Investing In Currencies
Hi everyone, and welcome back to Melissa Making Cents!
CERTIFIED FINANCIAL PLANNERS™ know that most people want to know about their investing options. But, unfortunately, just one or two things simply won't cut it! First, mutual funds are easy to understand and well-diversified options for those who wish to invest their hard-earned cash. And while generally safe and predictable, having options is great, some people would rather have something that grows faster than a mutual fund.
Luckily for people like that, there are plenty of financial fish in the sea! Stocks, bonds, exchange-traded funds, commodities, and more are at the disposal of those who wish to invest with their financial representatives! One such option is currency trading!
Lessons in Currency Exchange
Before I start today’s blog post I want to offer a personal story to show the risk of currency trading. While currency trading is relatively easy to do, as I’ll explain later. It also comes with risks that should be considered.
I took a finance course in college that went pretty heavily into corporations and how they account for currency exchange with their world wide entities. It was beyond fascinating, and the professor was extremely passionate about the foreign exchange part. He got sidetracked one class and went into detail about traveling, and the first thing he did at the airport when he landed was examine the currency exchange desks looking for an arbitrage. He would make a few transactions and walk out with a little more money in his pocket.
A currency arbitrage is a forex strategy in which a currency trader takes advantage of different spreads offered by brokers for a particular currency pair by making trades.
It sounded so easy! I studied his strategy, and on my very next vacation out of the country, I gave it a go. Well… it didn’t work out as well for me, and as a result I decided to hang up my currency trading hat.
What is a Currency?
You know about currency, whether you're aware of it or not! We're all super familiar with currency/currencies. We use them almost every day, whether electronically or in a more traditional paper and metal form.
As an American, the currency that I'm the most used to (and most likely all of you are) is the United States Dollar! Of course, the currency comes in many forms, and the USD (or United States Dollar) is just the currency's formal name. The bills associated with the dollar range from 1, 5, 20, 50, and 100.We can also speak of currency in terms of coins! We have pennies, nickels, dimes, and quarters in the US.
However, when we're talking about currency in terms of trading currency to make a profit - we're generally talking more about the currency as a whole instead of a specific dollar or coin. We're typically speaking about one currency compared to another country's currency - like the dollar compared to the British Pound.
Why Would you Invest in Currency?
There are tons of reasons a person might want to invest in currencies! However, the root cause of most people's reasoning either has to do with maintaining the value of their wealth or increasing it.
One common reason people may want to invest in currencies, or trade currency, has to do with diversification! Diversifying essentially means not putting all of your eggs in one basket in order to lower the risk. This concept converts (see what I did there?) to currency! Suppose all of your money is tied to one country's economy. In that case, the value of your wealth is wholly dependent on that one country's economy. If that country's economy is doing great, there's no issue. However, if something were to happen to that country's economy, then the purchasing power of your wealth is significantly decreased. By spreading the value of your wealth over multiple regions, governments, and currencies - you're increasing the likelihood that your money's value will be worth roughly the same at the end of the day.
Another reason you may wish to exchange or trade currencies is to increase the value of your wealth! Again, there is a market for trading currency and pitting it against other currencies. If you do this, there may be an opportunity for your wealth to come out greater at the end of the day. Everyone likes to make money, and if there's an opportunity to make money, even in a strange way, people will find a way to try it!
Basics of Currency Trading
Before we get too much more specific about trading and exchanging currencies as an investment option, there's some housekeeping that we need to go over! As with just about any subject in the financial field, understanding some basic terms and concepts is required to make sure we're all on the same page moving forward!
What is Forex?
A Forex is short-hand for a foreign currency exchange market. This is where or how you exchange currencies for one another. You may see forex shortened further as FX. A Foreign exchange currency market, forex, or FX, is simply a marketplace for currency. Unlike other trades, there isn't a centralized way to trade. To fill this gap, private foreign exchanges popped up around the globe! You'll see them in airports, online, and maybe even around town in major cities!
What is a Pairing?
When you purchase a currency, you must buy it with… currency. This exchange of one currency for another is referred to as a pairing. For example, if I were to exchange dollars for euros - that would be a pairing. If I exchanged Euro for the British Pound, that would also be a pairing! More accurately, a pairing is the price quote between two currencies. The first is the currency being bought, and the second is the currency being used to make the purchase.
A base currency is a currency being used to trade for another. If I were purchasing British Pounds with US dollars, the dollar would be what is referred to as the base currency
The quote currency is the currency being purchased. In the same example used for base currency, the British Pound would be the quote currency.
Major pairs refer to the most traded four pairs of currencies. This group includes the USD/JPY (US dollar/Japanese Yen), EUR/USD (Euro/US dollar), GBP/USD (Great British Pound/US dollar), USD/CHF (US dollar/Swiss franc). These four pairs make up the majority of trades in the forex. EUR/USD makes up 20% of all currency exchanges. There is debate about whether more pairs should be included or not in the major pairs tier.
Minor pairs are also referred to as cross-currency pairs. These are pairs that don't include the US dollar. At the start of currency trading, currencies needed to be exchanged using USD as a middle-man. Now, these exchanges may be made without using the dollar. The Euro, Pound, and Yen make up some part of most minor pairings.
Exotic pairs are a pair that includes one major currency and one currency from an economy that's growing but smaller, and less liquid than a major or minor currency.
