Spread bet and CFD trading companies report growing interest in trading forex. Indeed, some futures firms are seeing more than half of their annual trading volume from clients who want to trade forex. But what is behind this sudden popularity, and why are investors now looking at currency trading when they ignored it before
Trading forex means getting access to one of the most liquid financial markets in the world, and a market that is open around the clock, five days a week. This is because it has no central exchange: instead, banks and fund managers that want to trade forex do so with each other. Large banks are then able to quote the going rate to brokers who can then offer these prices to their spread bet and CFD customers.
In the UK the most popular way to trade forex is via a spread bet, because it is tax free and also offers traders the use of leverage (they only need to fund a fraction of the trade themselves, while the spread bet company finances the rest). Because the forex market is so big, it is very easy to buy and sell at the price you are quoted, unlike, for example, with some shares.
Investors trading forex generally focus on the major currencies, namely the US dollar, euro, British pound, and Japanese yen. However, spread bet companies also offer other currencies like the Canadian and Australian dollars, the Swiss franc, and European currencies like the Danish krona.
In the wake of the financial crisis, investors have been turning to currencies as an alternative to shares and bonds. Low interest rates around the world mean one of the key drivers of currency prices – the relative difference in base rates between the main economies – has been absent. Few countries have started to raise interest rates yet, but growing inflation means investors are now expecting some central banks to do so soon.
When trading forex, most investors will trade one currency in a pair against the US dollar. For example, taking a view on the yen will usually mean trading USD/JPY (represented by the number of Japanese yen to the dollar). If you think the yen is likely to get stronger against the dollar, you would go short USD/JPY as you would be betting the JPY figure will get lower (dropping in the yen’s case to a low of less than 77 against the dollar after the recent earthquake and tsunami). If you think the yen will weaken against the dollar, you would buy this currency pair, or ‘go long.’ You would be betting the dollar would gain ground against the yen.
Since 2009, many forex traders have been buying and selling the USD against other currencies. The dollar was punished severely in the credit crisis, and fell against many other currencies. However, despite challenges from China and other countries, it remains the world’s reserve currency. This means more central banks around the world prefer to hold dollars and dollar-denominated assets than any other currency. There are a number of reasons for this, but foremost amongst them is that the USD and the US economy is considered a relatively safe bet.
Those who want to start out trading forex will usually follow the dollar, often against a major currency like the yen or the euro or indeed their home currency if it is available as a CFD or spread bet. Many UK traders like to trade forex using the pound (GBP) against the dollar and the euro.
Because of continuing fears surrounding the global economy, including unrest in the Middle East, higher commodities prices, natural disasters and inflation, analysts and traders have started talking about a ‘risk on, risk off’ situation in the markets. This means investors veer from wanting to take more risk in the market, but then retreat again when something bad happens, like the tsunami or fears about inflation in China. When investors retreat, they tend to buy assets they trust, and this usually means buying US dollars or dollar assets like Treasuries (US government bonds).
Consequently, we have seen over the last few months a US dollar market that has literally bounced around as risk appetite waxes and wanes. It has provided a high level of volatility for those trading forex (rapid and sudden shifts in currency prices). This has been good news for short-term traders who measure their trades in hours or days, but is less useful for longer term investors. Big investors cannot make their minds up as to whether the worst is over, and until they feel more secure, they will buy or sell the USD on a regular basis.
If you are trading forex, this means there is the potential to make some short term profits relatively quickly, but you must be sure to protect yourself by not taking on more leverage than you can afford, and by setting stop losses (automatic sell orders which close your position when a trade hits a certain price). Because prices can change quite suddenly at the moment, it is better to take a small loss than end up losing thousands of pounds when a currency moves unexpectedly quickly. Some professional traders and hedge funds suffered severe losses in the yen market following the recent tsunami in Japan: there is no reason to follow their bad example.