Are the currency markets right for you?

Published by Sarah Coles on 25 May 2010.
Last updated on 26 May 2010

currency on chart

The closest most people come to playing the currency game is deciding whether or not to change their money back to sterling after their holiday.

But with the currency markets going through one of their most volatile periods in history, there are opportunities to really make money from them.

Currencies depend on a host of things, from the relative interest rates of the countries concerned through to the economic prospects, house prices, unemployment rates and manufacturing figures of those same countries – and every other economic indicator in between.

They also depend to a large degree on opinion, rumours and sentiment. During the financial crisis, there were plenty of extreme indicators and crazy sentiment to get rates swinging wildly.

For example, in 2009, between December and the beginning of March, the euro fell 10% against the dollar. Then, during the following eight months it grew by 20%, and by the end of the year it had fallen 4.5%.

The euro has since suffered as the economic woes of Greece dragged it down against the US dollar, but then it rebounded as fears eased.

Sterling, meanwhile, has had a torrid time. Against the dollar, it started 2008 at almost $2, and hit roughly this sum again during the summer. But by December it had plunged to around $1.47.

It staggered back up to $1.66 in November 2009, before crashing back to around $1.50 at the beginning of 2010. Against the euro, sterling fell 23% in 2008 to around parity. By the spring it had clawed back some ground, to 92p, before getting back to 84p during the summer.

Since then it has swung wildly between 80p and 95p. The key to making money in this market is guessing what is going to happen next.

It's always notoriously tricky to tell, because currencies can fluctuate based on so many unpredictable variables. And in the recent turbulent times it has become even harder to predict.

The US dollar is a case in point. Before the crisis hit, it was generally viewed as overvalued and due a correction, but when the tough times came, money flooded into the currency in search of a safe home.

Signs of a recovery and a fall in the trade deficit have boosted it further. But what next? Further strong figures would help the currency remain strong, but it's vulnerable to nasty surprises, and there always remains the risk that the correction will come.

Pressure on the pound

Sterling remains under real pressure. As the last major economy to emerge from recession, with weak economic data persisting and warnings of a slow and prolonged recovery, things don't look set to pick up in the UK in the immediate future.

A slowdown in the housing market, and some worrying manufacturing and retail sales data would seem to indicate more tough times ahead. However, the better unemployment data would indicate there is still the chance of a surprise on the upside.

Drastic measures to rebalance the books in Greece, along with statements that if push came to shove, Greece could be pushed and shoved out of the currency, could mean the euro is back on a steadier path.

Strong signs of recovery, particularly in Germany, would support a period of strength for the euro. However, the mixed fortunes of the area mean it is still susceptible to local difficulties, making the path of the currency hard to predict.

There are a few ways to bet on the foreign exchange markets. Investors can spread bet or use contracts for difference (CFDs), in the same way that they would bet on any other financial movement.

Or they can buy currency exchange traded funds (ETFs), in the same way they would buy any other ETF, as a low-cost way of gaining exposure to general movements rather than investing in a particular stock.

Alternatively, they can buy and sell currencies on the foreign exchange markets (usually called FOREX). This is done by trading currency pairs. You will have a base currency and a quote currency – for example, GBP/USD, where sterling is the base and dollars are the quote.

If you bought GBP/USD, you would be selling sterling and buying dollars. If, however, you sold GBP/USD, you would be buying sterling and selling dollars. You are therefore interested in how these two currencies move against each other.

The trades are done in 'lots', which tend to start at 10,000 of the base currency (called 'mini lots') or 100,000 (called 'standard lots').

You don't part with all this cash; you only need to put up a margin, which is usually between 1% and 2.5% of the trade, although usually it is closer to 1% for the major currencies.

So if you wanted to make a £10,000 bet, a margin of 1% would mean you need to keep £100 in your account.

However, because of the volatility involved, you would usually need more like 5%-10% (£500 or £1,000). Otherwise, every time the currency swings against you, you'll be asked to deposit more.

You can keep this position open for as long as you like. If you sell a currency pair, you need to pay interest on this position, although if you buy it you'll be paid interest.

This generally tends to be a small part of the overall exposure, unless you were to hold the position for a very long period.

The attractions of foreign currency trading are clear. It's a 24-hour market, letting you buy and sell at any time, and because there is no shortage of currency, you never run into problems with liquidity.

You can gear up your investment (100:1 leverage allows you to gain up to 100 times more than your margin deposit) dramatically and the markets move quickly, so it is possible to make a lot of money in a very short period of time.

However, of course, the reverse applies, and you can lose an awful lot very quickly too. If you have traded on a margin, it's also possible to lose far more than you invested – even owing money if the market moves quicker than expected, especially where the margin is just 1%.

It's worth using a service that allows you a practice run first. Using pretend money will give you an idea of just how far and how fast these markets move, and how much you could stand to make or lose.

It's an exciting area, but not one to go into without fully understanding the potential exposure.

How can I trade?

If you decide (against all the odds) that sterling will go up against the US dollar, you could buy one standard lot (100,000) with a 1% margin.

Let's assume for argument's sake, that at this point you get a price of $1.50. It would mean you would need $1,500 in your account to cover the margin.

If the exchange rate then rose to 1.5050, it is said to have earned 50 pips (pips are the smallest unit of any currency). It means you would have made about $500, and you would get your margin deposit back too.

If, conversely, it fell the same amount, you would lose $500. Bear in mind that this sort of movement is perfectly possible within one day.

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