FOREX Trading for Beginners (The Complete Guide 2019)

FOREX Trading for Beginners

Introduction to FOREX Trading for beginners

When people think about investing in the financial markets they typically think about stocks, bonds, mutual funds, and exchange-traded funds. This guide explains the complete FOREX Trading for beginners. 

 

Risk Management

The most important concept for any trader to learn and understand is risk management. Risk should be a calculation based on statistics and probabilities. Risk should never be a gamble. The difference between gambling and speculation is risk management.

 

The most basic risk management includes leverage, position size, and stop loss. By considering each of these, a trader can calculate the potential losses and adjust accordingly to bring the potential losses in line with what the trader is willing to risk with each trade.

 

In the example we used in The Mechanics of Trading Currencies section of this blog, using a 50:1 leverage, and investing $1,000 in a trade (the position size), a single pip loss in the EURUSD would result in a 0.5% loss in the value of the trader’s position.

 

If the trader’s total account value was $100,000, this would be equivalent to a 0.005% loss in value. Using these calculations, the trader can set the positions to stop loss to an acceptable level. For example, a 100 pip stop loss would limit the loss of this trade to 0.5% of the trader’s total account value.

 

The next steps in risk management would include observing the market to identify trend reversals and reduce the risk of a stop loss, observing the strategies profitability to adjust risk accordingly and test how changes in various settings affect the overall profitability and risk: reward ratios.

 

What is Quant Trading?

Quantitative trading is the method of creating trading strategies based on an analysis which relies on mathematical computations to identify trading opportunities.

 

Price, volume, and momentum are some common data inputs used in quantitative analysis. The benefit of algorithmic trading in the foreign currency market is eliminating trader psychology, the speed of execution, and the ability to trade 24 hours a day.

 

The Process of Developing an Algorithm

The process of developing an algorithm is extremely rigorous and takes several months to create, and sometimes years to optimize. The general steps in developing an algorithm are:

1. Identifying a pattern in the markets.

2. Quantifying the pattern with mathematical formulas (this becomes the beginning of the trading model).

3. Observing the markets to see if the model holds up, and to identify and quantify any instances of false positives.

4. Programming the trading model.

5. Backtesting the trading model against several years of market data. Identifying patterns that affect risk: reward ratios, return to Step 4...

6. Forward testing the model in live market conditions. Again, identifying patterns that affect risk: reward ratios, return to Step 4...

 

The cycle of programming, backtesting, forward testing, and programming again may continue hundreds of times. In addition, walk forward testing is the process of continually testing proven algorithms against current market conditions.

 

For example, a proven algorithm may be continually running a dozen or more tests on different variables that may affect risk: reward to identify more optimal settings for current market conditions.

 

Investors

Before beginning our analysis, it is worthwhile noting that this blog ultimately aims to help a particular type of individual: investors. These individuals, who have the capital to invest deriving from various sources (savings, inheritance, proceeds from the sale of real estate, etc.), are those most concerned by what follows.

 

They want to invest this sum of money so it yields a profit, thereby increasing their capital over time. So investors look first and foremost for a return, which may take the form of regular income, capital gains, or both at once.

 

At this stage, it should be noted that the expected return for the given time horizon must be positive in order to achieve the desired growth.

 

It must also be higher than average inflation so that investors can preserve their purchasing power over time, and therefore their real wealth. Furthermore, net return—that is return after tax—should ideally be taken into account.

 

So, along with the risk of capital loss, inflation is one of the two greatest risks for investors, as it can seriously affect their capital over time. As such, it is worth defining more precisely.

 

Inflation

Inflation can be defined as an increase in general price level, with the chief consequence of a decrease in consumer purchasing power. Conversely, deflation is defined as a decrease in the general price level.

 

 Salaries, retirement pensions, and other social security benefits are generally indexed to inflation, thus enabling consumers to maintain their purchasing power over time.

 

The objective generally fixed by central banks for inflation is around 2%. However, in absolute terms, this figure should be revised upwards from an investor's point of view, considering the product categories most relevant to consumers in the price index. Indeed, when focusing on price increases for food, housing, energy or health-related spending, the average rate of inflation appears to be much higher.

