The Smart Investor content is intended to be used and must be used for informational purposes only. We are not an investment advisor and you should NOT rely on this information to make investment decisions.
And as we know, volatile is bad for investors – but great for traders. It's only part of the reasons why we see more and more people are finding it a breeze to enter the foreign exchange market nowadays.
Years ago, only banks and other financial companies with deep enough pockets traded in foreign currency. Today, almost anybody with a few hundred dollars can become a forex trader. Many forex brokerages have opened the forex market to single investors who want to do their own trading. Investors can just open a trading account then buy and sell foreign money anywhere and anytime with hardly any restriction.
Sure, an investor can make a lot of money instantly by trading in foreign currency and get other advantages too. However, the investor will also face enormous risks.
So, read this article before you start investing in foreign currency.
Forex Trading – Benefits And Risks
Investing in foreign currency carries a huge amount of benefits as well as risks.
The foreign currency market is the broadest and most liquid market in the world. Many of the risks in forex trading are unique to the market and particularly different from equity or bond markets. It is also a more volatile market to invest in owing to the prevalence of higher leverage in the community. This volatility increases the risk in forex investing. To help you understand more about these benefits and risks, we prepared the discussion below.
Forex Trading – Benefits
Forex market is the biggest and most liquid market in the world.
Nothing comes close to the foreign exchange market when it comes to breath and reach. It is undoubtedly the biggest market in the world. It is also the most liquid market there is. The aggregate average volume of in a foreign currency trade can reach four trillions of dollars daily. Investors who want to learn about foreign exchange have nearly every day each week to pick a thing or two. By buying and selling on a daily basis, an investor can become an expert in no time.
Just the same, to be successful, knowing the trading processes is a must. Investors must also be able to make good decisions on whether to buy, sell or hold their currencies. This will help them make the most trading income for their transactions.
Diversification Is The Key
It provides a great opportunity for diversification. The foreign exchange market offers investors a vast opportunity to diversify. One is not limited to trading in US dollars. In fact, holding many different foreign currency assets reduces an investor's risks.
You can't find this characteristic in a standard equity market. This kind of benefit allows investors to trade in different currencies and generate profits regardless of how the US dollar performs.
The market is open 24 hours every day. The forex market is awake generally 24/7. This means that investors can buy or sell anytime depending on their preference. Forex trading can already be a full-time career or employment or it can be a part-time venture.
It depends on what the investor wants or what he finds most suitable for him. Technology has broken down the time and geographical barriers such that traders can transact round the clock.
It allows investors to trade in many currencies
The forex market gives investors the freedom to trade in many currencies. Generally, investors can hold trading assets in different currencies. They are not restricted to US dollars or to the currency of the country where they live. They can also shift to other currencies any time. This provides investors with a certain level of protection by minimizing losses or boosting income from a strong currency.
It is open to all. An investor can trade in forex anywhere – even right in the comfort of his living room. Many brokerage firms and companies offer online platforms and applications that let individuals trade forex on their own convenience. This means that just about everybody can be a forex trader and make it a career.
Forex Trading – Risks
High leverage usually marks the forex market. The foreign exchange market moves in small steps but the currency rates jump or fall accordingly every moment. This is why investors must understand that high leverage is essential for their margins. This increases the trading risks of an investor especially those directly doing buy and sell of foreign currency.
The market is exceptionally volatile. Investors should know that pretty much everything affects the foreign exchange market making it highly volatile. No currency really remains stable for a very long time. Fiscal policies, economic situations and political conditions have a great influence on the currency values. Many central banks also intervene to try to stabilize their own currencies. What all of these things do is cause the rates to either soar or fall significantly for every factor.
Investors should institute risk controls and management procedures against these factors. The objective is to eliminate or lessen the risks and make money in the long run. An investor should also aim to store adequate funds that he can use when an opportunity arises. This would avert the need to leverage in case a good opportunity comes along.
Top Currencies To Trade
US Dollar (US$) – It is widely known as the ‘greenback' owing to the dominant shade of green for all its denominations. Everyone knows that it is the official currency of the United States, the biggest economy in the world. Just the same, the US dollar is highly influenced by the Federal Reserve and any pronouncements about interest rates. This currency is the benchmark for other currencies. Major currencies like the Euro, Japanese yen and British pound gauge their values against the US dollar.
European Union Euro (EUR) – The Euro is the official currency of the economic group Eurozone, consisting of 28 member states of the European Union. The European Central Bank in Frankfurt, Germany serves as the overall administrator of the currency. It is currently the second largest reserve currency in the world next to the US dollar.
Japanese Yen (JPY) – Investors popularly trade the Japanese Yen using the carry trade strategy. In this strategy, traders borrow a currency with a low interest rate to build funds. They then use the funds to buy a different currency with a higher interest rate. The yen has a low interest rate and is ideal to fund purchases of currencies such as New Zealand and Australian dollars. Trading this currency is often unpredictable so investors should be technically prepared. They would normally have to make extended decisions because of changes in the exchange and interest rates.
