Pete dives into trading currency spreads to remove USD from the equation. Cross currency pairs increase your number of unique trades and can increase your ability to keep a portfolio uncorrelated.
Forex vs Traditional Futures
Traditional futures and forex futures operate in the same basic manner. A contract is purchased to buy/sell a specific amount of an asset at a specific price on a predetermined date in time.
Cross Currency Futures Spread
In order to trade cross currency futures, you need two contracts: one that you buy and one that you sell against the one that you purchased.
Benefits to trading cross currency spreads are:
- Lower margin requirements (generally less risk)
- Profit ‘potential’ regardless of price direction
- Increased number of strategy options
What Are Currency FX Futures?
Currency futures are an agreement (futures contract) to trade one currency for another at a given date.
Typically, the price of the future is in terms of U.S. dollars per unit of other currency (given that one of the two currencies is the US dollar). When the U.S. dollar is not one of the currencies, this is called cross currency.
Cross Currency Definition
A pair of currencies traded in forex the excludes the U.S. dollar. One currency is traded for a different currency without exchanging the currencies into American dollars.
When trading currencies, it is import an (as always with futures) to keep in mind the notional value. If the futures of two different currencies represent significantly different amounts of currency, they need to be balanced out. To do this, we need to find the spread ratio for the currencies.
What Is A Spread Ratio?
To place an inter-market spread, you must first derive the spread ratio from the currency futures.
The spread ratio indicates the ratio of futures that must be held in the markets to equalize the value of the position held on both legs of the spread. This can be a little confusing, so let’s look at an example.
Calculating A Cross Currency Spread Ratio
Remember, to find the notional value of a contract, we multiply the amount of currency one contract represents by the price the future is trading at. Check out the examples below…
Euro FX futures are currently trading at 1.1425 and one contract represents 12,500 Euros. The notional value would be: 12,500x1.1425 = $14,281.
British Pound futures are trading at 1.5894 and one contract represents 6,250 Pounds. The notional value would be: 6,250x1.5894 = $9,935.
Now that we have the notional values, we can determine the spread ratio that we want to use for a cross currency trade.
To figure out the ratio, we divide the Euro's notional value by the Pound’s notional value. $14,281/$9,935 = 1.43.
This translates to approximately 2 Euro FX contracts to 3 British Pounds contracts, or a hedge ratio of 2:3.
Strategies: Cross Currency Spread
Products Discussed In This Episode: /M6E, /M6B
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