101-15 Investing in Currencies, Foreign Exchange Markets

In this final section, we seek to understand the essentials of commodities trading, how the money markets work, and finally, what the appeal of bonds is.

There are other ways to speculate in the stock market that are not stock or commodities-related.  In this section, we look at the currency markets, treasuries trading, and bonds.

Foreign Exchange Market

As an enabler for international trade, the Foreign Exchange Market (FX) is the biggest, most liquid market globally.  The FX market is multiples larger than all the stock markets in the world put together.  Every day over $4 trillion of currency is exchanged.

The FX market is different because there is no central exchange; the transactions flow around the globe electronically to the exchange that is currently open at the time; this means traders can trade 24 hours per day, five days per week.

The main participants in the market are banks, institutions, and individuals.

Individuals

Individuals may use the FX market to exchange money before and after going on holiday to a foreign country.  These transactions are usually committed through a bureau de change or a local bank.

Retail FX Traders

Due to improved access and a plethora of new retail FX brokers joining the market, it is now possible for individuals to speculate on the FX markets.  This represents an ever-growing portion of the market.  However, retail speculation is still a tiny proportion of the overall market.

Institutions

Institutions may use the FX market to speculate to make a profit based on the fluctuations in the valuations of the different currency pairs.  A currency pair is, for example, the USD/EUR, the value of the US Dollar versus the euro.  Major institutions such as central banks and commercial banks account for more than half of all transactions.

Central Banks

Central Banks usually hold substantial amounts of foreign exchange as an investment.  The more they exchange their own currency for another currency, the more they affect the value of the currencies.  They can use this method to stabilize or strengthen a currency depending on the pursued economic strategy.

A weakening currency (meaning the currency is losing value) can be very good for businesses located in that country as it means that their exports become cheaper, therefore boosting trade.  This is a double-edged sword because if the country needs to import many raw materials to make its products, then the imports become more expensive.

Trading FX

The foreign exchange market enables the exchange of one currency into another.  Therefore they are traded in pairs.

The most traded pair today is the USD/EUR or the EUR/USD.

Understanding the pricing

Example 1

USD/EUR

In the currency pair above, the first listed currency is the USD; this is known as the base currency, and the value of the base currency is always 1.  The EUR, the second currency, is the counter currency.

Example 2

USD/EUR 0.79

In this example, 1 US dollar can buy 0.79 of a Euro.

Example 3

EUR/USD 1.25

In this example, 1 Euro can buy 1.25 US dollars

Example 4

Day 1 – EUR/USD 1.25

Day 10 – EUR/USD 1.30

On day one, the quote for EUR/Dollar means you can buy 1.25 dollars per euro.  By day ten, you could buy 1.3 dollars for each euro.  The base currency (Euro) has strengthened against the counter currency (Dollar).

So if you had purchased euros using dollars on day one and then exchanged the euros back to dollars, you would have realized a profit of 0.05 dollar cents per euro owned.  This would equal a gain of 4%.

A key advantage of investing in foreign exchange is that foreign exchange markets are highly liquid and competitive; this means low spreads (the difference between the Bid and Ask Price).

A significant disadvantage is that the price fluctuations are tiny, so retail investors usually use a large amount of leverage to make a reasonable profit.

Leverage is when you borrow money to add to your capital to invest.  This helps to magnify the gains but also increases the risk exponentially.

If you have $10 to invest and you borrow $90, you will have $100 to invest.  With this capital, you invest and make a 10% profit.  Now your total equity is $110.  When you pay back the lender the $90, you are left with $20.  This means you have made a 100% profit as you started with $10 and ended with $20.

If I had made a 10% loss instead of a 10% gain on my investment, I would have lost all my money.   Eventually, this is what happens to most inexperienced retail investors; they lose all their money.

Trading foreign exchange is a high-risk gamble, and you are up against large institutions and professionals across the globe.

If you intend to trade currency, you need to be an expert in technical analysis and market timing.  The nature of FX is that any errors mean you lose a lot; expert technical analysts in institutions practice currency trading, so do not speculate with your money unless you know what you are doing.

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