A recent addition to the forex market within the last few months to retail traders has been forex options.
In this article we will explore this new derivative and give our opinion on the matter. We will also look at the two major forex options broker on the internet today and give our pros and cons to both.
If you do not know what an “option” is may I suggest that you skip this article as it assumes the reader has some prior knowledge in this instrument (there are plenty of free resources on the internet that can help you learn).
Having come from a stock options background we were quite excited with the prospect of forex options, however upon further investigation our hopes did not live up to expectations.
Forex Option Characteristics
Forex options have several unique advantages that normal conventional stock/future options do not.
Here is a quick list of some characteristics of forex options:
- You can determine your own exercise price.
- Options can expire at two different times of the day.
- Apart from those two characteristics every other aspect of the forex option is similar to its stock/future option counterpart.
Unfortunately these characteristics can more be a disadvantage to the average trader than would otherwise seem.
The obvious one coming to mind: Which strike price should you use?
However, another irk I have is: Who makes the market?
If you have come from an options background you will know that the entity responsible for creating the bid/ask spread of the option is generally a market maker. Now market makers aren’t renowned for being nice and giving away money – they need to pay their employees and their shareholders at the end of the day too. So what is this other danger: to put it mildly you could be screwed if you use non-round number strike prices.
Still don’t quite understand? That’s alright.
Listen carefully: a market maker provides the bid/ask spread of the option you want to deal in. As you may or may not know there is no market depth with the forex option – you don’t even know if other people are out there purchasing/writing the same option you are about to transact. So, if no “market” exists bar the one your “friendly” highly profitable forex option broker is quoting, how do you know if they are not inflating/deflating prices?
Well, they will need to know what you are doing. If they inflate price then you can write the option and wait for the option to fall back to “fair” price and collect the premium. If they deflate price you can buy the option and wait for the price to rise back up “fair” price and collect the profit.
Let’s say that they quote a “fair” price with your transaction, not knowing if you are going to buy or write. Once you are in, they now know what your transaction is. Who is to say whether they start quoting an unfair price according to your position? There’s no regulated forex options exchange where you can check. You are at their mercy.
The above concern would be found if you traded forex options through Saxobank. They offer bid/ask spreads on their forex options, and their only trade restriction is that you can only deal in forex options that have no less than 7 days prior them expiring (they all expire at 1400 GMT on the day of expiry) and no later than 7 months. The multiplier for their forex options ranges from 250,000 to 50 million.
If it Quacks Like an Option, Is It?
The second of two forex option brokers that we reviewed seemed to throw this concern away. The second forex option broker being Refco Spot. Their setup is completely different to Saxobank, so much so that we even began to ponder whether we were trading options at all!
Refco Spot seem to make forex options trading much easier for those new to options trading. All you need do on their browser-based platform is:
- The amount of money you would like to make.
- On the currency pair you wish to speculate on.
- To hit (or not hit) a certain price.
- In the amount of time you set.
When your requests have been entered Refco will then display a cost to complete your trade. Depending on the type of trade you have requested the cost can range from
US$10 to as much as the amount of money you wish to make (which will leave you with zero net profit of course). However, the benefits of this type of trading is that you know what your worst possible loss can be if you happen to get it totally wrong.
However, nothing is as rosy at it seems, upon further investigation we found quite a few imposing restrictions, here are some of them:
- Trades can only be placed no less than 12 hours prior to expiry and no more than 1 month away (options expire at 10AM or 10PM NYEST each trading day).
- The smallest amount that you can place to make is US$100, the largest US$10,000.
- You cannot reverse or exit an open trade (you will just need to enter into a new one).
- Barriers (price targets) for the options can only be set to as low as ~60 pips away from the current price and as far away as ~300 pips.
- Be mindful the barrier price is Refco’s bid price – if the bid price hits your barrier then the trade is completed.
- All pay-outs are made at expiration.
- To us, Refco’s options platform seems more like a gambling/spread-betting platform than an options one. Although they might derive their cost using an option’s calculator, the ability to not be able to exit out of positions seems to give the feel that we have more of a gambling facility than a trading facility. Take it whichever way you will.
Well so far we’ve done nothing but complain, what changes would we like to see before we would even consider looking at forex options again? Here are our recommendations for Saxobank style forex option brokers (we don’t care to comment any further on Refco style option brokers):
- A global regulated exchange of the forex options market (market makers generally don’t have our best interests at heart, so we need to make sure we are receiving a “fair” price!).
- Volume and Open Interest data of option contracts (we want to see others involved with the option we are dealing with – i.e. there’s not just a market provided by the market makers).
- Guaranteed stops (although not really a prerequisite, but something that would be favorably looked upon).
- Trades can be placed right up to the day and time of expiration
Are forex options all that they are cracked up to be? We don’t think so, not yet anyway. Maybe when more market makers enter this area we could see better improvements, but for the time being I would encourage others to continue trading the spot market.