FOREX trading, or trading in foreign currencies, is big business. For the average investor, though, FOREX trading is not necessarily needed as a step to reaching financial goals like saving for retirement. But if you’re curious about trading foreign currency and wondering if it’s right for you, you’re in the right place. We’ll talk about how FOREX trading works – and the risks it poses.
FOREX Trading: The Basics
The currency market is the largest market in the world. It’s a way to buy one currency and sell another at the same time, by trading in currency pairs. For example, an investor could buy EUR/USD, a euro-dollar pair. FOREX trading is basically betting on the small changes in the value of a foreign currency relative to the dollar or another currency. A FOREX trade by its nature creates one loser and one winner (this is known as a zero-sum game). Someone bets that the value of a given currency will increase (this called being “long”) and someone else bets that it will decrease (this called “shorting” the currency). Only one party can be right.
Wondering how to trade FOREX? In the old days, retail investors had no way of accessing foreign exchange markets to make trades. It was an exclusive realm, where banks ruled. The internet has enabled average investors to get in on the action, for better for worse. If you want to dabble in FOREX trading, you can hop online and do so. But you’ll be going up against professionals who have sophisticated computer models at their disposal, so it’s important to be aware of that.
Say you opt for a EUR/USD trade, and the exchange rate for buying euros and selling dollars is 1.5. That means 1.5 dollars buys you one euro. So, let’s say you buy 10,000 euros for $15,000. Then, if the exchange rate for selling euros and buying dollars is 1.6, you can make the opposite transaction, selling your 10,000 euros and making $16,000. This is known as closing your position. And you, my hypothetical friend, just made $1,000. But if the exchange rate had moved the other way, you would have lost money.
FOREX Trading: The Risks
Real talk: FOREX trading is generally not seen as a reliable way to grow your money over time and pursue major financial goals like saving for a house, paying for college or securing retirement income. It’s a high-risk approach to investing that can leave you with big losses. Plus, FOREX trading involves leverage. That means you pay less to trade more, but accept that you’ll either win big or lose big.
If you make leveraged investments (also known as trading on margin) you stand to lose not just your initial investment, but potentially much more, depending on the agreement you have with your broker. Be aware that you stand to lose big-time if you, say, bet that the pound will increase in value and its value falls. Plus, there are fees and commission payments to factor in when you calculate how much FOREX trading is going to cost you.
In addition to the built-in risk of foreign exchange trading, there’s also the risk of fraud. It’s a good idea to be suspicious of any emails, tips or websites that promise astronomical returns. Check broker credentials against the records of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commision (CFTC). FOREX trading is a magnet for fraudsters, so it’s important to approach with caution.
If you’re going to dip a toe into FOREX trading, you’ll need to have a high risk tolerance – not to mention money you can afford to lose. Remember, you don’t have to get involved with FOREX trading. You’ll likely be just fine if you want to leave the FOREX trading to the professionals and stick with something like a low-cost index fund.
Photo credit: © iStock/vinnstock