This post was written in partnership with TheFXview.
The Foreign Exchange market, also known as forex or fx market, is the world’s largest and most liquid market. Unlike the stock market which is centralized, the fx is decentralized which means it is running consecutively, 24/7. Most investors view the currency market as highly speculative and volatile, and thus, steer away from investing directly into it. I personally see it as a staple ingredient of an investment portfolio, and in this article I will explain why.
This article won’t explain how to make currency predictions. This topic is too wide and deep to cover in the same article explaining the basics of the fx market. If you want to read more about this aspect find it here.
Currencies Impact All Investors
Even if you have completely disregarded the fx market and never even thought of dealing directly with it, you must have diversified your investment portfolio in a way it would consist at least some foreign securities. If you have invested into a domestically traded ETC which tracks a foreign index, the impact of currency rate differentials might have been neutralized (in some cases, not all); if you have directly purchased a stock in a foreign exchange, its value will also heavily rely on its currency performance.
As an example, (American) Joe bought Deutsche Telekom AG stocks (DTEGY) on the German DAX. The stock went up 5% over the course of the year, but the Euro has lost 5% against the US dollar. Although he cherry-picked a winning stock, he also cherry-picked a losing currency. After paying fees and a currency markup for a bilateral currency exchange… Joe will lose a pretty penny in the deal.
How to Protect Against Currency Movements
Once we have established the fact currency movements can impact all investors, we need to figure out a way to protect against them. One way is to focus solely on domestic investment. This way you eliminate the risks, but on the other hand, if the local economy crashes your entire portfolio will be wiped out. Indeed Warren Buffet said that “Wide diversification is only required when investors do not understand what they are doing”, but the term wide diversification is highly subjective.
The best way to protect against currency movements is through derivatives. These are contracts that enable you to buy a certain amount of fx for a set price, for an upfront-paid premium.
The simplest of these contracts is the Forward Contract. This is a non-tradable contract between two parties that dictates that on a certain date in the future (usually up to 12 months), one party could purchase a certain amount of fx from the other party for a set price.
Private clients would usually have to pay 10% of that amount upfront, in addition to premiums and rather wide spreads in comparison to the spot price spreads.
The second most popular option is buying Call or Put fx options. Each option dictates for its buyer that it can buy 10,000 foreign currency units for a pre-agreed price in a certain execution date. The difference between this option and Forward Contracts as follows:
- Forward Contracts are obligatory. At the agreed date, both parties must make the transaction that was pre-agreed. Fx options are, as their name hints, optional. If upon the execution date the strike price is worse than the spot rate, the option will expire without being executed.
- Fx options are tradable. That means that an option trader can set up much more complex hedging strategies, and also gain a possible upside which goes to a further extent than just protection.
FX Speculations
For the reasons stated above, currency option trading has became one of the most popular speculative tools for day traders. A single option bought at the right time can yield 10,000% over the course of a single month (while, accordingly, these sort of options have a 99.99% chance of losing 99.99% of their value within one month).
Seasoned traders with plenty of expertise and the ability to make algorithmic trades can be highly successful in this market. George Soros is probably the most famous currency speculator in the world, and there are many others who broke the bank doing so. The small-time basement trader has no chance against these giants, though. Due to its massive liquidity, the fx option market is priced to perfection. Unlike with stocks, there are no arbitrages to be found – if there are, the algo-trading machines pick them up in a heartbeat and correct the market.
FX Speculation for Newbies
Non-experts still try to figure out ways to enter the fx option market. They are aware they are at a disadvantage but that makes no difference to them. They are aware of the fact there’s a possibility, a very slight one but a possibility nonetheless, of “making it” with fx option trading.
This is exactly why the CFD market was born. CFD’s are a different type of option that is used for speculative purposes only (unlike normal fx options which are used for both hedging and speculation). CFD stands for contract for differences, and what it entails, is that you basically bet on the movement of a certain currency. They are very leveraged, up to x1000, which means that they are very short term.
Companies like eToro even further simplify speculative fx trading. They boast a social trading platform that allows certain users to copy other users. That means that you can tap into this market even if you know nothing about it. You can check the performance of hundreds or thousands of traders over their entire eToro experience, and see follow the ones you like. They even opened a new product named CopyFunds which mimics ETC’s.
Summary
The FX market is a non-separable of economy and investing. You cannot ignore this highly important aspect, even if you don’t want to invest directly into it. If you do want to trade currencies, options, or CFD’s directly, proceed with caution – you will be facing head to head against the big boys.