If you are considering playing the foreign exchange (FX) market, there are three key things to think about: leverage (the amount of borrowed money you're using to trade); counterparty risk (the chances of your broker going bust); and costs. Let's take leverage first. Retail investors can gain access to eye-watering levels of leverage one popular broker advertises 200:1, and others even more. At 200:1, for a £50,000 deposit, you can trade in £10m of FX. So a 0.5% move the wrong way in your chosen FX rate would mean you'd lose all your money but gains are magnified if you get the bet correctly. When you consider that last week the Swiss franc lost 10% against the euro in minutes, you can see the risks involved.
Counterparty risk is also worth thinking about. If you use a broker to trade FX, read the small print. If a UK-based spread-betting firm was to go bust, for example, you may be covered for exposure to the broker of up to £50,000 under Britain's Financial Services Compensation Scheme. Brokers based outside Britain might also be covered under their own country's guarantee funds, but check the details.
Are there any alternatives? On both leverage and counterparty exposure risks, exchange-traded currencies (or currency ETCs) score well. Most are unleveraged, offering a one-for-one exposure to your chosen FX rate, meaning there's no danger of a margin call from your broker. (There are some 300%-leveraged ETCs, but these should be used for short-term trading only.) The ETCs are also fully collateralised. So if the issuer, ETF Securities, goes bust, your funds should be protected. So how do they work? Currency ETCs charge an annual fee, plus a daily spread to cover the cost of rolling FX positions forward. This all adds up to 1%-2% a year, which is deducted from the ETCs' return. Add a typical bid-offer spread of 0.2%-0.3% a trade, plus the fact that most major global currencies now pay very little if any interest, and you have some costs to cover before you start making money and that's if you pick the right currencies to invest in.
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But if you have a strong conviction on a particular cross-rate, especially one that doesn't involve your home currency, these ETCs allow you to take a view easily, without the scale of the risks involved in spread betting.
Paul Amery edits www.indexuniverse.eu, the top source of news and analyses on Europe's ETF and index-fund market.
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