To Trade... Or Not to trade Forex
Currency is the most abundantly traded commodity in the world. With about the equivalent of 1.8 trillion USD changing hands around the world daily, there is great potential for gaining (or losing!) vast amounts of money. So what should the smart investor do? This depends on your trading philosophy. If you are a long term trader, or “Value” investor, it is probably best that you steer clear of investing in foreign currency. This doesn’t mean that you should stay away from foreign stocks completely, just the currency itself. I will go into more detail on this in the stock section. Currency is much more dynamic than common stock because there are more factors to consider when determining a final price. One of these factors, political atmosphere, was alluded to above. One cannot predict the political (or economical) outlook of one’s own country 10 years down the road. Even for a scholar, it makes little sense to attempt to predict where other countries are headed as well. Elections, wars, and coups are all unpredictable occurrences. Currencies are usually hit much harder than individual businesses, especially those businesses with an international, and thus more stable, clientele (think Sony, Nestle, BMW, etc.).
Is it possible to predict shorter-term oscillations in the market? Many investors participate in the Forex market attempting to do just that, the vast majority of them on the losing end of trades. There are a select few who make a very good living trading currency, though. It’s not a crapshoot, either. There is a method that successful traders use to time entrances and exits to trades, whether it be through fundamental analysis, technical analysis, or a mixture of the two. This concept is closely related to the trading of domestic stock, which I will discuss later. One place to look for the beginning trader is at a country’s trade deficits and surpluses. If a country has a rising deficit, meaning more money is leaving the country than is coming into it, investors generally begin to be wary. If this is the case, traders will be tempted to take their investment elsewhere. When a country has a trading surplus, investors will see this as an attractive investment. As trading increase, more and more investors will be willing to put their money into that particular market, hoping to gain a part of the returns. While this is not a concrete identifier of when to buy or sell a specific currency, it is one of the main tools that investors look to when trading currencies.
Of course, the more a commodity permeates the market, the less attractive it becomes. This is one of the basic principles of high school economics. As supply increases past a certain point, demand decreases, driving prices down. This is one of the reasons why we see swings in otherwise prosperous trends.
But why would someone trade currency, of all things? Stocks are much easier to understand. Currency, however, can be traded with much less available capital. While stocks are more reliable over the long run, currency has the potential to make more money over the short term. This is because of the vast quantity of money pumped into the market daily. Sharp swings in daily trading are not uncommon.
There are a few different types of traders in the currency market. Some traders are speculators; they trade for the sole intention of making money by manipulating the up and downswings of the international market. Like a trader of stocks and bonds, these speculators take on a high level of risk predicting that the market will act in their favor.
Perhaps the biggest players in the Forex market are multinational corporations. These institutions trade currencies so that they may be active in more than one country at a time. If a US based company also intends to do business in Europe, it is necessary for that corporation to trade for the Euro. The smart investment specialist will make sure that they trade for the best rates possible, thus ensuring a small profit just through their international exchanges.
Closely related is the concept of hedging. Large corporations and other major investors will often buy currency in order to protect a foreign investment. This partially reduces the risk inherent in any investment since by hedging you are investing in both sides of a trade. This method (in theory) locks in at least minimal profits since you are betting on both sides of the investment.
There are also government-backed traders. These usually take the form of large central banks whose job it is to protect the value of their respective currency. By buying or selling large quantities of their own currency, central banks can control the supply of money, which in turn leads to manipulating demand and thus price. However, because of the vast amount of trading that occurs worldwide, a central bank has only limited influence on exchange rates.