Currency investing has recently attracted more interest as economic uncertainty has enveloped the globe. Historically, trading currencies was reserved to multi-national corporations and well-financed investors, but this market has been opened up to the average investor. (For an in-depth guide to foreign exchange trading, check out our Forex Walkthrough.)
IN PICTURES: Top 10 Forex Trading Rules
The foreign exchange market (forex) is where currencies are traded. For multinational companies, this market provides a means of doing business in other countries, facilitating the payment of bills in the local currency. For speculators, this market provides opportunities to take advantage of movements in exchange rates. Here are some reasons to consider investing in currencies.
You can use currencies to balance your portfolio, particularly if it is heavily focused in U.S. equities. For example, it you believe the dollar will drop in the future, you can buy one or more currencies that you think will rise.
One difference between stocks and currencies is that stocks move independently of each other while currencies move relative to each other. With currencies, when one is rising, another must be falling. (Learn more in Take Advantage Of Moves In The Dollar - Get Started With Forex!)
- Level Playing Field
Unlike stocks, the news that drives currency prices is available to everyone on a real-time basis. In theory, there are no "insiders" in the foreign exchange market which operates 24 hours a day around the world. Since currency valuations are driven by actual monetary flows and events that influence a country's economic health, you can do your own analysis of how these events might impact its currency.
IN PICTURES: Break Into Forex In 12 Steps
- Global Economic Hedge
There is a growing fear that current U. S. fiscal and monetary policies will generate inflation and weaken the dollar over time. Growing budget deficits, record low interest rates and the amount of money being created by the Federal Reserve are all reasons for concern, and these developments are being closely tracked by currency traders.
The currency market allows you to select currencies based on how you perceive their relative values will change over time. You can bet both ways, either long or short depending on which direction you think a particular currency is headed. You can allocate your risk across the currencies of several countries, allowing you to profit from changing global macroeconomic conditions.
- Capital Appreciation
Currencies are akin to commodities and stocks because they offer the potential for capital appreciation. If the value of your currencies rises against the dollar, you will profit. If your currencies fall relative to the dollar, you will lose money. (Don't get caught. Read Protect Yourself From A Falling U.S. Dollar.)
- Hedge Against Political and Event Risk
Currencies can be played against each other based on your tactical assessment of important events going on around the world. Examples are changes in top leadership, interest rate fluctuations, currency revaluations, wars, political upheavals, trading sanctions, new tariffs, monetary policy changes, trade deficits, recessions, tax changes, import restrictions and health-related epidemics.
Risk vs. Reward
Currencies are subject to risks that go well beyond the borders of each country, so an understanding of the interaction of global economies is important. Perception can be more important than reality since it's impossible to know exactly how critical world events will all play out once they start. Any of these events can happen in an instant without warning, making currencies subject to significant short-term volatility.
The risks and rewards of the forex market are amplified by leverage. Your potential profit or loss is multiplied by the leverage ratio, which can be in excess of 100:1. It's similar to trading stocks on margin because you can risk more money than the value of your capital account. This opens the door to profits on tiny moves in currencies if the trade goes in your favor, but your losses are multiplied if it goes in the wrong direction.
To minimize risk, spread your investment like you would with equities, choosing the currencies of countries that you are following closely. It's important that those countries have a stable financial and banking system. Also, if you are going to use leverage, start slow and work your way up. (Ready to get started? Don't miss How To Place Orders With A Forex Broker.)
The Bottom Line
Before engaging in currency trading, consult with a broker who understands the markets and can help you determine if currencies are appropriate for your personal portfolio. While currencies have a reputation of being highly volatile, they actually trend with less volatility historically than many stocks.
Unless you are an experienced trader, it's not advisable to engage in currency day-trading. You will be up against professionals who make a living studying these markets. Over the longer-term, currencies provide another option for taking advantage of unfolding events on a global scale. (Try forex investing for free with our Forex Simulator.)
For the latest financial news, check out Water Cooler Finance: The End Of The Recession.