Fast and furious: how to play currencies

Sooner or later many spread betters are tempted by the biggest market in the world - foreign exchange, or forex. Daily turnover here regularly exceeds that of the equity market by a factor of ten or more. It's fast, furious and at banks all over the world vast sums are won and lost in a matter of seconds.

Yet few of us have a clue about any of that when we quietly queue for foreign currency at our local bank before going on holiday. The principles are actually very similar in both cases. But what will catch you out, unless you are well prepared, is the sheer speed at which live exchange rates sometimes move.

But first things first: what are you betting on? Currencies come in pairs. You bet on one rising against another. As such, some people call it a 'zero sum' game as, unlike, say, the equity market, not all currencies can rise together (unless it is against the value of some other asset altogether say gold but we won't be worrying about that here). That means that it is no use just thinking the dollar will rise. You need to decide what it will rise against the yen? Sterling? The euro?

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Say, for example, you decide that the pound is due to strengthen against the US dollar. You could place an upbet on the GBP/USD pair (every currency has a three letter acronym). A quote might be 1.5034/1.5037. You buy the pair at 1.5037 and agree to bet at £10 per 'pip' or 'tick'. That's the smallest movement in the currency recognised by your broker and the market here a 0.0001c movement. Hopefully you're right and the pound might strengthen and take the spread to, say, 1.5080/1.5082. Now you could close out by selling the spread and take away a 43 pip profit (15080-15037), or £430 at £10 per pip. Nice work.

However, there's an obvious catch. Had the dollar strengthened instead you could be facing a similar-sized loss, and fast. That's where stop losses come in handy. Buying one will widen the spread slightly, but it's well worth it in case a currency moves against you.

Most people start by betting on the major currencies. These are sterling (GBP); the euro (EUR); the US dollar (USD); the Canadian dollar (CAD the 'loonie'); the Swiss franc (CHF); the Japanese yen (YEN); and the Australian dollar (AUS).

However, many brokers will let you place bets on all sorts of others, ranging from eastern European to South American currencies. So if you have the knowledge to make a call on the direction of something more exotic, you can. However, bear in mind that the more unusual the currency, the wider the spread will be. So if you're playing something really obscure, you'd better be confident of your trade.

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So what moves a currency? The blandest, and most truthful answer, is 'anything'. Exchange rates are sensitive barometers of a country's health. So any piece of news that affects an economy can move a currency. Top of the pile usually is interest rates. After all, if you can earn 10% in US dollars and 5% in pounds, you want to be out of pounds and in dollars. Indeed, some speculators will borrow in cheap currencies and invest in more expensive ones if they think interest rates are likely to remain some distance apart. That's known as a 'carry trade'.

Bear in mind that, as in any market, if everyone trading forex thinks the same thing about interest rates, the exchange rate will move. You don't need to be the 'first mover' as, once established, currency trends tend to persist. But the earlier you spot one the better. So keep an eye on any news flow that might influence central bank interest-rate policy. GDP figures, inflation data, unemployment statistics and the like are all relevant. And because exchange rates can sometimes move fast, make sure you have stop losses in place, particularly if you will be away from your screen for any period. Otherwise you may be cleaned out before you turn your PC back on.

The currencies to focus on now

Currency markets continue to be divided over the outlook for 2010, says Boris Schlossberg, director of currency research at GFT. Bulls point to the fact that GDP growth in every G20 economy has finally turned positive. But set against that, fiscal deficits in Europe and the US will remain at record levels for the foreseeable future.

In Europe the outlook is worst for the economies of Greece, Spain and Portugal. In America, the Federal government is now running a deficit of more than a trillion dollars and is projected to continue to do so in 2011 as well. Indeed, as the issue of government debt financing grows, the currencies of the better-managed economies should see more investor flows. Two stand out.

Switzerland has a positive trade balance and a minuscule budget deficit of less than 1% of GDP. It also boasts the cleanest balance sheet in the region. So the Swiss franc should continue to perform well in 2010. In particular, I favour being short the EUR/CHF pair.

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Meanwhile, Canada has much better finances than its neighbour down south. It has a budget deficit of only 3% of GDP and a trade balance that has moved into surplus over the past few months. So my second preferred trade is to short the USD/CAD pair.