Spots, options and futures: take advantage of market opportunities at 100%
In 1972, for the first time in history, traders in the U.S. were able to make money on the exchange rate differences of different currencies. Currency trading took the form of futures contracts. The Chicago Stock Exchange at that time allowed trading of agricultural commodities, but after assessing the prospects of the currency market, it was decided to give it a chance to exist.
In 2008 the volume of trading in the foreign exchange market reached $3 trillion. Nevertheless, most currency traders use only a fraction of the opportunities available, because the foreign exchange market provides spots for trading, futures and options.
There are clear trend configurations in the currency market, the complexity of interpreting which becomes more complicated in proportion to the shortening of the trading time interval. This problem is relevant to many traders, but it is solved quite effectively by using combinations of spot, futures and options trades.
Problems arising in spot trading
After the "Commodity Futures Modernization Act" was passed in 2000, trading in the foreign exchange market became especially popular. A trader could open a deal with only $300 on his account, with the leverage of 500:1. Naturally, even small jumps of quotes in such conditions could bring considerable profit or big loss during short period of time.
Another disadvantage of currency spot trades is the cost if the duration of the trade goes beyond the 24-hour time frame.
Many people think that trading on the spot market is quite difficult, but there is a much more comfortable way to make deals.
Transactions in futures contracts were allowed on the foreign exchange market in order to protect banks and corporations from the risks that are inevitably associated with buying currency at a floating rate. This allowed the reversals in the long-term trend to be ignored in the short-term time frames. After 40 years, the situation has remained virtually unchanged.
In the spot market continue to apply for protection transactions with futures, and options, in turn, provide an opportunity to secure transactions with both futures and spot. Most traders focus their attention on making quick profits and use only stop-loss as protection, thus using the possibilities of the currency market only for a third.
With the help of a clever combination of spot market opportunities, options and futures, the trader gets an opportunity not to miss short-term fluctuations in quotations, staying in a long-term trend, which is impossible with the use of spot trades alone.
Threat of losses in operations on the spot market
In Figure 1 you can see that the euro exchange rate has increased from $1.44 to $1.66 per euro. Accordingly, the difference of 16 cents when trading a standard lot on the spot market means a potential profit of $16 thousand.
During the period from February till April 2008 the Euro/Dollar pair demonstrated several pullbacks. For example, on March 17, 2008 the rate fell from $1.56 to $1.53 per Euro, i.e. the losses reached $3 000. As a result, the pair finished the rebound, but the trader didn't know about it beforehand.
Nevertheless, the loss of $3,000 is quite tangible, if not critical, for most retail traders. The trader could correctly identify the trend, but mistakenly timed his entry into the market.
Based on money management rules, a competent trader is unlikely to hold a losing position until the end. But it does not cancel the necessity of correct identification of minimums and maximums for effective trading. There is a way to protect your money in such cases.
Figure 1 clearly shows upward trend. Naturally, it is necessary to open longs on the euro in order to make a profit (Figure 2). And in order to protect oneself in case of short-term pullbacks, one should either buy "Put" options on the Euro, or sell the Euro on the futures market.
Using futures contracts and options to reduce risk
When using euro futures contracts, you should pay attention to two factors: the margin for using the contract and the likelihood that the market will turn in the opposite direction to the spot transaction.
The amount of margin in the futures market depends on the size of the contract - minimum or standard. The best protection against loss is a standard-size futures contract. On the other hand, if the price moves against the open position, every cent will result in a loss of $250. When using a minimum contract the opposite problem will occur - the value of one cent will be $625, but fluctuations of one cent will cost $ 1 thousand. Accordingly, there will be $375 without insurance, which makes it pointless to open a position on the futures market.
Another way of insurance can be the use of "Put" options on the euro. The value of the option will fluctuate according to the volatility, which depends on the asset and the time remaining until the expiration of the option. For example, simultaneously with the opening longs for Euro on the spot market, you can buy a "Put" option at the same price. In this case, the value of the option will be approximately equal to its strike price.
Typically, the cost of an option is 10-20% of margin in the futures market. The range is between $300 and $600. Considering that it will protect against a $3,000 loss, such costs are justified.
It is also worth taking into consideration that losses under an option are limited to the volume of investments, which means that the risks will never exceed the level of the premium. Accordingly, the trader may not worry about losing $250 on a one-cent change in quotations.
Figure 3 shows how the euro/dollar pair rebounded from the low and entered the positive zone relative to the entry point. If there was no insurance in the form of options, the loss would have reached the size of $3 thousand. The only insurance for most traders would be stop loss And then there is the hope of a price reversal.
Futures, spots, and options must work together to protect each other. Traders who limit themselves to the spot market deprive themselves of the use of effective risk control tools. However, it is worth noting that combinations of spot futures and spot options are not ideal. The first combination may be too costly and carry additional risks. The second combination has the opposite effect. Neither option will provide 100% insurance against loss.
Trading on the spot market with the simultaneous use of futures and options makes it possible for the trader to count on a longer term perspective. Apart from the fact that the trader may not be afraid of pullbacks and holding unprofitable positions, such operations allow hedging, which used to be considered the prerogative of banks and large funds.
There are three ways to trade futures: independently, with a managed account, or by joining an investor association. These three ways are important, the riskiest one is when an investor starts to manage his money on his own - because then all the risks are on his shoulders.