 

In general, a market basket is used to calculate price changes. This basket includes a representative selection of goods and services consumed by private households. It is subdivided into various categories of expenditure, and each main category is weighted according to the share it represents in household expenditure.

 

Types of Stock

So-called common stocks are those which give their holder all the rights mentioned above. Dividend-right certificates, however, only confer economic rights. This type of stock is limited in practice and the most common example is the dividend-right certificates of the pharmaceutical company Roche.

 

Firstly, we can distinguish value stocks or income stocks, which pay regular, high dividends. Investors looking for regular returns will try to identify a stock that is considered good value for their level of earnings and dividends.

 

Growth stocks are generally characterized by very high market value in relation to current profits but offer the prospect of future earnings growth. They do not usually pay high dividends as they reinvest practically all their profits to ensure their growth. Price fluctuations are more significant and they are considered riskier than value stocks.

 

Secondly, we can distinguish small and large capitalizations, but the size and definitions vary from country to country.

Stocks are also differentiated according to their reaction to the economic climate. Companies sensitive to economic cycles, such as airlines or auto manufacturers, are called cyclical stocks. Conversely, companies less sensitive to cyclical fluctuations, such as those in the healthcare or food industries, are called defensive stocks.

 

Finally, preferred stocks are hybrid securities between stocks and bonds. They give preferential rights to dividends; preferred stockholders are paid before any dividend payout to common stockholders.

 

A fixed preferential rate is promised, provided that the company can distribute dividends. If not, dividends may accumulate to the following year. These are known as cumulative preferred stocks. In case of bankruptcy, holders of these securities are below bondholders in the order of reimbursement but above common stockholders.

 

b) Developed and Emerging Countries

Stocks can be classified into two main categories depending on the country: those of developed countries and those of emerging markets. By emerging countries, we mean all countries that are not considered advanced according to the criteria defined by the International Monetary Fund (IMF). This list is the same as the one mentioned above.

 

c) Industry

Other than the cyclical and defensive sectors defined above, it can also be useful to distinguish between different industries in order ultimately to select individual securities (stock picking). 

 

d) Forms of Investment

Investment in this asset class can consist of buying individual stocks directly, equity funds, market or sector index funds (tracker funds), or futures contracts. An equity fund offers the advantage of investment diversification with low capital and management by specialists who can react quickly to market information.

 

However, most equity funds practice so-called “relative management”, that is in relation to a benchmark or reference index. They measure their performance in reference to the benchmark. In practice, 80% of funds underperform their benchmark and a fund that outperforms its benchmark never stays at the top of the rankings for 10 consecutive years.

 

Moreover, equity funds suffer from mild illiquidity as investors cannot exit the market immediately, unlike selling stocks or index funds. They must await the NAV (Net Asset Value), calculated daily at best, to find out their exit price.

 

Finally, equity funds generally involve a significant fee structure. We recommend instead investing directly in the benchmark, by simply buying a market or sector index fund, or using futures.

 

An index fund (or tracker fund) offers more flexibility by making it possible to set purchase or sale limits, or even stop losses (which is not possible with equity funds), costs investors less and provides attractive diversification in terms of exposure to a market or a particular sector.

 

Counterparty risk must, however, be taken into account for this type of investment. Indeed, it is important to be familiar with the product structure and how the positions are held (directly or by borrowing).

 

Nonetheless, index funds can be criticized on several points. Firstly, equity funds specifically allow gamblers to be taken in relation to an index with the aim of outperforming it, while an index fund will at best achieve the same performance as the index.

 

Furthermore, because of their construction based on the market capitalization of companies, securities included in some indexes may represent a huge proportion, thereby biasing the homogeneity of the index.

 

In some cases, a few securities may represent over half the index, as with the SMI (Swiss Market Index). An equally weighted index can be an attractive answer to the problem of market capitalization weighting, but investors have to accept a performance gap compared with the initial index.

