Once your investment feet get wet with securities, it won’t be long before you start thinking of using other profitability tools. The forex (foreign exchange) market and the options market are your next logical steps. We will go over the fundamental difference between a currency (forex) and a securities derivative (options). We’ll also discuss how these different instruments are very similar in practical use.
Similarities Between Options Trading and Forex Trading
Before moving into how forex and options trading are different, it’s important to note how they are similar. The basic rules of trading — supply and demand and news absorption — apply to both markets. Understanding these rules and how they apply to all markets is essential to investment success.
To keep things simple here, we will assume that we are comparing the options markets within major trading indices (the S&P 500, the Dow Jones Industrial Average or NASDAQ) to forex trading. We discuss how things can get complicated a little later.
If you have a leveraged account, you can own more assets in that account than your money would normally buy. Brokers give leverage just like banks give loans. With the proper setup, you can purchase forex currency pairs or options contracts on margin, meaning that you are using leverage.
Forex brokers offer more leverage on trades. Depending on the broker you choose, you may be able to open an order at 1,000 times your own capital, for example, trading $1,000 worth of currency for every $1 you hold in your forex account. No reputable options broker will ever have leverage this high but you must consider that options itself is leverage. Every options contract that you purchase, whether call or put, represents 100 shares of the underlying stock.
Modern brokerages make it incredibly easy to trade the exact financial instrument you want. (We have a list of brokerages that you can use to trade forex and options, and you can read this FOREX.com Review for a good introduction to the most well-known forex broker in the world.) This is in stark contrast to previous generations of investors who were often limited in their choice of instruments.
You may run across opinions that advise you against forex or options because of the difficulty in accessing one instrument over the other. Check the timing and the veracity of the sources — you may be dealing with out-of-date information that bleeds over into dated investment advice.
Both forex and options trading invoke regulations to limit the potential risk investors take on. These regulations may come from different places but they all serve the purpose of protecting traders from taking unmanageable risk. If you plan on trading forex, you should get used to putting a stop-loss in with your buy orders. Many brokers will not allow you to execute an order without a stop loss.
By law, trading options on a U.S.-based brokerage requires that you self-assert your level of trading expertise and net worth, among other financial information. Depending on the answers you give, that brokerage will assign you an options level. Brokerages may not check this information, but it doesn’t help you to lie. Higher options levels expose you to more trading tools but also bigger risk that you may not be prepared to take on.
Differences Between Options Trading and Forex Trading
As you might assume, there are also some major differences between options and forex. Below are 3 of the biggest that should help you determine which investment tool is right for you.
Forex market investors trade currency pairs, which are assets that you own directly. This is known as spot trading. When you trade options, you are trading a contract on an asset. Options are known as asset derivatives. As such, you can actually trade options on forex currency pairs. Options have characteristics that assets do not have and may be used in sophisticated trades that play the buy and sell side at once. Options can also lose money more quickly than assets.
The options market is open only during the normal market hours of Monday to Friday, 9:30 a.m. to 4 p.m. EST. The forex market is open 24 hours per day even for forex beginners. During dead hours, the prices of options “freeze” even though news may be coming in that changes the market.
At the start of the new trading day, investors may experience a sudden jump in price (up or down) as the market responds to the new information. This phenomenon can cause options to completely jump over automated stops (orders you pre-fill based on certain conditions and entrust an algorithm to execute). Before committing to an options trade, you must be sure that you are prepared for these possible jumps at the start of trading.
Forex markets can experience jumps over the weekend, as the majority of forex brokers are closed on Saturday and Sunday. News will continue to flow and may cause price gaps on the following Monday. The 24-hour trading schedule of forex usually keeps huge price gaps from occurring on weekdays, although it can occur.
The forex market is the most liquid market in the world. Liquidity means that trading is easy. Forex’s liquidity attracts mainstream investors who are looking for efficient, stable markets, and as a result, also makes forex the biggest market in the world.
The contrast with the options market is stark. Depending on the options you choose, you could be trading against only a few people across the entire world. Liquidity in this case is objectively lower and price becomes more volatile.
Pros and Cons of Options Trading
There are some other advantages and disadvantages to options trading based on the differences between the asset types.
|Automatic leverageCan create nondirectional and hedging strategiesPotentially higher ROI than trading underlying assets directlyLess capital required to control more assets||Not all losses tax deductibleRelatively low liquidityHigher barriers to entryFixed fees for trading|
Pros and Cons of Forex Trading
Here are a few additional points you should consider before diving into currency trading with forex.
|Less susceptible to volatility shocksHighest liquidity of any financial marketInvestors protected against fraud and theft of funds through KYC standardsDefault risk limitersNo middleman fees||Less volatility means less short-term growth potentialSusceptible to unexpected political eventsGains easily tracked and taxedTemptation of extremely high leverage|
Best Brokers for Forex Trading
You must do business with reputable forex platforms to take full advantage of the market’s strengths. Consider the following list:
CommissionsSpreads start as low as $1 But vary based on trading volume
Commissions$10 value per pip
Best Brokers for Options Trading
If you’re trading options seriously, your options broker will definitely influence your chances of success in the market. You may want to test the following brokers to see which one best fits you:
Commissions$0 $6.95 for OTC Stocks
Currency or Derivatives?
Forex currency pairs and derivative options are two different asset classes, which naturally produce different strategies for success. When you are deciding the next market to take on, consider your own personality and investment goals before committing to one or the other. If you have more than $30,000 and you are willing to forego some short-term growth for a smoother experience, the forex market may be your play. If you have less money, need built-in leverage and don’t mind a bit of volatility, then options could work for you. As always, never invest money that you are not willing to lose — both of these markets and asset types carry risk.
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