One type of investing many people are interested in now is foreign currency exchange, referred to as forex. While the concept of forex trading seems fairly simple, actually being successful requires more knowledge and practice than an investor might expect.
Make sure you carefully evaluate your own financial and emotional risk tolerance before you start investing in foreign exchange.
What is the forex market?
At its most basic, the forex market is the largest, most liquid market in the world. It's where currencies are traded – volume can exceed $5 trillion per day.
When you trade on the forex market, using a broker or deal maker, you are basically trading based on how you think one currency will do against another. If you think that the euro will rise against the U.S. dollar , you'd buy EUR/USD. On the other hand, if you think the euro will drop relative to the dollar, you'd sell EUR/USD.
Making money is based on the difference – or spread – between the buy price and the sell price of a currency pair. So, before you can profit, you have to overcome the spread. Your profit or loss is the excess after the spread is covered.
Each investor must know how to read forex quotes and make a trade.
As mentioned, forex trading takes place in pairs. The first currency listed in the pair is its "base" and your trade takes into account what you think will happen. With EUR/USD, the most traded pair in the world, you buy or sell the euro in relation to the dollar.
Maybe you think the euro will gain against the dollar, so you buy EUR/USD. However, you also think that the U.S. dollar is going to gain against the Canadian dollar, so you also buy USD/CAD. In this situation, one trade assumes that the dollar will lose out, while the other trade assumes the dollar will gain in the pair.
When investing in the forex market, it's important to evaluate each pair and place trades accordingly.
Getting used to trading forex can take some time, so it's a good idea to look for platforms that offer demo accounts. Practice making moves with a demo account and get a feel for when to buy and sell – and how that platform works – before you risk any of your money.
One of the realities of investing in forex is that your profits are going to be small. Even if you're overcoming a small spread, your profits might still be only pennies at a time. Forex quotes are made to the hundredths of cents, so a big profit is hard to obtain unless you're trading large amounts.
In order to buy bigger lots of currencies, you might need to use leverage – and that means trading on margin . For example, if you were trading 200:1 leverage, you could set aside $10 in your trading account and have access to $2,000 in currencies. The ability to buy on margin can magnify your gains.
The downside, though, is that leverage also magnifies your losses. If you want to reduce your chance of losing more than you can handle, you might try reducing your leverage. You'd need $40 to control $2,000 at 50:1 leverage, but you'd limit some of your losses.
Because the currency market moves so frequently, and there's almost always trading happening, it's easy to make and lose large amounts of money. Before you start, understand the risks. People have lost everything by trading on margin in the forex market.
If you're not confident in your ability to trade on the forex market, you can decide to use currency exchange-traded funds, or ETFs . These funds are still speculative, however. Some experts consider them riskier than using stock and bond ETFs.
You can find currency ETFs that track specific currencies against another currency, or against a basket of currencies. For example, the CurrencyShares Euro Trust (ticker: FXE ) heads higher when the euro is doing well. It can also get a boost when the U.S. dollar drops.
With a currency ETF, you can add exposure to the forex market without actually trading yourself. Instead, you buy the ETF on the stock market and add it to your portfolio.
Carefully consider your asset allocation before you move forward, however. For many investors, adding currency exposure can provide additional growth – or protect a portion of the portfolio against a market downturn – but it might also change the risk profile of the portfolio .
For some investors, it makes sense to limit currency ETFs to 10% or less of the portfolio (although some investors might have a higher risk tolerance and benefit from a higher asset allocation toward currency ETFs).
As always, any time you invest, you need to be prepared to lose money. Don't trade on the foreign exchange market with money you can't afford to lose. And, carefully consider your long-term investing plan before you add currencies in any form to your portfolio.