The foreign exchange market owes its existence to the 1971 abandonment of the Bretton Woods accord and the subsequent unwinding of the regime of universal fixed exchange rates.

According to the 2001 triennial survey by the Bank of International Settlements (BIS), global foreign exchange turnover amounts to more than $1,200bn per day, over 50% of which is transacted on the London market alone. Global turnover, however, is markedly down on the 1978 BIS survey figure of $1,490bn. The BIS attributes this to the launch of the euro, banking mergers, the growth of electronic broking at the expense of voice and telephone dealing (leading to fewer transactions) and non-banking consolidations that have reduced the need for foreign exchange.

1. The players

Although currency trading is inherently governmental (central banks) and institutional (commercial and investment banks), the foreign exchange market is also the province of non-banking international corporations, hedge funds and individual private investors and speculators. However, technological innovations like the internet have made it feasible for private investors to monitor currency markets and to trade via intermediaries.

2. The attraction for private investors

The main attractions of currency dealing to private investors are:-

• 24-hour trading, 5 days a week with continuous access to global dealers
• An enormous liquid market making it easy to exchange most currencies
• Volatile markets offering profit opportunities
• Recognised instruments for controlling risk exposure
• The ability to profit in rising or falling markets
• Leveraged trading with low margin requirements
• Zero dealing commission

3. Five ways to trade forex

Private investors can trade directly or indirectly in foreign exchange through:

• the spot market
• forwards and futures
• options
• contracts for difference
• spread betting

We shall examine each of these instruments in turn, but first a risk warning.

4 Margin trading: risk and reward

All the aforementioned forex instruments are margin products, which means that your investment exposure can be a multiple of the cash that you lay down (i.e. the margin).

The main advantages of margin are that:-

• Margin enables private investors to trade in markets with high minimum units of trading (e.g. the spot market where the minimum size trade is 100,000 units of the base currency).
• Margin trading enhances the rate of profit.

The principal disadvantage of margin trading is that it has the habit of inflating rates of loss, on top of systemic risk. For example, currency options are inherently riskier than spot market trades, because a small change in the underlying spot rate can generate a disproportionately large change in options prices. Sell naked call options and there is no limit to potential losses. Add leverage to the cocktail and you have the potential for large profits and large losses.

5 Learning to trade forex

Forex is still relatively fresh territory for private investors, having really only been rendered feasible by the advent of the internet. Like any financial discipline, the best investment is a sound and practical education.

The spot market accounts for nearly a third of global foreign exchange turnover. It can be broadly divided into two tiers:

• The interbank market where currency is bought and sold for delivery and settlement within two days, with the banks acting as “wholesalers” or “market makers”.
• The retail market made up of private traders, who deal over the telephone or the internet through intermediaries (brokers).

The forex market has no centralised exchanges. All trades are over-the-counter deals, agreed and settled by individual counterparties known to one another. The forex market is truly global and operates 24 hours a day, Monday to Friday. Daily trading commences in Wellington, New Zealand and follows the sun to (inter alia) Sydney, Tokyo, Hong Kong, Singapore, Bahrain, Frankfurt, Geneva, Zurich, Paris, London, New York, Chicago and Los Angeles before starting again.

1. Currency pairs and the rate of exchange

Every foreign exchange transaction is an exchange between a pair of currencies. Each currency is denoted by a unique three-character International Standardisation Organisation (ISO) code (e.g. GBP represents sterling and USD the US dollar). Currency pairings are expressed as two ISO codes separated by a division symbol (e.g. GBP/USD), the first representing the “base currency” and the other the “secondary currency”.

The rate of exchange is simply the price of one currency in terms of another. For example GBP/USD = 1.5545 denotes that one unit of sterling (the base currency) can be exchanged for 1.5545 US dollars (the secondary currency). The base currency is the one that you are buying or selling. This elementary point is often lost on beginners.

Exchange rates are usually written to four decimal places, with the exception of Japanese yen which is written to two decimal places. The rate to two (out of four) decimal places is known as the “big figure” while the third and fourth decimal places together measure the “points” or “pips”. For instance, in GBP/USD = 1.5545 the “big figure” is 1.55 while the 45 (i.e. the third and fourth decimal places) represents the points.

1.1 Bid offer spread

As with other financial commodities, there is a buying price (“offer” or “ask” price) and a selling price (“bid” price). The difference is known as the “bid-offer spread” or “the spread”.

The spread is written in a particular format, best demonstrated by way of an example. GBP/USD = 1.5545/50 means that the bid price of GBP is 1.5545 USD and the offer price is 1.5550 USD. The spread in this case is 5 points.

1.2 The major pairings

All pairings with the US dollar are known as the “majors”. The “big four” majors are: 

EUR/USD denoting Euro/US Dollar
GBP/USD denoting Sterling/US Dollar (known as “cable”)
USD/JPY denoting US dollar /Japanese Yen
USD/CHF denoting US dollar/Swiss Franc

1.3 Cross rates

Pairings of non-US dollar currencies are known as “crosses”. We can derive cross exchange rates for GPB, EUR, JPY and CHF from the aforementioned major pairs. Exchange rates must be consistent across all currencies, or else it will be possible to “round trip” and make riskless profits.

The following “major” exchange rates (red) imply the “cross rates” (blue). An illustration of how cross rates are computed is given in Appendix A.

Table A

		Secondary
		USD	EUR	GBP	JPY	CHF
Base	USD		0.9935/40	0.6308/10	120.25/30	1.4554/59
	EUR	1.0060/65		0.6347/48	120.97/121.08	1.4642/54
	GBP	1.5847/52	1.5753/55		190.56/70	2.3063/79
	JPY	0.008310/316	0.008250/259	0.00524/525		0.01209/211
	CHF	0.6869/71	0.6824/30	0.4333/36	82.62/63

2. Buying equals selling

Every purchase of the base currency implies a reciprocal sale of the secondary currency. Likewise, sale of the base currency implies the simultaneous purchase of the secondary currency.

For example, when I sell 1 GBP, I am simultaneously buying 1.5545 USD. Likewise, when I buy 1 GBP, I am simultaneously selling 1.5550 USD.

