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 stocks or mutual funds, or shoring up your investment strategy with bonds. Learning the basics, however, can give you a solid foundation to build on if this is an asset class you’re interested in exploring. This guide walks you through everything you need to know to get started with investing in currency.
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, one currency has to be exchanged 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’s how foreign currencies are typically grouped:
- Major pairings: This group includes the most frequently traded currencies. The U.S. dollar (USD), euros (EUR), the Japanese yen (JPY), and British pounds (GBP) are typically included.
- Minor pairings: This group also 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, USD may be paired with the Hong Kong dollar (HKD) or Singapore dollar (SGD).
- Regional pairings: In this category, currencies are paired together based on region. So you might see Asian or European currencies from the same geographic region being exchanged for one another.
Why You’re Investing 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 tied to 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 quote currency. The exchange rate is used to calculate how much you’d have to pay in the quote currency to buy the base currency. Any time you buy a currency pairing, you’re buying base currency and selling quote currency.
The Mechanics of 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 is managed by banks and other financial institutions. All trades take place electronically and trading can be done 24 hours a day, 7 days a week.
Forex trading can be done through a brokerage. 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 and 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 in the future. The spot price will be settled and you’ll insulated from volatility when it’s time to trade.
- Future trading: Future trading s similar to forward trading, with one key difference. In a future trading contract, you’re legally bound to make the trade. The price of the contract is based on the foreign exchange rate of the currencies involved.
Once you’ve decided how to trade, you determine whether to buy or sell. The exchange rate may influence that decision. If you’re buying a pairing, you expect the base currency will go up in value. If you’re selling a pairing, you’re selling the base currency and buying the quote currency. You’re also hoping the base currency’s value will drop so you can buy it back at a cheaper price.
Bid and Ask
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 what these terms mean 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.
Pros and Cons of Forex Trading
Investing in currency can offer several advantages:
- Convenience and accessibility: Stock market exchanges operate during set hours. While you can trade pre- or after market, it isn’t 24/7. Forex trades, on the other hand, can be made 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 may be fewer commissions associated with trading foreign currencies. That allows you to hold on to more of your returns.
There is one main drawback to investing in currency:
- Potential volatility: While forex trading can be lucrative, there may be more ups and downs than the stock market. That could creat a steep learning curve for beginners. The risks may also be higher compared to other investment strategies, so it’s important to assess your risk tolerance carefully before jumping in.
Investing in currency may be new territory and it’s important to understand the ins and outs of how it works. It’s also helpful to have some perspective on how foreign currencies may be impacted by movements in the broader stock market, geopolitical concerns and the economic climate in the countries you’re interested in investing in. The more you know, the better for making informed decisions when making currency trades.
Tips for Investing
- Consider talking to a financial advisor about investing in currency and whether it’s a good fit for your portfolio. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will 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, compared to trading forex through a broker as these funds are actively managed.
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