Trading in foreign currency
Trading in foreign currencies has become more popular with local investors in the past few years. Here's how you can get started.
Choose a broker with care
Each day around the globe, $US4 trillion worth of currencies are traded and, thanks to the internet, there is no shortage of foreign exchange (forex or FX) brokers to choose from, including many based overseas. Unlike, say, the sharemarket, there is no single body or institution that regulates the currency market, so it pays to choose your broker with care, because they will be handling your money.
"Look for a broker that holds an Australian Financial Services Licence (AFSL) - this will appear on the broker's website," cautions Milica Nikolic, a senior dealer with easy-forex. "Or check with the Australian Securities and Investments Commission (ASIC) that a broker is licensed. It means you are protected in the event of a dispute."
Once you have confirmed a broker is licensed, check the online trading forums to get a feel for the broker's reputation and how user-friendly the platform is.
Be sure, too, that you understand the cost of placing a trade. Forex brokers charge a "spread" - the difference between the prices at which a currency can be bought or sold at any point in time. While spreads vary between brokers, they should not be the deciding factor.
A decent help desk can be worth its weight in gold when you begin trading.
Set up a trading account
The process of opening a trading account works in much the same way for most brokers. Start by clicking the "register" tab (or equivalent) on the broker's website, and enter details of your name, contact phone number and so on.
Next, you'll be asked to choose a type of account. If you are new to trading, your best bet is to select the "standard" option rather than a premium account. The spreads may not be as tight, but the minimum deposit is likely to be less.
From here you'll be asked about your level of experience in forex trading. Letting your broker know upfront that you're a novice can work in your favour.
"Our account service team phones each new client shortly after registering to provide some basic training," says Nikolic. "By understanding a client's level of experience we can help them learn about forex and find their way around the platform sooner."
All that remains is to submit some personal ID (this can usually be verified electronically) and deposit funds in your trading account - a minimum of $1000 is generally recommended. Once your account is funded you're ready to trade.
Master the basics
Beforeyou get started in the market, it's worth taking time to understand some ground rules.
Currencies are traded in pairs. The value of a particular currency is always expressed relative to another currency - for example, the Australian dollar (AUD) compared with the US dollar (USD), or the $A relative to the euro (EUR). So forex trading involves taking a view on how one currency will move in relation to another. This means you need to select a currency pair.
Sticking with one of the main currency pairs makes it easier to research the market and the spreads will be tighter. According to broker IG Markets, around 85% of trades involve major currency pairs. There's nothing to stop you trading in obscure currencies but it's going to be a lot harder to keep track of, say, the Algerian dinar or the Vietnamese dong than the Japanese yen or Swiss franc.
Leverage is both friend and foe. Leverage, or borrowing, is central to forex trading. In a nutshell, it means you can take out a high-value contract for a far smaller sum of money. The leverage provided by your forex broker is expressed as a ratio - usually 100:1, which means that for every $1 you invest in a trade, you have exposure to $100 worth of market movement. It works this way because currency movements are generally very small, measured in fractions of a cent (or "pips"), and without leverage you'd have to trade using enormous sums of money to make worthwhile profits.
The advantage of leverage is that it amplifies your gains and a small market movement can give you a juicy profit in a short time.
The downside is that if you make the wrong call, your losses are also magnified. As easy-forex's Nikolic says, "Leverage is why we urge people to start trading with small sums of money." You can always increase the stakes at a later stage.
Research the market
Researching will give you a feel for how currencies behave and this can eliminate (or at least reduce) the "punting" element of trading. Two types of research - technical analysis and fundamental analysis - are used to varying degrees by most forex traders. Technical analysis looks at price trends mapped out on charts. If you plan to use charts, check that your broker offers access to them.
Fundamental analysis looks at the extremely broad spectrum of issues that affect currency movements - anything from interest rate announcements through to inflation figures, political decisions and even natural disasters. Clearly there is a lot to cover, but just staying in touch with financial markets and economic news will make you better informed about how forex markets are behaving.
Accept that there'll be losses. The global currency market is vast and values are constantly fluctuating. In this sort of environment it is unrealistic to expect you'll make money on every trade. Most traders simply aim for their profits to outweigh their losses.
Use the demo account
Demonstration accounts are valuable tools, regardless of how much or how little trading experience you have. Most of them closely replicate the real thing. There may be variations with spreads and deal sizes, but you're still dealing with live data and real trading tools such as stop losses.
What's missing from demo accounts is the emotional factor that comes with dealing in real money, which makes them a great place to get up to speed and develop a feel for how a chosen currency pair behaves.
Importantly, stick with the demo account until you are confident you know how to use the platform and you understand how you could make - or lose - money in currency markets. Nikolic notes that even experienced traders use demo accounts, often returning to them to test new strategies.
Follow the tips for success
Easy-forex's Nikolic offers three valuable tips for trading success:
Develop a methodology and stick to it. Without a planned approach, foreign exchange trading can quickly become a guessing game. A trading methodology involves targeting specific profits and setting a limit on what you are prepared to lose.
Inexperienced traders tend to hold on to losing positions in the hope things will improve - and that can just lead to even bigger losses. On the other hand they tend to close out winning positions too early and for a profit that is unnecessarily small. That's why it is vital to plan your trade - and trade to your plan. Make use of stop-loss and take-profit tools that help you stick to your methodology.
Never risk more than 5% of your capital on a single trade. Placing a significant amount of your capital on a single trade increases the risk that you could make a big loss. By limiting the value of your trades to 5% of your capital, you have some money left to trade with on another day.
Don't let emotion shape your trades - emotions are the single biggest thing standing between you and a profit. If things are going against you, scale down your trades. If things are going well, be prepared to trade a little more aggressively.
Forex options: When you're ready for something a little more advanced, or if you'd like to hedge your risk, a foreign exchange option could be the solution. The option gives you the right, but not the obligation, to trade a currency pair at a specified rate for a predefined period. It can be insurance - protection against financial loss if the market moves against you. Forex options are available from a growing number of brokers and some, such as easy-forex, offer three platform levels -"new to options", "basic" and "advanced".
Nicola Field is a freelance writer.