*** Why trade currencies...?
*** The 7 forex favourites...
*** What makes a currency move...? and more...

From the still overworked laptop of Julie Brownlee

Dear Investment Academy Reader,

I hope you’ve managed to survive the first full week at work we’ve had in a whole month! It’s been a long week, but I’ve got a great way for you to make some extra cash – trading forex! So, here’s exactly what forex is and why it’s worth giving it a shot...

Once the preserve of big banks and dealers, the huge currency trading market (also known as forex or FX) is now open to retail investors through spread trading. But tread carefully – there’s plenty of jargon to master before diving in – mistakes in this fast-paced market can prove costly.

Why trade forex?

For an answer, you could turn to hedge-fund manager George Soros. He sprang to fame for betting successfully that the pound would exit the European exchange rate mechanism in 1992. By shorting (selling) the pound, he made around $1 billion in a matter of days in a trade that displays two basic features of forex.

First, unlike equities where everything can fall together – as anyone invested in any major stock market throughout 2008 knows only too well – currency trades are “zero sum”. That means, if you’re trading the pound versus the US dollar (a trade known as a “cable” for historic reasons), one must move up as the other moves down. This means forex traders can make money in any economic climate. They just have to pick the right currency. What’s more, they can make money fast. Currency swings can be dramatic – if you have some pounds, try buying a beer in France this year. If you do, you’ll feel the pain first hand of sterling’s recent dive against the euro if you compare the effective price you’re paying, reflecting the Bank of England’s aggressive interest rate cuts. The same is true of profits and losses for spread traders. That’s because currency spread trading magnifies the effect of an exchange rate change.

How it works

Currencies trade in pairs. You don’t bet on the pound falling in isolation – you bet on it falling against another currency. There are seven major world currencies, so an obvious choice would be one of the other six. Aside from sterling (GBP), they are the US dollar (USD), the euro (EUR), the Japanese yen (JPY), the Swiss franc (CHF), the Canadian dollar (CAD) and the Australian dollar (AUD). (You can’t trade the rand.)

You might decide sterling is heading for a big drop against the USD and sell the GDP/USD pair. The full bid offer quote from your broker might be 1.4292/1.4296. You sell at the bid of 1.4292 for R10 per point (also known as “pips” or “ticks” in FX), which means you’re staking R10 for every 0.0001 movement in the exchange rate. A few bad days for the pound later, the GDP/USD pair’s quoted at 1.3834/1.3838. So you close the bet at your broker’s offer of 1.3838. The difference in pips is 454 (14292-13838), meaning a profit of 454 points at R10 per point (that’s a gain of R4,540). Of course, if it went the other way and the pound rose, you’d lose the same amount, so it’s important to use a stop loss when trading.

What moves an exchange rate?

Almost anything! The market’s massive, highly liquid and highly responsive to events. Most obvious are interest rate decisions – if, for example, the Bank of England drops the base rate, sterling becomes less attractive to investors. So money may move out of the UK currency and into something else, taking say the GBP/USD rates down in the process.

Remember, a currency is a bellwether for its economy – if investors lose faith in the economy, the currency suffers. A good trader will keep a close eye on major economic announcements that give clues about the relative strength of the major economies. Good examples include employment data (for the US the “non-farm” figure is particularly important), inflation data, GDP data, services and manufacturing data.

Many traders also try to predict what the big fish, such as Soros, are doing or will do next. That’s because momentum is a key feature – and ally – in the forex markets. Once a currency starts rising or falling, the trend can continue for long periods: For example, the pound’s been sliding pretty much non-stop for months. As such, a favourite cliché of the currency trader is “the trend is your friend”.

Tune in for next Friday’s Investment Academy to discover the best strategies to play the markets!

Happy trading!

Julie Brownlee
For the Investment Academy

This article was adapted from a MoneyWeek feature.