Investing is an important part of preparing for your financial future. Many people invest in securities like stocks, bonds, mutual funds, and exchange-traded funds (ETFs), but there are many investment choices beyond those most popular ones.
You can also invest in currency. Investing in currencies is quite different from other types of investments, which makes it an option for people who want to diversify their portfolios. However, the differences also mean you’ll have to take the time to understand investing in currencies before you get started.
What Are Currencies?
Currencies are the money used by different countries to handle transactions. For example, the currency of the United States is the dollar. Many countries of the European Union use the euro as their currency. Japan has the yen, Switzerland has the franc, and the U.K. has the pound.
There are dozens of currencies used throughout the world, some widely used and sought after and some used almost exclusively for small, local transactions.
Investors can buy and sell foreign currency, which lets them invest in foreign currencies.
What Determines the Value of A Currency?
Investing is all about buying an asset and profiting from it either by selling it for more than you paid or receiving any cash flows it produces. To make money by investing in currency, you’ll need to buy a currency at a low price and sell it at a higher one.
To be able to invest effectively, you have to understand what influences the value of currencies.
Historically, many countries used the gold standard — a promise that you could exchange a set amount of money for a set amount of gold. This helped hold currency values stable but had many drawbacks. Today, most countries have abandoned the gold standard and issue what is called fiat money or fiat currency.
Effectively, fiat money has value because the government issuing it says it does and the people who use it agree on its value. Part of its value is also derived from the fact that governments demand tax payments in the currency.
The value of a fiat currency is based on many factors, most of which relate to supply and demand.
For example, a country with high inflation will likely see the value of its currency drop compared to other currencies, as inflation reduces its purchasing power.
Higher interest rates tend to result in higher currency values as investors who hold the currency can earn greater returns. Lower interest rates correlate with lower currency value.
Factors like political stability and government debt also play a role. Unstable governments with high levels of debt may see price volatility or see the value of their currencies drop as people lose faith in the currency.
Some well-established currencies from stable countries, like the U.S. dollar or the euro, enjoy “reserve currency” status. Reserve currencies tend to be more stable than other currencies. Many countries’ central banks keep some amount of foreign currencies in their treasuries, which they can use to weather major volatility in currency value and to pay debts they owe. Some countries with volatile currency struggle to get loans unless they agree to repay those loans using a reserve currency.
The power of a country’s economy also plays a significant role in its currency value. If a country enters recession, the value of its money might drop.
All these value changes occur in relation to the value of other currencies. If multiple countries experience a recession at the same time, the value of their currencies relative to each other might not change much.
In short, currency values depend on many factors and it can be hard to keep track of all of them. Before you start investing in foreign currencies, make sure you have a basic understanding of the global economy and current events because they can play a major role in shifting currency values.
Why Invest in Currencies?
There are many reasons you might consider investing in currencies.
One is diversification. Building a diversified portfolio is one of the most popular ways to reduce investment risk. If you hold 100 different stocks instead of just one stock, you won’t feel the pain as badly if one of the companies you own goes bankrupt.
However, there is still some level of correlation between similar assets. If the stock market as a whole drops, it’s likely all the stocks you own will lose value to some extent. Holding a different asset class, such as bonds or currency, provides additional diversification in your portfolio.
Another reason some people turn to currency investing is that there’s a low barrier to entry. Although there are ways to start investing in stocks, bonds, and mutual funds with a small amount of capital, you often need to have hundreds or a few thousand dollars before you can start with a traditional brokerage.
With forex — short for foreign exchange, or the trading of foreign currencies — you can start with much smaller amounts of money, making it easier for people who don’t have the money for traditional investments to try their hand at investing.
A more utilitarian reason to invest in a currency is if you’re planning to vacation or move to a new country. You can spend the time before you move trying to buy that country’s currency at a low price. This lets you save money and have funds available in the native currency when you arrive. With proper planning, you’ll pay much less for the same amount of money compared to exchanging your dollars when you step off the plane.
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Types of Currency Trading
There are two primary types of currency trades that retail investors can use when making forex transactions: spot trades and futures contracts.
Spot trading is the simplest type of transaction. You and another party agree to exchange two currencies and the price at which to make the exchange, then complete the trade immediately.