 

Performance may also sometimes be inferior to that of equity funds for a given observation period. Moreover, when the cost of rebalancing is considered, tracker funds' performance can sometimes be lower than that of the index. Finally, some empirical studies have shown that securities included in an index perform less well than those excluded.

 

The choice of either a broad market index fund or a sector index fund is very important, as it will define the desired market exposure. A sector index fund may be more suitable as it is more selective than the market as a whole, or even a tracker certificate on a basket of securities, which ultimately amounts to stock picking.

 

It is also possible to use index futures contracts. These are standardized contracts between investors and a clearinghouse, with the advantage of being publicly traded and therefore highly liquid. Costs, moreover, are very low, with much lower minimum investment amounts than those for buying stocks or index funds directly.

 

In fact, only an initial margin need be deposited in a margin account, the size of which will depend on the volatility of the underlying security (generally between 5% and 15%).

 

Profits and losses are calculated on a daily basis, using the “marking to market” process. At the end of each trading day, according to the future's price movement, the margin account is readjusted to reflect the gain or loss of the open position.

 

If the balance of the margin account falls below the maintenance margin requirement, the investor receives a margin call and must pay into the account to return it to the initial margin, or the broker will close the position.

 

Our Advice

In view of the above, we suggest combining the use of broad market or sector index funds or futures with a selection of individual securities, which amounts to adopting a so-called classic or improved “core-satellite” approach. 

 

 Risks Associated with Stocks

In view of the various risks listed below, it is difficult to maintain that volatility alone constitutes an appropriate measure of risk. In our view, stocks are risky assets by definition.

 

a) Total Risk

Generally speaking, total risk comprises the specific risk associated with shares in a particular company and market risk, which depends on macroeconomic conditions and fluctuations in the stock market in general. 

 

It is possible to reduce exposure to specific risk through diversification, leaving only market risk. Inadequate diversification can lead to concentration risk: for example, one stock representing 25% of a portfolio.

 

Moreover, it is essential to have an intelligent diversification strategy that helps minimize exposure to the same risks. This implies being fully aware of the portfolio's different positions.

 

For example, judging by the number of securities, a portfolio made up of 25 financial stocks appears at first glance to be diversified, but in fact, remains strongly exposed to a particular sector.

 

However, too great a diversification may lead to overdiversification, which is expensive and may potentially reduce returns. Investors must find a good balance and, to do so, we suggest considering the following principles:

  1. do not invest in a single asset class;
  2. avoid very small positions in a portfolio that have a negligible impact on overall performance. Invest a minimum of 1%–2% in a position;
  3. maintain sufficient diversification between industries and regions. Do not accept too much exposure to a single industry or particular region;
  4. avoid large concentrations in a portfolio. In general, an individual position should not account for more than 10%. However, much depends on the type of product.

 

b) Risk Associated with Speculation

At this stage of our analysis, it is worthwhile for investors to consider what they are really buying when they acquire a stock. Besides the equity instrument giving them economic and social rights, and the potential income and capital gains, investors also acquire a certain number of risks that we will list below, including the risk associated with speculation.

 

Speculators, whose primary goal is short-term profit, constitute a specific category of investors. With improved access to information and the globalization of trade and financial markets, their number has increased considerably over the last few years. They aim to get rich quickly and easily by taking advantage of various opportunities that present themselves on the market.

 

Chartists—followers of technical analysis—often belong to this category. They try to predict market entry and exit points in the short term by analyzing graphs and their forms. 

 

Investors, on the other hand, usually adopt investment strategies with longer time horizons, and take into account various factors to determine the attractiveness of an asset class and its prospects for future development. For them, graphical analysis is an additional decision-making tool.

 

When investing in stocks, investors must accept exposure to price fluctuations which, due in large part to speculators who enter and exit the market quickly, may prove to be considered in the short term. They must, therefore, be capable of holding a position for the time horizon they have set themselves.

 

In this analysis, we consider that market risk encompasses the risk associated with speculation. Any investor who buys a stock is, at the same time, buying a share in speculation over which they have very little influence. However, investors can attempt to profit from this, as we will see later.

