Forex trading (also known as foreign exchange trading or simply FX trading) has grown substantially over the past decade. This used to be a market just for large institutional investors who had deep pockets and access to the banks. Now, retail brokers have sprung up, offering people like us access to buying and selling many different currencies.
It is a completely separate asset class to traditional stock investing which we mostly speak of here at the Motley Fool. Yet in a hushed whisper, could it be that forex trading may offer me better returns and should it demand more of my attention?
Having been around financial markets for longer than I care to mention, and having good friends who trade forex regularly, the main danger for most retail forex trading is the use of leverage.
For most brokers, they use what is known as margin lending/trading, whereby you only have to deposit a small sum in order to have large size positions in the market. For example, if you had £1,000 in your account, and a margin rate of 100:1, you could put on a position worth a notional amount of £1,000,000!
Getting to understand your actual position size is something that most retail investors don’t get round to, and therefore only a small move in the currency markets can wipe out your entire account balance. But wait, I hear someone say, only a small move in your favour can make you large profits. True, but being exposed either way to such a high level of risk/reward is not informed trading. It is mostly luck (or I should say, gambling).
You can trade stocks on leverage too, but mostly they are traded 1:1, so your £1,000 only buys you £1,000 of a stock. The vast majority of forex trading is on leverage.
Mixing asset classes
Putting leverage to one side, I do think that you can be smart and make money from forex trading. What is even better is to potentially combine forex and stocks together.
You can do this in various different ways. For example, you could buy into a company that has a high concentration of manufacturing operations in another country (and thus another currency). If you believe the local currency could weaken in value, then the firm will benefit from the cheaper currency via wage costs and material costs.
Alternatively, you could buy into a FTSE 100 ETF, which is denominated in a different currency. The denomination of an ETF simply means what currency you need to pay in order to buy it. Most FTSE 100 ETF’s are in British pounds, as the companies on the index are listed in pence.
However, you can buy an ETF in US dollars, or euros. By buying an ETF in a different currency, you are exposed to the currency movements between that currency and the British pound.
In conclusion, the fact that most forex is traded on leverage makes me worried that even a small move in currency can have a big effect on my cash balance. However, I don’t think that investors should shun forex trading all together. I think that smart investors can look to play the forex market alongside stock investing, either indirectly via the specific firms they invest in, or directly by holding a product that is denominated in a different currency.
Jonathan Smith and The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.