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.
Currency futures vs forex
What are the advantages of trading currency futures as opposed to foreign exchange?
If you recall from the April 2010 column, we discussed the implications of government regulation, dealing desks, and counterparty risk when it comes to deciding between currency speculation in the futures or forex markets. However, there are a few other things to keep in mind, such as the true costs, liquidity, margin, and access to options.
Transaction costs: The forex industry has done a great job at marketing commission-free trading. Accordingly, speculators have flocked to forex brokerage firms that are structured as dealing desks. These firms make money on the fixed-pip spread rather than a transparent commission charge. On the surface, this seems to be an advantage over trading futures, which involve commission and exchange fees. Nevertheless, the typical forex pip spread of three to five pips provides the brokerage firm with a handsome reward and although it isn’t obvious, the retail trader is paying sizable transaction costs to participate in such a market.
In the futures market, there are crystal-clear expenses related to trade execution, but that doesn’t mean that it is more costly than forex trading. Futures brokers charge a commission on each transaction and in addition, clients will pay exchange fees to the Chicago Mercantile Exchange (Cme) and a small National Futures Association (Nfa) fee. Futures commissions are negotiable based on the type of service that you seek, account size, and volume, but the associated fees are not.
Although transaction costs in the futures markets are much more visible, they are most likely not as costly as those in commission-free forex. Unlike the forex dealing desk that profits from charging clients an artificial fixed pip spread (strategically wider than market pricing), currency futures brokers provide their clients access to the Cme’s Globex market place in which the bid/ask spread is created by the market, not the brokerage. A typical spread in the futures market is a single tick, or $12.50 in most contracts. On the contrary, a commission-free forex firm might be charging a spread of three to five pips. This expense might not hit your statement, but it can have a substantial impact on your bottom line.
Liquidity: Another selling point used by forex marketers is the massive amount of market liquidity that forex provides. The actual spot currency market is the world’s largest with more than US$1 trillion traded per day, but what most don’t realize is that for those trading against a dealing desk, rather than the true interbank market, they might be subject to extreme illiquidity.
Margin: In general, forex traders are granted much more liberal margin rates relative to futures traders. Some forex brokerage firms go as far as to offer as much as 100 to 1 in leverage (although there are rule proposals that could change this), but I argue that this is probably too much of a good thing. This means that a forex trader could control a currency contract with 1% of the contract value in their trading account, and that exceeds the leverage granted by the Cme. Remember, higher leverage magnifies winning trades, but it also amplifies the losers, so this should not be valid reasoning to opt for forex.
Options: If you have followed this column for a while, you may have noticed my bias toward option trading. Both futures and forex traders have access to options written against the underlying currency (or currency pair) via an electronic platform in which live bids and asks are provided. However, options on futures trade in an open outcry pit side by side to the electronic options, and this enables traders to execute multiple-leg spread orders that are not possible in the spot forex options.
There are a few benefits of trading forex options such as the ability to trade both US and European-style options and other various exotic derivatives. Nonetheless, liquidity could be a significant burden for forex option traders as bid/ask spreads can be a large disadvantage and this shifts the odds against the trader.
Micros: Another attractive aspect of forex is the ability to trade micro lots with mitigated risk and reward prospects. However, in the spring of 2009, the Cme group introduced e-micro currency futures to compete with the micro forex products that attracted small speculators to the world of forex. The micro futures are a tenth the size of the original contracts, meaning that the contract value varies between $10,000 and $12,500 for most. In the case of the e-micro euro, each tick is worth $1.25 per tick — which might be more manageable than the $12.50 per tick in the original version.
Another benefit of trading the micro contracts over the full-sized futures contracts is that they are cash settled. This means that if you hold the position into expiration, you won’t take delivery of the underlying currency, but your account will simply be adjusted in value instead. That said, you want to avoid this method of account adjustment if at all possible, as the settlement often isn’t favorable.
Rebates: Some forex brokers offer rebates to clients for each transaction executed. In essence, they are returning a part of the pip spread back to the trader in return for choosing them as their brokerage firm. While this is certainly an attractive feature, it is also important that you do your homework. After all, if the brokerage can afford to give you a piece of the profit margin, the service is likely overpriced in the first place. It can be looked at similarly to a car dealership that marks up auto pricing just before hiking a zero percent financing campaign.
In conclusion, only you can decide which trading arena is best for you, but it is important that you do your homework. Knowing when to buy and sell is only half of the challenge; creating a favorable environment for your risk and reward parameters along with being properly aware of the true costs involved will have a large impact on your bottom line.