 

As Graham pointed out early on, “everyone knows that speculative stock movements are carried too far in both directions, frequently in the general market and at all times in at least some of the individual issues”.

 

If we take this analysis to the extreme by assuming that the share of speculation is very large, the market becomes a veritable casino manipulated by speculators, and the only factor that can generate returns is luck. In some markets, speculation is so strong that investors would be forgiven for wondering what exactly it is that they are buying.

 

The satisfaction that comes from stock betting would thereby replace satisfaction from returns, turning stock markets into giant lotteries or racecourses where the horses are stocks to gamble on.

 

Some may believe that there is nothing random about this type of race and that only the best may win, but here we will let the investor or the gambler make up their own mind.

 

The profitability of casinos and gambling is generally very high, just like the exploitation of the stock market. One may sometimes wonder whether it is worth risking one's money by investing in the stock market, as the likelihood of significant losses is often greater than commonly believed.

 

Investors must be conscious of this. They must understand and analyze market mechanisms and the various stakeholders involved, all of which will have an influence on the price of their securities. Using the tools described below will help to limit the risk of losses.

 

c) Risk of Falling Stock Prices

When the stock market and stock prices fall, investors suffer a loss of value of the capital investment that can be significant depending on the size of the downturn. In the event that a decline is anticipated, it is possible to hedge against this risk in several ways.

 

i) Placing a Stop Loss Order

Investors may decide to set a price limit at which a sale order will be triggered. In the event of a sudden downturn, the final execution price may be lower than the stop-loss level, as the order is executed at the first available exit price.

 

Investors should note that depending on the type of instrument and the market under consideration, it is not always possible to place stop loss orders.

 

Stop losses are free to place and easy to renew. However, once executed, they leave investors with cash although the drop may only be temporary. As we will see below, a put option, on the other hand, allows investors to profit if the price of their security recovers before the option expires.

 

ii) Buying a Put Option (Right to Sell)

This insurance has the advantage of eliminating risk asymmetrically, i.e., it protects investors against downside risk while allowing them to participate in rising markets.

 

Unlike stop losses, this insurance has a cost, which may be high depending on the option's strike price, time to expiration and volatility. The higher the coverage sought, the more expensive the put.

 

Furthermore, as with all strategies using options, timing is an important aspect and future development is uncertain. It is possible to be right, but too early (the put expires too quickly) or too pessimistic (a correction does occur but the strike price is set too low).

 

Moreover, often only American options are available, which means having to pay more for the possibility of exercising the option at any time. Differences between the bid (sale price) and the ask (purchase price) are sometimes large and it is often difficult to master the costs of such a strategy.

 

iii) Sale of Futures Contracts

The sale of futures contracts lets investors reduce their exposure to stocks and thereby limit the loss of value of their investments in case of market downturns.

 

In this case, they eliminate market risk symmetrically, that is, they hedge against any market downturn but do not participate in market upswings (in the case of complete hedging).

 

When a downturn is expected, they can sell a certain number of futures corresponding to the amount to be hedged. If the downturn does occur, the profit generated by the sale of contracts (closure of the position by buying back the same number of contracts) therefore compensates for the loss in value of the stock.

 

However, this strategy requires setting aside an initial margin and daily calculation of variation margins. Open futures contracts are marked to market daily, i.e., the process of evaluating gains or losses is carried out every day, and this can lead to margin calls. Consequently, investors must have enough cash to meet potential margin calls if the maintenance margin requirement is no longer met.

 

This strategy is certainly simple to set up, but investors must monitor the movement of futures prices carefully, and consider placing stop loss orders to limit losses on the futures contracts if the market were to move in the opposite direction.

 

Finally, this hedging strategy is often imperfect; the number of contracts is often rounded off, variations in stock prices do not necessarily correspond to the variation in the futures contracts and the expiry of the contract used does not always correlate to the time horizon of the hedge (basis risk).

 

Therefore, the hedge is often partial and the futures contract used does not perfectly represent the positions held in the portfolio (correlation risk).