It’s much like going to the store to buy something or selling something to another person at a yard sale.
This is the simplest way to invest in currency. You buy when you think the price is low and sell when you think the price is high.
A futures contract is an agreement to buy or sell something at a set price on a set future date. When that date comes, the two parties in the contract complete the transaction.
This lets you lock in the price of a transaction ahead of time, which can be helpful if you know you’ll need to make the transaction and want to know exactly how much it will cost.
Futures also lets investors make bets about how the value of currencies will change.
Consider this example. On January 1, $100 is currently trading for 80 pounds. You might buy a futures contract agreeing to pay someone 100 U.S. dollars in exchange for 75 pounds on April 1.
With this contract, you’re betting that the value of the dollar will decrease and that the value of the pound will increase. On April 1, you must complete the transaction, so if you bet wrong, you’ll pay more for the pounds than you would have paid on the open market. If you bet right, you’ll buy pounds at a discount.
Futures contracts are traded on an exchange and can be bought and sold through a broker like E*Trade. The party buying the contract has to pay a premium to the party selling the contract. Typically, the premium is very small compared to the amount of currency involved in the contract. You might spend $10 for a contract that involves trading thousands or tens of thousands of dollars for another currency.
This makes futures popular among people who want to leverage their portfolio because you can get involved in large transactions with small amounts of cash. However, this also makes them highly volatile and risky because small changes in currency values can result in big changes in the value of a futures contract.
You also have to be careful to close your futures positions before the expiration date of a contract comes. If you’re holding the contract on its expiration date you’ll be obligated to fulfill the transaction, whether you have the funds to do so or not.
How to Invest in Currencies
If you’ve decided forex trading is right for you, this is how you can get started.
Choose a Brokerage
First you need to decide which brokerage you want to work with. There are many brokers that let you trade in the forex market, but they’re not all equal.
Look at factors like the commissions and fees charged by each broker, account minimums, and the research tools and trading platform each offers. Try to choose the broker that charges the least for the type of trading you want to do. If you plan to trade on margin, don’t forget to account for the cost of borrowing money as well.
If there are a few different brokers that look similar, check to see whether any of them offer sign-up bonuses. You might be able to get some extra cash to jump-start your trading.
Once you’ve chosen a brokerage, you’ll have to fund your account. Remember that, like all investing, foreign exchange is subject to risk, so only deposit money you’re willing to lose.
After you’ve opened an account at a brokerage, you have to think about the currencies you want to trade. These are commonly called currency pairings.
Like all investing, currency exchange relies on knowledge and research, so it’s often better to focus on just a few currency pairings instead of trying to trade dozens of different currencies at once.
Typically, you’ll see price quotes for currency pairs listed like “GBP/USD = 1.4.” This means 1 British pound can be exchanged for US$1.40. Conversely, “USD/GBP = 0.72” means you can trade one U.S. dollar for 0.72 British pounds.
There are as many currency pairs as there are currencies in the world, however not all currencies are traded frequently. Major world currencies like the U.S. dollar, Canadian dollar, British pound, euro, Japanese yen, Australian dollar, and Swiss franc are among the most frequently traded.
Because the U.S. dollar is the world’s top reserve currency, accounting for almost 60% of all currency reserves according to the IMF, the U.S. dollar is involved in all the major currency pairings.
Minor currency pairs, which are pairs involving two currencies other than the U.S. dollar, experience less volume. That means the market is less liquid and the bid-ask spread — the difference between the highest price someone is willing to buy at and the lowest price someone is willing to sell at — may be higher.
The most liquid and widely traded minor currency pairs are those that involve major currencies, like the euro and the pound.
Finally, there are exotic currency pairs, which involve a major world currency and one from an emerging market. These can be highly illiquid and volatile, making them risky to invest in.
Foreign Exchange vs. Cryptocurrencies
If you’re interested in trading foreign currencies, there’s a good chance you’ve also thought about investing in cryptocurrencies. The concept is similar because of the ways in which cryptocurrencies act like digital currencies you can buy and sell using your local currency.
However, the forex markets and cryptocurrency markets are very different, and it’s important to understand those differences.