We can express this equivalence by inverting the GBP/USD exchange rate and rotating the bid and offer reciprocals, to derive the USD/GBP rate i.e.

USD/GBP = (1/1.5550) bid; (1/1.5545) offer = 0.6431/33

This means that the bid price of one USD is 0.6431 GBP (or 64.31p) and the offer price of one USD is 0.6433 GBP (or 64.33p). Note that USD has now become the base currency and that the spread is 2 points.

3. Practical spot trading

3.1 Units of trading – lots

As we have already seen, every forex transaction is an exchange of one currency for another. The basic unit of trading for private investors is known as a “lot” which consists of 100,000 units of the base currency (although some brokers may arrange trading in mini-lots).

• Using the data in Table A, the purchase of a single lot of GBP/USD will involve the purchase of 100,000 GBP at a price of 1.5852 USD = 158,520 USD.
• Similarly, the sale of a single lot of GBP/USD entails the sale of 100,000 GBP at 1.5847 USD = 158,470 USD.

3.2 Margin

A private investor who purchases a GBP/USD lot does not have to put down the full value of the trade (158,520 USD). Instead, the buyer is required to put down a deposit known as “margin” which enables the investor to gear up the trade size to institutional level.

Since the sale of one currency involves the simultaneous purchase of another, the seller of a GBP/USD lot will have bought a volume of USD, and will also have to put down margin for the value of the deal (158,470 USD).

The normal margin requirement is between 1% and 5% of the underlying value of the trade. The currency denomination depends on the brokerage through which you execute your trade. If you are dealing through an American broker (say online), then it is likely that you will have to deposit margin in USD even if you are resident in the UK.

With 5,000 USD in your margin account and with margin requirement of 2.5%, you can open positions worth 200,000 USD. Your positions will be valued continuously. If the funds in your margin account drop below the minimum required to support your open positions, then you may be asked to provide additional funds. This is known as a “margin call”.

If your trade is denominated in a currency other than that accepted by the broker, you will have to convert your gains and losses back into an acceptable currency. For example, if you trade a USD/JPY pair, then your gains and losses will be denominated in JPY. If your broker’s home currency is USD, then your profits and losses will be converted back to USD at the relevant USD/JPY offer rate.

3.3 Going short – going long

When you buy a currency, you are said to be “long” in that currency. Long positions are entered into at the offer price. Thus if you are buying one GBP/USD lot quoted at 1.5847/52, then you will buy 100,000 GBP at 1.5852 USD.

When you sell a currency, you are said to be “short” in that currency. Short positions are entered into at the bid price, which is 1.5847 USD in our example.

Because of the symmetry of currency transactions, you are always simultaneously long in one currency and short in another. For example if you exchange 100,000 GBP for USD you are short in sterling and long in US dollars.

3.4 Closing out

An open position is one that is live and ongoing. As long as the position is open, its value will fluctuate in accordance with the exchange rate in the market. Any profits and losses will exist on paper only and will be reflected in your margin account.

To close out your position, you conduct an equal and opposite trade in the same currency pair. For example, if you have gone long in one lot of GBP/USD (at the prevailing offer price) you can close out that position by subsequently going short in one GBP/USD lot (at the prevailing bid price).

Your opening and closing trades must the conducted through the same intermediary. You cannot open a GBP/USD position with Broker A and close it out through Broker B.

4. Worked examples

4.1 Betting on a rise

Assume that you start with a clean slate and that the current GPB/USD rate is 1.5847/52.

• You expect the pound to appreciate against the US dollar, so you buy a single lot of 100,000 GBP at the offer price of 1.5852 USD.
• The value of the contract is 100,000 X $1.5852 = $158, 520. The broker wants margin of 2.5% in USD, so you must ensure that you deposit at least 2.5% of 158,520 USD = 3,963 USD in your margin account
• GBP/USD duly appreciates to 1.6000/05 and you decide to close out your position by selling your sterling for US dollars at the bid rate. Your gain is: -
  100,000 X (1.6000 – 1.5852) USD = 1,480 USD, the equivalent of 10 USD per point
• Your rate of return is 1,480/3,963 = 37.35%, on an exchange rate movement of less than 1%. This illustrates the positive effect of buying on margin.
• Had GBP/USD fallen to 1.5700/75, your loss would have been:-
  100,000 X (1.5852 – 1.5700) USD = 1,520 USD, a return of –38.35%

The lesson is that margin trading magnifies your rate of profit or loss.

4.2 Betting on a fall

You expect sterling to fall from GBP/USD = 1.5847/52 so you decide to sell 1 lot of GBP/USD.

• The value of the contract is 100,000 X 1.5847 USD = 158,470 USD. You have effectively sold 100,000 GBP and bought 158,470 USD.
• Your broker requires 2.5% of 158,470 USD as margin in US dollars, namely 3,961.75 USD in cash• GBP/USD falls to 1.5555/60 and you are sitting on a paper gain of: - 100,000 X (1.5847 – 1.5560 USD) = 2,870 USD
• Your 2,870 USD paper gain is credited to your margin account where you now have 6,831.75 USD. This enables you to maintain open positions worth 273,270 USD• However, GBP/USD starts to rise. When it reaches 1.6000/05, you are sitting on a paper loss of: -
  100,000 X (1.6005 – 1.5847) USD = 1,580 USD.
• Your margin account is debited by 1,580 USD, taking it down to 2,381.75 USD which is sufficient to support 2.381.75 USD/0.025 = 95,270 USD worth of open positions. Your current exposure, however, is:- 100,000 X 1.6005 USD = 160,050 USD

Your “shortage in equity” is therefore 160,050 USD - 95,270 USD= 64,780. USD

The broker makes a margin call for 2.5% of 64,780 USD = 1,619.50 USD. If you do not
come up with the money tout de suite, the broker will liquidate your position.

• You eventually close out your position at GBP/USD = 1.5720/25. Your gain is:- 100,000 X (1.5847 – 1.5725) USD = 1,220 USD.

Now that you have no more open positions, you can withdraw the full 5,181.75 USD from your trading account in cash. Alternatively you have enough margin to support 207,270 USD worth of positions.

