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A Currency Markets Primer with Four Ways to Pocket a Profit

By , Contributing Writer, Money Morning •

If you haven't traded in the currency markets, you're missing out on the largest financial market in the world.

Average daily trading volume in the global foreign-exchange markets (forex or FX markets) was $3.98 trillion in 2010, according to the Swiss-based Bank for International Settlements, and estimates put current totals well above $4 trillion.

Daily forex trading dwarfs volumes for all other leading investment vehicles - by a huge margin. Bloomberg estimates average daily trading volume for all U.S. Treasury securities at roughly $300 billion. Stocks barely register at all in comparison; average daily volume on the New York Stock Exchange (NYSE) is just around $25 billion.

Even if you combined the volume of all the world's stock exchanges, it still wouldn't equal the value of daily forex trades.

One reason the forex market can be so huge is that it isn't confined to a physical location, nor does it have a central exchange. Unlike the NYSE, which has a trading floor for stocks and bonds as well as a computerized trading network, the forex market is strictly an "interbank" or "over-the-counter" enterprise.

That means banks and other large currency traders can either deal directly with one another, or they can match their foreign-exchange needs via one of several Electronic Brokering Services (EBS) such as the Society for World-Wide Interbank Financial Telecommunication (SWIFT).

The forex markets also operate 24 hours a day, five and a half days a week - shutting down only on Saturday and early Sunday.

Given the huge volumes, the bulk of currency trading is conducted by banks, Wall Street-type institutions, governments and other truly major players. However, forex markets are structured to allow fairly easy access for individual traders.

This means there are trillions of dollars trading each day that you should be a part of - and here's how.

Types of Currency Trades

Currency trading is generally conducted via five different types of transactions or trading vehicles:

  • Spot transactions - The buying of one currency with an equivalent amount of another currency for immediate delivery.
  • Forward transactions - Negotiated (as opposed to standardized) contracts in which one party agrees to exchange a specific amount of a given currency for an equivalent amount of another currency at a set value on a specific date in the future.
  • Foreign-exchange swaps - These are trades involving the simultaneous purchase of one currency and sale of an equivalent amount of another, but with differing delivery dates. Typically, one side of a swap will call for immediate delivery of the currency, while the other calls for future delivery, although some trades call for future delivery on both sides.
  • Currency swaps - These are actually derivative products in that they involve other financial vehicles - typically loans - and call for converting principal and interest payments denominated in one currency to payments denominated in an alternate currency.
  • Currency futures, options and other products - These are standardized contracts traded on regulated exchanges (or their electronic networks) like Chicago's CME Group. They either call for future delivery of a certain amount of a given currency (futures) or for later delivery of a specific futures contract or a set amount of a given currency (options).

As should be obvious from the above descriptions, world currencies are always traded in "pairs" rather on an individual basis, with the value of a given currency determined solely by its relationship to the other currency in the pair.

Pick a Pair to Profit

The majority of currency trades are executed to physically own a specific currency, but you can use the markets to profit by buying a pair of currencies you think will move inversely.

Say you thought the Swiss franc (CHF) was going to increase in value relative to the euro (EUR). You'd buy the CHF/EUR pair, then you'd collect a nice profit as the franc rose and the euro declined.

In this case, the Swiss franc is what is known as the "base currency" and the euro is referred to as the "quote currency." A given pair's price reflects how much of the quote currency you would need to purchase a single unit of the base currency - e.g., based on recent quotes, you'd need to pay 0.8719 euros for each Swiss franc you wished to purchase. Conversely, if you had Swiss francs and wanted to buy euros, you'd need to pay 1.1492 Swiss francs for each euro.

In currency futures pairs involving the U.S. dollar, the dollar is always the "quote" currency, meaning the prices you see indicate how many dollars it takes to buy one unit of the foreign, or base, currency.

It's important to recognize that currency values reflect the collective sentiments of currency traders around the world, and currency pair "prices" vary widely depending on how they are paired. As economic forecasts change, so will the best pairs for profit.

It's also important to use your stop-loss orders.

For example, if you wanted to trade the EUR/USD pair, the minimum position would be 100,000 euros having a value of $143,700 based on recent quotes.

However, the FX markets offer extreme leverage - 100 to 1 - meaning you'd only have to post a margin deposit of $1,437 to secure the position.

But your profits and losses are based on the full $143,700 value of the position, so always utilize strict stop-loss orders when trading directly in currency markets.

"Whenever we initiate a currency position, we always have stops in - always!" said Money Morning Capital Waves Strategist and experienced currency investor Shah Gilani. "And we always raise our stops steadily as a position moves in our favor."

Margin requirements to trade currency futures contracts also vary from contract to contract and change with some regularity, depending on the exchange's view of perceived volatility and risk. (Note: Options on futures must be paid for in full at the time of purchase.)

However, the leverage in currency futures is also quite high - you usually have to post only 5% to 10% of the value of a contract - and the strict use of stops is equally important when trading in these markets.

Three More Ways to Play Currency Markets

If the high leverage and potential risk of even minimum positions in the forex and futures markets is too much for your tastes, there are a few more ways the average investor can participate in the currency markets. They include using exchange-traded funds (ETFs) that invest in specific currencies, or opening a bank account denominated in a currency other than U.S. dollars.

Given the current U.S. debt problems - and their potential impact on the economy, interest rates, and inflation - most analysts are currently quite bearish on the dollar. That includes Money Morning Global Investing Strategist Martin Hutchinson, who recommended seeking safe haven in the Swiss Franc or the Singapore dollar.

To follow that advice using ETFs, you could buy shares in either:

  • PowerShares DB US Dollar Index Bearish (NYSEArca: UDN), recent price $29.005 - The US Dollar Index (USDX) is a weighted index of the value of the U.S. dollar relative to a basket of six foreign currencies - the Euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc. UDN tracks the Index, but does so by playing the short side of the dollar against the same basket of currencies. Thus, when the dollar falls, the price of UDN shares rises.
  • CurrencyShares Swiss Franc Trust (NYSEArca: FXF), recent price $120.68 - This ETF holds actual Swiss francs on deposit in a trust account, issuing shares in blocks of 50,000 as the money on deposit in the account increases. As such, the value of the shares fairly closely tracks the shifts in the exchange rate between the franc and the dollar, meaning shares should rise if the dollar continues to weaken.

With respect to opening foreign-currency denominated bank accounts, the best choice is probably Everbank (**), an FDIC-insured Internet bank that offers deposit accounts, money market accounts and certificates of deposit in both individual currencies and baskets of currencies.

Everbank offers deposit accounts and CDs in the Swiss franc, as well as in the Euro, yen, British pound and most other major currencies, plus in the Singapore dollar, which Hutchinson favors.

You can also get a basket account featuring nearly all of the leading world currencies - good if you're anticipating a general decline in the dollar as a result of America's ongoing debt and budget woes.

(**) Special Note of Disclosure: Money Morning's parent company, Money Map Press, has a business relationship with Everbank.

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