A Beginner's Guide to Investing in Foreign Currency

Investing in foreign currency can be a great way to diversify your portfolio. Foreign currency trading, or forex for short, is a little more complex than trading in stocks, bonds or mutual funds. Learning the basics, however, can give you a solid foundation to build on. If this is an asset class you would like to explore, this guide will walk you through what you need to know.

For questions about forex or other types of investments, a financial advisor can help.

What Is Foreign Currency Investing?

Investing in currency involves buying the currency of one country while selling that of another. This is done through the foreign exchange market, or “forex.”

Forex trading always happens in pairs. For a transaction to be complete, it’s necessary to exchange one currency for another. For example, you might buy U.S. dollars and sell British pounds, or vice versa.

While you could technically exchange any foreign currency that’s traded on the market exchange for another, it’s more common to trade using pre-establishing pairings. Here are the typically groupings for foreign currencies:

Major pairings: This group includes the most frequently traded currencies. It typically includes the U.S. dollar (USD), euros (EUR), the Japanese yen (JPY) and British pounds (GBP).
Minor pairings: This group includes many of the frequently traded currencies in the major pairings category, with the exclusion of USD.
Exotics: Here, you’ll typically have pairings of a heavily traded currency against a thinly traded one. For example, the USD may be paired with the Hong Kong dollar (HKD) or Singapore dollar (SGD).
Regional pairings: In this category, currency pairings are based on region. So, you might see Asian or European currencies from the same geographic region being exchanged for one another.

Why Invest in Currency?

Forex trading attempts to capitalize on fluctuations in currency values. It’s similar to trading stocks. You want the currency you buy to increase in value, so you can sell it at a profit. Your profit depends on the currency’s exchange rate, which is the ratio of one currency’s value against another.

When looking at pairings, you may want to consider how they’re ordered. For example, in a USD/GBP pairing, USD is the base currency, while GBP is the quoted currency. The exchange rate is used to calculate how much you’d have to pay in the quoted currency to buy the base currency. Any time you buy a currency pairing, you’re buying the base currency and selling the quote currency.

The Mechanics of Investing in Currency

A trader researches investing in currency.

Stocks and mutual funds are traded on a centralized exchange, such as the Nasdaq or New York Stock Exchange (NYSE). Forex is not. Instead, it’s traded through the foreign exchange market, which banks and other financial institutions oversee. All trades take place electronically, and trading can occur 24 hours a day, seven days a week.

Forex trading is available through a brokerage. Technically, there are three ways you can trade foreign currency:

Spot trading: In this kind of trade, currency pairs are exchanged when the trade is settled. This is essentially instant trading. The spot price represents the price at which a currency can be bought or sold.
Forward trading: When you trade forex forward, you agree to buy or sell foreign currency at a set price on a set date. The spot price will be settled, and you’ll be insulated from volatility when it’s time to trade.
Future trading: Future trading is similar to forward trading, with one key difference: in a future trading contract, you’re legally bound to make the trade. The contract price is based on the foreign exchange rate of the currencies involved.

Once you decide how to trade, you’ll need to determine whether to buy or sell. The exchange rate may influence that decision. If you’re purchasing a pairing, you expect the base currency will increase in value. On the other hand, if you’re selling a pairing, you’re selling the base currency and buying the quote currency. You’re hoping the base currency’s value will drop, so you can repurchase it at a cheaper price.

Bid and Ask in Forex Trading

There are two other forex trading terms every investor should know: bid and ask. The bid is the price at which a broker will buy a foreign currency pair from you. The ask is a broker’s asking price for a particular currency. The difference between the two prices is the spread. Knowing these terms can help you read forex quotes and understand the price of a trade.

A quote for a pairing might look like this:

EUR/USD = 1.2545/1.2572

The first number is the bid. So, in this kind of pairing, the broker would pay you 1.2545 USD for one euro. The second number is the ask, which means the broker wants you to pay 1.2572 for one U.S. dollar.

