If you like investing, you may know something about how currency exchange rates can affect investment returns for better or worse. But even a lot of seasoned investors aren't fully aware of a whole other "world" out there where dollars, pounds, euros, yen and other currencies are traded just like stocks. IN PICTURES: Top 6 Most Tradable Currency Pairs
The Other Market
That other world is the Foreign Exchange Market (forex), and it actually makes the stock markets look kind of small. It spans the globe and boasts a trading volume of around $4 trillion daily. That dwarfs the approximately $50 billion in volume (in 2009) transacted each day on the New York Stock Exchange (NYSE), the biggest equities exchange in the United States.
How Forex is Different
Before there was electronic trading, currency transactions were pretty much limited to financial institutions with millions of dollars like major banks and large investment firms. But now, virtually anyone with a computer and an internet connection can trade currencies on forex 24 hours a day, except for weekends. The NYSE and other major stock exchanges usually only operate from 9:30am-4pm ET, during weekdays.
Like the big stock exchanges, forex is highly liquid, so trading is very quick, efficient and low-cost. However, it has no central exchange or clearinghouse, and it isn't regulated nearly as much. Because it's "decentralized," forex is a bit more like the Wild West of investing. There are lots of "market makers" to exchange currencies with and there can sometimes be noticeable differences in exchange rate spreads between market makers.
Bigger Risk, Bigger Reward
You should also be aware that currency trading is highly risky. You can make a lot of money quickly, but can lose much or all of your investment just as fast, due to extreme volatility in currency values, and because forex trading usually involves a high degree of leverage, or borrowing. Speculative investors often use leverage because it can greatly magnify investment returns, but it can magnify losses just as much. (For additional information, take a look at Forex Leverage: A Double-Edged Sword.)
So if you're thinking of making currencies part of your investment strategy, consider leaving the trading to the pros and get in with the help of an experienced broker or through mutual funds and/or exchange-traded funds that specialize in currencies. It would be wise to speak with an independent financial advisor about currency trading, too.
IN PICTURES: 5 "New" Rules For Safe Investing
If you'd like to do your own forex trading, there are precautions to take before diving in and risking your hard-earned capital. First, find a reputable market maker. They're easy to find with an internet search. The key is to make sure yours belongs to at least one self-regulatory body, such as the National Futures Association (NFA), so you'll have as much protection as possible. Some of the more reputable market makers belong to a number of foreign self-regulatory organizations, as well as the NFA.
The best ones also offer a free demo account, so once you've chosen a market maker, consider taking advantage of that feature - especially if you have little or no forex trading experience. A typical demo account allows you to begin practicing with a large hypothetical starting balance, so you can learn the ins and outs, see the risk potential firsthand and get a sense of your ability to earn profits before you risk any real money.
The Bottom Line
Once you feel ready, you can open a live account with as little as $100, depending on the market maker. Be sure not to invest more than you can afford to lose, and don't feel bad if you end up worse off than when you started. You wouldn't be the first.
Try trading Forex with our FREE Forex trading simulator!
For the latest financial news, see Water Cooler Finance: Poverty Rates Increase - And So Do Millionaires.