Investing in a foreign currency can be a lucrative, albeit risky venture. Although institutional investors and banks dominate the international foreign exchange or forex market, forex brokers offering margin accounts give retail traders access to this highly liquid market. With the right information and adequate training, it is possible to turn a good profit from trading in foreign currencies. In this short guide, we offer insights on what it takes to start investing in foreign currencies.
What is Investing in Foreign Currency?
Investing in foreign currency is the process of buying foreign currencies and selling them off at a profit. Foreign currency investing relies on the volatility or movement of the forex market to create price differences that allow for profitable trading. Depending on the direction the market is moving, you can either make money from buying or from selling. Investing in foreign currency offers a high risk/high reward alternative to more conservative investment vehicles like mutual funds and stocks.
Types of Foreign Currency Investments
- Standard Forex Trading Account: An investor opens a trading account with a forex broker, which gives them access to the global forex market and allows them to place buy and sell orders.
- Certificate of Deposit: An investor buys foreign currency CDs that earn interest at local rates in their respective countries.
- Foreign Bond Funds: An investor buys into mutual funds that invest in foreign government bonds. These government bonds earn interest in their currency denomination.
- ETFs and ETNs: Exchange Traded Funds (ETF) and Exchange Traded Notes (ETN) allow investors to benefit from foreign currency fluctuations without investing directly in the forex market.
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What You Need to Invest in Foreign Currency
Starting foreign currency investing is easy, but it takes time to learn how to trade successfully. Thankfully, you do not need to take formal classes to learn how to trade in forex. By taking the time to understand the concepts highlighted below, you can create a solid foundation for foreign currency investing.
Research is the backbone of successful forex trading. Seasoned investors will tell you that every successful trade is because of the research they put into it. Since you are starting, you need to familiarize yourself with the basics first, which include understanding the terms and mechanisms that go into trading forex.
- Foreign Exchange Market
The foreign exchange market or the forex market is a highly liquid global over-the-counter (OTC) or decentralized market for trading foreign currencies. In 2019, its global market capitalization hit $6.6 trillion, making it the largest market by liquidity on the planet. The foreign exchange market operates with multiple layers with large global banks at the apex and retail traders at the bottom. The foreign exchange market determines the relative prices of all currencies in the world.
- Mechanisms of Forex Trading
Forex trading relies on two underlying mechanisms – buying and selling. Since all currencies trade in pairs (base currency and quote currency), these two actions are more accurately described as a currency swap. When buying, or going long, a trader buys the base currency, and short sells the quote currency in the hope that the base currency will appreciate and allow a sale at a higher price. When selling or going short, a trader sells the base currency and hopes it depreciates, allowing them to repurchase it at a lower price.
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- Technical Analysis
Technical analysis is the study of price movement. The underlying theory is that price action is cyclical and that studying past changes can statistically infer current positions and anticipate future prices. Technical traders rely on various tools like Bollinger bands and stochastic oscillators to analyze charts and identify historical trends. Technical analysis does not predict the future but instead creates a statistical framework of probability by which to formulate a trading strategy.
- Fundamental Analysis
Fundamental analysis is the study of economic data, news, and reports affecting currency prices. In other words, it is the study of how market forces like supply and demand move prices up or down. Important fundamental indicators include interest rates, unemployment rates, manufacturing rates, and different countries’ monetary policies. By studying these factors, a forex trader learns how to ride the market based on economic data.
A trading platform is a software that allows a forex trader to place trades and monitor those trades through financial intermediaries (also called forex brokers). Most trading platforms come bundled with additional tools like news feeds, real-time quotes, and technical analysis charting tools. Trading platforms come in two flavors – commercial platforms and prop (proprietary) platforms. Retail traders use the former and the latter are customized platforms used by financial institutions.
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Like any investment, you need starting capital to invest in forex. You can start with as little as $5, although this will not give you any meaningful returns. How much you should start with to get better returns depends on your risk appetite, financial capacity, and trading acumen. Because direct forex investing involves high risk, you need to ensure you have capital preservation protections in place. The most important protection is a limit on how much you should risk (called risk management), which is usually 1% per trade. That means, if you want to risk $10 for each trade, you need $1,000 in capital or $10,000 to risk $100 per trade.
A forex trading strategy is a set of rules that signal when to buy or sell a specific currency pair. Traders use either technical analysis or fundamental analysis or both to formulate a trading strategy. Utilizing a trading strategy, a trader sets triggers or trading signals that trigger buy or sell actions. A forex trading strategy can be either manual or automated. Automated trading strategies rely on “bots” called expert advisors (EA), which perform specific actions based on predetermined parameters.
Test Your Plan
Successful forex traders test their strategies before implementing them in a live account using two tools, namely, backtesting and paper trading. Backtesting involves applying a forex trading strategy to historical market data. That is, if it works for past market movements, it may work for future market movements. Paper trading involves using a demo account. The account has a set amount of “demo” capital that you can trade on the real market and test your trading plan.
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Risks and Benefits of Investing in Forex
- Leverage Risk: Risks associated with leveraged trades that can result in a margin call.
- Transactional Risks: Risks associated with time and market differences between buying and selling a currency.
- Counterparty Risks: Risks involving forex brokers’ solvency and ability to honor spot and forward contracts.
- Low Fees: Most forex brokers make money from spreads, and so do not charge any other fees.
- Lot sizes: You can trade with larger lot sizes and make more money from each trade.
- Leverage: With a small amount of trading capital, you can take relatively large positions that yield higher returns.
- Liquidity: High liquidity allows you to buy and sell currencies instantaneously.
- Volatility: Market movements provide daily entry and exit points, allowing traders to make daily profits.
Steps to Investing in Foreign Currency
Now that we have covered the basics of investing in foreign currency, what are the steps you should take to get started?
Step 1: Take a Free Forex Trading Course
While this guide has given you the basics to get you started, taking a free forex trading course is essential if you want to become a successful trader. A website like Baby Pips offers comprehensive trading courses for free. It is highly recommended you complete a beginner course before taking the next step.
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Step 2: Develop a Trading Strategy
Decide whether you want to become a technical trader or a fundamental trader, a decision that will set the trajectory of where to focus your forex trading strategy. When determining a trading plan, you can either use one you find on the Internet or develop your own. Remember to ensure your strategy has robust risk management rules to protect your capital.
Step 3: Trade on a Demo Account
Select a forex broker, open a free demo trading account, and start testing your strategy. When setting up your demo account, pick settings (capital level, lot size) that match your trading strategy. For example, if you plan to open a live account with $1,000 and trade using a 0.1 lot size, use these settings in your demo account.
Step 4: Open and Fund a Live Account
Once you are confident in your trading strategy, open a live account, and fund it. It is advisable to start with a small amount to limit your exposure to loss. Ensure all the trades you enter have stop losses in place that limit your losses per trade and adhere to your risk management rules. Start slow and gradually learn the rhythm and flow of the market until you become an expert trader.
Investing in foreign currency can be a rewarding venture, especially if you develop a successful trading strategy. However, successful trading starts with knowledge and learning, so you must take the time to learn as much as you can about forex trading before putting your capital into the live market. Forex trading is a high risk/high reward investment, and so is not for everyone. Only consider forex investing if you have a high risk appetite, have dedicated capital that, if lost, will not significantly alter your life, and if you are ready to take the time to learn how to become a successful trader.