5. Controlling risk

Trading currencies entails risk and, as we have seen, margin trading can greatly magnify both positive and negative returns. Forex trading demands constant vigilance and does not fit in easily with the human condition that requires time out for food, rest, “comfort breaks” and leisure.

Orders that are executed immediately at current rates are known as Market Orders. However, there are a number of automated orders that can be triggered at pre-set price levels and that can be deployed to control the downside and consolidate the upside: -

• Stop loss: An order to close out a position automatically when the bid or offer price touches a given level.

If you have a long position, you may issue a stop loss order below the current exchange rate. If the market price falls through the stop loss trigger price, then the order will be activated and your long position will be closed out automatically.

If you have a short position, then you would set your stop loss above the current price to be activated when the offer price touches the trigger level.

A “trailing stop loss” is one that is adjusted behind a position as it moves into profit. This is a good strategy for locking in gains. By raising the stop loss trigger price as the position becomes increasingly profitable, the trader can ensure that most of the paper gain is realised if the market turns downwards.

The problem with stop orders is that exchange rates may move through the stop loss trigger prices in volatile markets, making stops impossible to execute at the precise limits.

• Take profits order (TPO): The opposite of a stop loss (i.e. a stop gain). The TPO order specifies that a position should be closed out when the current exchange rate crosses a given threshold.

For a short position, the TPO order will be set below the current exchange rate, and vice versa for a long position.

• Limit order: A buy or sell order that is activated when the current exchange rate passes beyond some pre-set threshold price.

A trader may set a “buy” limit order when the exchange rate falls below a pre-set threshold. Alternatively, a “sell” limit order may be given for an exchange rate above a given threshold

Limit orders can be good for a specified period (e.g. a day, a month) or “good till cancelled” (GTC). A good-for-the-day limit order is held open for the balance of the trading day unless it is filled before then. A GTC limit order is held open indefinitely (unless filled) and is only terminated on instructions by the account holder.

• One cancels the other (OCO): A combination of a stop loss and a limit order (or two limit orders) at opposite ends of the spread. When one is triggered, the other is terminated.

For a long position, the stop loss will be set below the market spread and the limit sell order above the market spread. If the base currency rate breaches the limit order threshold then the position will automatically be sold and there is no longer the need for the stop loss which will be cancelled. Alternatively, if the rate falls to the stop loss trigger price, then the position will be closed out and there will be no need for the limit order.

For a short position, the stop loss is set above the market spread and the limit order below. If the exchange rate rises to the stop loss trigger price then the position will be closed out and the limit order will be cancelled. If the exchange rate falls to the limit order trigger price, then the limit order will be activated, the position will be bought back and the stop loss will be cancelled.

6. Screen-based spot trading

The technology for trading forex has evolved from the telephone and telex (not forgetting voice dealing) through to the modern Electronic Broking System (EBS) that enables “straight through processing” (STP) with integrated quotation, transactional and administrative functionality.

EBS-type technology is now available to individual, private investors who can receive live, streaming data from and transact directly through their chosen brokers. The private dealer, however, does not deal on the highly competitive inter-bank market with its tight spreads. In practice, brokers add points to the price spread in lieu of dealing commission.

A private trader requires: -

• A margin account broker with internet access and a fast connection
• A computer terminal capable of running several programmes simultaneously
• Proprietary software to open and manage positions and to display technical analysis tools.
• Sufficient monitors to handle market data, submit dealing instructions, display technical analysis; and for keeping tabs on open positions, managing orders (e.g. stop loss, TPO, limit etc.) and viewing the state of the margin account. For demonstrations of the kind of proprietary software available, visit Pronet Analytics (www.pronetanalytics.com) and Nostradamus (www.nostradamus.co.uk)

Pronet Analytics provides the only chart-based software package approved by Association of Cambistes Internationale, the governing body of professional forex trading. 

6.1 The screens

The trading screen is where you monitor bid and offer prices in multiple currency pairs. A typical EBS-style screen format will highlight the “pips” (i.e. the second and third decimal places) where most of the movement takes place. All you have to do is pick your moment and click on the buy and sell key.

Forex traders rely heavily on technical analysis, which uses historical activity and price data to forecast future prices and trends. The serious trader needs a separate monitor (and possibly more than one) to display a range of analytical tools simultaneously.

We will return to the tools of technical analysis in the next section.
.
Appendix A

Computing cross rates – an example

Assume that the following major exchange rates are known: -

EUR/USD = 1.0060/65
GBP/USD = 1.5847/52
USD/JPY = 120.25/30
USD/CHF = 1.4554/59

To calculate GPB/CHF

GBP/USD: Bid: 1.5847 Offer: 1.5852
USD/CHF: 1.4554 1.4559

GBP/USD X USD/CHF = 1.5847 X1.4554 1.5852 X 1.4559

GBP/CHF = 2.3063 2.3079

We now look beyond the spot market and examine how private investors can deal in foreign exchange in the futures and options markets and through Contracts for Difference (CFDs).

Derivatives are financial instruments that “derive” their value from underlying assets like shares, market indices, bonds, interest rates and, of course, currencies. They are important instruments for speculation and hedging of risk, and enable investors to dabble in financial commodities without necessarily having to own them.

FORWARDS AND FUTURES

1. Forward v futures

Forwards and futures contracts are both agreements to buy or sell a quantity of a financial or physical commodity (known as the underlying asset) at given price, on a specific future date.

• A forward contract is a private over-the-counter transaction between counterparties known to each other, on terms agreed between themselves.
• A futures contract is a forward contract that is traded on a public exchange like the International Money Market (IMM) division of the Chicago Mercantile Exchange (CME), the New York Board of Trade (NYBOT) and Finex, its Dublin-based division. Private investors transact through brokers who are members of the exchange, but the counterparties will not be known to one another

A futures contract will have standardised features (e.g. units of trading, delivery and settlement dates, minimum price increments etc.). The futures exchange itself acts as a counterparty through the provision of clearance and settlement facilities to safeguard the interests of the parties.

Futures and forward contracts are binding on both parties at expiry, where one party receives and the other delivers. However, investors can buy or sell back their contracts before expiry at the prevailing offer and bid prices respectively.

