My Experience with Forex

While my personal investment style is conservative and focused largely on index funds, one of my goals for this site is to learn about and introduce some of the lesser-known investment opportunities available. With the proliferation of internet access and the rise of the “online broker” over the last decade, even those opportunities that seemed reserved for professionals and the elite are becoming available to the common investor.

One example is the upcoming launch of the Facebook IPO, which will reportedly be made available to investors with accounts at E-Trade and TD Ameritrade.

Playing with Forex

If you’ve ever taken a college-level finance course or browsed some of the brokerage websites out there, you may have heard of Forex. But if you’re like me, it’s very likely that you’ve never looked into what it means to be involved in trading Forex and how you can benefit.

What do I mean by “Forex” exactly? Forex is one of many terms to describe the foreign exchange market, essentially the market where different currencies from around the world can be traded. Some of the other names include “FX” or “currency market,” according to Wikipedia.

World Currencies

Comparing two currencies to one another is done in the form of a ratio. Essentially, you might get 10,000 Bongo Bucks for every 1 Dollar, or 6.57 Googoos for every 1 Dollar, and so on.

As currencies are traded and the forces of world markets act on currencies as a whole, and individually, these ratios will change. That’s what happens when you hear about the dollar, or another currency getting “stronger” or “weaker”—it’s worth with respect to other currencies is improving or worsening.

Currency trading attempts to exploit these shifts in relative value. Just like like the stock market mantra “buy low, sell high,” the idea with currencies is to “buy weak, sell strong,” picking up world currencies when they are undervalued and sell them back when their value grows.

One unique characteristics of trading currencies is that you always have money—you’re not trading your cash for stock in a company, or for a commodity, but simply exchanging it for another county’s form of money. Pretty neat, if you ask me.

Risk

Until the last few years or so, “the thing” to do if you were living in Poland, where most of my family resides, was to invest as much of your savings as possible in U.S. Dollars. There were a ton of banks in Poland offering strictly dollar-based accounts.

The main reason is that the Polish Zloty was subject to hyper-inflation after the Cold War wrapped up. In fact, the Zloty was redenominated in 1995 with 10,000 “old” Zloty being exchanged for each “new” Zloty. Inflation continued, with the Zloty worth less each passing year against the dollar, which meant that those who were holding dollars in their account were not only getting interest, but investment gains to boot.

The exchange rate of the Zloty against the Dollar held in the 3.5 to 4 Zloty-per-Dollar range for the better part of 2000 to 2005. Then a curious thing happened—it fell to nearly 2.0 in 2008. All of the dollars Poles had in their accounts now had only half the buying power in Poland as only a few years before. The rates eventually recovered to the low-3 range, where they have stayed for the last few years.

This example illustrates that, while there is tremendous upside potential and risk protection potential in currency trading, there is also a lot of potential downside risk to consider.

Conclusions

Online brokers are making long-term and short-term currency trading available to the everyday consumer. As these methods become more commonplace, it’s important to understand their risks and benefits, so make sure you meet with your financial professional or investment advisor before taking any action.

(Photo credit)

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One thought on “My Experience with Forex

  1. Here are my 2 cents on investing in Forex.

    First, there are NO accepted models for predicting exchange rates. There are models to predict fair prices for most other securities (stocks, bonds and options), and the difference between investors lie in assumptions. In Forex, even underlying logic isn’t agreed to. So, if you think you understand how forex values work, you are probably wrong.

    Which brings me to a second point. Forex is a recipe to loose your shirt. While stocks and bonds have fluctuating values, except for shocks in the market, they vary within a tight range. Look at any currency pair even pre-2008, and you can see that they can vary a lot. If I understand the mechanics of investing into forex, when values move you have to set aside money in your margin account to reflect current prices. If you ever got margin calls from your broker, it’s about as pleasant as calls from a collection agency (hearsay here, never had the pleasure)

    What you are describing about Poland (and similar thing has happened in Russia), is that a country decides to keep their currency within a certain range to a US dollar, or, in extreme case, peg it to US dollar. The central bank of that country has to very aggressively buy or sell local currencies to keep prices within that range. Sometimes, the flow of currency becomes so extreme that a central bank can no longer support it, which happened in a lot of countries, at which point, the currency collapses. It happened in Brazil, Asia, Russia and brought down LTCM (read When Genius Failed by Roger Lowenstein)

    Forex trades are meant as hedges for companies with multinational sourcing and sales contracts that wish certainty of their profits in their own currency. Unless you have a risk you are trying to hedge, I personally think individual investors should stay away from forex. Buy lottery tickets instead, your likelihood of making money is about the same, but at least your downside risk is limited to the cost of the lottery ticket.

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