“A lot of people are making good money on their equity positions here [in the U.S.]. But is that real money? Is that real value? If you take a look at what’s happening to the value of the U.S. dollar against some of the other major currencies...net overall you’re really not making that much. And that’s why sometimes you need to diversify into FX [foreign exchange],” Eugene Hawkin, chief operating officer of CMS Forex in New York City, said.
The foreign exchange market (also called forex or FX) is the largest asset class in the world, with a global trading volume of more than $2 trillion per day, Hawkin said. “It’s a market of both exchange and speculation on currency prices.”
The forex market is 10 to 15 times the size of the bond market and 50 times the size of the equities market, Richard Olsen, founder of Olsen Limited, a Zurich-based e-finance technology and service provider, and one of the founders of OANDA FX Trade, a retail foreign exchange dealer, said.
Despite its enormous size, the forex market has only recently become popular with retail investors, Hawkin said.
“Retail investors make up maybe 1 to 2 percent of the total volume traded on the market....The major players are large banks, multinational corporations, anyone from Toyota and Honda doing large transactions to both offset their currency exposures as well as actually transfer funds from continent to continent.”
Because the market is global, trades are happening 24 hours a day, seven days a week. Constant trading makes for a liquid, volatile market.
The forex market developed out of the need to exchange funds from currency to currency. While the U.S. dollar was pegged to the price of gold—until the late 1970s—and many other major currencies were pegged to the U.S. dollar, the market remained fairly stable. But “once the peg had been removed, currencies started moving against one another,” Hawkin said.
This opened up the opportunity for currency speculation. Today, “about 85 to 90 percent of all volume traded on the market is purely for speculative purposes,” Hawkin said.
One major market factor that impacts currency demand is interest rates. “Interest rates really create the basis for the supply and demand for different currencies,” Hawkin said. “When you see higher interest rates in a given currency, you see people moving money there, buying up that currency so they can invest and receive those higher interest earnings.”
Other factors include geopolitical events, such as wars and political crises, which also can “create fairly large currency moves,” Hawkin said.
Country economic indicators, political issues and natural disasters are all capable of affecting the forex market, forex investor James Cheong said.
Olsen said he has a different view on what causes currency moves. “I kind of don’t believe in the traditional arguments, where people say it’s political news, interest rates, etc. I think actually the true driving force of markets is people who get it wrong, that is, who are being forced out of positions,” he said.
For example, many investors who put money into yen, incorrectly speculating that it will rise, end up having to close out their positions and sell when it drops. “They’re suddenly sellers of yen against their own intent, and will drive the yen down even further,” Olsen said.
Potential returns are one of the forex market’s biggest attractions. “Investors should focus on those markets that offer the biggest potential return....Foreign exchange offers by far the biggest return relative to other markets,” Olsen said.
Diversification is an obvious benefit to forex investing. Many investors are concentrated in an equities market that is “completely locked to what’s going on in a particular country,” Hawkin said.
“You could obviously go and diversify amongst multiple markets and multiple international exchanges, but that tends to be very difficult and not very cost effective for most retail investors,” he said.
Forex makes it easy for investors to invest into “essentially, the economies of any one of numerous countries,” Hawkin said.
Retail brokers offer many efficient products that make forex trading simple and convenient; OANDA, for example, has a “very simple user interface where you just buy the currency, sell it again; it’s...kind of like going to the store, buying apples and selling the apples again,” Olsen said.
“Most of our clients trade online,” Hawkin said, although they can also trade by phone. Placing a trade can be “just as simple as hitting the ‘buy’ button on a certain currency.”
Because the market is so large, “you don’t have the same risks associated with FX as you do have with equities in terms of potential for fraud and market movement,” Hawkin said. “You buy currencies of predominantly stable large countries with pre-set economic policies.”
The foreign exchange market offers astounding amounts of leverage. Hawkin said his firm will give up to 400 to one leverage on smaller forex positions, in contrast with the 50 percent maximum margin leverage seen in equities markets.
Leverage “can magnify your profit potential and at the same time...it can also obviously magnify your losses,” Hawkin said. “It’s something we see a lot of traders forget.”
“I usually caution clients not to get carried away with the leverage. Yes, you see maybe average leverage of one to 100 or something in that rate, so essentially you only need to have 1 percent as margin, but you really shouldn’t be trading at those levels. Those are kind of the maximum levels where you should be going, and I think most professional traders would never trade so highly exposed,” he said.
Many newcomers to the market take advantage of leverage too aggressively without recognizing its dangers, Olsen said. Leveraged investors incur a loss when the market moves against them, and “the really dangerous thing about it is...this loss is deducted from his base capital, so as losses accumulate, his leverage de facto increases relative to the underlying capital...so it’s an exponential curve with a ratchet effect that can push him out of the market far faster than he expects,” he said.
These temptations make self discipline, patience and planning crucial qualities for a successful forex trader, Cheong said.
Investors who want to get started with forex trading can research it online, where there are many free educational resources available.
Forex trades can be made through futures accounts or money managers, for investors who already have those relationships established.
A variety of retail brokers are available specifically for forex trading. Many offer analysis tools, charts and other technology to support investors.
Online research will help to determine which broker is a good fit for the investor. Credibility, reputation and fees are the most important factors to consider.
Most retail forex brokers don’t charge commission for trades, Hawkin said. “Just like in any other market, there’s obviously a difference between the bid price and the ask price, which is known as the spread, and that’s really your only kind of transaction cost.”
That spread cost can vary widely; some brokers charge roughly 0.04 percent, while others charge as little as 0.01 percent. Although the difference may seem small, it can make a big impact on profits and is a crucial consideration in choosing a broker, Olsen said.
Although research is excellent for getting started, “practice is key,” Hawkin said.
Cheong said that new investors should practice with a virtual account before investing their money in the market.
Many firms offer free demo accounts so investors can simulate trading and get practice. Once the investor is comfortable with that, Hawkin said investing a small amount, perhaps $200, can be a good way “to learn a little bit about the market and just get the hang of it,” because “trading with real money...always changes things a little.”