 

iv) Sale of Stock

If a strong decline is expected, it is better to sell the stock directly so as not to suffer the loss of value. Obviously, for investors who are unwilling to accept potential capital losses, and for whom preserving capital without risk of fluctuation is essential, this asset class should not be considered.

 

d) Liquidity/Solvency Risk Associated with Stocks

Liquidity risk is the risk that a company will no longer be able to meet their short-term financial commitments, such as interest payments, principal repayments, payment of suppliers, etc.

 

It is difficult for investors to hedge against this type of risk, but before investing, examining the ratios used to measure short-term liquidity may prove useful.

 

The most commonly used in practice are the current ratio, which generally should be higher than 2, or the quick ratio, which should at least be equal to 1 to be sure that the company has enough cash and liquid assets to cover their short-term debts.

 

It is important to be able to monitor the movement of these ratios over a three to five-year period and to know their average value for the industry the company operates in so that comparisons can be made. 

 

A short cash cycle will not pose any cash flow problems, while a longer cycle may, clients paying their invoices too slowly in relation to the payment of supplier invoices by the company. Cash is therefore essential for its survival, as even if it is making a profit, a company can go bankrupt if it lacks cash.

 

Long-term solvency risk is the risk that a company will not be able to meet its financial obligations in the long term, which can ultimately lead to the company going bankrupt.

 

Once again, it is difficult for investors to hedge against this type of risk, but examining the ratios used to measure long-term solvency may prove useful before investing. The debt ratio and the interest coverage ratio are the most commonly used in practice.

 

Here again, it is important to be able to monitor their movement over a three to five-year period and to know their average value for the industry the company operates in so that comparisons can be made.

 

e) Bankruptcy Risk Associated with Stocks

This is the ultimate risk associated with the company's future survival. In the event of bankruptcy, stockholders can only hope to recover a share in the proceeds of liquidation.

 

It is difficult to hedge against this type of risk, apart from avoiding investment in stocks altogether. Examining the various ratios indicated above and more comprehensive analysis of the company's operations both help limit exposure to this risk. Nonetheless, it is associated with any stock investment.

 

f) Operational Risk of the Company

Human error, fraud, corruption, exceptional expenditure and the loss or unavailability of employees or managers are operational risks that can prove to be significant or even catastrophic for a company.

 

Investors holding shares in a company are obviously powerless to control these risks, making it practically impossible to hedge against such consequences. There are hazards and, unfortunately, black sheep in every profession, but exposure to this risk can be limited by swift reactions to news and rumors circulating about companies held.

 

g) Reputation Risk Associated with Stocks

This risk relates to events that affect the company's image (defective products, court cases, reputation in the industry, with clients or suppliers, etc.).

 

 It is difficult for investors to hedge against this type of risk, but this factor must also be considered as part of the investment process. Following news related to the company again helps limit this risk.

 

h) Risk Related to the Economic Environment/Industry Risk

Macroeconomic conditions, the economic climate and the various seasonal or economic cycles obviously have an influence on companies. Interest rate movements, changes in growth and unemployment rates or commodity price movements affect various industries and therefore companies directly. The degree to which companies are affected and react will vary from one industry to another.

 

It is difficult for investors to protect themselves against this type of risk, but a detailed analysis of macroeconomic conditions, the relevant industry, and future prospects help to limit it and to find an appropriate position within this asset class.

 

i) Political Risk Associated with Stocks

A lack of political stability in a country can affect assets held within it and have an impact on the companies operating on that soil. This risk is more manifest in emerging countries. Economic conditions can also incite governments to make decisions that affect particular industries and their long-term profitability.

 

 It is difficult for investors to hedge against such a risk, apart from avoiding investing in stocks in emerging countries. Taking this factor into consideration can help select stocks with low political risk by turning to the developed markets.

 

j) Legal/Regulatory Risk Associated with Stocks

The legal and regulatory framework defines the limits of a company's operations and any modification can have significant consequences. Changes in Swiss bank secrecy and their consequences for banks are a prime example.

