How to invest in foreign currencies?
Investing in currencies is more popular than ever. When you start investing in currencies, you use one currency to buy another currency. When the currency you buy then increases in value you earn money. But how does investing in currencies work, and how can you make money from trading currencies?
Why is currency trading so popular?
- You do not pay set commissions: You can invest with little money.
- The foreign exchange market is the largest market on earth: this makes it very stable.
- The foreign exchange market often moves through fixed patterns and is relatively predictable.
- You can also make money at declining exchange rates by short selling.
- Using orders, you can easily manage your strategy & maximize your profits.
How to trade in currencies?
Trading foreign currencies is normally done by a broker. A broker is someone who makes it possible to buy and sell various currencies. This is normally done by using derivatives: for example, CFDs are very suitable for trading various currencies.
A good party where you can invest in CFD currency pairs is eToro. With eToro, you do not pay set commissions when you trade in a currency. Use the button below to try currency trading for free with an unlimited demo:
How does currency trading work?
A currency such as the euro always changes in value compared to another currency. Therefore, currency trading is a matter of interrelationships. For example, an illustration of an exchange rate is the value of the euro measured in dollars: we call this combination a currency pair, and we denote it as EUR / USD.
It is possible to go both long and short. When you go long, you predict that the euro will rise against the dollar. When you take a short position, you predict that the euro will fall against the dollar. As soon as you become adapt to analysing charts you recognize the different patterns, and you can earn money trading the currencies.
What are the known currency pairs?
When you invest in currencies, in many cases you trade in one of the seven majors. The majors are the most popular and most used currencies in the world. You can trade in combinations of:
- USD or American dollar
- AUD or Australian dollar
- GBP or British pound
- CAD or Canadian dollar
- EUR or Euro
- JPY or Japanese Yen
- CHF or Swiss Frank
You never trade only in dollars or only in euros. No, you always trade in a currency pair. The first currency is called the base currency and the second currency is called the counter currency or quote.
If you trade in the EUR/USD pair and the price is 1.1, you can buy $1.1 for one euro. On the Forex market you always invest large amounts: for example, you buy 1100 dollars for 1000 euros.
Take note of the spread
When you start investing in currencies, you will see that there is always a difference between the bid and the ask price. The bid price is the amount you receive when you sell the currency pair, and the ask price is the price at which the currency pair is sold. The difference between these two prices is the transaction cost or spread. Transaction costs on major currency pairs are typically low: for example, at EUR/USD, they can be 0.0001.
When you invest in currencies, these costs are often expressed in pips. A pip indicates the minimum price change of a currency. For almost every currency, one pip is 0.0001. The only difference can be found in pairs involving the Japanese Yen where one pip has a value of 0.01. When the EUR/USD rises from 1.1 to 1.11, the price is up by 100 pips.
How is the exchange rate of a currency pair determined?
When you want to invest in foreign currencies, it is important to understand how the exchange rate works. The exchange rate indicates the value of a currency. There are two possibilities:
- Appreciation: when the price of a currency rises.
- Depreciation: when the price of a currency falls.
Whether the price of a currency falls or rises depends entirely on the amount of supply and demand. For example, if people need more dollars, but fewer euros, the dollar will rise against the euro. Only when a balance is found between supply and demand, the price movement stops.
By predicting how the supply and demand for a currency will develop, you can consequently decide whether it is smart to buy or sell the currency.
What are variable and fixed exchange rates?
When you start investing in currencies, you may be dealing with both floating and fixed exchange rates. Most exchange rates are floating exchange rates. Floating exchange rates can move freely, and the government does not actively manipulate the exchange rate.
A fixed exchange rate is subject to strict government supervision. If the exchange rate rises or falls sharply, the government can intervene. If you invest in a fixed exchange rate, you will not achieve a substantial profit quickly. After all, this exchange rate fluctuates less and as an active trader, you can benefit from strong price fluctuations.
What does it mean to go long or short on a currency?
When you invest in currencies, you can take both long and short positions. With a long position, you indicate that you expect the base currency to rise in relation to the counter-currency. On EUR/USD, you can then speculate on a rise in the euro against the dollar.
