Few people look at foreign exchange as market to invest in. It is promoted by Forex dealers and trading platforms in such a way to maximise returns for the brokers and be as reliable as the blackjack table for returning money to traders. For instance a $100,000 contract can be bought or sold for around $1000. This may mean you are controlling a huge amount of money at very low cost but if the market moves 1 cent against you, your $1000 will be gone. The risk is huge if you don't know what you are doing. Trading platforms offer a range of indicators and tools like stop losses to manage risk but these can often make it easier to lose money than make it.
Trading any commodity or equity is risky and usually far more risky than investing. The difference between an investor and a trader is that traders look purely for short term capital gains. Investors are interested in more than capital gains short term or long term. They will look at the underlying value of the product being bought or sold, its potential to earn income while they own and what the hidden costs of ownership are. An example is the property investor who must weigh up rental returns against mortgage repayments and maintenance costs.
So how is buying and selling money a way to invest?
Think of it more as a way of moving your money from one country to another or investing in countries. When you buy shares you are investing in companies. Buying Forex is investing in a country. At any time one country is doing better economically than another. As I write Australia is leading the other western economies because of its resources based economy and the growth of China, strong jobs markets, moderate inflation and interest rates above 4.75% means its currency the Aussie dollar (AUD) is far more attractive than the USD. So in the last year it has risen over 30% which is an impressive return on investment for anyone buying AUD in April 2010.
But capital gains like these are fickle and fear drives the markets down faster than sound economic reasoning drives them up. Just like share markets, when fear is in the air money exits foreign currencies and goes back into American accounts where it is perceived as being safe.
When this irrational fear is driving markets lower, savvy investors will go looking for reliable bargains. They can buy shares in a company with solid earnings and a good dividend or they can buy a piece of a country's economy. If you sell your USD for AUD, you can get 4.750% - 0.25% = 4.5% interest. This is far better than the interest offered by any US bank or even the dividends of many top US companies.
How do you trade currencies?
Before you do any investing, read, research, learn the way currency markets work and seek out professional guidance. Don't use the information provided in one article as an inducement to go and lose money.
If you have the means you can move money between international bank accounts. But most ordinary people don't. Forex trading accounts can provide a means provided you research all the providers' options and fees and choose the right one.
Some trading accounts allow you to hold all or part of your account in foreign currency without being 'in the market'. This allows you to trade without trading. It is useful if you believe a currency is undervalued or overvalued and want a lower risk way to achieve capital gains. But using this method to trade or invest will usually forgo the benefits of earning income from foreign interest rates.
Look also for accounts that allow you to vary the leverage on the trade. Don't enter trades at 1:100 if you can avoid it as you will find yourself gambling around $1000 for every 1 cent change in value on a standard contract. This doesn't allow you leeway to manage the volatility in the currency market. If you are trading with somebody else’s money make sure you use stops. Lower leverage will allow you to place them further from the action.
Understand the interest rates offered by each country. This is a major driving force behind the movement of money. It isn't just the current rate but the prospects of rate rises in the short to medium term that will determine the value of a currency. Interest rates are used by central banks to control inflation so look at the economic health and vitality of the country. Understand also the economics of a country. What does it sell to earn money? Is the price of those commodities going up or down?
Make sure you know the way the trading account charges you for the money you borrow each time you trade. Many will charge the interest differential if you sell a higher interest currency to buy a lower interest one. Doing this is not a wise investment decision but may be a good trading choice if the currency sold is overheated. If you believe several higher interest currencies are due to fall in value against a lower interest currency you should sell the one with the lowest interest rate to keep the daily fees low and avoid profits from capital gains being eaten.
How do you invest in currencies?
The investment potential of trading currencies comes when you sell a lower interest currency like the USD to buy higher interest currencies like the EUR, AUD or NZD. Some currency trading accounts will pay you a percentage of the interest the traded money is earning while in a foreign currency. FX account providers do make money from the interest differentials so look for one that returns a reasonable percentage to the trader on positive differentials. When a trade is earning you interest you can hold for longer in anticipation of more capital gains as that income from interest keeps the perception in the market that your position is a good investment.
Timing in Forex is very important and difficult to predict. Unlike a good share which can rise exponentially in value. Currencies trade in relatively narrow bands. The AUD has a 10 year high of USD1.10 and low of USD0.48. For the range to grow much wider than this either the US or Australia would have to default on its debt repayments or become an economic black hole. The same can be said for other major currencies. When a country's currency is too high its ability to trade profitably diminishes while its ability to buy foreign goods goes up. This can fuel inflation and interest rates but ultimately in an economy that relies on foreign trade for income the market will cool off as jobs are lost and interest rates fall to stimulate the economy.
In the end it is all relative. Modest growth in the US is perceived by the markets as being of greater value than high growth in rest of the world so a small increase in US interest rates or change in US monetary policy could see the higher interest currencies fall in value while still providing better income from interest rates. But these changes affecting US currency would likely also see other investments products like shares and futures fall in value as well.
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