1.1 Advantages

Forwards and futures have a vital role in the mitigation of currency risk. The main beneficiaries are international corporations who use them to hedge against adverse changes in exchange rates that affect the profitability of projects.

For example, a European manufacturer importing raw materials priced in US dollars would suffer a financial loss if the euro fell against the US dollar. Likewise, a conspicuously-consuming British importer of a luxury European car would be severely out of pocket if sterling were to fall against the euro before payment. Both would benefit from buying their respective US dollars and euros in advance at guaranteed exchange rates.

Private investors might also take a purely speculative interest in currency forwards and futures. Investors would be attracted by the ability to profit in both rising and falling market, by the opportunity to leverage profits through margin trading and the ability to close out contracts before delivery.

1.2 Pricing forwards and futures

Because a forward or futures contract involves the delivery and the settlement of a currency trade in the future, the forward/futures and spot exchange rates will be numerically different, albeit related to one another.

The relationship between the spot and the forward/futures rate is determined by the difference in the rates of interest earned on the respective currencies in the pair (the net “cost of carry”). The “fair” price is the rate that prevents an investor from making a riskless profit by “round tripping” and exploiting the interest rate differential.

Assume that a private investor has 100,000 USD. He has a choice of (a) putting it on deposit at 1.25% p.a. for 3 months or (b) converting it into GBP, investing it at 4% p.a. for 3 months and simultaneously entering into a forward or futures contract for delivery and settlement in 3 months.

If the spot and the forward/futures rates are the same, then our investor could: -

• Borrow USD at 1.5% for 3 months
• Sell USD for GBP at the spot rate
• Enter into a forward/futures contract to buy back USD for GBP at the same rate
• Invest the GBP at 4% p.a. for 3 months
• Buy back the USD with sterling after 3 months and repay the USD loan
• Pocket a riskless profit roughly equal to the interest differential over 3 months.

Generally speaking, the forward and futures exchange rate should trade at a discount to the spot rate for the currency with a positive interest rate differential For example, GBP/USD futures should trade at a discount to GBP/USD spot where sterling base rate is, say, 4% vis-a-vis USD base at 1.25%. Conversely, USD/GBP futures should trade at a premium to USD/GBP spot.

1.3 Risk

Since the currency futures rates are related to spot rates by the cost of carriage, it follows that the risks are comparable.

The same range of stop loss, limit and OCO orders are available for the control of risk in the futures market as in the spot market (Refer to the relevant section of The Spot Market in Part I.)

2. Practical futures trading

We can now look at some examples of forwards/ futures trading. The basic principles are the same for forwards and futures.

With a futures or forward contract, the rate you pay is related to the spot rate by the net interest differential on the currency pair. For a forward contract, that is the end of the matter, save only for receipt and delivery at the future date. With futures contracts, the exchange will declare an exchange delivery settlement price at expiry.

The future and forward rate will converge towards the spot rate as the contract approaches expiry, as the net cost of carry decreases towards zero over time. If investors want to close out before expiry, they can do so at the prevailing bid or offer price.

2.1 Speculating on a rise

Assume that GBP/USD = 1.5847/52 (spot). If the US base rate is 1.25% p.a. and UK base is 4% p.a.

• You think that the GBP/USD rate will rise over the next 3 months, so you buy 2 futures contracts on the CME International Money Market (IMM) through your UK margin broker. The standard unit of trading for sterling is 62,500 GBP.
• The GBP/USD futures rate with 90 days to delivery should be about 1.5741/46
• The value of your purchase is:

  2 X 62,500 X 1.5746 = 196,825 USD

• You don’t have to pay all of this up front. Your margin will be determined by the IMM minimum plus any supplement charged by your broker.

• As expiry approaches, the spot and futures prices converge. Let us say that the settlement price turns out to be 1.6100. Your gain will be:-

  (1.6100 – 1.5746) X 62,500 X 2 = 4,425 USD

• Had the settlement price been 1.5650, your loss would have been:-

  (1.5746 – 1.5650) X 62,500 X 2 = 1,200 USD

2.2 Insuring against a fall (hedging)

You are the finance director of a British manufacturer that has just negotiated a purchase of raw materials to be delivered and paid for in US dollars 90 days hence. At the time of closing the deal, the GBP/USD spot rate is 1.5847/52. The contract is worth 500,000 USD or 315,517 BP at the bid spot rate.

• You fear that the deal could be unprofitable if sterling falls, so you decide to enter into a forward contract to sell GSB/USD for receipt and delivery 90 days hence.

• The 90-day forward rate for GBP/USD is, say, 1.5741/46. You buy sell 317,642 GBP at the bid rate, i.e.

  317,642 GBP X 1.5741 = 500,000 USD

  This represents an “insurance premium” of (317,642 – 315,517) = 2,125 GBP

• Your fears turn out to well founded. Spot GBP/USD falls to 1.5219/24 thirty days later and the forward GBP/USD rate falls to, say, 1.5151/56 at the end of 90 days. Had you not hedged, the consignment of raw materials would have cost the company £328,537 (13,020 GBP more).

• You have saved the company 13,020 – 2,125 = 10,895 GBP. You are tipped for higher things.

• Had GBP/USD spot risen to say 1.6100/06 after 30 days, the cost of the raw materials would have fallen to 310,559 GBP. Had you done nothing, the company would have saved 4,958. Instead, the company has paid 317,642 GBP, a difference of 7,083 GBP.

• You are demoted to internal auditor. That’s insurance, kid.

2.3 Closing out before delivery

GBP/USD spot is trading at 1.5847/52. You feel that the rate will rise over the next 90 days and buy a futures contract for 1.5746 valued at: -

62,500 X 1.5746 = 98,412

After 30 days, spot has risen to 1.6100/06 and the futures rate has risen to 1.6028/34. If I were to close out now I would earn: -

62,500 X 1.6028 = 100,175 USD, a profit of 1,763 USD or 1,095 GBP when converted back at the spot offer rate.

Had GBP/USD spot fallen to 1.5219/24 after 30 days, the futures rate would have been, say 1.5156/62. Had you closed out, you would have lost: -

62,500 X 1.5156 = 94,725 USD, a loss of 3,687 USD or 2,432 GBP when converted back.

