World currencies are traded 24 hours a day on the foreign exchange market, or Forex. While most of us use this system for simply changing one currency into another, some traders seek to profit by betting on movements of currencies relative to each other.
Although currency trading can be a potentially lucrative endeavor, it requires expertise and experience to achieve success. To enter the market, investors have numerous tools at their disposal, each with their own benefits and drawbacks. Here are four of the most popular.
Fundamentally, the interbank, or spot market, involves trading currencies among banks and financial institutions. It is one of the most popular formats for direct involvement in currency markets, according to Stan Dash, vice president of applied technical analysis for online brokerage firm and trading platform, TradeStation.
"The interbank currency market is a dealer market," he explains. "Traders will be buying and selling versus the dealer with which they have an account, although many dealers will make prices available from additional participants to keep the bid/ask spread close."
Currency trading in the interbank market involves high leverage, which has both opportunities and risks for investors, Dash explains. Trades require only a small percentage of the overall value on deposit, which magnifies both losses and gains.
With currency options, investors pay a premium for the right, with no underlying obligation, to buy or sell a currency at a particular rate for a specific amount of time. This premium will vary, depending on the number of contracts purchased.
Forex option trading poses numerous advantages over some other currency investment instruments. With no underlying obligation to trade, options may involve less risk than some other vehicles, as well as a low up-front cash requirement. However, there are also numerous drawbacks associated with options.
"Unless you work at the currency option desk at Goldman Sachs, don't mess around with currency options," says Bill Hammer, vice president of Wealth Management at Vanderbilt Partners. "This is an extraordinarily difficult market to understand and forecast."
Premiums can also vary, depending on the option's price and strike date, meaning that the risk involved also varies. In addition, even though you are putting up very little money, options that expire worthless cause you to lose all of your initial investment, Hammer explains.
A currency futures contract is an agreement to purchase a particular currency at a specified time in the future, for a price set today. These contracts are bought and sold by traders looking to profit from price fluctuations in the market. Contracts have fixed maturities, and positions held to those dates result in delivery. However, most participants are simply speculators, who usually close their positions before the settlement date.
Similar to the interbank market, the futures market offers high leverage, liquidity and "true pricing," Dash explains. "They directly reflect the price movement in the currencies." As a result of the high leverage, they often carry a large risk/reward ratio.
Foreign bond funds
Foreign bond funds are mutual funds that invest in foreign government bonds. These bonds earn interest in the foreign currency, and this value goes up or down, depending on the fluctuations of the foreign currency in relation to your local currency.
Many traders choose these bond funds because they may not correlate directly with the US bond or equity market, offering a good source of diversification for an investment portfolio, explains Hammer.
However, foreign bond funds also usually involve hefty fees compared to some other investment instruments, which can sometimes outweigh these advantages.
In addition, Hammer explains, "Bonds should be the stable, predictable part of your portfolio. Foreign bonds have more equity-like risk characteristics, so include them in your equity allocation if you must. If not, stick to domestic bonds for your fixed income."