Powered by developments in electronic trading, the foreign exchange (currency exchange) market has grown into a global business turning over $4-trillion (U.S.) a day, according to the latest Bank for International Settlements triennial survey (2010).
Online trading by retail investors accounted for a significant part of this growth. Are you missing out on this massive and expanding investment opportunity?
Let's start with some fundamentals. The basic currency trading unit is a futures contract to exchange a set amount of one currency for another currency at a specified future date and exchange rate. One Canadian dollar futures contract is worth $100,000. All trades are settled in U.S. dollars. To trade currencies, you must open an account at a firm that trades currency futures on an exchange or forex over the counter. You must keep enough money on deposit (collateral) to meet the margin requirements for the contracts you hold.
Investors who venture into currency trading can be split into two distinct groups: those who love trading and those who want to hedge their exposure to a foreign currency.
Those who love trading live for the rush of buying and selling. In truth, many would be happy trading any commodity. The attraction of trading currencies is the high leverage available. A contract for a commodity such as oil might require collateral of 5 per cent to 10 per cent of the contract value, in other words a margin ratio of 20:1 to 10:1. Currencies, on the other hand, can be traded at margin ratios of 50:1 or higher. Some online forex brokers even offer retail investors contracts with margin ratios of 200:1.
If you are a trader at heart and are new to currency trading, you should start by gaining a basic understanding of futures trading, as well as the special features of currency trading. The high-risk, high-reward, around-the-clock world of do-it-yourself (DIY) online currency trading requires especially meticulous preparation. Potential DIY traders would be well-advised to begin their career trading at a full-service brokerage using an adviser who is an experienced futures trading specialist. Advice is critical in futures trading and working with a pro provides a crucial reality check.
Traders who then decide to pursue the DIY route need to shop carefully for a suitable broker. Some online currency trading firms are based outside Canada and are not members of the Investment Industry Regulatory Organization of Canada. As such, they do not participate in IIROC's Canadian Investor Protection Fund (CIPF), an insurance program to compensate clients of any member firm that becomes insolvent. If the firm holding your account is not part of CIPF and becomes insolvent, getting your money back will be difficult, if not impossible.
Those who hedge their exposure to foreign currency do so for a variety of reasons.
Investors in foreign stocks seek to remove exchange rate fluctuations from the investment equation. According to Aaron Fennell, a futures specialist with ScotiaMcLeod in Toronto, this makes financial sense for individuals who own several hundred thousand dollars worth of foreign stocks. This is a textbook case of currency hedging. For example, a $500,000 U.S. stock portfolio could be perfectly hedged by buying five Canadian dollar futures contracts. To maintain the hedge, as the contracts expire, they would be rolled over into new contracts.
A person who has inherited a significant sum of money in a foreign currency wants to convert the money to Canadian dollars and avoid bank exchange rate charges. This can be accomplished by holding the appropriate currency futures contract(s) to maturity and taking physical delivery of the contracted sum in Canadian dollars at the end of the contract. This option is only available four times a year.
A Canadian who has signed to buy a Florida condo wants to ensure that he has sufficient funds in U.S. dollars on the deal closing date. For example, let's assume that the Canadian dollar is at par with the U.S. dollar and the deal for the $200,000 condo will close in three months. To protect against the Canadian dollar falling in value against the greenback before the deal closes, the condo buyer can lock in the exchange rate by selling two Canadian dollar futures contracts expiring after the condo closing date. The margin requirement for one contract is $3,105 (U.S.), so our Canadian deposits $6,210 (U.S.) in his futures trading account.
Once the condo purchase is completed, the buyer closes out the contracts by buying two Canadian dollar futures contracts, which offset the ones in his account. If the Canadian dollar has fallen in the interim, the contract price will be lower and the profit on the transaction will offset the exchange rate loss. If, for instance, there was a one cent decrease in the Canadian dollar, the buyer would make a profit of $2,000 when he closes the contract. There is a wrinkle to this strategy. If the Canadian dollar falls sufficiently, our buyer will be required to deposit more money in his account to meet margin requirements.
Currency trading has earned a well-deserved reputation as a useful tool for business. Whether it also belongs in the tool box of individual investors depends on their specific needs. Any prospective currency trader would be well advised to begin by taking heed of this vital piece of advice from futures specialist Mr. Fennell: Understand how powerful leverage can be.
Gail Bebee is the author of No Hype - The Straight Goods on Investing Your Money.