OPTIONS

1. Introduction

An option represents the right but not the obligation to buy or sell an underlying asset at a given price (the “strike” or “exercise” price), on or before a future date (i.e. “expiry”). Currency options are traded on the New York Board of Trade and its Dublin-based FINEX division. Investors can also trade options in currency futures on the International Money Market (IMM), a division of the Chicago Mercantile Exchange (CME). The private investor can access all these markets through margin brokers.

Options are the most fascinating and intellectually challenging of the derivatives and deserve a much more detailed treatment than can be presented here.
One warning; the theory of options is underpinned by some Nobel Prize-winning financial mathematics devised by Fischer Black, Myron Scholes and Robert Merton in the 1970’s. Scholes went on to found the Long Term Capital Management (LTCM) hedge fund, which nearly brought down the world financial system in 1998. Engrave that on your mind.

2. Option styles

There are two styles of options: -

• American-style which can be exercised at any time up to expiry
• European-style which can only be exercised at the formal expiry date.

3. Exchange-traded and over-the-counter currency options

Exchange-traded currency options are standardised American-style contracts that are bought and sold anonymously on recognised exchanges like NYBOT and FINEX, with quarterly expiry dates in March, June, September and December. The underlying currency pair is usually a “major” (i.e. a pairing with USD) although some crosses are available.

Exchange traded options are cleared and settled through official clearing houses (e.g. the New York Clearing House), which guarantees that contracts are honoured.

Over the counter (OTC) options are flexible arrangements negotiated between parties known to one another and conducted and settled outside the exchanges without the safeguards of the official clearing houses. OTC options can be American or European-style.

4. Puts and calls

There are two kinds of currency options: -

• Calls that give you the right (but not the obligation) to buy a currency pair at a set exchange rate (the “exercise rate” or “strike rate”), on or before a specific date (i.e. expiry).
• Puts that give you the right (but not the obligation) to sell a currency pair at a strike rate on or before formal expiry.

Put and call options can be bought or sold (“written”). When you buy an option you are said to hold a “long” position. If you sell (write) an option then you are said to hold a “short” position.

4.1 Long/short calls and puts

There are four basic option positions, which can be adopted singly or in combination for strategic purposes: -

*but not the obligation

Each option has a price or “premium”. As with other financial commodities there will be a bid price and an offer price.

4.1.1 Reciprocal calls and puts

Because purchase of one currency entails the simultaneous sale of another, it follows that each currency option involves one call and one put.

• A long call option on GBP/USD means that A has bought the right (but not the obligation) to buy GBP from B at the strike rate in USD. The mirror transaction is that A has bought the right (but not the obligation) to sell USD to B at the strike rate in GBP.
• A short call on GBP/USD means that A has sold B the right (but not the obligation) to buy GBP from A at the strike rate in USD. The mirror transaction is that A has sold the right (but not the obligation) to B to sell USD to A at the strike rate in GBP.

A GBP/USD call is therefore equivalent to a USD/GBP put.
4.2 Long call

A currency investor who is bullish about spot sterling vis-a-vis the US dollar buys the right to purchase GBP/USD at a given rate of exchange (the strike price). The cost of this right is the “premium”.

• • A long call is profitable (“in the money”) when the spot or futures rate of exchange is greater than the strike rate. The deeper into the money, the greater the profit from exercising the option.
• • A long call is unprofitable or “out of the money” if the spot or futures exchange rate is lower than the strike rate. If the situation remains unchanged until expiry then the option will expire unexercised and the buyer will lose the premium paid for it. The maximum loss is limited to the premium even if the spot or futures rate goes to zero.
• • Where the strike and spot/futures exchange rates are equal, the option is said to be “at the money”.

For more about long calls, click here: http://www.liffe.com/products/strategies/graphs/lcall.gif

4.2.1 Long call held to expiry – worked example

The current GBP/USD spot exchange rate is 1.5770/75. I think that GBP/USD is going to rise over the next three months. I buy one 3-month call option contract in GBP/USD spot on NYBOT with a strike rate of 1.6000, expiring in the third week of March.

Assume that the call option premium is quoted at 0.0233/0.0235 USD. The basic unit of trading for sterling on NYBOT is 125,000 GBP.

• My call option costs 125,000 X 0.0235 = 2,938 USD, which represents my margin requirement.
• At expiry, NYBOT declares a closing spot rate of 1.6350. My profit is: -
  
  (1.6350 – 1.6000) X 125,000 – 2,938 = 1,437 USD on an outlay of 2,938 = + 48.9% return on margin.
• Had the closing price at expiry been 1.5650, I would not have exercised the option and would have lost 2,938 USD (i.e. 100%)

4.3 Long put

The currency investor who is bearish about GBP/USD buys the right to sell it to someone at a strike rate. The option will be in the money when the spot or futures rate is below the strike rate and out of the money when the spot rate exceeds the strike rate

An option that expires out of the money will not be exercised. The buyer will take a loss equal to the premium paid.

For more about long puts, click here http://www.liffe.com/products/strategies/graphs/lput.gif.

4.3.1 Long put to expiry – worked example

The current spot rate for GBP/USD is 1.5770/75, but I am bearish about sterling. I buy one 3-month put option contract in GBP/USD at a strike price of 1.5500. The option is quoted at 0.0295/0.0298

• • My margin is 125,000 X 0.0298 = 3,725 USD
• • GBP/USD falls to 1.5150 at expiry. I make: -
  
  (1.5500 –1.5150) X 125,000 – 3,725 = 650 USD, a return of +17.45%
• • If the closing price for GBP/USD had been 1.6000, I would not have exercised the option and would have lost the 3,725 USD premium (100%).

4.4 Short (naked) call

• An investor who is bearish about GBP/USD sells someone the right to buy GBP/USD at a strike rate on or before a given date. The investor is said to have “written” a call for which he has taken a premium from the buyer.
• The short call is in the money to the buyer when the spot or futures rate is above the strike price. As there is no theoretical ceiling to the spot or futures rate, there is no limit to potential losses for the seller. Writing options is therefore extremely risky. A short call without a simultaneous holding in the currency itself is known as a “naked call”.
• A naked call is out of the money to the buyer when the spot or futures rate is below the strike rate. The maximum profit to the seller is only the premium taken in, even if spot or futures rate falls to zero.
• Naked calls are considered inefficient, because they offer limited upside and potentially unlimited downside to the seller.