With a short position, you indicate that the base currency will fall in relation to the counter-currency. In that case, you speculate in EUR/USD on a fall in the euro against the dollar.
Successful currency trading
The exchange rate of currencies is influenced by countless factors: think of, for example, the Central Bank’s policy, the balance of payments, the economic situation… Price is also continuously influenced on a smaller scale. When Panasonic receives its profits from America in dollars, they will most likely trade these dollars (at least in part) for the Japanese Yen. Because US dollars are sold and the Japanese Yen is bought, the price of the Yen rises compared to the dollar.
Of course, as a small party, you have little influence on the exchange rate: this means there is a certain degree of stability in the foreign exchange market. The price regularly moves in predictable patterns where there is a clear upward or downward trend. Quite often, it also happens that the exchange rate mainly moves between two levels.
Currency rates often move in predictable patterns over an extended period of time
It is virtually impossible to interpret all the news correctly on the foreign exchange market: it is possible to recognize these general movements. Once you recognize these movements, you can take positions with higher certainty, and you are more likely to win than to lose. In any case, if this is the case, you can achieve good results in currency trading.
How to invest in currencies?
Fortunately, investing in currencies does not work by exchanging large amounts of money. This would be very impractical: you would pay high transaction costs that way and the continuous transfer of large amounts of money is not very pleasant.
Most people invest in currencies using CFDs. CFDs are derivatives that make it possible to trade price differences between currency pairs. When you invest through a CFD in, for example, the dollar, you never actually own dollars.
With a CFD, you only make the agreement to buy a certain currency at a certain price. This allows you to take full advantage of the currency fluctuations, but you do not have to constantly buy and sell currencies. Do you want to find out more about how CFDs work? Read all about it in our section on CFDs!
How to hedge currency risk?
There certainly are some investors who invest in currencies to achieve immediate exchange gains. However, there are also plenty of investors who want to hedge their currency risk. Let us explain with a simple example.
When you live in a European country using the euro you would pay international stocks in euros. In this example you buy an American stock, and the price rises 10 percent in a year. The value of the euro against the dollar fell by 10 percent over the same period. This eliminates your entire return. When you sell the share, you want to get the money back in euros.
When you sell the stock, you get 10% more dollars because the stock has become more valuable. Then you get 10% less euros because the dollar is now stronger against the euro. This way, returns can go up in smoke! You can hedge these types of risks by taking short positions on currencies through, for example, options.
How to apply a lever to currency investments?
When investing in the foreign exchange market, you can apply a lever. If you simply go to a currency exchange office, you will receive the comparable dollar amount for $100. This does not have to be the case when you actively trade in currencies.
When you start trading in currencies, you can apply a lever. Applying a lever increases the amount of your investment without having to put in more money yourself. You can apply a lever from one to thirty. This means that with an investment of $1000 you can open a position of $30,000.
But what is the consequence of applying a leverage? As a result, both your profit and loss increase a lot faster. When the euro’s exchange rate against the dollar rises by one percent, your result using a lever of 1:30 is as follows:
- 30% profit when you have bought the euro.
- 30% loss when you buy the dollar.
Consequently, you must be careful with a lever! Keep in mind that when trading currencies you can always determine the level of the lever you use.
Improved currency investing
Do you want to strengthen your skills at investing in currencies? The following articles can help you build the right skills:
- Recognizing trends: Learn how to recognize a trend in a currency pair.
- Reading candlesticks: learn when to open a position.
Can you get rich from trading currencies?
Currency trading is often cited as a way to get rich quickly. In practice, this is not true. However, in the long run you can build good capital through currency.
When you want to achieve good results, it is important to start calmly. Learn from your mistakes and build a good plan. It is wise to practice extensively with a demo before starting to trade currency using a large amount. Would you like to start with a demo? Then use the button below to try out the best demos:
Investing in emerging markets
You can also choose to trade in emerging market currencies. Whereas the exchange rates of the major pairs are often very stable, with these types of pairs you see strong fluctuations. The trading volume of the currency is lower, and the socio-economic climate is often more uncertain. This allows the price to make stronger jumps up and down, making investing in emerging markets especially suitable for the advanced investor.