 

Once again, apart from belonging directly to a major lobby, it is difficult for investors to protect themselves against this risk, but taking these factors into account during the process of investment in an asset class, a sector or particular security helps limit exposure to it.

 

k) Risk Associated with Emerging Countries

Besides political and liquidity risk, it is often difficult for investors to obtain information about a company operating in an emerging country. In addition, there are often restrictions on foreign investment and stakes in these companies.

 

Finally, transaction costs are often very high and can sometimes be ten times higher than those paid on the American or English markets.

 

On this type of risk, please refer to indications given above for bonds.

l) Monetary Risk Associated with Stocks

Some countries may pursue monetary and fiscal policies leading to higher inflation, interest rates, borrowing costs and, ultimately, a recession. This can also have an impact on the domestic currency.

 

A weak currency favors exports, but penalizes imports, while a strong currency penalizes exports and favors imports. Therefore, the impact will vary according to the company's business activities and whether it is import or export focused.

 

 Investors have difficulty hedging against this type of risk, but their decision to focus on export or import companies should depend on their expectations for currency movements.

 

m) Currency Risk Associated with Stocks

In the case of investments in a foreign currency, i.e., other than the reference currency, exchange rate fluctuations can have a significant impact on the final return.

 

i) Hedging Currency Risk

Exchange rate movements are virtually unpredictable; the best forecast for tomorrow's rate (and the following days') is today's exchange rate. In the short term, partly because of the considerable number of speculators and stakeholders, it is very difficult to forecast exchange rate movements.

 

An established trend may continue until a turnaround, but further, than that, any forecasting is very problematic.

 

However, many experts recognize that currencies tend to follow a “mean reverting process”. In other words, even if the price deviates over short periods from the long-term mean (which may itself change), in the end, the net result should be neutral. Over short periods, however, the impact can be significant.

 

The time horizon and the asset's holding period may provide some clues as to whether it is worth hedging or not.

If investors intend to hold the asset for a short period, they should consider hedging against short-term exchange rate fluctuations, which can impact significantly on returns. On the other hand, if investors intend to keep certain investments for a very long period, hedging against currency risk may not be necessary.

 

In the long term, although it undergoes fluctuations, the average performance of the exchange rate can approach zero and only the performance of the asset will have been decisive.

 

However, even in the case of long-term asset holding, it may be feasible to hedge at certain times against currency risk and not at others, wagering on both the asset rise and appreciation of the foreign currency. 

 

In practice, if investors have no particular conviction about a currency, they will remain neutral. If they are comfortable taking the risk of foreign currency fluctuation, they will not hedge.

 

On the other hand, if they do not want to be exposed to this risk, they will ensure the position is hedged appropriately, in order to focus solely on the asset's return. In case of a strong conviction, they will hedge if they expect the investment currency to weaken.

 

The question of what proportion to hedge (100%, 50% … of the position?) will again depend on the degree of conviction and the risks investors are willing to take. The volatility of the asset class should also be considered.

 

Certainly, for bonds, seeking an additional 1%–2% return while risking a currency loss of 3%– 4% seems unjustified. It may be useful to compare the volatility of the currency with the volatility of the asset class. The use of limits or stop losses helps limit the risk of losses.

 

The use of forwarding exchange contracts as a hedging instrument provides protection against the currency risk associated with positions in foreign currency, and investments in the investor's reference currency avoid this risk entirely.

 

Finally, some consider currency as an asset class in itself or as a form of diversification that must be managed accordingly. We will leave this question open but, in our view, investors must first decide what to invest in and then contemplate whether the investment currency is worth hedging. Investors can also limit their exposure to this risk by investing in their reference currency.

 

Brokers who deal with options traders

Of course, you’ll need a brokerage account to trade options. However, you also will deal with many other institutions that have a critical role in developing options, ensuring that trades clear, and regulating the industry.

 

Keep in mind that the financial services industry has been going through a lot of upheaval in recent years. Tons of mergers, acquisitions, start-ups, and other changes may make some of the information in this blog outdated almost as soon as I type it, let alone by the time you read it. That’s part of the creativity of the industry.