For more about short calls, click here: http://www.liffe.com/products/strategies/graphs/scall.gif.

4.4.1 Short call to expiry – worked example

I am bearish about GBP/USD which is trading in the futures market at 1.5750/55. I decide to write one March GBP/USD futures call option contract at a strike of 1.5500, attracted by the prospect of taking in a premium. The option premium is quoted as 0.0446/0.0493 Because of the risk factor, the margin broker will probably have special margin rules.

• I take in a premium of 0.0446 X 125,000 = 5,575 USD
• NYBOT declares a settlement price of 1.5400 at expiry
• My short call finishes out of the money for the buyer. I am not exercised and keep the premium of 5,575 USD

Assume instead that GBP/USD has risen to 1.60 at expiry.

• The buyer would certainly exercise the option. I would have to buy a GBP/USD futures contract at around 1.6000 and deliver it at 1.5500, although I would keep the option premium .My loss would be: -
  
  (1.6000 – 1.5500) X 125,000 – 5,575 = 675 USD

Note that because there is no ceiling on GBP/USD, my losses are potentially unlimited while my maximum possible gain is 5,575 USD.

4.5 Short put

• You sell someone the right to sell you GBP/USD at the strike rate on or before expiry.
• The option is in the money to the buyer when spot is lower than strike, and out of the money when spot is higher than strike.
• The maximum possible profit to the seller is the premium taken in, even if spot goes to infinity. Maximum loss occurs when spot hits zero (most unlikely).

For more about short puts, click here: http://www.liffe.com/products/strategies/graphs/sput.gif.

4.1.4.1 Short put to expiry – worked example

You are bullish about GBP/USD (trading at 1.5770/75 in the spot market) so you sell one 3-month March GBP/USD put contract at a strike price of 1.6000. The put option premium is 0.0567/0.0571

• You take in 0.0567 X 125,000 = 7,088 USD
• You call the market wrongly. At expiry, the settlement price is 1.5100. You will be exercised and you lose:-
  
  (1.6000 – 1.5100) X 125,000 – 7,088 = 4,162 USD
• If the settlement price had been above 1.6000, however, you would not have been exercised and would have retained the 7,088 USD premium.

4.5.1 Put – call parity

As we have observed, a (naked) short call is highly risky because it offers unlimited potential downside. The situation is transformed if the investor has a simultaneous holding in the underlying currency (a covered call). The combined effect is to transform the short call into a short put, which has limited upside (the premium) and significant though capped downside.

Likewise a long put together with a long position in the underlying currency is transformed into a long call with limited downside and unlimited upside – a classic hedging strategy.

The equivalence of puts and calls is known as “put-call Parity”. Puts and calls can be transformed into one another by going long or short in the underlying currency itself.

5. Closing out

Thus far, we have only considered situations where options run to expiry. In practice, buyers and sellers tend to close out their positions before expiry by adopting equal and opposite new positions that exactly cancel out the original positions.

• If I have a long/short call position in GBP/USD, I can close it out by selling/buying the identical call option at the respective bid/offer rate.
• Likewise, if I have a long/short put position in GBP/USD, I can close it down before exercising by selling/buying the identical put option at the bid/offer rate

5.1 Closing out before expiry – worked example

GBP/USD spot is 1.5770/75. I am bullish about GBP/USD and decide to buy two 3-month call option contracts at a strike price of 1.6000. The GBP/USD long call premium is quoted at 0.0233/0.0235.

• I buy in at 0.0235 USD, putting up margin of 5,875 USD
• Sterling duly appreciates to 1.6400/05 after 1 month and I decide to close out without waiting for expiry. Meanwhile, the option premium has risen to 0.0503/0.0507. My profit is:-
  
  (0.0503 – 0.0235) X 125,000 X 2 – 5,875 = 825 USD

  Had GBP/USD fallen instead to 1.5600/50 and the option price to 0.0206/0.0208, my loss would have been :-
  
  (0.0235 – 0.0206) X 125,000 X 2 = 725 USD

6. Option pricing

Thus far, we have not answered the question of how options are priced. The option premium is made up of two components, intrinsic value and time value.

option premium = intrinsic value + time value

6.1 Intrinsic value

Intrinsic or “objective” value measures the degree to which the option is in the money. Out-of-the-money and at-the-money currency options have zero intrinsic value. In–the-money currency options have intrinsic value equal to the difference between the spot and exercise rate.

6.2 Time Value

Time or “subjective” value reflects the probability that a currency option will expire in the money, which is measured by the delta statistic. The delta also estimates the movement in the option price as a result of a change in the underlying currency.

Factors that determine time value of currency options are: -

• Term to expiry: The longer an option has to expiry the greater the probability that it will expire in the money.
• The volatility of the underlying currency pair: Rising historical volatility is reflected in rising option premiums. The sensitivity of time value to changes in volatility is measured by the vega statistic.
• Interest rate differentials: Call option premiums rise when the base currency interest rate falls relatively to that of the secondary currency, and vice versa for puts. The sensitivity of time value to changes in interest rates is measured by the rho statistic.

The most important property of time value is that it decays to zero by expiry. The rate of decay is gradual at first but accelerates as the option draws to expiry. The rate of time decay is measured by the theta statistic.

Time value is maximised at the money. Deep out-of-the-money options have low time value because the probability of expiry in the money is small. Deep in-the-money options also have low time value because the market is reluctant to pay much of a premium for an event (i.e. expiry in the money) that looks highly likely.

For currency option buyers, the option price at any time reflects the state of a continuous tussle between intrinsic and time value. Even if a currency option moves into the money, the option price will fall if the gain in intrinsic value is overwhelmed by falling time value.

Finally, although at-the-money options have the most time value, they have the greatest amount of time value to lose over the remaining term to expiry.

