How to play the currency markets

The closest most private investors get to foreign exchange dealing is when they buy their holiday money. Yet they could be missing out on some great profit-making opportunities. Foreign exchange (forex, or FX) is by far the biggest of the financial markets. According to International Financial Services, London (IFSL), in April average daily global turnover exceeded $2.7trn, over ten times the combined daily turnover of the world's equity markets. (This is an extended version of a story that appeared in MoneyWeek issue 334. See also: The MoneyWeek guide to Forex jargon and Paul Rodriguez's full recommendations in What are the best bets in Forex now?)

Currency trading is undeniably riskier and faster moving than other markets. As financial writer Hugo Dixon says, some view it as the ultimate example of "casino capitalism in action". But there are plenty of advantages to knowing how the FX market works. For a start, you can protect yourself against adverse currency movements useful if your portfolio has exposure to overseas investments. And unlike parts of the equity and bond markets, trading is quick, costs are low, and liquidity (the ability to buy and sell when you want) is deep. It's also becoming more accessible to retail investors. The number of UK brokers offering FX dealing to private investors doubled last year and the rise of spread betting has made it easy to get involved. So if you're tempted to dabble in the world's largest market, what do you need to know?

The basics of the forex market

A foreign exchange deal is just two people swapping a fixed amount of one currency for another at an agreed price, the exchange rate. This can take place at today's rate (known as dealing spot') or at a rate negotiated today, with the two currencies being exchanged at a future date (known as dealing forward'). The latter is often used by firms looking to protect against currency movements before paying an overseas supplier or receiving cash from a foreign customer.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

One key point to remember is that, unlike shares, bonds or commodities, the value of one currency is directly linked to the price of all the others. As the FT puts it, the currency market is "relative rather than absolute". In a stockmarket bubble, shares can all rise together and everyone makes money; but if the dollar rises, it does so at the expense of another, weaker currency. Every winning up bet is matched by an equal losing down bet and vice versa; FX is a true zero-sum game.

What determines exchange rates?

As with anything else, the value of a currency is largely down to supply and demand. More buyers than sellers for sterling will push up the exchange rate and vice versa. The tricky bit is deciding what's actually causing people to buy and sell in the first place.

Currency markets are underpinned by the principle that money flows to where it can earn the highest return for the least risk. If a country's assets, such as shares and bonds, offer high rates of return for low risk, then people will demand that currency in order to invest there (most US bonds have to be bought with US dollars, UK gilts with sterling and so on). Overall, a currency can be viewed as a bellwether for the economy's health. As a rule, a growing economy with stable prices and a wide range of competitive goods and services (such as the UK) will see more demand than one in political turmoil, with high inflation and few exports (such as Zimbabwe). Right now, £1 buys a lot of Zimbabwean dollars.

Foreign exchange: what should you watch out for?

Political and economic events can have a huge impact on exchange rates, far more so than with equity markets, so it's important to keep an eye on macroeconomic indicators. Inflation expectations are crucial. For example, if prices are expected to rise in the UK, then the Bank of England is likely to have to raise interest rates in response. This makes the pound more attractive relative to other currencies, driving up the exchange rate.

Also watch the balance of payments; this tells you whether a country is a global net provider (as it is when it has a surplus), or a consumer (deficit) of goods and services. A large growing deficit and a weakening currency often go hand in hand. A cheap' US dollar, for example, should help to correct the huge US trade deficit by encouraging consumers to spend less on foreign goods and foreigners to spend more on US ones. More mundane decisions about how much currency to print also influence the money supply and in turn the exchange rate. Broadly speaking, the larger the supply of notes and coins, the lower their value will be against a less abundant currency.

If that all sounds a bit daunting, the good news, as trader Tom Tragett points out, is that once a forex trend is established it tends to last, as the fundamental drivers behind it can last months, or even years.

How to trade currencies

Trading the currencies themselves in spot deals is the first option. This won't suit most small investors because of the relatively large minimum deal sizes (£50,000 is common), but it's a good way to demonstrate how trades work.

Let's say your broker quotes a minimum deal size of £60,000 and an initial margin rate of 5%. The initial deposit paid is 0.05 x £60,000, or £3,000. You think the pound will strengthen against the dollar. Your broker quotes a GBP/USD spread of 2.0100/2.0105. You buy at 2.0105. You are later proved correct when the rate rises and your broker quotes a new GBP/USD spread of 2.0170/2.0175.

If you now close the position by selling at 2.0170, the profit is 0.0065, or 65 ticks' (2.0170 2.0105). With a deal size of £60,000, this is a profit of 0.0065 x £60,000 or £390. That's a 13% profit on the initial margin of £3,000. Of course, the rate could just as easily have moved against you and it's vital to remember that when you trade on margin, relatively small exchange-rate movements can result in big profits or losses. Not only that, but your losses are unlimited if the rate moves far enough against you, you can lose far more than your initial deposit. The usual solution is to agree a stop loss with your broker, the best being the guaranteed stop'. There will be a charge for this, but it ensures that your losses are always capped.