Bid, Ask and Spread
Lastly, we must understand the difference between the bid, ask and spread. SmartAsset says, "The bid is the price at which a broker will buy a foreign currency pair or buy from you. The ask is a broker's asking (selling) price for a particular currency. The difference between the two prices is the spread…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 EUR for one US dollar.
Types of Currency Trades
There are several different types of trades one can make with currency!
This can be thought of as "on the spot" trading! In this type of currency exchange, you and another party agree to trade currency at a specific rate. You exchange currency, and you're on your way!
Forward trading is a currency trade you do it in the future at today's price! For example, on Monday, you and I agree to trade my one dollar for your two pounds on Thursday. No matter what the markets of these two currencies do during the time in between, we trade for the pre-agreed rate on Thursday. As the one making the trade, it is up to you whether or not the transaction finalizes.
A future trade is essentially a mix of spot trading and forward trading. For example, we agree on Monday to make a trade on Thursday at Thursday’s price. On Thursday, we trade one US dollar in exchange for the current market rate of your Euro. In a future trade, we are obligated to make the trade whether or not the initiator wishes it to continue.
Pros and Cons of Currency Exchange Trading
Several aspects of trading currency include both pros and cons. So instead of making a list of both, I've opted to just make a list of features in currency exchange and then list their reasoning for being on the list.
One outstanding attribute of trading currency is that it's an inherently liquid process. With many investing assets, your money is tied up in this or that and can't really be used right away. Or you may be waiting on some date down the road to avoid a penalty and maximize your investment. With currency exchange - none of that matters. It's all cash, all the time - which can be a great (or bad) thing!
Suppose all of your assets are in some sort of cash or another sitting in your trading account. You can use it whenever you want to (as long as whoever you're buying from accepts said currency). You won't be penalized for using your money so long as it isn't stored in an account that requires it to be held for a specific amount of time.
However, if a market sours unexpectedly and most of your money is in that country's currency - you may have a hard time recovering from that loss. Your purchasing power (with that currency) will be effectively reduced, and trading put of that currency won't really be a great option - you just have to wait for the country's currency to (hopefully) rebound.
If you're investing correctly and keeping your assets diversified, investing in currency can be fantastic! You can shield yourself from economic crashes by having some percentage of your wealth in various currencies. Of course, you'll have to be sure not to over-diversify, but diversifying your money through currency exchange is a great way to at least partially shield yourself from isolated economic incidents.
Unfortunately, there may not be anywhere for your money to hide in a worldwide economic crisis. Many investors experienced this pain during the quarantine and shut-down period of the covid pandemic.
24/7/365 Trading Market
Want to be able to trade at any time of the day? Currency trading is absolutely for you! It never stops… And I mean, it never stops. The market for currencies is continuous and is active twenty-four hours, seven days a week, three hundred and sixty-five days a year. So if you're serious about wanting to be able to trade at all hours - this is the only market in which that can truly be done.
However, the obvious drawback to being able to trade 25/7/365 is that you'll need to keep a vigilant eye on your investments. Unfortunately, a currency can drop or rebound overnight, making it quite a bit more challenging to sleep at night.
Another reason that trading currency is loved by many is that there are limited brokerage fees and commissions. If your forex has them, chances are they're low!
Institutions in the game of lending money to be leveraged on the currency exchange markets are serious. They'll typically lend a lot more than you have (margin) to be used for currency exchange. This means that you could make a good bit of money by future trading currency. But, unfortunately, if you make some bad moves with currency exchange, this also means that you could lose a significant amount of money that isn't yours.
High Volatility & Risk
We've all heard it - "high risk, high reward." That's one of the defining pillars of the currency exchange market. Trading one currency for another happens continuously, and a country's economy can be highly nuanced and unpredictable. Because of this, the rate of change on a day-to-day basis for currency is relatively high.
No Maturity Date, Interest, or Dividends
This ought to go without saying and ties in with our first point on liquidity - but there aren't any extra strings attached with currency. It's simple to trade, and tons of people love (or hate) that. This no-frills approach to investing comes with no maturity date, interest earned, or dividends to be obtained. What you see is what you get (or, more accurately, what you get is what you get).
How to Get into Currency Trading
At least to me, as a financial planner, one scary thing about currency trading is that just about anyone can get into it fairly quickly. It's just about as easy as opening an account with a forex and linking your bank account. I'm not scared because I'll lose business; I'm afraid of the potential harm that could bring to inexperienced investors. All of your hard-earned and saved money could be gone at a moment's notice. You could be left wondering what on earth just happened. I've seen situations like that up close and personal. I'm here to tell you it's genuinely heartbreaking.
Alternatively, if you're interested in investing in currency the right way, you should contact your financial planner. People who work full-time (or even part-time) jobs during the day will have a tough time keeping up with all of the world's currency markets and current events that could have an economic impact on their investments. But that's essentially why financial planners, like myself, exist! We're here to help you do the dirty work, so you don't have to!
Mutual Funds Offer Currency Diversification
It’s important to note that a diversified mutual fund or ETF also has the benefit of currency diversification. These funds often make global investments, and by virtue of their holdings they give the added benefit of currency diversification. So weigh the benefits of investing in currency with a CERTIFIED FINANCIAL PLANNER™
If you're interested in learning more about investing, trading, or exchanging currencies - please feel free to call or email to schedule an appointment with me. We can create a financial plan that incorporates multiple types of investment options to keep you well-diversified and on the path to creating wealth for you and your family!
Until next time...this is Melissa Making Cents!
Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.