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Introduction.
The object of this guide is to briefly explain in straightforward plain-language some of the many risks involved in trading in currencies and currency options. It also attempts to describe some basic concepts of financial risk itself in a way that is not only understandable, but also useable in evaluating the risks of trading in currencies and currency options. For it is precisely and only the assumption of risk of loss that gives rise to the opportunity for profit in the first place.
Risk is fundamental to profit. The terms risk and profit are inseparable, opposite sides of the same coin. So the profit potential of any given financial opportunity can only be assessed in the context of its attendant risks.
This booklet is divided into two sections. The first section is a brief, general discussion on the concept of financial risk. The second section will try to identify some of the specific risks and other significant aspects of trading in currency options. If you trade, you are certain to confront these risk-related issues. Both sections, loosely termed here as systematic and specific risks, are necessarily incomplete and should serve only as an introduction to the concepts and aspects of fu-tures and options risk.
About Financial Risk.
An exhaustive study of the concept of risk would span subjects from mathematics to philosophy, psychology to economic behavior, and include quantitative as well as qualitative analyses. Ultimately, the interpretation of risk is highly subjective and personalized.
Where someone falls on the Risk Aversion Curve, in other words, their "risk tolerance," depends on many di-verse and unique considerations. While risk and reward are always commensurate, the implications and effects of the potential or actualized gain or loss on any given individual can be very different from another.
In the final analysis, the question must be answered qualitatively: Will an investor's quality of life be improved more by the expected gain than will it be decremented by the potential loss? The very essence of the economic con-cept of the Diminishing Marginal Utility of Money.
Risk has two aspects: 1) The probability that a loss will occur, and 2) the amount of money that is at risk if the loss does occur. In other words, the probability and magnitude of the potential loss. To illustrate, on the extreme ends of the risk spectrum are a lottery ticket and a US Treasury bond. The lottery ticket has an extremely high probability of a loss occurring, but a very small amount of money at risk. On the other hand, the Treasury bond has a very small chance of loss, but, if a loss does occur, a much greater amount of money would be lost.
Between these two extremes on the spectrum of risk lie virtually all financial investments, speculations and gambles. The risk evaluation process must weigh and consider both aspects of risk to be effective.
Futures markets (and to a lesser extent options) are anticipatory price discovery mechanisms. The futures price constantly changes placing premiums and discounts to re-flect future expectations of market participants. Some aca-demics theorize that at any given time the current market price of any commodity (stock or other liquid asset) reflects all known information about that market, and any future price movement is an absolute uncertainty, completely ran-dom in nature (i.e., Random Walk Theory).
The mental picture of all market participants divided into two equal groups captures this concept. Half think the market will go up, the other half think it will go down. When one market participant changes his or her mind and moves to the other side, the market price will change until all market participants are again divided into two equal groups.
Theoretically and practically, no one knows which way the market will move. Not your broker, not the principals of the firm, not the exchanges, not market-makers, not even the government, Federal Reserve Board Chairman or the President of the United States himself. We emphasize this point because it should always be kept in the forefront of one's mind while viewing the futures market or any other market. (In fact, if anyone did ever truly know in advance where the market was going, the very integrity of the market itself would be beached.) Furthermore, it is philosophically true and statistically proven that the past price movement of any given market is not, and cannot be, predictive or even indicative of future price movement.
The futures markets, and other liquid markets, reflect the uncertainty that looms over all human affairs. Indeed, the origin of the futures market itself is derived from people's innate desire to identify and avoid such uncertainties. One of the major functions of modern futures markets is to transfer risk. Those who are willing to accept the transfer of these risks do so in hopes of generating a profit, because they are speculating on whether the price will rise or fall from its current level.
Risks of trading in currencies and currency options.
In considering whether to trade in the high risk trading in currencies and currency options markets where there exists a substantial degree of price volatility and financial leverage, you should understand and seriously consider all of the following real risk factors which you are certain to encounter:
1. Trading in currency and currency options involves an extremely high degree of risk of loss. Investors can and do lose all or part of the money they deposit. Because of the volatile nature of trading in currencies and currency options, the market price and, consequently, the value of your account can rise and fall sharply without notice. The use of leverage and/or options can substantially increase your risk of loss. Deposit only risk capital, in other words, money you can afford to lose.
2. As the result of an adverse price movement, or other factors, you may sustain a total loss of your initial deposit (including commissions paid) and any additional funds that you deposit. You may also be subject to losses that exceed the amount deposited in your account when trading in futures and short (opening sell) options. The use of leverage generally causes the value of your market position to change at a greater rate than that of the underlying asset, substantially increasing the risk of loss.
3. An option is an extremely complicated trading vehicle, which carries substantial risks that are not inherent to the trading of the underlying asset.
