By John | Published: August 21, 2012

Speculation as a concept is not unique to the foreign currency markets. Indeed, as a financial concept, speculation—the trading of financial instruments or assets for the purpose of profiting from fluctuations in price—is applicable to most every asset class, whether stocks, commodities or a wide variety of financial instruments. As it specifically relates to the currency markets, speculation involves the buying or selling of currencies in order to profit from movements in exchange rates; these movements between pairs of currencies can be instigated by political events, or by economic factors such as inflation, interest rates and an increase or decrease in import and export figures. All told, exchange rate movements can be influenced by a variety of factors which may be difficult to predict, but which may nonetheless spark the onset of a trend which the retail currency speculator can identify and recognize if he follows his chosen currency pair(s) sufficiently closely. As with the trading of stocks and other equities, the key to achieving success in currency speculation lies not only in knowing how to spot a trend, but further, in developing a talent for knowing when to get in, when to hold and when to get out.

In order to more closely determine how to successfully speculate in the currency market, it’s necessary to first understand both the basics of how the currency markets work as well as the parameters of where currency investing ends and currency speculation begins. Most foreign currency transactions undertaken today are not of a strictly speculative nature but rather, are entered into for a specific, non-speculative purpose. Whether entered into for speculative purposes or not, forex transactions occur in one of two varieties: the first is the so-called “spot” transaction, which involves the sale of one currency for another at an agreed-to price, which is typically the prevailing market rate (“exchange rate”) on the date that the contract is entered into, and the second is the so-called “forward” transaction, involving the sale of one currency for another at an agreed-to price which is locked-in today, for an exchange of currency to take place in the future. In the most general of terms, businesses and sovereign governments enter into spot transactions in order to meet their foreign currency obligations (for example, to pay for delivered imported goods), and enter into forward transactions in order to hedge against their perceived foreign currency exchange rate risk (for example, if a US company with overseas subsidiaries and employees, or paying overseas rent denominated in a foreign currency, believes that the foreign currency will strengthen against the dollar, that company can enter into a contract today at a more advantageous exchange rate in order to minimize the risk of increased future forex costs). To the foreign currency speculator, both contractual scenarios may represent the opportunity to profit from speculative activities.

In the spot forex market, speculative transactions are entered into for the very shortest term, with the intent of profiting quickly from exchange rate fluctuations. When coupled with the proper use of the generous leverage offered by forex brokers to their retail forex trading clients, speculative spot transactions can prove to be very lucrative: the smallest movement in exchange rates of only a pip or two can result in handsome profit when the retail trader has only staked their forex contract with a fraction of the funds needed to purchase a minimum lot size, relying on the leverage offered by their broker for the rest. As a matter of fact, the most successful retail forex traders are those who enter into and exit out of their spot contracts very rapidly, scalping their profits from each quick exit.

Attractive profits can also be made by speculating in the forward currency markets. If a retail forex trader who closely follows a currency pair and who does their proper and thorough research feels strongly that a certain currency will appreciate against the other currency in the pair in the future, the trader can enter into a forward contract now at the weaker price; upon completed execution of the contract on the agreed-to future date, the trader will realize a profit equal to the difference between the contracted price and the actual stronger price by simply selling the contracted currency at then-market rates. It’s simple enough to do if the trader has the conviction that their research and gut instincts have pointed them in the right direction.

Currency speculation isn’t hedging, in which transactions are entered into in order to mitigate a perceived future risk, and it isn’t investing, in which profits are made by virtue of the fundamental ownership of the underlying asset and its attributes (such as dividends, or stock ownership, or even real estate ownership). Speculation is more akin to arbitrage, which seeks to exploit the difference in trading prices for a good or asset in different markets at the same time, since neither seeks to profit from the asset’s underlying value. Unlike arbitrage, however, which arguably provides no benefit to anyone but the arbitrageur, speculation is an undertaking which provides residual benefits to other market participants beyond the speculator himself: through the increased buying and selling which it brings with it, speculation adds needed liquidity to the currency markets; further, and equally importantly, by assuming a great degree of market risk upon himself, the currency speculator serves to keep risks low for other forex market participants, by evening out the differences between bid and ask prices through the volume of transactions which speculators represent.

In the final analysis, it can be argued that foreign currency speculators operating in the forward markets have the ability to drive the forex markets  in the direction they choose, simply by virtue of their betting on the direction in which a currency may move: if enough speculative traders believe, for example, that the euro will depreciate against the dollar, and if these traders enter into forward contracts on the strength of that belief, then barring unforeseen movements in inflation or interest rates (which are typically used to calculate forward foreign exchange rates), the market will react to these forward contracts as if the euro has already weakened against the dollar, making the speculators’ collective activities the impetus for a self-fulfilling prophecy. Indeed, anyone familiar with the most famous foreign currency speculation of all time, perpetrated in the early 1990’s by the well-known financier George Soros, knows this to be true: believing the British pound to be overvalued vs. the US dollar, and betting that the pound would soon weaken, Soros famously took out substantial pound-denominated loans, which he converted into dollars; when the pound indeed weakened (based largely on Soros’ own widely-publicized opinion regarding the pound’s true value), Soros converted his loans back into pounds and pocketed the difference.

You don’t need the financial reach of a George Soros to profit in currency speculation, rather, you need only to understand the movements of your chosen currency pair after much research, evaluation and observation, and to have the discipline to analyze, chart and watch your chosen pair’s fluctuations to the closest pip. Start small, and get out of your position as soon as you’ve profited without getting greedy. Before you know it, you’ll be successfully scalping your forex profits, and you’ll soon be considering entering into forward contracts to hedge against loss. By then, it’ll be official: you’re a currency speculator.

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