Playing the FOREX Game

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Forex Plays

For a private investor in the UK, there are four main ways to speculate on currencies. You can open up a specialist forex account, take out a spread bet, trade a contract for difference (CFD), or buy a covered warrant call or put. Each alternative has unique advantages and disadvantages, as we explain below.

To open an account with a specialist forex market maker or to trade currency CFDs, you will need to demonstrate six month's experience in the forex markets. However, no such rules apply to spread betting or trading covered warrants on currencies. What's more, experience in the latter two qualifies you to apply for the former two.

Specialist Forex Accounts

The minimum deal size for a currency trade is usually set in blocks of 100,000, be it $100,000 or £100,000 - far higher than for spread bets or covered warrants.

You can work out what your dealing costs are by counting the pips. In the Hargreaves Lansdown example on page 5, the spread was five pips. For a trade of 100,000 GDPUSD, each pip costs you $10. For a trade of 200,000 EURGBP, each pip costs you £20. For a trade of 500,000 USDEUR, each pip costs E50.

Notice that, in the example on page 5, the two sterling trades cancelled each other out and that the profit or loss was in the second currency of the trade - in this example, US dollars. This will usually be the case with a dedicated forex account, since it is the second currency that is affected by movements in the exchange rate. When you come to convert profits or losses back into sterling, you will do so at the prevailing exchange rate (so your profits are exposed to fluctuations, too).

Spread Betting

The standard way to measure deal size with a spread bet is not by your total currency exposure, but by the amount you bet per pip - often as low as £1 per pip. "In spread betting, your profit or loss is your initial stake times the pips that the market moves between your opening bet and your closing bet," explains Simon Denham of Capital Spreads.

"So if you are trading EURUSD and you made a £20 up-bet by buying at 1.3045, and then you subsequently sold at 1.3075, you would have made 30 pips (13075-13045) on £20, or £600."

But notice that any profit or loss is automatically worked out in sterling - even if you are speculating on two foreign currencies. That saves you the cost and inconvenience of translating winnings (or losses) into sterling.

Whether or not you prefer a spread-bet account to a direct currency account will depend on your experience, the size of trades you are contemplating, the speed of the trading platform and the total costs. Given the absence of commissions, those costs boil down to the spread, any administration costs and any 'haircuts' applied to the overnight interest rate.

For a spot trade that you open and close on the same day, the only cost is the spread. For a rolling bet (one that you intend to keep open for a few days), the cost is the spread adjusted for any 'haircut' that the spread-better applies to the interest rates earned/charged on your pair of currencies. Some spread-betters also apply a fee to roll over a bet from one day to the next.

If you want to apply a stop-loss on your trade, you can do so free of charge. However, a guaranteed stop-loss - which would hold good even if the dollar fell 5 per cent in a minute - will cost you more. That extra cost will be factored into the spread, widening it by four or five pips. For a forward trade, the only cost to consider is the spread, which will always be wider than for a spot trade.

Contracts for Difference

A typical contract for difference (CFD) is an agreement between you and a broker, such that, if a share rises, he will pay you the difference between its price when you opened the contract and when you chose to close it - if it falls, then you must pay him the difference. You are not liable for stamp duty although, unlike spread bets, you are liable to pay capital gains tax if your profits exceed £8,200 in one tax year.

The big advantage with CFDs on currencies is that the spread is likely to be tighter than for spread bets. Most CFD trading is in shares, but a lot of brokers will also offer them on currencies.

The spread for a currency CFD should always be at least as narrow as for a currency spread bet - and usually narrower. The spread on cable is six pips wide for both IG Index and City Index spread bets, for example, while their CFDs have spreads of three pips and four pips, respectively - and City is likely to reduce that to three pips before long.

As for charges, some equity CFD trades still attract commissions, but you should never have to pay extra fees when trading currency CFDs. "Anyone charging commissions for CFDs on currencies is ripping you off royal," is how one broker put it.

Depending on the broker, you can trade CFDs with stop-losses and guaranteed stop-losses (for an extra charge that equates to around five pips on the spread, in the case of City Index).

Covered Warrants

Covered warrants come in two types: call warrants and put warrants. You would buy a GBPUSD call if you were bullish about sterling against the dollar, and a put if you were bearish.

There are 59 currency warrants listed on the London Stock Exchange (LSE), 21 of which are on GBPUSD and 16 on GBPEUR. For example, SG's S926 call warrant gives you the right, but not the obligation, to 'buy' sterling at an exchange rate of $1.90 to the pound at the expiry date of 19 December 2005.

Suppose sterling rises above the $1.90 level by then. The warrant will finish 'in the money'. You will have the right to buy sterling at $1.90, but you could buy it on the open market for more by then - let's say it is trading around $2.00. For every warrant that you hold you could theoretically exercise your option to buy at $1.90, and then sell on the open market for $2.00.

In practice, warrants are cash-settled, which means that, even if you hold the warrant at expiry, you need not buy or sell the currency. Instead, you receive the cash equivalent. For the simplest warrants, that would be the 10¢ difference between the $1.90 strike price and the market price of $2.00. But each currency warrant gives you the exposure to 10 units in the underlying currency (in the jargon, currency warrants are said to have a nominal value of 10). That turns a 10c profit into a $1 gain - or 50p at the new exchange rate.

At the time of writing, this $1.90 call warrant trades for about 20p. If sterling does climb to $2.00 by December, the warrant will rise to 50p - a return of 150 per cent. But, bear in mind, that if sterling just scraped to $1.90 or $1.91, you would lose money. Technically, the warrant would finish in the money, but that excludes the price you had to pay. For this reason, you should always know the break-even level for any warrant you are thinking about buying.

But this emphatically does not mean you have to wait for sterling to rise to $1.937 to see a profit on your warrant trade. Think of the break-even level as a way to work out the cost of the downside insurance you always get with a covered warrant (you can never lose more than your initial stake).

In real trading, warrants are often bought and sold on the same day. The biggest profits tend to be made by people who buy warrants when they are just on the wrong side of making even a sliver of profit, but which then move into the money.

The standard advice is to research the variety of covered warrants available on a single underlying using a scenario selector. This software lets you see what would happen to each warrant under a wide range of market scenarios. Unfortunately, it does not work for currency warrants.