Summary
- Foreign exchange trades the value of one currency against another with the goal of making a profit as values rise and fall.
- You can invest in foreign exchange through direct forex trading, ETFs and ETNs, foreign currency accounts, and international stocks and bonds.
- Foreign exchange investing has risks, including leveraged positions, which could mean you owe more money than the initial investment. You could also see fraudulent forex dealers, not to mention money deposited that isn’t FDIC-insured.
- For any investment, a consultation with an expert is helpful. Unbiased can connect you to a financial advisor to help you evaluate whether or not foreign exchange investing belongs in your portfolio.
What is foreign exchange?
Foreign exchange (forex) is the trading of one country’s currency against another with the goal of making a profit as values go up and down.
The forex market is the largest financial market on the globe. Trillions of dollars are exchanged each day in a decentralized market between investors of all sorts: central banks, banks, hedge funds, businesses, brokers, and individual investors.
Currencies are always traded in pairs because their value is measured in relation to each other. Currencies traded are considered major, minor, and exotic. Major pairs are traded with the largest stable economies, like the U.S. dollar. Minor pairs are major currencies aside from the U.S. dollar paired with less common currencies. Exotic pairs are major currencies paired with the currencies of smaller, emerging markets.
Major currencies include the following:
- USD: US dollar
- JPY: Japanese yen
- EUR: Euro
- AUD: Australian dollar
- NZD: New Zealand dollar
- CAD: Canadian dollar
- GBP: British pound
- CHF: Swiss franc
Forex trading often uses leverage and margin to increase profit. However, you run the risk of losing more than your initial investment.
Ways to invest in foreign exchange
There are a few main ways investors can invest in foreign exchange, including direct forex trading, currency ETFs and ETNs, foreign currency accounts and CDs, and international stocks and bond funds.
Direct forex trading account
A direct forex trading account can be opened with a specialty brokerage dealer registered with the Commodity Futures Trading Commission (CFTC), and you buy and sell currency pairs yourself. It’s the most hands-on approach, similar to day trading, but also the riskiest. On highly leveraged positions, even small market moves could wipe out your account. It’s best for experienced investors who understand the risks.
Currency ETFs and ETNs
ETFs (exchange-traded funds) and ETNs (exchange-traded notes) allow investors exposure to currencies without opening separate forex accounts for direct investment. ETF and ETN shares track the performance of a currency through a standard brokerage account.
Foreign currency accounts and CDs
Holding certificates of deposit (CDs) or savings in foreign currencies could offer exposure to more favorable interest rates as well as currency fluctuations. The net return on this investment includes any currency movements.
International stocks and bond funds
Investing via international stocks and bond funds is an indirect way to gain currency exposure. Your money is converted to the local currency to buy the investment. When you sell, it is converted back, and you’re likely subject to the exchange rate (unless your investment is hedged with a pre-determined exchange rate). The main issue is that the currency conversion won’t always be favorable to you.
How much do you need to invest in foreign exchange?
The amount you need to start investing in foreign exchange varies based on your goals, risk tolerance, and brokerage.
Minimum deposit requirements start at $50, but the amount needed to invest may be much higher, requiring leverage and margin.
What are the pros and cons of investing in foreign exchange?
Because of the risks of foreign exchange investing, it’s critical to weigh possible benefits against the drawbacks.
Pros
- Profit in any market: Your position could earn a profit in either a bear or bull market, depending on whether the market moves in the direction you invested in.
- Diversification: Currencies don’t move with traditional markets, which can help stabilize a portfolio. Some safer currencies, such as the Swiss franc, provide stability during turbulent markets.
- Inflation protection: Strong currencies can help offset domestic inflation.
- High capital efficiency: With margin and leverage, you can get into a position with a relatively low investment. Just keep in mind you can also experience larger losses.
- Lower minimum investment: Forex investing has a lower investment requirement; however, the dealer will likely require you to trade at a higher amount, which will require the use of leverage.
- Easy trading: You can trade around the clock, five days a week. Forex trading is also highly liquid and uncorrelated to stock markets.
Cons
- Complex: Investors need an understanding of economics, central bank policies, and geopolitical events that affect the currency.
- Highly volatile: The forex markets can swing drastically, which can magnify losses when you’re trading on margin.
- At the mercy of your dealer: The dealer controls the platform and access to your trades. You’ll only see their quoted prices for currencies, and all associated fees and commissions. Many investors don’t end up with a profit after all the costs have been accounted for.
- Fraud risk: Forex markets have been the target of fraudsters who attempt to gain access to your money via social media with promises of higher leverage and higher returns.
- Active management: Investing in forex requires thorough knowledge of forex investing, global currency markets, and active management to enter and exit positions at the right times.
What are the risks of investing in foreign exchange?
Foreign exchange investing comes with some risks, especially when it comes to leveraged positions and fraudulent dealers. The CFTC warns of the following:
Most traders lose money: The CFTC reports that only a third of forex customers made any money. After factoring in credits, fees, financing charges, and other charges, a full 67% did not make a profit on forex trading.
Deposits are not protected: If the dealer goes out of business, your money isn’t FDIC-insured. Your money in a forex account isn’t protected from the failure of the dealer.
Dealer has control: Your dealer has all the control, which gives them the power to take advantage of customers. When you trade, you’re not connecting to a live exchange; you’re connecting to the dealer’s platform, which can show you what it wants. You’re always trading against the dealer, who acts as both buyer and seller. If you deposit money with an offshore dealer, you may find you’re unable to withdraw your money without paying high fees.
Risky margin calls: Forex traders often operate on margin, and you could end up owing more than you deposited.
Fraud is becoming more common: The CFTC warns of fraud originating from social media. The promise of outsized returns in a short amount of time with unregistered dealers outside the U.S. is a red flag.
Economic and geopolitical ties: The foreign currency exchange is tied to central bank policy and geopolitical events that can trigger unpredictable movements in the forex market and ruin your position.
The bottom line
Forex trading can help diversify your portfolio, but it isn’t for everyone, and should be added to a portfolio with careful consideration.
Unbiased can connect you to an expert to discuss your investing options, including when and how to add forex investing. Connect with a financial advisor from Unbiased today.