By Carley Garner
The Forex market has quickly become a popular playground for speculative trading; but is it the best arena to be trading currencies? Those looking to profit from fluctuations in currency valuations have two primary trading forums, the spot market often referred to Forex or simply FX, or currency futures which are primarily traded on the Chicago Mercantile Exchange. Each alternative has advantages and disadvantages associated. As a trader, it is imperative that you are aware of these differences and are comfortable with where your trading account is housed.
While there are several articles, blogs, etc. written on the advantages of Forex vs. Currency Futures, albeit most published by FX brokerage firms trying to sell their services, there are few to display the opposite argument; and even fewer that brush upon the topics that we will be discussing. It is our goal to present the information that traders deserve to know from an objective point of view.
We are going to brush upon a few of the primary differences between trading spot market FX and currency futures. While this list is not meant to be exhaustive, we hope that it is helpful.
A futures brokerage house must follow regulations set forth by several governing entities such as the National Futures Associate (NFA), the Commodity Futures Trading Commission (CFTC) and the exchanges themselves.
The CFTC is the primary federal body governing commodity options and futures transactions in the United States, while the NFA assures that market participants and, more specifically, solicitors such as brokerage firms, brokers, and commodity trading advisors are conducting business in an honest and candid manner.
While the two U.S. governmental bodies noted above oversee the entire futures industry, currency futures on the CME are first and foremost regulated by the CME itself. Through divisions such as its Clearing House and Audit Department, the CME strives to ensure the financial integrity of its products and its member firms acting as executors and solicitors of CME products.
Although the NFA is making a valiant effort to regulate the FX industry within the United States, they seem to be facing a challenging task. FX clearing firms located in the U.S. are currently required to register with the NFA, which leaves them subject to regulation. Conversely, those soliciting retail accounts, selling trading software, systems or signals are not required to be registered with the NFA. This provides them with the right to freedom of speech, regardless of the credibility of the claims.
Because the FX market is global in nature, and doesn’t have a physical location, creating and enforcing rules for market participants has yet to be accomplished. Many have compared the industry to the “Wild West” in reference to the lawlessness experienced in North America in its early years. Of course, not all Forex firms are in the business of misleading the public; but the opportunity is there. This is something that you must be aware of and be willing to accept before trading spot currencies.
Forex Dealing Desks
There are primarily two types of FX brokers; market makers, or those that operate with a dealing desk, and those who offer Electronic Communications Network, or ECN trading.
Most retail firms are market makers. Market makers generate revenue by charging traders a fixed pip spread that is intentionally beyond that of what those directly trading through the inter-bank are paying.
The term “dealing desk” is often thrown around, but few realize that a dealing desk is simply a trading desk. If a Forex broker has a dealing desk, they are taking the other side of your bets. Clearly put, you are trading against the house. When you place a trade, your brokerage firm is taking the opposite side. This poses an incredible conflict of interest. After all, they can see your stop and limit orders. It can be compared to playing poker and letting the competition see your hand…but you can’t see theirs.
An ECN broker is providing you access to the actual inter-bank market. An ECN will not have a predetermined bid/ask spread. The spread is determined by market liquidity. There are certain times of the day in which the spread may be as low as 1, or even 0. To compensate the brokerage firm for their services, an ECN charges an execution commission.
If your brokerage firm uses a dealing desk, your buy and sell orders never actually reach the true Forex market. In other words, you do not have access to the inter-bank market. Instead you are buying and selling at prices set, and potentially manipulated by the dealing desk.
It is in this so called synthetic market that the trader is seeing. The bid and ask displayed on the trading platform are based on a predetermined pip spread and is a function of the actual inter-bank rates. A Forex trader subject to a dealing desk can be compared to a traveler exchanging U.S. Dollars for Euros at the airport.
