Looking ahead forex
Investing in foreign currency can be a great way to diversify your portfolio, here's how you can go about it. Image Credit: Supplied

Dubai: Currency trading is simply the process of buying and selling currencies such as the US dollars, the euro, the British pound, Japanese yen, and Swiss franc, at a profit. So it involves purchasing one currency while simultaneously selling another, while generating profits from forex movements.

One area where forex trading is applied is when money is sent overseas. Foreign currency exchanges swap one local currency into another, allowing a customer to convert their existing currency into the desired foreign currency, using exchange rates based on the global trade markets.

Why is it worth looking into forex trading?

“Investing in foreign currency can be a great way to diversify your portfolio,” said Amit Trivedi, UAE-based long-time forex trader and analyst. “Foreign currency trading, or forex for short, is a little more complex than trading stocks or mutual funds, or shoring up your investment strategy with bonds.

Investing in foreign currency can be a great way to diversify your portfolio

- Amit Trivedi

“Learning the basics, however, can give you a solid foundation to build on if this is an asset class you’re interested in exploring. This guide walks you through everything you need to know to get started with investing in currency.”

How is foreign currency traded and where?

As mentioned above, investing in currency involves buying the currency of one country while selling that of another, and it is done through the foreign exchange market. Forex trading always happens in pairs. For a transaction to be complete, one currency has to be exchanged for another.

For example, you might buy US dollars and sell British pounds or vice versa. While you could technically exchange any foreign currency that’s traded on the market exchange for another, it’s more common to trade using pre-established pairings.

Forex technology
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How foreign currencies are typically grouped

Major pairings: This group includes the most frequently traded currencies. The US dollar (USD), euros (EUR), the Japanese yen (JPY), and British pounds (GBP) are typically included.

Minor pairings: This group also includes many of the frequently traded currencies in the major pairings category, with the exclusion of USD.

Mixed pairing: Here, you’ll typically have pairings of a heavily traded currency against a thinly traded one. For example, USD may be paired with the Hong Kong dollar (HKD) or Singapore dollar (SGD).

Regional pairings: In this category, currencies are paired together based on region. So you might see Asian or European currencies from the same geographic region being exchanged for one another.

Here’s an illustration on how currencies are paired
A quote for a pairing might look like this: EUR/USD = 1.2545/1.2572

The first number is the bid. So, in this kind of pairing, the broker would pay you 1.2545 USD for one euro. The second number is the ‘ask’, which means the broker wants you to pay 1.2572 for one US dollar.

How to invest in foreign currency

Stocks, bonds mutual funds are traded on a centralised exchange or bourse, forex is not. Instead, it’s traded through the foreign exchange market, which is managed by banks and other financial institutions. All trades take place electronically and trading can be done 24 hours a day, 7 days a week.

Forex trading can be done through a brokerage. There are three fundamental ways you can trade foreign currency:

Spot trading: In this kind of trade, currency pairs are exchanged when the trade is settled. This is essentially instant trading and the spot price represents the price at which a currency can be bought or sold.

Forward trading: When you trade forex forward, you agree to buy or sell foreign currency at a set price on a set date in the future. The spot price will be settled and you’ll insulated from volatility when it’s time to trade.

Future trading: Future trading is similar to forward trading, with one key difference. In a future trading contract, you’re legally bound to make the trade. The price of the contract is based on the foreign exchange rate of the currencies involved.

Protecting Forex investments
Investing in currency can offer several advantages

Perks and risks of forex trading

Investing in currency can offer several advantages, some of them include:

Accessibility: Stock market exchanges operate during set hours. While you can trade pre- or after market, it isn’t 24/7. Forex trades, on the other hand, can be made at any time of the day or night.

Diversification: Diversifying your portfolio can help manage risk. Foreign currency is an alternative asset class to the traditional mix of stocks, bonds and mutual funds.

Lower costs: Unlike trading stocks, there may be fewer commissions associated with trading foreign currencies. That allows you to hold on to more of your returns.

However, while the above reasons make up for most reasons why majority investors would invest in currencies, there is one main drawback to investing in currency – volatility.

“While forex trading can be lucrative, there may be more ups and downs than the stock market, making it risky for newbie investors or beginners. The risks may also be higher compared to other investment strategies, so it’s important to assess your risk tolerance carefully before jumping in,” Trivedi added.

While forex trading can be lucrative, there may be more ups and downs than the stock market, making it risky for newbie investors or beginners

- Amit Trivedi

4 factors to consider when investing in currencies

The behaviour of currencies is very difficult to predict in the short term because their performance depends on numerous variables. So here are four key factors to weigh when trading currencies:

1. What is first, second (BASE/QUOTE or BUY/SELL)

If you are looking to trade currencies, when looking at currency pairings, you may want to consider how they’re ordered. For example, in a USD/GBP pairing, USD is the base currency while GBP is the quote currency.

The exchange rate is used to calculate how much you’d have to pay in the quote currency to buy the base currency. Any time you buy a currency pairing, you’re buying base currency and selling quote currency.

2. Fluctuating exchange rates

“Forex trading attempts to capitalise on fluctuations in currency values. It’s similar to trading stocks. You want the currency you buy to increase in value so you can sell it at a profit. Your profit is tied to the currency’s exchange rate, which is the ratio of one currency’s value against another,” explained Trivedi.

A currency of a country is valued according to supply and demand. So, it always is in a state of flux. Such kind of exchange rate is known as floating exchange rate. Similarly, a currency’s value is determined by market forces. Factors like imports and exports, interest rates and inflation affect the currency’s value.

Pepperstone UAE Forex trading
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3. Currencies reflect economic strength

By contrast, currencies are influenced by multiple economic and political factors. So it is not just a question of predicting how a country will perform in absolute terms, but of determining how it performs relative to another region.

That said, some currencies are more stable or predictable than others because the economic characteristics of regions impact the depreciation or appreciation of their currency in the long term. For instance, the Swiss franc is the strongest currency in the world, on the back of the country’s stability.

4. Consider regional assets apart from currencies

“Another thing to bear in mind when investing in currencies is that there are several alternatives to choose from. One of them is to buy assets from the country or region in question. In the case of the Swiss franc, for example, this would mean buying bonds or shares in Swiss companies,” Trivedi added.

When investing in currencies is that there are several alternatives to choose from, one of them is to buy assets from the country or region in question

- Amit Trivedi

How do currency exchanges work, make money

Currency exchange firms or platforms serve as the basic link between the local and the overseas market for currency. Once a bank or a currency exchange quotes the exchange rate, the customer chooses to accept the rate or not. If they accept, the transaction goes through.

On top of the exchange rate conversion, certain transaction fees might also be applied to send or receive an international money transfer, which includes their profit margin. Rates and fees can differ greatly from bank to bank, and from one exchange to another.

Separately, there are also trading platforms that allow currency traders to buy and sell currencies through forex transactions, which is based on how they expect currency exchange rates will fluctuate.

When the value of one currency rises relative to another, traders will earn profits if they purchased the appreciating currency, or suffer losses if they sold the appreciating currency.