The Ins, Outs, Ups, And Downs Of Currency Trading

10 mins

The Ins, Outs, Ups, And Downs Of Currency Trading

Mentioned in story

Why You Should Care About FX

Currency markets are big. Really, really big. In fact, they’re the biggest market in the world, with more than $5 trillion changing hands each day. They’re also old. Really, really old. After all, it’s nearly 2,000 years since Jesus got bolshy with the money changers in the Temple.

Give me the lowdown. There are some 180 currencies around the world today. Whether florins in Aruba or Ethiopian birr, each pumps through their nation’s veins. That’s fine within a single country: a Malaysian shopkeeper can swap their ringgit for dinner down the road, and everyone’s happy.

But whenever we cross a border we hit a snag. A Nigerian naira isn’t much use at an American Walmart checkout. So what’s to be done?

Enter the currency markets (also known as “foreign exchange”, “forex”, or just “FX”). A Nigerian can use their naira to buy US dollars to pay Walmart. But first they have to find someone else to buy their naira and sell them good ol’ greenbacks. Fortunately, giant middlemen step in. They’ll buy the naira and hold them until someone else wants them: perhaps a foreigner looking to buy in Nigeria.

How do they know what to swap for? Most currencies nowadays “float”, which means their value constantly changes relative to others. When we talk about exchange rates, we mean how much of one currency you can buy with another. £1 might get you about $1.30 today, but back in 2008 it’d get you over $2.

Why do I need to worry about any of this? As an investor, your wealth will be directly affected by currency swings on the daily – even if you don’t own a passport. Any time you invest outside your home country you buy into another currency, whether you like it or not. And even if all your investments are in domestic companies, they’ll almost certainly be buying from or selling to foreign firms – meaning currency moves will hit their profits.

There are also plenty of venues offering you the chance to speculate on moves in currencies – if you’re willing to take a risk. But we’ve gotta be franc: trying to actively trade currencies can give your wealth a pound-ing.

So, even though we wouldn’t recommend that newbies sit at home trading currencies, we still think it’s useful for all investors to be aware of how this fundamental market functions.

How Currency Trading Works

Currencies can only change their value relative to each other – so FX traders mainly refer to them in pairs. For brevity, they also assign each currency a three-letter abbreviation. So the US dollar is “USD”, the Japanese yen is “JPY”, the British pound is “GBP”, and so on.

Traders might say they’re “buying USD/JPY” (known as a currency pair), which means they think America’s currency will strengthen against its Japanese rival. That means they think that in future, $1 will be able to buy more yen than it can today. Buying USD/JPY means you’re buying dollars and selling yen. If the dollar does strengthen, you can then sell your dollars, which will now buy you more yen – and make you a profit.

Unlike moves in stocks, daily currency fluctuations are rarely dramatic. Instead, you’ll normally see constant tiny changes of a fraction of a percent, which might add up to a chunk of change over time. The more you put in, the bigger your returns – but only if you’re right about which direction the currency goes in.

But what moves the value of currencies? Macroeconomics always has a finger (or three) on the scales:

🔹 Interest rates: Higher interest rates in a country mean a greater return on its investments, so investors buy more currency to invest there – driving up its value.

🔹 Trade balance: If a country is exporting more than it imports, lots of people overseas are buying the country’s currency in order to pay the exporters for their goods – and the high demand will boost that currency’s value.

🔹 Politics: Events like elections and referendums can squash currencies. Market belief that a new leader’s policies might hurt the government’s finances or economic growth can undermine a currency’s value. Fewer people will want to invest – and lower demand for the currency equals lower prices.

Is speculation the only game in town? You can attempt a “carry trade” to exploit the difference in interest rates between countries. Since Japanese interest rates are much lower than in the US, you could borrow yen, swap them for dollars, and then invest those dollars in American government bonds.

Once you've got a satisfactory return, you can sell the bonds, convert your dollars back into yen, and pay back your Japanese loan. Your profit is simply the interest rate you’ve been paid on the bonds, minus the cost of borrowing – if the exchange rate has stayed constant. But if the dollar weakens during the trade, your swapping might not peso good.

But what’s the appeal of straightforward forex trading?

The Appeal Of Currency Trading

What can FX trading do for me? The most active market in the world is open 24 hours a day, five days a week, with major currencies constantly traded between lots of different players. Unlike stocks or bonds, that liquidity offers quick trades no matter when you log on.

Forex trading also offers massive “leverage”: borrowing money in order to magnify your gains, or indeed your losses. Many people active in the currency markets are buying with money they’ve borrowed, hoping for fat returns. In some countries (including the UK) “spread betting” is a tax-free method of leveraged trading – but that comes with risks we’ll look at in the next session 🎲

FX can be a gambler’s game of choice for speculative short-term bets on exchange rates or long-haul gambits on a nation’s success or downfall. For example, were the American economy set to slow, that’d probably mean a stumbling dollar. Your Yankee currency might be better off swapped for, say, Japanese yen for a while.