One major difference is simply age. Major world currencies have been around for centuries. Bitcoin, one of the oldest cryptocurrencies, is just over a decade old. The forex market is much more established and better understood than cryptocurrencies.
Cryptocurrency is also more volatile than the currency market, which can make it even riskier than investing in foreign currencies.
While there are similarities between forex and investing in cryptocurrencies, you should treat them as different types of investments that require their own due diligence and research.
Pros of Investing in Currencies
There are a lot of advantages to investing in currencies that might draw you into the market.
The foreign exchange market is one of the largest markets in the world by volume. According to the Bank for International Settlements, more than $6 trillion changed hands in foreign exchange markets each day in 2019. With that much volume, as long as you’re trading a major currency pair, you’ll have no trouble placing orders and getting them fulfilled quickly.
In the United States, the stock market is typically open from 9:30am to 4pm Eastern time on weekdays but closed on weekends and holidays. There are premarket and aftermarket trading hours, but the volume traded outside normal hours is quite low.
By contrast, the foreign exchange market operates almost 24/7 year-round. The volume traded on the forex market might be lower on holidays or during certain times of the day, but you’ll almost always be able to place orders.
Forex trading usually has very low costs. According to Ally Bank, most brokerages don’t charge commissions for forex trades. Instead, transaction costs are built into the bid-ask spread, and brokers are compensated in this way.
If you’re trading stocks or options, some brokers charge commissions that can eat away at your returns, which makes forex comparatively attractive to people who want to avoid fees.
Most brokers that offer forex trading let their customers trade using borrowed money, called margin. Depending on how much margin your broker allows, you could invest multiple times the amount of money you actually deposit to your account.
According to Ally Bank, you can leverage up to 50:1 in the forex market if you find a willing broker. This is compared to just 2:1 in the stock market, typically. That means with a $1,000 deposit, you could trade up to $50,000 worth of currency, which could greatly accelerate your gains—if your trades go your way.
Cons of Investing in Currencies
There are drawbacks to investing in currency that you should be aware of before you get started.
Just as leverage is an advantage of forex, letting you earn larger returns with a smaller amount of money, leverage greatly elevates the risk of forex investing.
Consider this scenario: you deposit $1,000 to your account and borrow $19,000 on margin. You trade the $20,000 for euros, hoping that the euro will rise against the dollar.
Imagine the euro drops instead, losing 3% of its value compared to the dollar. When you sell your euros for dollars, you’ll only get $19,400 back, for a loss of $600 — more than half of your initial deposit. If you hadn’t used leverage, you would only have lost $30.
If you leveraged 50:1 off your $1,000 deposit, you would have traded $50,000 for euros. When you turned those euros back into dollars at a 3% loss, you would get back $48,500. You’ll have lost your entire $1,000 investment and owe a $500 debt to your brokerage.
Foreign currencies can be highly volatile. In a single day, there can be large swings in the exchange rate between any two currencies.
For example, according to Bloomberg, in the past, the value of the Australian dollar has changed by nearly 2% in a single day.
This is especially true for minor and exotic currency pairings.
For example, according to DailyFX, the exchange rate of the U.S. dollar and the South African rand has moved as much as 25% in a bit over a month.
This volatility creates opportunities for savvy investors to buy low and sell high multiple times in a short period, but it creates just as many opportunities to accidentally buy at a high point and lose money. Such swings can also make it hard for investors to hold on to a position as they see its value change rapidly.
No Cash Flow or Intrinsic Value
Unlike assets like bonds and stocks, currencies don’t pay dividends, produce a cash flow or have an intrinsic value, such as representing ownership in a company. You don’t gain any benefit from holding a currency for the long-term, other than the chance that it will continue to appreciate in value.
This makes foreign currency suitable for people who want to make frequent trades but makes it less appealing to buy-and-hold and other hands-off investors.
The foreign exchange market gives everyday investors access to large amounts of leverage and the opportunity to make — or lose — a lot of money by trading different currencies.
Active investors who want a market that’s almost always open and ideal for active trading will enjoy investing in foreign currencies. People who have a passive investing style will probably want to pass on foreign currency investing.