7. Controlling Risk

Risk may be controlled by setting stop losses (otherwise known as barriers) or by combining put and call positions to create limited risk/ limited profit and risk-averse volatility strategies

7.1 Barriers

• Out of the money knock out: An order to cancel a position (by taking an equal and opposite position) if spot moves through a set rate. The trigger rate is set below the strike rate for long calls and short puts, and above the strike rate for short calls and long puts
• In the money knock out: An order to cancel out a position if spot moves past a pre-set “in-the-money” rate. The trigger rate is set above the strike rate for long calls and short puts, and below the strike rate for short calls and long puts
• Double knock out: An order to cancel out a position if spot moves through one of two pre-set levels, one in the money and one out of the money.

7.2 Combinations

Currency option traders can combine the basic four option positions to manage risk: -

7.2.1 Limited risk limited profit trades

• Long call spread: A long call (lower strike rate) + short call (upper strike rate) yielding capped profit (when spot rises) and loss (when spot falls)
• Short call spread: A short call (lower strike) + long call (upper strike). Capped profit (when spot falls) and loss (when spot rises)
• Long put spread: A short put (lower strike) + long put (upper strike). Capped profit (when spot falls) and loss (when spot rises)
• Short put spread: A long put (lower strike) + short put (upper strike). Capped profit (when spot rises) and loss (when spot falls)

7.2.2 Risk-averse volatility trades

With volatility trades, we do not care about the direction in which the spot price moves. We are merely concerned with the magnitude of the movement.

• Long Straddle: A long call + a long put at the same strike rate. Unlimited profit when spot is rising and significant but limited profit when spot is falling. Maximum loss is limited to the sum of the premiums. To be profitable, the spot rate must deviate from the strike rate by more than the sum of the premiums (market neutral and bullish volatility).
• Long Strangle: A long put (lower strike) + a long call (upper strike). Unlimited profit when spot is rising. Significant but limited profit when spot is falling. Maximum loss is the sum of the premiums paid. To be profitable the spot must rise beyond the upper strike rate or fall below the lower strike rate by at least the sum of the premiums (market neutral and bullish volatility).

Straddles and strangles may be combined to produce other risk-reducing combinations, e.g.

• Long iron butterfly: A long straddle financed by a short strangle with strike prices above and below the long straddle strike rates (neutral direction and bullish volatility) Short iron butterfly: A long strangle financed by a short straddle and the inverse of the long iron butterfly. (Neutral direction and bearish volatility Long iron condor: A long strangle + a short strangle with strike rates above and below the long strangle strike rates (neutral direction and bullish volatility).
• Short iron condor: A short strangle + a long strangle with strike rates above and below those of the short strangle (neutral direction and bearish volatility).
  
   

CONTRACTS FOR DIFFERENCE

1. Introduction

Contracts for Difference (CFDs) are derivatives that are settled daily on the basis of the movement in the underlying asset price.

A CFD is a contract between an investor and a broker or market maker rather than between two investors. In theory CFDs can be created in just about any financial commodity, but are usually confined to individual shares and market indices.

Currency CFDs are a rarity.

How it works

If you think that one currency will rise relative to another, you buy or ‘go long in’ at the offer price. If you think that the price of the underlying currency is going to fall, then you sell or ‘go short’ at the bid price. You can therefore use CFDs to speculate, or to hedge against an adverse change in the exchange rate.

Each contract represents a “lot” of 100,000 units of the base currency. Your “marked to market” account is debited or credited daily in accordance with the movement of the underlying currency. This process continues indefinitely until you close out your position and crystallise your gains or losses by conducting an equal and opposite trade in the same currency pair through the same broker. Your realised gains or losses are then posted to your interest-bearing ledger account.

3. Margin trading

You do not have to pay for full exposure to the underlying asset when opening a position. The broker requires initial margin of a fraction of your underlying exposure
As your position is marked to market every day, your margin requirement changes daily. If the funds in your account (‘equity balance’) fall below the minimum margin then you will have ‘shortage in equity’ and will face a ‘margin call’.

4. Charges

There are two main charges on currency CFDs: -

• The bid-offer spread which reflects the spread in the spot market
• Interest adjustments

Interest is debited for running a short position and credited for a long position. This is the reverse of the practice on equity CFDs where long positions are charged interest and short positions credited with interest on the client account.

In any event, the amount of interest debited or credited to your account depends on the interest-rate differential.

5. Controlling Risk

With conventional (free) stop losses, the broker does not guarantee to close out the position at the precise stop rates. Guaranteed stop looses are available, however, at the cost of extra points on the spread.

6. Worked examples

6.1 Speculating on a rise

USD/JPY is quoted at 124.34/124.38 by the broker. You expect USD/JPY to rise, so you buy 5 CFDs worth 500,000 USD at 124.38 = 62,190,000JPY. The broker wants 3% margin i.e.

3% of 62,190,000 = 1,865,700 JPY or 15,000 USD

• Three weeks later USD/JPY is quoted at 127.55/127.50
• You decide to close out your position at the bid price. You make:-
  
  (127.55 – 124.38) X 500,000 = 1,585,000 JPY

However, there is an interest adjustment to your account based on the USD and JPY interest rate differential. Since you are long in USD and short in JPY and because USD interest rates are higher than JPY interest rates, you will receive three weeks worth of credit interest.

6.2 Hedging with guaranteed stop loss

You are bearish about GBP/USD and sell one GBP/USD contract quoted at 1.5844/50. However, you want a guaranteed stop loss which costs you 6 points from the mid-price and another 3 points for the Limited Risk premium. That means that that the effective bid rate is 1.5847 – 0.0006 – 0.0003 = 1.5838

• You set a guaranteed stop loss at 1.6000 in case you have misread the entrails and GBP/USD rises. Even if the market gaps to 1.6500 you are guaranteed to close out at 1.6000. Your maximum loss on this position is therefore:-
  
  (1.6000 – 1.5838) X 100,000 = 1,620 USD


• GDP/USD quickly falls to 1.5825/30 and you are sitting on a paper profit of: -
  
  (1.5838 – 1.5830) X 100,000 = 80 USD credited to your margin account.