As you can imagine; the freedom that a dealing desk has results in several temptations. There are rumors circulating about price “spiking” or “stop loss fishing”. Spiking is the act of temporarily skewing the prices in the advantage of the brokerage firm. For example, a stop loss placed and filled at price X with one dealing desk, may not necessarily mean that that price occurred for clients trading through another dealing desk.
Price manipulation such as this 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
The NFA requires that all futures brokerage firms hold customer funds in segregated accounts. What this means to you is this; the money that you deposit into your futures trading account will be housed in a customer segregated bank account. In other words, the brokerage firm has two bank accounts; one account for their money and one for their clients’ money.
This is very important in that it provides traders with piece of mind regarding the “safeness” of their account funding. In the wake of the Refco debacle, it is comforting to know that even if your brokerage firm becomes insolvent, your money will still be safely in the bank and accessible to you. Keep in mind, that there is a small 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. However, this is not a likely occurrence.
When you write a check to your FX firm to be deposited into your trading account, the money isn’t necessarily earmarked for your use only. Your check is deposited directly into the bank account of the Forex broker. This money may or may not be used to finance company operations, but it is certainly not in a segregated account safely hidden from the burden of the bankruptcy of your FX broker.
It is well known that most traders lose. In fact, the overall probability of loss has been said to be 80%. The success rate is even bleaker among FX traders. Forex Brokerage firms know this, and capitalize on that fact by accepting money for your trading account with the hope that they never have to give it back to you. For some, the temptation to spend the money to aid their own growth becomes too great.
The Chicago Mercantile Exchange guarantees each transaction. This means that if you go long a currency futures contract and your speculation was correct, you will walk away from the trade with your profit even if the person that took the other side of the trade fails to pay. This is extremely important. After all, it is hard enough to make money as a speculator; the last thing that a trader needs to worry about is whether or not they will actually see the monetary reward from a winning trade.
Unlike futures currency traders, Forex traders are exposed to counterparty risk. The person on the other end of your trade may be the dealing desk of your brokerage firm or it may be an actual inter-bank market participant, nonetheless, your profitable trades are dependent on their ability to “pay up”.
There are FX traders that 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.
One of the primary draws of retail accounts to Forex is the idea of commission free trading. FX brokerage firms working with a dealing desk make money on the fixed pip spread offered to clients, but don’t charge a commission. On the surface, this seems to offer discounted transaction costs relative to the futures market. However, it is important to note that the typical FX pip spread of 3-5 pips provides the brokerage firm with a handsome reward.
On the other hand, in the futures market there are a few more transparent costs to executing a trade. For one, the futures brokerage firm charges a commission on each and every transaction. In the case of currency futures, on top of the commission the trader will pay a Globex fee (Globex is the electronic exchange in which CME currency futures are traded), as well as a clearing and NFA fee. Commissions are negotiable based on account size, volume, experience, etc.; but there is no way to get around the associated fees.
Depending on your futures brokerage firm, you may have to pay for an upgraded trading platform in order to get the same real time point and click functionality that FX traders have come to enjoy. To give you an idea, most upgraded platforms run $50-$100 per month. There are a few that offer a per trade rate, which would be preferable for those that don’t execute a large number of trades.
It is important to note that even though transactions costs in the futures market are much more visible, they are likely not more than in Forex. CME currency futures do not involve a fixed bid/ask spread. Instead, the spread adjusts to the market’s liquidity. The front month is typically a 1 point spread. In the case of the Euro currency futures one point is equal to $12.50. Forex firms offering a fixed 3-5 point spread may not be charging traders commission outright, or even in a form that shows up on an account statement, but there are significant costs built into the synthetic market that they provide to you.
To determine whether futures or Forex is the lower cost alternative, each trader must evaluate their individual circumstances. For example, is your FX broker an ECN or do they have a dealing desk. The number of trades per month will also have an effect on this decision.
|Forex||Non-Dealing Desk Forex||Currency Futures|
|Fixed Spread||Yes, higher than the actual inter-bank spread||No, variable based on liquidity||No, variable based on liquidity|
A well publicized advantage of FX over futures is the amount of liquidity. The spot currency market is the world’s largest market. There are over one trillion U.S. dollars traded per day. When it comes to volume, CME currencies pale in comparison. However, in order for FX traders to benefit from the difference in liquidity, they must be trading through an ECN, or non-dealing desk firm. Those trading through a dealing desk are subject to extreme illiquidity.