British Pound (GBP) – The British Pound is another volatile currency. Traders also call it the “pound sterling” or “cable”. In a given day, traders should expect the exchange rates to move numerous times. The sways can vary anywhere from 100-150 pips. The pip is a very small measure of change in a currency pair in forex trading. The British pound can narrow as low as 20 pips in one trading day.
Swiss Franc (CHF) – The Swiss banking system operates a little differently from the other central banks. It assumes the role of a central bank but it has public and private rights ownership. Traders have always considered the Swiss Franc as a stable currency because the government carefully keeps its value at a certain range. The currency enjoys a unique relationship with the Euro – their values hardly stray too far from each other.
Canadian Dollar (CAD) – The Canadian dollar moves about 30 to 40 pips each trading day. Interestingly, several currency values and commodity prices shift at about the same time. There has been a long-existing correlation between the Canadian dollar-US dollar exchange rate and crude oil prices. This could be because of the large volume of energy-based goods that Canada sells to the United States. This correlation between the Canadian dollar rate and crude oil price is a unique and distinct feature of the currency.
Australian/New Zealand Dollars (AUD/NZD) – Both the Australian and New Zealand government have agreed to a common inflation target and are working to promote it. This has caused their currencies to become one of the more stable ones in the market. As a result, they have become the popular choice of many carry traders. The Australian and New Zealand dollars provide the highest yields in comparison to the major currencies traded in many markets.
South African Rand (ZAR) – The South African rand is one of the most notoriously turbulent currencies in the market. It can move to a range of 1,000 pips in a given day. However, in terms of dollar values, the 1,000 pips remain insignificant. It basically moves according to the movement of the pounds sterling. Carry traders love to pair the South African rand with the US dollar. Investors often look at the rand's relationship to the prices of gold and platinum.
How To Invest Directly In Foreign Currency?
It can be complicated to participate in the largest and most liquid market in the world.
With an average daily volume that can reach trillions of dollars, it can easily intimidate a small trader. The market is now actively composed of banks, investment companies, trust companies, insurance firms, hedge funds and even government treasuries. However, there is also a very, very long list of individual retail investors in the market. Everybody can sell, buy, exchange and speculate on different currencies in the forex market.
Forex investors can trade specific currencies on the market through foreign exchange brokerages. They make it more simple and more convenient to retail investors.
Through these firms, an investor can make a preliminary deposit of as low as three hundred to five hundred dollars. He can then start to buy other currencies with margin ranges of 10:1 to over 10,000:1. The brokerage firms provide access to the market because technically, banks still do forex trading ‘interbank' among them. The firms make money by collecting fees whenever you make a trade.
Having an account in a brokerage firm also gives an investor access to forex leverage. Basically, forex leverage allows the investor to control a larger account than what he has in his account. This increases his opportunities to make more profit but also increases the amount of risk he can take.
Success in forex trading also begins with the choice of a top and reputable brokerage firm. This is because the US government does not strictly regulate the forex market as much as the equities market. Many investors find it better to use a brokerage firm that is free from regulations by global authorities.
There are also other ways an investor can make money in the foreign currency market. These are:
- Foreign currency futures
- Foreign currency options
- Investing in exchange-traded funds (ETFs) and exchange-traded notes (ETNs)
- Buying foreign currency Certificates of Deposit (FXCDs)
- Foreign bond funds
What Is Currency Hedging?
A foreign currency trader should be wary of an exchange risk that is present all the time. A serious investor will usually protect himself against this risk by doing a strategy called currency hedging. Employing a currency hedge safeguards his position against any undesirable exchange rate shifts. A properly done hedge will protect an investor from any hitch risk. If he happens to hold less of a currency pair, hedging will protect him from an upside risk.
The main way to hedge is by using spot contracts and foreign currency options. Retail forex traders mostly use spot contracts for their transactions. They have a quick delivery deadline, mostly only up to 48 hours. The quick turn-around does not make this the most effective way to hedge.
In fact, the more spot contracts a forex trader uses, the more he needs to hedge.
Forex options are the most common among traders when it comes to hedging.
They work similarly to the options used in other securities trading. It offers the trader to buy or sell the currency at any specific exchange rate of choice in the future. Investors make use of different standard positions to reduce their risk of losses on a particular trade. They can be: long straddles, long strangles, and bull/bear spreads.
Currency Hedged Funds
Take note that not all available trading platforms have hedging capabilities.
It is therefore wise to thoroughly study the features of the platforms on your shortlist. Some brokers do not allow hedging on their platforms. So, before you begin to trade, do good research about your brokerage firm. You may want to consider hedging to stay safe from rate shifts and its potential losses. The downside to hedging is that it somehow limits the investor's opportunity to diversify.
The most popular currency hedged funds are the following:
- Wisdom Tree Europe Hedged Equity Fund (NYSE: HEDJ)
- Wisdom Tree Japan Hedged Equity Fund (NYSE: DXJ)
- iShares Currency Hedged MSCI EAFE ETF (NYSE: HEFA)
If you really want to invest in foreign currency, you might as well try ETFs first. You can conveniently trade this with any stockbroker when you want. It has lesser leverage risks.
However, if you really want to trade directly in foreign currency, it is best to register with a forex broker. You should open an account and start trading with a margin.