Risks of Leverage in Forex Trading

One of the most appealing and risky aspects of forex trading is leverage. Leverage allows investors to control a larger position in the market with a relatively small amount of capital. For example, a 50:1 leverage ratio means that with just $100, you could control $5,000 worth of currency. While this can significantly increase potential profits, it also exposes traders to greater risk.

The upside of leverage is the ability to amplify gains. If a currency pair moves in your favor, even a small change in the exchange rate could result in a substantial return on your original investment.

The downside, however, is that losses are amplified just as easily. A relatively minor shift in the wrong direction could wipe out your initial capital or trigger a margin call from your broker, requiring you to deposit more funds or have your position automatically closed.

Because of this, risk management is critical when using leverage in forex trading. Setting stop-loss orders, which automatically close a trade at a predetermined loss threshold, can help limit downside exposure. Beginners should start with lower leverage ratios and trade with capital they can afford to lose. As with any investment strategy, education and discipline are essential to using leverage responsibly.

Pros and Cons of Forex Trading

Forex trading offers exciting opportunities for profit, thanks to its liquidity, accessibility, and leverage. However, it also comes with significant risks and complexities. It’s essential to have a well-thought-out strategy, proper risk management and sufficient education before diving into this volatile market.

Investing in currency can offer several advantages that include:

Convenience and accessibility. Stock market exchanges operate during set hours. While you can trade pre-market or after-market, the stock market isn’t 24/7. In contrast, you can make forex trades at any time of the day or night.
Diversification. Diversifying your portfolio can help manage risk. Foreign currency is an alternative asset class to the traditional mix of stocks, bonds and mutual funds.
Lower costs. Unlike trading stocks, there are often fewer commissions when trading foreign currencies. That allows you to hold on to more of your returns.

Alongside these upsides, however, it is worth noting the one main drawback to investing in currency:

Potential volatility. While forex trading can be lucrative, there may be more ups and downs than in the stock market. That can create a steep learning curve for beginners. The risks of forex trading may also be higher in comparison to other investment strategies. As such, it’s important to assess your risk tolerance before jumping in.

How a Roth IRA Can Fit Into Your Overall Retirement Plan

A Roth IRA is often one part of a broader retirement strategy rather than the only account someone owns. Many investors contribute to an employer-sponsored retirement plan while also saving in a Roth IRA, giving them different sources of retirement income in the future.

Holding different types of retirement accounts can provide greater flexibility when it comes time to make withdrawals. Because Roth IRA qualified withdrawals are generally tax-free, some retirees use them alongside taxable retirement accounts to help manage their overall tax situation. The right withdrawal strategy depends on individual circumstances and tax laws in effect at the time.

Your investment strategy does not have to be identical across every retirement account. For example, some investors hold income-producing investments in one account while emphasizing long-term growth in another. Others prefer to maintain a similar asset allocation across all of their retirement savings and view their accounts as a single portfolio.

As your career and income change, the role of your Roth IRA may also change. A workplace retirement plan with an employer match, changes in contribution limits or new financial goals can all affect how much you contribute to each account from year to year.

Looking at your retirement accounts together instead of separately can help you evaluate whether your savings, investment allocation and long-term objectives remain aligned. Periodically reviewing your overall retirement strategy may also help identify opportunities to adjust contributions or rebalance your portfolio as your needs evolve.

Bottom Line

Investing in currency may be new territory. Before diving in, it’s important to understand the ins and outs of how it works. It’s also helpful to have some perspective on the impact of movements in the broader stock market, geopolitical concerns and the economic climate in the countries you want to invest in. The more you know, the more informed decisions you can make when trading currency.

Tips for Investing

Consider talking to a financial advisor about investing in currency. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area. Then, you can have a free introductory call with your advisor matches to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Consider investing in currency exchange-traded funds if buying and selling on the forex market seems too complicated. These funds trade on an exchange like a stock, but they tend to be more tax-efficient than other mutual funds. Foreign currency ETFs may also carry a lower risk factor, due to their active management.