One of the most publicized differences between currency futures and spot Forex is the margin requirements. FX traders are granted much more liberal margin rates; some brokerage firms offer as much as 100 to 1. This means that an FX trader could control a currency contract with 1% of the contract value in their trading account. This far outweighs that granted by the Chicago Mercantile Exchange. Remember, higher leverage magnifies winning trades, but it also amplifies the losers. Increased leverage can be an advantage, but it is a double edged sword.
Both the futures and the Forex markets offer traders the ability to trade derivative contracts known as options. There are a few primary differences that you should be aware of before delving in.
FX options are considered to be more convenient to trade in some aspects. For one, some Forex brokers provide option quotes, including a bid and ask, at no cost to the trader through electronic front end platforms.
CME options, on the other hand, are traded in an open outcry environment. As a result, bid/ask quotes are only available to those that have direct access to the trading floor. A good futures broker will be able to call the floor to get you an accurate quote. The only way to get around this, is to pay for real time quotes through a quote vendor. This can become very expensive, and real-time bid/ask spreads in an open outcry environment aren’t necessarily practical. Most likely, you would be using your quote service to calculate real-time theoretical values based on the Black and Scholes model. From there, you would have to estimate what the bid/ask spread should be based on your experience with that particular market. As you can see, this isn’t exactly user friendly.
Forex options also provide traders with more “options”. There are two primary types of options available to the retail Forex trader. First, there is the traditional option, which comes in the form of a call or a put; these are also known as Vanilla options. Then there is Singe Payment Option Trading (SPOT). The SPOT is said to give traders more flexibility.
SPOT options are a lot like placing a bet on a specific scenario. You put your money down, if the event that you predicted occurred you are compensated. For example, if you think that the Euro will drop below 12900 within 13 days, you can place your bet. Keep in mind, SPOT options are not tradable…once you are in there is no getting out. SPOT options are not available through the CME.
Additionally, many FX brokers offer both American and European style options. American options can be exercised at any time prior to expiration, European options can only be exercised at the time of expiration. CME options are available in American form only.
Liquidity can be a major disadvantage to trading options in the Forex market as opposed to futures. Depending on the underlying, the bid/ask spreads can become significant. This puts the odds sharply against the trader.
The Forex and futures market are identical in at least one way, software and system vendors are not required to be registered with any regulating body. Thus, they enjoy the same freedom of speech rights that you and I benefit from. In other words, they can make claims that aren’t necessarily true, or cannot be proven. Of course, if enough complaints arise they will eventually draw attention to themselves and attract legal trouble, but they are more likely to get away with it.
Regardless of which market you choose to speculate in, approach it with the attitude that if something sounds too good to be true, then it is. Don’t be fooled by the hype, or as we like to call it the smoke and mirrors.
Currency trading is complex, regardless of the forum that you choose and the amount of money that you spend on trading courses, software, etc.
This article is not intended to dissuade you from participating in Forex or currency futures, instead it is meant to give you a bigger perspective on the issue. Some of the information contained in this writing is not readily disclosed to the novice trader, but should be. You deserve to know the inner workings of the market prior to involving yourself.
Speculation is a zero sum game, however, for every loser there are two winners…the person on the other side of a trade gone wrong and the brokerage firm. In order to be successful in the world of currency trading, it is imperative that you know the fundamental, technical and logistic factors involved. Most importantly, choosing the forum that best fits your needs as a trader, as well as whom your competition is.
Carley Garner is dedicated to trader education through www.CommodityTradingSchool.com and is a broker at Alaron trading and principal to a Commodity Trading Advisory. Carley can be reached at email@example.com