How to trade currencies successfully

Whether you're going to New York for a weekend break or buying wine from a french vineyard, currency, and in particular the exchange rate you get, will make a significant difference to your spending power.

But, it's not just something to bear in mind for your holiday spending. Fluctuations in the relative values of currencies mean it's also possible to tap into this dynamic as an investor.

Currency can certainly add another dimension to your investment strategy. Chris Saint, head of currency dealing at Hargreaves Lansdown, says he's seen a lot more interest from investors.

"There's a lot of talk about the value of sterling at the moment, especially with all the activity in the eurozone," he says. With many UK investors holding the majority of their assets in sterling they may wish to consider looking at safer currencies if the pound is devalued."

As well as protecting you if values slide, currency can bring diversification to your portfolio. Although the strength of a currency can be affected by economic factors such as interest rates, gross domestic product and unemployment figures, it is uncorrelated to other asset classes such as    equities, property and fixed income. This means that even when other asset classes are falling, it's still possible to achieve a return by trading currency.

Indeed, unlike investing in shares where you're always looking for an increase in value, currency trading involves taking a view on how one country's currency will perform relative to another, which means as long as there is movement in the market, there is always an opportunity to make money.

The characteristics of the foreign exchange (or forex) market also add to the appeal. According to figures from the Bank for International Settlements , more than £4 trillion (£2.6 trillion) is traded every day, dwarfing the activity on the world's stockmarkets. "It's a very deep, liquid market so a price is always available and the market's open 24 hours a day, five days a week so you can access it when you like," says Paul Hayward, head of sales and acting managing director for the EMEA region at forex trading firm Oanda.

And, as with other markets, there are a number of different ways to gain exposure to currency, with each having its own merits and potential pitfalls.

Forex trading

One way to add currency exposure to your investment strategy is by trading forex, which is also known as spot forex. This is offered by a number of brokers including Barclays Stockbrokers, IG, Interactive Investor, Oanda and TD Direct.

Generally regarded as a short-term trading strategy, it allows you to take a position on how the exchange rate between two currencies, known as a currency pair, will move. As an example, say you thought the value of sterling will rise against the US dollar, you could buy, which is also known as going long, sterling and sell, or go short, US dollar. If your view is correct and the value of sterling rises, your return will be based on the number of points, or pips, the exchange rate increases.

To add a further level of complexity, forex is traded on margin. This means you only need to deposit a fraction of the amount you want to trade, with most forex trades only requiring you to put down 1 or 2% of your exposure as a deposit. For example if you put down a deposit of £3,000 you'd get £150,000 to £300,000 of exposure. Richard Miller, manager of TD Derivatives, explains: "Currency exchange rate fluctuations tend to be small and 1% represents the realistic movement you could expect in a day. If the margin is 1%, this means that if the exchange rate does move 1% over a day, you could double your money or lose the lot."

Importantly, losses won't necessarily stop at the deposit you've put down. If the market moves against you, you could be asked to deposit more money or have your position closed. Unsurprisingly the brokers are keen to avoid this, as Chris Beauchamp, market analyst at IG Group, explains: "To prevent losses from escalating, we encourage our customers to use mechanisms such as stop losses. These are free and guarantee the position will be closed when the exchange rate hits a set point."

As well as weighing up the risks, it's also important to understand the costs involved. Although there are no dealing charges, brokers take their cut from the spread between the buying and selling price. This is often very tight, especially on the well-traded currencies. For example, on the euro/sterling pair, TD Direct's spread is just two pips.

On top of this there's a potential charge if you hold a position open overnight. This is based on the difference between the interest rates in the two countries or regions, which means that in some cases you might end up receiving rather than paying interest.

Because of all the complexities surrounding forex trading, many of the brokers, including Interactive Investor, Oanda and TD Direct, offer practise accounts that allow you to get a feel for the market without having to commit any money.

But, while a practise account is risk free, Mark Bodega, director at HiFX, warns that it's not for the fainthearted. "Currency speculation is a high-risk and complex business. Predicting what will happen is notoriously difficult and over the short term, volatility can leave speculators exposed."

Exchange traded currencies

Exposure can also be achieved through an exchange traded currency (ETC). Again these track the exchange rate between two currencies, but there are some key differences to forex trading. "ETCs are fully funded investments so you'll never be asked for more money if it doesn't perform as you expected and you can also hold them in an ISA or a SIPP," explains Neil Jamieson, head of UK and Ireland sales at ETF Securities.

His firm was the first to launch ETCs in the UK, initially offering 18 that paired the US dollar with G10 currencies. It now offers 80 products, including emerging market currencies such as the Chinese yuan.

Like any exchange traded product, there are no minimum investments, although you must buy whole securities. However, as they are bought and sold through stockbrokers, dealing costs can make small holdings uneconomical.

There are also management charges to consider, which are taken through the spread between the bid and offer prices. These do tend to be relatively low though, typically around 0.2%.

While the structure and low running costs associated with ETCs makes them a lower-risk option than trading forex, Ben Seager-Scott, senior research analyst at Bestinvest, still recommends caution. "These are sophisticated products that tend to be used tactically, with investors using them to express a short-term view over a period of around six months."

This feature was written for our sister publication Money Observer

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