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Currency trading: A high risk punt on money - thisismoney.co.uk


The following piece was written by Philip Scott in This is Money on 28 February 2009, investigating the world of the currency trader and explaining the risks. Thank you Philip.

Currency trading: A high risk punt on money

The rapid decline in the value of the pound and the fluctuating fortunes of international economies have sparked renewed interest in currency trading as an investment. But investors considering dipping their toes into the murky waters of the currency markets should beware – this is a high risk game where any number of factors can swiftly turn a fortune into a loss. Investing correspondent Philip Scott, investigates the world of the currency trader and explains the risks.

The fate of the pound has been hogging the limelight for some time - chiefly because of the bank rate heading south, which in turn devalues the pound.

And the fall of sterling from its strong standing against the dollar and euro, has delivered renewed interest from investors in playing the currency market.

But experts are urging even the most risk-friendly investors to exercise caution if they intend to dabble in this highly volatile market.

Even at the best of times exchange rates can be notoriously difficult to forecast and in the present economic climate this task becomes even more intricate.

Speed of recovery from recession, government borrowing and spending, risk-aversion, currency speculation and interest rates – the slashing of which has only served to weaken the pound - are the primary issues to watch.

And currency brokers are warning that it is very likely that the pound will continue to remain weak against all other major legal tenders.

If you intend to plunge into currency trading, be sure you know what you're in for and who you are dealing with and beware of any firm offering 'too-good to be true' type returns.

Just look at what happened last year. The pound started the year worth €1.359 and ended it down 23%, at €1.043. It also declined rapidly against the US dollar, starting the year with £1 worth $1.985 and ending it worth $1.467.

On the surface, investors who predicted a weak UK economy and bet against the pound would have seen a handsome return, but the story was not that simple.

The pound had a yo-yo year and was still worth almost $2 in late summer. It only collapsed at the tail end of the year, with the speed of its decline surprising many experts and hastened by speculation.

How can you trade currency?

There are a number of ways to trade currency but be warned, it is a high risk and complex business, and therefore not for the faint-hearted.

Foreign exchange trading

In forex trading you trade currency pairs. For example, if a trader buys GBP/USD, they effectively buy British pounds and sell US dollars; if the trader sells GBP/USD, they sell British pounds and buy US dollars. You buy a currency pair if you expect the exchange rates to increase in value; you sell a currency pair if you expect the exchange rates to fall in value.

With forex you trade in lots. Minimum lots typically start at $10,000 and increase by $10,000 to $100,000, while maximum lots are based on $100,000 increments.

You must have more money in your account than you are betting and there is a requirement to keep a minimum in there, called a margin.

When you buy and sell a currency pair, you need a minimum margin requirement typically between 1% and 2.5% of the lot size, so if you wanted to make a $10,000 bet, a margin at 1% would mean that you must keep £100 in your account.

Even though you only require a small percentage for the margin in order to trade a Forex lot, you realistically need about 5% to 10% to cover volatility and avoid a margin call, where the broker will ask you to deposit more money to cover the margin on a losing position.

Dary McGovern, of Time to Trade, a currency broker explains: 'With a minimum trade on a $10,000 GBP/USD trade you make or lose dollars for a change in the exchange rates; it is essential to understand the inherent risk that come with varying trade sizes - therefore consider carefully your lot size and the associated risk and margin requirement before opening a position.

'If you buy a currency you get paid interest; if you sell a currency you have to pay interest. To trade a currency pair you have to buy one currency and then sell another, therefore for long term positions you will receive interest on the currency bought and pay interest on the currency sold.'

The base currency for Forex trading is US dollars. So for example with a $10,000 GBP/USD trade, you are buying sterling and selling dollars – or in other words, moving from dollars into sterling. Until you decide to close the position the investment is open-ended as you have effectively purchased that currency.

You therefore make money if sterling increases in value, relative to the follar. If you make cash, you can close the trade and stick the money in a bank account, or keep it on account with your broker.

McGovern explains: 'The interest rates on each currency varies; for example if you buy pounds and sell US dollars, the interest rate on the pound is higher than the dollar therefore you will receive more interest than you have to pay out; this can be used to generate an income on a difference between the two rates.'

Spread betting

Spread betters gamble on whether a share, index or currency will rise or fall over a certain period. For instance, a punter bets £2 that BP at 540p will rise by June. He collects £2 for every penny it is higher by at that point, or losses £2 for every penny it has fallen. He can also close the bet and realise a profit or loss before the end of the contract.

Similarly with currency spread betting, you typically bet on exchange rates increasing or decreasing with a minimum bet of £1 per 0.0001 movement in the exchange rate, therefore if you take recent volatility that saw the pound swing between 1.4300 and 1.4600 against the dollar within 24 hours, it would have resulted in a gain or loss of £300 if a minimum bet of £1 per point was placed. - Read our guide to spread betting

Contracts for Difference (CFDs)

CFDs are a derivative product designed for active traders which allow them to make money on share price movements without buying the shares themselves.

Similarly with currency it allows traders to make money on currency movements without buying that currency.

They again are high-risk financial products and allow people to sell something that they do not actually own in the hope of profiting from rising or falling markets. CFDs typically require about 5% to 10% of the contract size and are normally cash settled.

Dangers of currency trading

Longer term exchange rate trends change gradually over time and are driven by economic factors such as interest rates, gross domestic product, employment and, of course, consumer sentiment.

Predicting what will happen is notoriously difficult and over the short term, volatility leaves investors exposed.

Dary McGovern says: 'The currency markets are ruled by technical analysis with a lot of short term trading activity generated by computerised algorithmic trading platforms.

'Don't try and compete with them by day trading intraday minute interval based strategies.

'Best results tend to be generated by following trends using 'longer' term swing trading strategies where you buy and sell over a time frame measured in days or weeks. Understand basic technical analysis and trend lines.'

Traders recommend potential investors look for trending currencies that are making swings from highs to lows.

How forex trading helps investors

Forex trading can also be an effective way of locking in gains on overseas investments that have been generated by favourable changes in the exchange rate.

Say 18 months ago an investor moves £5,000 into a US dollar trading account at an exchange rate of 2.0000 and receives $10,000. The $10,000 is invested in some US stocks. Today the investor's US investments are still worth $10,000 but the exchange rate is now 1.4500. If the investor was to sell their US investments and transfer the money back to British pounds, the $10,000 would be worth £6,896, which is a currency gain of £1,896.

The investor doesn't want to sell their US investments, but does want to lock in the currency gain, as they think the pound is going to rally against the dollar. So the investor buys a $10,000 lot of GBP/USD (i.e. buys British pounds and sells US dollars) via a Forex trade. The money deposited to cover the forex margin would currently generate income, as the British pound is paying out a higher level of interest than the US dollar, but this can change over time.

If the exchange rate moves from 1.4500 to 2.0000 over the coming months, then the forex trade will generate a profit, while the US investments' worth in British pounds will fall in value; the net effect is that any gains on the Forex trade offset the currency losses on the US investments. Vice versa, if the exchange rate falls, then the Forex trade will loss money, while the US investments increase in value. The investor is therefore hedged at an exchange rate of 1.4500 regardless of which way the currency moves; which makes for a better nights sleep. Experts advise that when you create a Forex hedge against overseas investments, the objective is to take a Forex position that will generate an equal and opposite gain or loss to the overseas investment worth in British pounds.

What about funds?

There are a number of fund's that invest purely in currency. For example there is Investec's Managed Currency (Sterling) fund and Close Wealth Management operates euro and dollar funds while Fidelity's offering allows investors to hold their cash in a different currency of their choice including euros, Australian dollars or Swiss francs.

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