substantial risk in trading options and futures, and it is not suitable for everyone.
As I delved into this question, I realized I could not do the topic justice within a single column. I will continue this discussion in the next issue; we will focus on the comparison of transaction costs, both hidden and obvious, market liquidity, margins, options, and others. Stay tuned!