Looking for a New Asset Class to Trade? The Case for Options on Currency Futures

In the search for products worthy of following and trading, the pros typically look for three things: liquidity, price action, and volatility. That’s a fancy way of saying traders typically prefer products and asset classes with tight bid/ask spreads, variability that’s decent (and chartable for technical analysis), and with enough players to allow fundamental data to be reflected in real time. Think of them as the “three pillars of tradability.”

And if it’s a derivatives market such as futures or options, purists would add a fourth pillar: natural hedgers. That is, players on all sides of the economic equation who would naturally use the product as a risk transfer mechanism. Take corn, for example. You’ve got farmers, end consumers, and a host of intermediaries in between, each with an economic incentive to use the markets as part of their risk management.

Looking for something that checks all the boxes? How about foreign exchange futures and options? There’s certainly a case to be made.

Exhibit A: Why Foreign Exchange Markets?

Foreign exchange (forex, or FX for short) is the exchange of one nation’s currency for that of another, expressed as a ratio between the two currencies in each so-called currency pair. So, for example, in May 2020, the most actively traded pair in the world—the euro versus the U.S. dollar (EUR/USD)—was trading for 1.0833. In lay terms, that means that to buy a euro, it would cost you one dollar and 8.33 cents.

Yes, currency pairs are taken out to at least four decimal places. And yes, those decimal places matter when you consider how much currency changes hands each day—more than $6 trillion daily, according to the latest survey from the Bank for International Settlements (BIS). So those fractions of pennies add up. The FX market is a dynamic, global market that’s open nearly 24 hours a day, six days a week. And the most actively traded pairs are quite liquid. 

Retail traders and investors have essentially two avenues to trade currencies: the retail forex market and the futures market. For more on the forex market, refer to this primer, and for more on currency futures and options, read on.

What drives FX? The short answer is interest rates and economic growth, or more precisely, interest rate and economic growth differentials between the two sides of each currency pair. It’s sort of a scorecard of current and expected interest rates, economic output, the stored value of raw materials, and fiscal and political stability. Because the value—real or perceived—of all these things is in constant motion, currencies fluctuate by the minute.

Take a look at figure 1, which shows a price chart for British pound futures.    

Exhibit B: Why the Futures Market?

In the futures market, what’s exchanged isn’t the actual underlying product, but rather a contract to make or take physical delivery (or its cash value, depending on the settlement terms). In other words, each contract is a legally binding agreement to buy or sell the underlying asset on a specific date or during a specific month. Futures contracts are typically traded electronically on exchanges such as CME Group, the largest futures exchange in the United States.

Most futures contracts are “standardized,” or effectively interchangeable, and spell out certain specifications such as quality, quantity, minimum fluctuation (tick size), and delivery logistics. But on that last point, delivery isn’t a concern per se; delivery rarely occurs, as most contracts are liquidated before the delivery date. TD Ameritrade clients who access the futures market on the thinkorswim platform are required to get out of futures positions before each contract’s first delivery date, either by liquidating or rolling out to another contract month. 

People and companies trade futures for a number of reasons. Banks, fund managers, and commercial interests use markets to hedge against adverse price movement, smooth out payment cycles, and apply other risk management strategies. Speculators look for opportunities—both long and short term—to buy and sell for a profit. Retail investors might do the same. 

One thing that makes futures enticing—but also risky—is leverage. When you buy or sell a futures contract, you don’t put up the entire notional value, but rather you post an initial margin requirement, which is essentially a “good faith” deposit. Because a small investment controls a large amount of notional value, leverage can magnify gains but also magnify losses. Before venturing into futures, make sure you understand the mechanics of margin and margin calls.

Exhibit C: Why Options?

If you’re a regular reader of The Ticker Tape, you’ve likely seen the pitch. Options can be versatile and flexible, with strategies designed for all types of market movement—up, down, or sideways; fast or slow; volatile or calm.

But you’ve also seen the cautions. Options can be less than straightforward—outright confusing at first, given the products have their own lingo—and they can also be risky. Options aren’t suitable for everybody. The key, of course, is education. Understanding how options work and the potential benefits and risks of the various options strategies can help you decide if and where they might play a role in your investing strategy.

A + B + C = The Case for Options on Currency Futures

If you’re already familiar with options and options strategies—perhaps you’ve sold covered calls or bought protective puts against stocks you own, for example—it might be easy to put it all together. Foreign exchange markets fulfill the three pillars of tradability—liquidity, price action, and volatility. FX futures add in the fourth pillar—natural users of products for risk management. After all, companies big and small—from the multinational coffee outlet to the neighborhood chocolatier expecting a shipment from Belgium—are exposed in some way to the international ebb and flow of money and its volatility (see figure 2).

If you’re already an equity option trader, it could be a natural jump over to the currency futures options market. Sure, there are a few subtle differences. First, the options are based on a leveraged product, so the double-edged sword of margin applies. Plus, standard equity options are deliverable into 100 shares of the underlying, but because futures contracts vary in size (see above), it’s important to know the specs before you trade.

Finally, equity options prices are typically skewed, with the implied volatility higher on the downside than the upside (as the stock market tends to express more “panic” during selloffs than rallies). Currency futures options might be skewed to the upside or downside, depending on the market conditions.

What’s not different? All the technical analysis tools you use to help inform your entry and exit points look just the same for currency futures as they do for stocks. The same can be said for options strategies—calls and puts, vertical spreads, straddles, strangles, iron condors, etc. They all graph out the same on the Risk Profile tool (available on the thinkorswim platform under the Analyze tab). 

So if you’re looking for exposure to the value of the euro or British pound relative to the dollar, and want to use those options strategies you currently use in the equities market, options on currency futures might be the answer.     

Case closed? Well, remember: these are complex products for advanced traders. Not all accounts will qualify, and options on futures aren’t for everyone. Learn more to see if these products are in your future.