by Jeremy C Bradley on 2011-06-21 1

If youre an investor or business person, one concept that will keep surfacing is the concept of diversification. And one way for investors to diversify pretty effectively is by investing in foreign markets. For many investors, their exposure to such markets is confined to international mutual funds or stocks. But there is another world out there that you may be interested in digging into a little more, and which is mostly built for those who are more aggressive traders. Its the foreign currency market. Remember that if you hold an international investment, then the currency exchange rate influences your gains or losses quite a bit and can dramatically alter your returns. It helps to understand the underpinnings of currency exchange and perhaps gain some insight on how this kind of market works. Those of you who have the tummy for it may want to delve into some aspects of effective currency trading too.

Forex is the nickname given to the foreign exchange market. And like any other market, you can make some bucks in it in various ways. A major component of this is currency trading, which well explore here.

What is Foreign Currency or Forex Trading?

The currency exchange rate is the amount at which one currency can be exchanged for another. For consistency, Ill use the U.S. Dollar and Euro as examples. The exchange rate is always quoted in a pair (EUR/USD or USD/EUR). Exchange rates can fluctuate widely based on economic factors like inflation, industrial production, and political occurrences or wartime conflicts.

Heres an example: on June 12, 2011 the currency exchange rate for EUR/USD was 1.00/1.43. In other words, every 1 Euro is worth $1.43 and every 1 Dollar is worth €0.696. While it may seem that those switching from dollars to euros are “losing money,” this is simply an illusion since were converting from one monetary unit (currency) to another. Money is not being lost here, and is only lost if the rate changes and you end up doing an opposite trade. Note as well that economic factors must also be taken into account. Consider this graph showing a 3-month trend:

On the left axis, the exchange rate is given as Euro (EUR) in US Dollar (USD). The bottom axis shows the date range. Here, we can see the wide variation, even within a three-month period. Investors interested in foreign markets follow the exchange rates closely to monitor the best circumstances and find the best opportunities for converting funds and investing internationally.

So How Does Forex Work?

Using data from the graph above, we can determine that the average exchange rate was 1.4348. The period low was on March 16th at 1.394. The period high was on May 5th at 1.484. But what do these numbers actually tell us?

For one, the rate represents the number of US Dollars that one Euro can purchase (you can also calculate the converse from this data). So heres how a trader would think: if I believe that the Dollar will increase in value against the Euro, then I will buy Euros with my US Dollars. Here, the word “buy” can mean at least two things:

(1) literally buying currency -– that is, converting actual Dollars to real Euros OR

(2) investing in a market that uses the Euro as its currency base. Once I’ve bought Euros, I can sell them back if the exchange rates fall, and I will make a profit!

But as you can see, May 5th, instead, would have been an excellent day to convert Euros to Dollars. On that day, 1 Euro was worth $1.484. March 16th would have been the opposite: 1 Euro was worth $1.394.

The Differences Between The Forex Market vs Traditional Markets

The mechanics of a currency trade are nearly identical to those in other markets. Let it be said that trading in foreign currencies carries a high level of risk. Your profitability hinges on timing the market successfully (and can easily be a gamble if you arent careful). Those seeking to invest in foreign markets must understand the fluctuations. A good source of tracking information is Oanda.com. a website that allows users to track the exchange rates and to learn how to trade Forex.

The foreign exchange market does differ from traditional markets in a few ways:

• Because we are trading in currency, the bulk of the market is liquid. Investors trade actual US Dollars for another “real” currency or they must have the liquid funds to invest in foreign country assets.

Forex Tools and Tips

In currency trading, investors and brokers use technical language that may be unfamiliar to those new to international investing. As you familiarize yourself with the terminology, trading Forex will become easier.

• Technical Analysis. To develop their own strategy, currency traders (a broad term that refers to anyone who trades currency or who opens an account in foreign funds) study currency trends and charts, like the ones available at Oanda.com. Past market movements are used to help predict future activity.

Should You Invest In Foreign Currencies?

Here, I speak from experience. I have several thousand dollars invested in Euros. I closely watch the exchange rate (almost daily) and I’m keenly aware of the political and social impact that the European Union and Eurozone can have on the exchange rate. When I started dealing in Euros, I was worried about the riskand that’s completely understandable. But anyone interested can try it out and gain experience along the way. It just requires a little bit of patience and setting aside a few minutes each day to check on the vital information.

If youre interested in adding some spice to your portfolio, then you may want to consider currency trading. If you want lower risk exposure to foreign currencies, then open a CD in a foreign currency. But be aware that the risk of loss still exists (due to currency risk), even with these CD products.

Categorized under: Investment