Investing in foreign exchange is a tremendous way to diversify your investment portfolio. Foreign exchange trading is, however, a little bit more complicated than trading stocks, commodities, cryptocurrencies, etc. With a daily turnover of $5 trillion, the foreign exchange market is one of the most liquid markets. Predominately dominated by banks and institutional investors, the foreign exchange market has become more accessible to everyone with the rise of online brokerages and readily available margin-trading accounts.
In this article, we will discuss what forex trading is and how to invest in the foreign exchange market.
What is Forex Trading?
Forex, short for foreign exchange, is the process of changing one currency into another currency. This process can be performed for a variety of reasons including commercial, tourism, and to enable international trade. The forex market is open to buy and sell currencies 24 hours day, five days a week.
The currencies are traded in pairs, with one currency exchanged for another. These currency pairings can be classified into:
- Major pairings: The most traded currency pairs are called ‘majors’ and they compose about 85% of the entire foreign exchange market. Note that they all include the USD. These major pairs are EUR/USD, GBP/USD, USD/CHF, USD/CAD. USD/JPY, AUD/USD, NZD/USD
- Cross pairs: Currency pairs that do not include the US Dollar are commonly known as ‘cross currency pairs. A few examples are GBP/JPY, JPY/CAD, etc.
- Exotic pairs: Exotic currency pairs are made up of one major currency and a currency of an emerging economy. USD/ZAR and USD/HKD are some examples.
How to Invest in Foreign Exchange?
There are various ways to invest in the foreign exchange market. There are three ways to invest in the foreign exchange market. They are:
1. Indirect investment through ETFs: Exchange-traded funds (ETFs) are one of the easiest ways for non-currency experts to invest in foreign currency. These funds purchase and manage a portfolio of currencies on behalf of investors using tools like swaps and futures contracts. ETFs are suitable for those investors that don’t want any leverage-related risk.
2. Direct investment: It is also possible to directly buy and sell individual currencies on margin (borrowed money) through a foreign exchange brokerage. Investors can enjoy high leverage depending on the margins provided by their stockbrokers. However, it should also be noted that greater leverage often translates to increased volatility and the risk of a larger loss.
3. Currency Hedging: Some investors may use currency hedges (risk-mitigation strategies) to protect against asset losses based on currency movement. For example, if they buy stock in European companies, they may also sell euros short against U.S. dollars to protect against any downward price move in the euro. The downside is that currency hedging removes some of the benefits of diversification.
There are numerous ways to gain exposure and invest in the foreign exchange market. However, each approach has its own risks and rewards and should be considered carefully before making any investment decisions.