• However, GBP/USD subsequently recovers to 1.5949/55 after 30 days and you decide to close out because you think that it will go higher. By IG concession you close out your position from the mid-point of the spread rather than at the offer rate. You lose:-
  
  (1.5952 – 1.5838) X 100,000 = 1,140 USD



• In the meanwhile, you have been charged interest at GBP rates and receiving interest at USD rates. Since GBP interest rates are higher than USD rates, there will be a debit interest adjustment to your ledger account.

 

1. Introduction

At first sight, a spread bet appears to be very similar to a CFD. The crucial difference is that, whereas CFDs are derivatives transacted though margin brokers, financial spread-bets are legally enforceable wagers between punters and licensed bookmakers. As such, spread betting gains are not liable to capital gains tax.

Spread betting is an attractive alternative to trading currencies in the spot or derivatives markets. Apart from the ability to profit in falling and rising markets and the benefits (and risks) of margin trading, currency spread betting has the following additional attractions: -

• Low minimum transactions sizes
• CGT-free gains
• Settlement in multiple currencies including sterling

2. The bookies

There are currently six online spread betting bookmakers making bets on a wide range of wager-able instruments. You can spread bet on individual shares, market indices and spot currencies, as well as on futures and options in equities, indices, interest rates, commodities and currencies.

3. The system

3.1 The spread

A bookmaker makes up a “spread” (i.e. the difference between the buy and sell exchange rate) based on such considerations as the current spot or futures rate, the liquidity of the underlying currency, the bet size and the term to expiry, as well as spreads quoted by rival bookmakers. Spreads will be wider than those in the spot or derivatives forex markets.

Buy and sell prices should be consistent across competing bookmakers or else the punters will be able to arbitrage, making riskless profits through simultaneous bets with different brokers.

3.2 The betting

Bets are traded on a daily, weekly, monthly or quarterly basis (March, June, September and December) and either settled on the last day or rolled over.

The punter places an “up-bet” (buy bet) or “down-bet” (sell bet) at a specified “stake” per point. Minimum and maximum stakes will vary between bookmakers.

Up-bets are made from the top of the bookmaker’s spread (the ‘buy’ rate). Down-bets are made from the bottom of the spread (the ’sell’ rate).

3.3 Margin

The bookmaker’s required margin is usually a Notional Trading Requirement (NTR) multiple of the betting stake. The NTR factor varies across different currency pairings, according to the liquidity of the particular market. For example, on CMC/Deal4free, the NTR factor for EUR/USD (spot) is 200 while the GBP/EUR NTR factor is only 100.

For example, if you are betting £5 per point on EUR/GBP, then your initial margin is 100 X £5 = £500.

Open positions are “marked to the market” every day and the paper profits and losses are posted to the margin account. Where margin is insufficient to support open positions, the bookmaker may make a “margin call”.

3. 4 Cost of carry

Where a spread bet is based on spot currency rates, the punter incurs an interest charge on the long position and receives an interest credit on the mirror short position. The cost of carry is therefore based on the interest rate differential.

On currency futures spread bets, there is no explicit interest debit or credit because cost of carry is already reflected in currency futures rates of exchange.

3.5 The finish

Unlike CFDs which are open-ended contracts, spread bets have expiry dates. Spread-betting positions, however, can usually be rolled over.

The close-out price at expiry will be an official “settlement price” calculated by the bookmaker using a formula set out in the customer agreement

Gains/losses will be the points difference between the settlement price and the opening buy/sell price times the stake per point.

3.6 Bolting

So you want to cut and run before expiry? An up-bet is closed out pre-expiry by placing an equivalent down-bet from the sell rate at the time. A down-bet is closed out by placing an equivalent up-bet from the buy rate at the time.

Profit/loss is based on the relative buy/sell prices at commencement and closure.

4. Worked examples

4.1 Down-bet to expiry

EUR/USD is currently trading at 1.6000/05. You think that USD will strengthen against EUR.

• The bookmaker’s spread for spot EUR.USD is 1.59/61, which is wider than the market spread
• You place a down bet on December EUR/USD at £5 per point. Since we are operating to 4 decimal places, this amount to £500 for every 1c movement in the exchange rate. Assume that the NTR is 200 times the stake. Initial margin is therefore:-
  
  200 X £5 = £1,000
  


• You turn out to be right and EUR/USD falls to a settlement 1.5855 at expiry. Your gain is: -
  
  (1.5900 – 1.5855) X £5 per point = 45 points X £5 = £225, representing a return on margin of 22.5%

4.2 Up-bet to expiry

You expect the euro to strengthen against the US dollar so you place an up bet of EUR/USD for expiry in December.

• The bookmaker is quoting 1.59/61
• You place an up bet for December EUR.USB at £3 per point
• Your margin is 200 X £3 = £600
• EUR/USD settles at 1.6215. Your profit is:-
  
  (1.6215 – 1.61) X £3 per point = £345 on margin of £600, a return of 57.5%

4.3 Closing out pre-expiry

The EUR/USD futures contract on the International Money Market is trading at 1.6000/05. You feel that the euro is going to rise over the next 3 months.

• You place an up spread bet in March EUR/USD futures quoted at 1.59/61, at £10 per point
• As the NTR factor is 200, your initial margin is 200 X £10 = £2,000
• EUR/USD falls to 1.5850/55 and the bookmaker is quoting 1.5750/60.
• On paper, you are losing :-
  
  (1.6005 –1.5750) X £10 per point = 150 points X £10 = £2,550



• Your margin account is now down to - £500 and you receive a margin call for £2,500
• The EUR/GBP futures contract strengthens to 1.5900/05 and the bookmaker is quoting 1.5800/1.5905. You decide to cut your losses and close out your bet. You lose:-
  
  (1.6005 – 1.5800) X £10 per point = £1,500



• You now have no more open positions, so you can withdraw the remaining £500 from your account and put it on a horse.

5. Spread-betting as entry point to forex

Spread betting has been tipped as the ideal entry point to the trading of forex, a relatively new area for the private investor made feasible by the internet.

There are several features of spread betting that are attractive to the first-time forex investor, principally: -

• The low minimum transaction size
• The absence of overheads (3-monitor trading stations, proprietary software et al.) with spread-betting websites providing live market data
• CGT-free gains, giving a clear advantage over CFDs
• The low volatility of the “big four” major currency pairings, and the impossibility of a global bear market in forex