Spread betting

Spread betting works in almost exactly the same way, with one key difference you don't need vast sums of money to get started. Another great feature of spread betting is that your gains are tax-free.The principle of spread betting is the same whether the bet concerns cricket scores or currency markets. The amount you win or lose depends on how many points' you are away from the spread-betting firm's initial prediction (or spread'). When betting on a forex market, one point is equal to one pip, or tick (a 0.0001 movement in a currency rate). Profits or losses are settled at a fixed amount of, say, 50p or £1 per point, depending on the spread-betting firm and size of the bet.

The three largest markets, according to MoneyAM, are euro/dollar, dollar/yen, and sterling/dollar (referred to in the market as cable'). Let's say you expect the pound will gain (strengthen') against the dollar, so you buy (go long') the cable rate at 1.9850. You bet £1 per point that the pound will continue to strengthen against the dollar. By the end of the day, the rate has increased to 1.9950 a 100 points rise. At £1 a point, this would have made you a £100 profit. But equally, a drop to 1.9750 would have resulted in a £100 loss and, as with the above example, you can lose far more than your initial stake, so it's vital to have a stop-loss in place. You can hold your position for as long as you like if a trade expires at the end of the day it can be rolled over.

Before placing the bet, the spread-betting firm will ask for a deposit. This is usually a multiple of the agreed stake per point (sometime referred to as a notional trading requirement', or NTR). The more volatile the currency being traded, the higher the NTR. If you were betting £1 a point, with an NTR of 250 (the range on major currency pairs with Cantor Index is anywhere between 150 and 500), then the initial deposit is £250.

Extra online-only content:

Contracts for difference (CFDs)

CFDs are very similar to spread bets indeed, Neil Daldy of E*Trade says "they are essentially the same product". You pay or receive the difference between the exchange rate for the nominated currency pair when the bet is opened and the rate prevailing when the bet is closed. Once again trading is margin based. The key differences are that CFDs attract capital gains tax and margin requirements tend to be higher due to the larger average contract sizes. Although bid and offer spreads used to be significantly tighter for CFDs, with the emergence of more and more spread betting brokers this is no longer a major benefit.

At the moment currency CFDs can only be accessed in the traditional way, "over the counter" - in effect a deal directly between you and a bank or broker. This is set to change later this year with the arrival of currency CFDs listed on the London Stock Exchange. The main advantages will be the ability to trade through any broker, not necessarily a specialist, improved transparency (since the contract will have a quoted price) and guaranteed stop losses.

Covered warrants

If the thought of losing quite large sums quickly, or having to negotiate expensive stop losses is off-putting, then covered warrants for currencies are available on the London Stock Exchange as an alternative, although the market is fairly small. These products allow you to take a view on a currency strengthening or weakening in relation to a fixed "strike" price by a specified date (Societe Generale's 2007 contracts expire on 15 June or 21 December).

So if you think that sterling might appreciate short term against the dollar you could buy a GBP/USD call (jargon for "the right to buy") warrant expiring in June. Equally if you believe sterling will fall or weaken then you would buy the "put" ("right to sell"). The main potential advantage of warrants over spread bets only becomes apparent if you get the currency direction wrong. Rather than facing unlimited losses, the warrant expires and you "just" lose the up front premium (though that's still 100% of your initial investment!).

Exchange traded funds (ETFs)

For those investors who feel uncomfortable with derivatives there is now another way to trade currencies, the exchange traded fund.

Also known as currency shares, the FT reckons that these New York Stock Exchange-listed securities are a liquid and cheap way to track the movements of eight currencies against the US dollar, those being; the Euro, Yen, Sterling, Swiss Franc, Mexican Peso, Swedish Krona, Australian and Canadian Dollars. Like other ETFs there is no stamp duty on purchase and, unlike spread bets, an open position can be maintained without the expense of having to roll it over beyond a fixed expiry or delivery date. However, being a share, any profits attract capital gains tax and the gains themselves are in US dollars, which is not ideal for UK investors.

The basic mechanics are straightforward enough; if you think that the Euro will strengthen against the US dollar you could buy the euro currency share (via a US broker like Charles Schwab). As the Euro strengthens the share price rises until the ETF is sold realising a gain net of any spread.

Those investors tempted to participate in a version of the much publicised "carry trade" (whereby hedge funds, for example, borrow in a low yield currency to invest in another typically with a much higher interest rate and pocket the difference) can also now do so. The Powershares Currency Harvest Fund (AMEX:DBV) tracks an index that goes long of the G10 currencies with the highest interest rates and simultaneously short those with the lowest. Over the last 10 years returns have averaged 11.1% versus just 8.42 for the S&P 500.

Forex trading: Where to start

The key to successful forex trading, as Philip Battley of MoneyAM puts it, is "practice, practice, practice". Most spread-betting firms offer demonstration accounts that let you hone your skills before trading for real, including CMC Markets and Capital Spreads. Stick initially to the commonly traded currency pairs, such as USD/JPY, EUR/USD and GBP/USD it's generally easier to keep an eye on the news flow that might affect these rates. And one thing we can't emphasise enough: make sure you protect yourself with a stop-loss.

You can compare leading forex trading accounts here.