What if I’m not feeling lucky? Forex might not be your money maker – but it could be a money saver.

Any investments outside of your home country expose you to currency risk. A Brit investing in US stocks would see any gains denominated in dollars. But when that comes home, you’ve got to convert it back into pounds – and a weakening dollar could leave you tarred and feathered.

Forex trading lets you “hedge”, or mitigate, that risk. There’s more on the ins and outs of this in our Futures & Options Pack, but briefly: so-called forwards let you lock in a future exchange rate, while options give you the right, but not the obligation, to use an exchange rate agreed now at a date in the future. You can activate the option if the exchange rate moves in your favor, or just let it expire unused if not.

A Brit (to take one example) could also bet against the pound in order to win whichever way the currency moves: either the pound falls and it’s payday on their bet, or else the pounds in their pocket simply increase in value. More on how to pull this off later.

Knowing about currency trading is essential for any investor – but that doesn’t mean it’s without risk. Time to learn about the FX rollercoaster.

The Risks Of FX Trading

What are forex’s risks? Currencies don’t grow in value like a company’s shares, nor is there regular income from dividends or bond interest payments. You can make money out of long-term bets on currencies, but it’s not really investing: just a long-term trade.

The currency market’s very appeal – its liquidity – can backfire on you. In certain circumstances, prices can move against you in a fraction of a second. We mentioned “leverage” in the last session – using borrowed money to trade with. Using leverage means that every movement in the currency’s price is magnified, so a sharp drop can quickly wipe out your holdings’ value.

Contracts for difference (CFDs) and spread betting are two popular types of leveraged forex trading available to Brits, but they’re particularly risky. Not only do they tend to offer you much more leverage than normal forex trading (which means your potential for losses is even greater), but they also don’t involve you owning the underlying currency when you trade – meaning it’s basically gambling. So while spread betting platforms masquerade as exciting investment opportunities, you’d statistically be more likely to win playing Russian roulette.

And other perils await. The forex market is poorly regulated (especially outside the US and UK), and dodgy dealers are on the prowl. If your trade starts going south, they can force you to cash out before it has a chance to recover – and you can lose far more than the amount you wagered.

Anything else? “Binary options” (now banned in Europe, but still available in the US) are another risky way to bet on currency changes. Here, you bet on, say, EUR/USD being 1.10 tomorrow. If you’re right, you get a payout – but if not, you lose your whole stake.

What about macroeconomic risks? When trading forex, you’re at the mercy of central banks, natural disasters, and angry presidential tweets. You can mitigate these risks by keeping informed and sticking to more stable developed markets (where dramatic economic changes are less likely). But no one can predict the future.

Now you’re fully briefed on the risks, we’ll tell you exactly how to trade currency.

How To Forex

How do I trade currencies? Find yourself a forex broker. And make sure they’re reputable. Check they’re registered with the financial authorities in your country and suss out what other traders say about them (we have your fellow Finimizers’ recommendations below).

The good news is, many forex platforms don’t charge a commission for each trade. But you still get squeezed: the platform keeps the difference, or “spread”, between the wholesale buy and sell prices of a currency. Check the “mid-market” price for a currency: the smaller the spread either side of that, the better for you. If the spreads look like those offered in an airport, you’re getting ripped off.

image

Once you’re in, you’ll see the option to buy and sell currency pairs, generally written like “GBP/USD”. Buying this pair is a bet on an increase in the pound’s value over the dollar. When the pound rises, the currency pair’s value goes up and you can sell for a profit. But if it falls, you’ll take a loss.

Is there a simpler way to trade currency? Nowadays you can buy exchange-traded funds (ETFs) that track the value of different currencies, whether you want to bet on a major currency against a basket of rivals or target a particular pair. These are much easier to get involved with, but that privilege comes with higher fees.

As we said earlier, most Finimizers are probably best off giving FX trading a wide berth – but at the same time, you’d be unwise to ignore its effects on your investments entirely. Whatever you do, be careful.

In this Pack you learned:

🔹”Forex” is not an Australian beer brand

🔹Currency trading takes advantage of exchange rate movements to make money

🔹These fluctuations are driven by underlying economic factors like interest rates and government spending

🔹Currency hedging can be a great money saver to protect your international gains

🔹But the FX market is very risky: disreputable dealers and scary leverage could wipe you out

🔹Currency-tracking funds listed on stock exchanges are the easiest way to buy into a currency bet

Finimize

BECOME A SMARTER INVESTOR

All the daily investing news and insights you need in one subscription.

Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

/3 Your free quarterly content is about to expire. Uncover the biggest trends and opportunities. Subscribe now for 50%. Cancel anytime.

Finimize
© Finimize Ltd. 2023. 10328011. 280 Bishopsgate, London, EC2M 4AG