 

Pricing and Trading Structures for Options

The main point of competition for many of the exchanges is how they handle orders after the brokers submit them. For the most part, this matters more to an institutional investor than to an individual. Still, it’s good to know how orders are handled after the broker submits them, both to understand how the market works and how it might change.

 

Many years ago, traders used paper notebooks to keep track of orders. Orders are handled electronically now, but the record is still referred to as the blog.

 

The Role of Market Makers

Market makers are members of an exchange who agree to place a bid on every order that is entered. Each market maker works with a different set of options.

 

They don’t have to place a bid at a price the customer wants, but they do have to be involved in the market. Some market makers are self-employed, most are part of firms that specialize in this aspect of the business, and some are associated with brokerage firms.

 

DEFINITION

A trader who is in the business of ensuring that there are buyers and sellers for a particular option is known as a market maker. If no orders come from the public, the market maker will take the trade. Most market makers then hedge their positions.

 

Here’s what they do: if someone wants to buy a Jan (short for January in standard options lingo) call on XYZ Company, a market maker has to make an offer to sell. The market maker doesn’t have to sell at any price, but the offer has to be made.

 

This is an important function. Market makers ensure there is some liquidity in the market. They ensure someone will take an order and there’s a price out there that can be used to determine the value of a given option.

 

Prices carry information, and that helps make the options markets efficient, which means people are willing to turn to it to manage risk. Without the market making function, there would be nothing for speculators to trade.

 

Most market makers are hedgers rather than speculators because they are taking on risk from their market-making activities. They will make trades elsewhere to protect their business, which is another way they create liquidity.

 

The Order of Trade

Orders come into the exchanges constantly. There are enough conflicts among them that the exchanges need to set a system to determine which orders are executed first and who pays the exchange.

 

Here are the different methods exchanges use to handle orders:

Customer priority If two orders come in at the same price, the customer orders are executed before orders placed by market makers. Market makers pay transaction fees; customers don’t.

 

  • Maker-taker Under this model, the market maker—the one who “makes” the orders—pays no transaction fee while the customer—who “takes” the orders—does. Price-time priority entered earliest at a fee.

 

  • Orders are given timestamps when they are submitted to the exchange. The order given price is executed first, and the person placing the order pays the transaction
  • Pro rata allocation Orders with the same priority are filled on a proportional basis if they can’t be filled completely.
  • Size allocation Orders with the same priority are filled largest to smallest.

 

  • The transaction fees usually run about $0.20 or $0.30 per lot of 100 options. It’s a small fee, but it can add up on large orders or for frequent traders.

 

Price Improvement

Price improvement means the customer pays less to buy an option or receives more to sell it than the order that was placed. It’s a good thing, and some options exchanges promote the ability to receive price improvement as a way to differentiate themselves.

 

If the market moves as an order is entered, price improvement might occur naturally. Customers placing large orders often want price improvement.

 

In that case, the broker will request it, and the trade will go through an auction process. Market makers can choose to take all or part of the order at a better price. Price improvement isn’t likely on retail orders or even on most institutional orders.

 

Where to Trade Options

Most options trade on organized exchanges. Unlike stocks and bonds, options are created by the exchanges where they trade and not by the underlying companies.

 

This means the features, benefits, and rules governing different types of options might be specific to the exchange that issued the option. The exchanges were once physical locations in impressive downtown locations, but now they are often nothing more than server farms.

 

Once a national exchange issues an option, it might be traded on many other exchanges. In exchange lingo, these are fungible, multiple-listed options. Some exchanges may have more trading volume, offer better pricing, or allow different order types than others. These differences might matter to your trading strategy or the particular option you want to trade.

 

Options Exchanges in the United States

BATS Options Market

The BATS (Best Alternative Trading System) market was set up to offer better execution for common stock.

 

The company’s options exchange, also known as BZX, handles orders on a price-time priority basis. The company has recently announced a new options exchange, EDGX, which accepts orders on a customer priority/pro rata allocation basis.

