Trading Forex ETFs Versus the Spot Market

01/27/2009 10:30 am EST

Focus: FOREX

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

It may surprise many aspiring forex traders that you do not need to open an account with a forex dealer to trade currencies. In fact, depending on what kind of investor you are, there may be many advantages to not trading forex with a dealer and turning to currency ETFs instead. Experienced spot FX traders may be incredulous that currency ETFs could offer any advantage over the spot market, but there are significant differences that they could use to their advantage. This article should dispel the myth that comparing ETFs and forex is like comparing apples and oranges. They are different, but each offer unique advantages in addressing this market.

Currency ETFs trade like stocks, and move in sequence with the underlying forex exchange rate, but for pricing convenience, the fund moves the decimal place on the exchange rate two places to the right. Other similarities between the spot FX market and currency ETFs include the ability to control the size of your position, sensitivity to economic announcements, increased ability to diversify across asset classes, and multiple currency pairs to choose from. Some of the differences include market hours, commissions, and margin. There are four other differences that traders should be aware of.Currency Trading

Spread

The spread on the EUR/USD in the spot market is around two pips on average. Two pips is .0002 of the exchange rate. The most popular EUR/USD currency ETF is priced with a $.02 bid-ask spread under normal market conditions. Although it looks different because the decimal is moved over on a currency ETF, the spread is exactly the same.

Rollover—Interest

Like futures, because the ETF sponsor has efficiencies of scale, the rollover, or "interest," is superior for currency ETFs over spot dealers. For example, right now, spot dealers are charging rollover on EUR/USD long positions, while the ETF version is paying an annual yield of about 1.2%. That interest is paid out to ETF shareholders on a monthly basis. 

Leverage

This is a touchy subject, but at LearningMarkets, we typically take the stand that the advertised margin and leverage rates (200:1+) in the forex are nothing more than gimmicks. No one can really trade with that level of leverage and actually survive—which is one of the big reasons why the forex has such a high drop out rate compared to equities (95% compared to 35%) within the first five years of trading. Currency ETFs trade like stocks, which means that the leverage is capped at 2:1. Because you are actually buying a share of the fund, you do not need margin—which also means that your risk is fixed to the amount invested.

Options

ETFs really shine if you want to be able to trade options in conjunction with, or instead of, an outright position in the forex. Currency ETFs are optionable, which means that it is possible to sell covered calls against them or buy and sell traditional calls and puts without having to maintain two accounts. ETFs can be traded in a traditional stock and options brokerage account. The options are exchange traded, which reduces the complexity and problems of OTC options offered by a few dealers.

Conclusion

The decision between trading currency ETFs or spot forex does not necessarily need to be a binary one. It is perfectly reasonable to maximize the options efficiencies of ETFs while continuing to speculate with a forex dealer with slightly higher leverage like normal. For traders new to the currency market, however, ETFs provide access with a traditional framework without having to deal with maintaining two accounts and trading platforms.

One of the real purposes of this article was to increase awareness of the products available to fit your needs. It is easy to be distracted or misguided by marketing messages or "conventional wisdom." Investigating all the opportunities available will increase your general market knowledge and could make your portfolio management much more efficient.

Click here to watch the video.

By John Jagerson, of PFXGlobal.com and LearningMarkets.com.

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