Magazine article Modern Trader

Trading Options on Currencies/forex: Most Retail Traders Generally Trade Currency Options on a Regulated Exchange and the Larger Institutions Stick with the OTC Market. While OTC Markets Have Held an Advantage in Trading Forex over Futures, Most Money Managers Trade Options on Currencies at the Chicago Mercantile Exchange

Magazine article Modern Trader

Trading Options on Currencies/forex: Most Retail Traders Generally Trade Currency Options on a Regulated Exchange and the Larger Institutions Stick with the OTC Market. While OTC Markets Have Held an Advantage in Trading Forex over Futures, Most Money Managers Trade Options on Currencies at the Chicago Mercantile Exchange

Article excerpt

Few forex trading platforms offer forex options because the big boys go directly to bank dealing rooms. That may be changing as more money managers and retails traders are turning to options.

Futures spoke to several futures commission merchants (FCM) and commodity trading advisors (CTA) to gauge the demand for forex options and see if they are trading at the Chicago Mercantile Exchange's (CME) regulated exchange or on OTC markets.

"[Our clients] are increasingly embracing options, not only for speculative purposes but also as tools to manage risk, increase portfolio diversification, and enhance income," says Dan O'Neil, principal at Xpresstrade. "One of the things that attracts investors to options is the fact that for almost any market outlook, time horizon and risk appetite, there's an appropriate options strategy. Some of the most popular strategies we're seeing include the sale of covered calls and the purchase of puts against long futures or forex positions," O'Neil adds.

A CME spokesperson says traders in general are becoming more sophisticated and utilizing the full range of instruments available to trade. "Currency options are becoming increasingly popular and are one of the best ways to hedge against adverse movements in exchange rates. Options are also more flexible than futures and allow traders to execute more complex strategies," she says. Average daily volume for CME currency options has grown 141% from the second quarter of 2001 to the second quarter of 2006.

"Forex options are tremendously popular in the institutional/corporate market but have yet to really gain the same sort of acceptance in the retail market," says Patricia Muchinsky, an options trader at Forex Capital Markets.

Most CTAs we spoke to focus their currency option trading to exchange traded currencies on the CME.

Ira Kawaller, managing partner of the Kawaller Fund, exclusively trades options on futures in his carry strategy, which takes advantage of differentials in interest rates in the countries or regions of the underlying currency.

"What's especially attractive in currencies is that futures prices are a function of interest rate differentials and they have a very poor value as a forecasting guide," Kawaller says. "If you were to see the futures price above or below the spot price, it's purely a function of interest rate differentials. That tells you nothing about whether the spot price is likely to rise or fall. Now if you use that as a starting point and see the futures price trading below the spot price, that creates an edge for the long futures position whereas if the futures price trades at a premium to spot, that creates an edge for the short position."

Rather than buying or selling futures in those conditions, he buys calls and puts. "Although time decay works against me, I only enter trades when the basis is in my favor relative to the time decay. This approach puts me in a very attractive position where I can own an option and if the spot price remains the same, my option will actually appreciate. If I can find those conditions in currencies that have generous interest rate differentials, like the yen, that's a good situation for my strategy," he says.

Donald A. Newell, principal of option-based Quiddity LLC, trades both options on currency futures at the CME and OTC currencies. He defines Quiddity's strategy as directional hedging, selling longer dated options and buying shorter dated options.

"Historically, the bulk of trading we do is on the CME, but if I could trade more on the OTC market, I would," he says. He prefers OTC because there are multiple dealers, which he says translates to better liquidity. He says he sticks to CME most of the time because he's limited by the structure of his accounts.

"We look at data that we think is going to affect the U.S. economy, whether it's unemployment, GDP, housing starts, we look at all that and ask ourselves what's that going to do to the U. …

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