 

The difference is important to institutions placing large orders via electronic systems, and this is an example of how competition among the exchanges is leading to services that meet the specific needs of some traders.

 

BOX Options Exchange

This exchange was set up to allow brokers to connect directly with its network. It offers a price-improvement period during the order execution that is designed to mimic the benefits of open outcry trading.

 

C2 Options Exchange  

C2 is an all-electronic exchange started by the CBOE. It uses a price-time order structure. Chicago Board Options Exchange The CBOE is the first and largest of the options exchanges. However, it is no longer the only game in town. The exchange has two key advantages, however:

  • It develops most of the options products traded here and on other exchanges.
  • It still offers open outcry trading for many of its products, which many in the industry argue allows for better execution of large trades.

 

It is mostly a futures and physical exchange, but it offers some options, and it handles over-the-counter transactions. ICE also offers contracts on unusual assets and has shown much willingness to experiment.

 

International Securities Exchange (ise.com ) The International Securities Exchange, or ISE, introduced the first all-electronic options exchange in the United States in 2000. It uses a customer-priority, pro rata (or proportional) market structure.

 

The company also operates a separate options exchange, ISE Gemini, which uses pure maker-taker pricing. Most of the offerings are traditional equity options, but the ISE folks have been willing to experiment with options on such things as cybersecurity.

 

Over-the-Counter Options

Over-the-counter (OTC ) options do not trade on an organized exchange. Instead, they are issued by brokers and rarely have a secondary market. These are sometimes known as exotics because they cover unusual assets or situations, often customized to meet a specific customer’s needs.

 

DEFINITION

Over-the-counter (OTC) options are options that do not trade on an organized exchange. They’re often customized by a broker to meet a particular customer’s needs. As an options trader, you might never come across an OTC option, but it’s nice to know that they exist.

 

Finding a Broker

Options trades are executed by brokerage firms, and almost all of them handle options trades. However, that doesn’t mean just any firm will be able to meet your particular needs.

 

The occasional options trader might not need to shop around, but someone who is day trading options or who plans to make a significant number of trades should check into different features that distinguish options brokers from the rest. The benefits in information and execution could be significant for you.

 

Some brokers use different brand names for their options trading services than their primary business.

 

For example, TD Ameritrade’s options brokerage is known as thinkorswim. The difference is usually related to the types of trading platforms (discussed later in this blog) available to different types of customers.

 

DID YOU KNOW?

Most brokers allow you to open a free demo account to let you test their services with play money. How important the different features depending on your own needs. The following sections highlight different features to help you comparison shop.

 

Commissions and Trade Execution

Brokerage firms charge commissions to make trades. That’s fair because they have to make money. Traders often fixate on the pretrade commission's different brokers charge, but it is only part of what you pay. You also pay any exchange fees, and then there’s the price at which you buy or sell.

 

Would you rather buy at a lower price or pay a lower commission? As a customer, you should look for the lowest overall price, especially if you will be trading options on a regular basis. The commission is just one part of the price.

 

Many brokers have different fee schedules based on how much money you keep in your account or how many trades you place. Keep that in mind as you check out different firms.

 

The discussion of the exchanges earlier in this blog included information about different pricing and priority structures. They often include tradeoffs between, say, paying an exchange fee and receiving priority in execution or getting a better price and having the order executed right away. Brokers must disclose information about trade execution prices and speeds once a quarter, so you can get that information to make comparisons.

 

TRADING TIP

Some brokerage firms don’t charge commissions. That doesn’t mean their services are free. They will be passed on to you in other ways, usually in the form of worse execution from their own market makers. When evaluating firms, look at the total cost of trading, and not at any one line item.

 

Position Limits

Brokerage firms have to manage their own risks, and one way they do this is by setting limits on what customers are able to do in their accounts. The broker might set a position limit, for example, which is the maximum number of open contracts an investor can hold in one account.

 

This might be expressed in terms of a number of contracts on one side of the market or in terms of the total long or total short delta. If you plan on being an active trader, you’ll want to check on this.

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