The primary goal of diversification is to capitalise on your returns through investments in various areas – preventing a wipe out of your positions should the market turn against you.
If you are looking into ways to diversify your portfolio, consider exploring the off-exchange retail foreign currency (forex) market. One reason, for starters, is that Forex, in conjunction with the interbank market, is one of the largest financial markets in the world and is rapidly growing as an asset class. However, just like any other investment, it is vital that you understand the fundamental concepts relating to retail Forex. If you trade other asset classes, you may already be familiar with some of these concepts. Let's explore the elements of FX trading to help you understand if Forex is a match for your existing investment personality.
Let's start with understanding currency pairs. Currencies in the retail Forex market are traded in pairs. You will buy one pair and simultaneously sell another, so when you buy the EUR/USD you are essentially buying Euros and selling US dollars.
The most commonly traded currencies are called the Majors. They are the EUR/USD, the USD/JPY, the GBP/USD and the USD/CHF or Swiss Franc. Many traders also consider the USD/CAD and the AUD/USD major currencies as well. According to the BIS Triennial Central Bank Survey published by the Bank of International Settlements (www.bis.org) in December 2007, the most heavily traded products are:
» EUR/USD: 27 percent
» USD/JPY: 13 percent
» GBP/USD: 12 percent
The US currency was involved in 86.3 percent of transactions, followed by the euro (37.0 percent), the yen (17.0 percent), and the sterling (15.0 percent).
The US dollar
The US dollar features in many of the currency pairs that are traded worldwide. However, the dollar hasn't always been the world's darling when it comes to reserve currencies, and there are fears that it might not be in the future. Forex traders are constantly exposed to doom and gloom tidings that seem to center around the US dollar. What you need to consider is that despite the doomsday scenarios, US currency has not collapsed and foreign banks, in particular Asian ones, continue to hold trillions in US dollar reserves. I have heard estimates of up to two-thirds of all global central bank holdings are US dollars, though official reserve holdings are allocations are not really published anywhere.
The Euro was born on January 1, 1999, signaling the end of currencies such as the Deutsche mark, the French frank, and the Italian lira. Out of the 27 countries that make up the European Union, thirteen of them use the euro as their currency. Eleven countries initially joined to form the Eurozone – Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain. Greece joined in 2001 and Slovenia joined in 2007. As a result the Euro has surpassed the US dollar as far as total value of cash in circulation.
The Japanese yen
The yen is the official Japanese currency and it is denoted by JPY. The yen was established as the official unit of currency by the New Currency Act of 1871. Rising crude oil prices influence the yen. Because it imports all of its oil as an export-dependent nation, Japan is highly sensitive to rising energy costs. One thing to notice is that when the strength of the yen rises, it tends to hurt the manufacturing industry of Japan, which is a large component of the Japanese economy.
The pound sterling is commonly referred to as the pound, cable or sterling. It is the legal tender of the United Kingdom and its Crown dependencies. The sterling is the third-largest reserve currency, after the US dollar and the euro.
The Swiss franc
The Swiss franc, or Swissy and CHF, is the legal tender of Switzerland and Liechtenstein. The franc banknotes are issued by the Swiss National bank, also known as the central bank of Switzerland; the coins are issued by the Swiss Federal Mint, Swissmint. The Swissy is the only version of the franc still issued in Europe. The Swiss franc is hailed as a safe haven currency due to the history of political neutrality, the near zero inflation rate, and the historical legal requirement that at least 40 percent of the currency has been backed by gold reserves.
The currency market is a 24 hour-a-day, 5.5 day-per-week market. It is a worldwide, decentralised, over-the-counter market. The main trading center is London, but New York, Tokyo, Hong Kong, Singapore, and Australia are all important centers as well.
The market begins its week in New Zealand, followed by Australia, Asia, The Middle East, Europe and then Americas. The US and UK markets account for about half of all market transactions, and nearly two-thirds of the New York trading activities occurs in the morning hours while the European markets are also open.
Swap – what is it and why does it matter?
Forex positions that are open at the end of the business day are rolled over to the new date. As part of the rollover, positions are subject to a charge or credit based on interest rates of the two traded currencies with an added a markup of +/-0.25 – 0.75 percent. This is referred to as swap. So, if you bought a currency with a higher interest rate than the one you sold you would have a positive amount credited into your account as part of the daily roll over.
Most brokers publish their swap rates on their websites or in their platforms.
However, if you want to calculate the swap yourself the formula is: Swap rate (short percent or long percent) x pip value x number of lots x number of days.
Remember that for some pairs the pip values are fixed and for others it fluctuates. Another thing to remember is that the date used in the calculation is always two bank days later. It works likes this, if you open your trade on Monday and keep it until Tuesday it counts as if you opened it on Wednesday and kept it until Thursday. However, if you open the position on Wednesday and keep it until Thursday it counts as if you opened it on Friday and kept it until Monday. That is why triple swaps apply to all positions that are held on Wednesdays. Swap is usually converted to your base currency at the time of calculation.
Leverage, margin and position size
Spot forex is typically traded on leverage, usually upwards of 100:1. A standard lot is usually $100,000 of the base currency. If the trader is using 100:1 leverage, they would have to post $1,000 of the base currency in order to enter the trade. This allows the trader to enter the market with less money than they would need to have at lower leverage.
Added to that is the ability for traders to open a mini account and even trade fractional lots. A mini lot is usually $10,000 of the base currency. If the trader is using 100:1 leverage, they would have to post $100 of the base currency in order to enter the trade. With fractional lots the required margin decreases again. This allows currency traders to begin trading in the market with smaller lots and less margin at risk.
Tips on getting started
Before you add Forex to your existing portfolio, it's essential that you create a trading plan to fit your individual needs – learning as much as possible about the retail FX market. There are countless forums, discussion groups, websites and an entire software industry that has grown up around trading strategies. Don't be afraid to ask questions and explore options. This should be an enjoyable process, not a hard or scary one.
Next, compare brokers and open a demo account. Pick at least two brokers that fit most of your criteria and open up demo accounts. Trade in different market environments. Learn all the different features of each trading platform.
Also keep in mind, investor's expectations change over time. That means you will have to be on your toes, watching for changes and emerging trends. Your trading plan should never be done – it should be a continuous plan you can review, tweak and fine tune as your performance drops or plateaus.
Marilyn McDonald joined Interbank FX in December 2005 as head of the marketing department. In her current role as the Vice President of Customer Experience, she is heading up the conversation between Interbank FX and its customers. She is responsible for the national and international events, public relations, customer education and orientation, and brand. Marilyn currently serves as an Associated Person and a Principal of Interbank FX with the NFA. She is a Series 3 licensed Futures broker and author of Forex Simplified and contributing author in SFO Personal Investor Series: Forex Trading.