For example, options lose value with the passage of time (time-decay); options are generally not fully responsive to the price movement of the underlying asset (delta). Option profitability is substantially dependent on the exercise (strike) price of the option relative to the underlying market price. An option with a strike price that is "deep out-of-the-money" is has only a remote chance of ever becoming profitable. Long (opening buy) options have risk that is limited to the amount of the option premium plus the commission, however, short (opening sell) options have unlimited risk. You should familiarize yourself with the specific and systematic risks, terminology, and workings of long and short, call and put options before depositing money for options trading.
4. No trading system has ever been devised that can consistently produce profits or predict the market. It is only the assumption of risk of loss that gives rise to the opportunity to profit. Some academics theorize that at any given time the current market price of any commodity or stock (or other liquid asset) reflects all known information about that market, and any future price movement is an absolute uncertainty, completely random in nature (i.e., Random Walk Theory). Past price performance is not necessarily predic-tive of future results. The trade recommendations of bro-kers, traders, advisors, and analysts represent only their opinions and are normally insignificant in the face of the overall market.
5. Placing certain types of orders, such as stop-loss or stop limit orders, which may be intended to limit the amount of loss, may not be effective because price movement or market conditions can make it impossible to execute such orders. Strategies utilizing spreads and/or straddles may have as much risk as simple long or short positions. It may be difficult or impossible to execute orders and offset or liquidate open market positions due to market liquidity and/or operations.
6. Commissions, bid/ask spreads, and other transaction costs can have a substantial adverse effect on your market positions' ability to break even, and, therefore, your ultimate profitability or loss. In order for you to achieve a net profit on any transaction, the price received upon the sale of the market position must exceed the purchase price by at least the amount of any commissions paid and other trans-action costs.
Trading futures and/or options may involve frequent purchase and sale transactions, resulting in significant commissions and costs. Commission charges and other such cost increase the risk of loss and can account for all or part of trading losses. Generally, to calculate your breakeven price, total all commissions and fees, divide by the unit quantity involved in the transaction, and then add the result to the buy price or subtract it from the sell price.
7. There is always a risk associated with the solvency of the exchange, the clearing firm and the counter-party to your transactions. There is no governmental or private institution or party that can truly "guarantee" performance on open positions in the any market, nor is the brokerage or clearing firm insured against default or insolvency.
8. Any transactions that are made in international over-the-counter markets outside of the jurisdiction of the United States government are not subject to US government regulation. Foreign markets may have regulations that differ significantly from those in the US, and may afford substantially less customer protection. While some off-exchange markets are highly liquid, such transactions may involve greater risk than trading in the US counterparts because there is no exchange on which to close out open positions.
9. Significant conflicts of interest exist between you and the brokerage firm, the clearing firm and the exchanges. A conflict exists because the brokerage firm and clearing firm stand to gain from increased trading activity in your account, which generates increased brokerage commissions and/or clearing fees. Both the brokerage and clearing firms are free to engage in any futures or option transaction, capacity or activity that either deems appropriate, despite whether it may present an apparent, potential or actual conflict of interest with your account.
10. Trading on an electronic trading system (ETS) may differ significantly from non-electronic trading environments. If you undertake transactions on an electronic trading system, you will be exposed to risks associated with the system, including the failure of hardware and software. The result of any system failure may be that your order is either not executed according to your instruction or is not executed at all.
You should have sufficient knowledge and experience in financial and investment matters as to be capable of understanding and evaluating the risks and merits of trading in currency and currency options. If you lack such knowledge and experience, or do not understand trading in currencies and currency options, you should seek the advice of a qualified attorney or trained financial advisor before depositing any money for trading purposes.
This brief statement cannot identify all of the risks and other significant aspects of trading in currency and currency options. You should, therefore, carefully study and understand the CFTC required Risk Disclosure Statement and all aspects of the account, the market, and the trading vehicle, prior to depositing any money for trading. If you do not understand any part of the Risk Disclosure Statement, seek the advice of a qualified attorney or trained financial advisor.
Suggested Reading.
Risk, Uncertainty and Profit
Frank H. Knight, McMillan Publishing Co.
The Remarkable History of Risk
Peter L. Bernstein, John Wiley & Sons, Inc.
Portfolio Selection & Efficient Diversification of Investments
Harry Markowitz, Baldwin Publishing
The Complete Guide to Futures Trading
Jack Schwager, Harper Business
Option as a Strategic Investment
Lawrence McMillan, New York Institute of Finance
Option Volatility and Pricing Strategies
Sheldon Natenburg, Probus Publishing Co.
Market Wizards
Jack Schwager, Harper Business
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FUTURES, FOREX, AND OPTIONS TRADING INVOLVE SIGNIFICANT RISK OF LOSS AND MAY NOT BE SUITABLE FOR EVERYONE. OPTIONS, CASH, FOREX,
& FUTURES MARKETS ARE SEPARATE AND DISTINCT AND DO NOT NECESSARILY RESPOND IN THE SAME WAY TO SIMILAR MARKET STIMULUS. A MOVEMENT IN THE CASH MARKET WOULD NOT NECESSARILY MOVE IN TANDEM WITH THE RELATED FUTURES, FOREX & OPTIONS
CONTRACT BEING OFFERED.
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