Q&A
Futures For You
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 https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C. Visit Garner at www.DeCarleyTrading.com. Her books, Commodity Options and A Trader’s First Book On Commodities, are available from FT Press.
FOREX ADVANTAGES
Is there a strategic advantage to trading currency options in the futures markets as opposed to foreign exchange?
The options traded in forex are vastly more diverse than the instruments traded in the futures markets or even stocks, for that matter. The primary difference between forex options and options written on currency futures is the fact that forex traders aren’t necessarily trading standardized contracts. Instead, they can negotiate specific terms with their broker such as expiration date and perhaps even the time of day. However, for simplicity’s sake, brokerage trading platforms often provide traders with a default expiration date and time.
Because forex options are not standardized and can be individually negotiated, they are not traded on a formal exchange. Instead, forex option trades are executed on a synthetic market created by the brokerage firm you are trading with. Simply put, the house is taking the other side of client transactions and acting as the market makers. Obviously, this eliminates the benefits of an exchange such as tight regulations, transparency, and exchange guarantees (no counterparty risk).
The lack of transparency in forex options creates a challenge in that it can sometimes be difficult to determine whether traders are being presented with fair market prices. After all, forex option traders are at the mercy of their brokerage firm when it comes to the price at which they can buy or sell (don’t forget, the forex broker is also the market maker).
In addition to the lack of transparency provided to forex option traders, players must rely on their forex brokerage firm to “make good” on their trade. For instance, a trader who buys a euro/US dollar (Eur/Usd) call option and later sells it at a higher price will only reap the benefit of that profit if he or she successfully withdraws the funds from his or her account. Until then, it is entirely possible (yet perhaps not probable) that the brokerage firm could declare insolvency, taking his or her profits down with it. This isn’t a common occurrence, but it can and does happen — remember Refco? A futures trader does not face the same challenges.
If you would like to speculate on currency valuations with options, the best choice is currency futures options traded on the CME.Keeping all of these things in mind, the largest disadvantage I can see to trading forex options, rather than exchange traded options written on currency futures, is the size of the spread between bids and asks. An option written on a futures contract involves freely floating bids and asks that represent the best price a retail trader can buy (ask) or sell (bid). The bids and asks are often provided by market makers (liquidity providers trading their own funds), but they might also be the working limit orders (buy or sell orders) of other retail traders.
Forex option traders, on the other hand, are forced to pay the price their brokerage firm is willing to sell for (ask) or sell at the price they are willing to buy (bid). As you can imagine, because the broker stands to profit from client losses (for every buyer there is a seller, and for every winner there is a loser), they prefer to keep the odds in their favor. Accordingly, the standard spread between the bid and ask of an forex currency option is 10 pips, while futures on option traders typically pay anywhere from one to four ticks, but usually two or three. To put this into perspective, 10 pips on 100,000 units of the Eur/Usd currency pair in forex represents $100! Therefore, a forex trader is immediately losing this amount simply by entering the option market. Options on futures traders face a much more manageable hurdle.
Perhaps one of the advantages of trading forex options over their futures counterpart is the ability to trade exotics. Exotic options are those in which there are unconventional characteristics, or simply any option that is not a vanilla option. For the sake of clarity, a vanilla option is the standard call and put that all of us are familiar with. A popular exotic option is the barrier. A barrier option is one in which a specific price is set and if reached will either “knock in” (enable) or “knock out” (disable) an option.
If you would like to speculate on currency valuations with options, the best choice is currency futures options traded on the Chicago Mercantile Exchange (Cme). Doing so provides traders the luxury of knowing they are participating on a transparent, regulated, and level playing field as opposed to being at the mercy of their broker, who is also their competition.