The Risks of Currency Trading

Originally published on US News & World Report, March 11, 2015.

Foreign exchange investing is tricky, so arm yourself with knowledge if you're determined to do it.

Taking a do-it-yourself approach to foreign exchange investing resembles a stab at handling your own plumbing: You may be able to do it, and perhaps do it well. But that doesn’t mean you should, especially when the chances of springing a leak, or flooding your financial foundation, run high.

“For do-it-yourself investors, forecasting in and attempting to profit from movements in currencies can be difficult and dangerous,” says Joe Jennings, senior vice president of PNC Wealth Management in Baltimore. “Without the proper tools, placing money in strategies attempting to profit from such moves boils down to speculation, not investment.”

That said, the game proves tempting for some, and can possibly be won with educated guidance and lots of homework, says Chris Gaffney, president of EverBank World Markets and based in St. Louis. “We like to look at currencies as the ‘stock’ of a country, and therefore suggest investors look at the underlying fundamentals of the representative country.”

Here are 10 factors to consider as you contemplate leaping into foreign exchange investing, also known as forex investing.

Political plays have a role. As with any international investment, currency value will bear some correlation to the internal conditions of a given nation. “Understand the political, economic and institutional setting in which a given currency trades,” says Werner Bonadurer, clinical professor of finance at Arizona State University’s W.P. Carey School of Business. It still doesn’t make DIY trading a great idea, but it could tip the knowledge base in your favor.

Central banks take center stage. The monetary policies central banks set have a direct correlation to how currencies perform. “Central banks make the rules, and we are all cooking in their kitchen,” says Lennon Sweeting, corporate dealer with USForex, an international currency payments provider, based in Toronto. He cites this real-time example of central banks in action: “The U.S. Federal Reserve is close to tightening monetary policy, while other central banks are loosening policy and creating an easy-money environment. This divergence should see global major [currencies] lose value, while tightening policy in the U.S. should see the greenback gain.”

One banking superstar can make a difference. Do you remember how much Democrats and Republicans loved former U.S. Federal Reserve Chairman Alan Greenspan? You could compare him to Raghuram Rajan, governor of the Reserve Bank of India. He already had a stellar track record as a chief economist for the International Monetary Fund and a University of Chicago finance professor.

“After taking office, Rajan’s strategy was straightforward: Reduce current account deficits, lower inflation and implement monetary reforms,” Gaffney says. “He’s a year and a half into his appointment, and the numbers are clearly headed in his favor.” Those numbers include an over 30 percent drop in the inflation rate over the past 16 months and huge increases in foreign investment in the first weeks of 2015, which are both robust signs of an economy and currency on the move.

Try foreign exchange through exchange-traded funds. As securities that track a commodity or asset group, ETFs often prove a profitable favorite for self-directed investors. “For those looking to get into the [forex] market but don’t have time to get trained, I’d encourage using the low leverage of currency ETFs,” says John O’Donnell, chief knowledge officer of the Online Trading Academy, based in Irvine, California. “These can invest in either a single currency or a basket of currencies.” He adds that currency ETFs can help new traders capitalize on the potential benefits of foreign exchange, as they hedge risk through diversification.

Treat currencies like small change. Although an upswing in a currency can reap handsome profits, the sector remains volatile because unpredictable market forces can act like gale-force winds. “They should be a small part of every portfolio, due to the fact that they’re almost entirely noncorrelated to the stock, bond and commodity market,” says Jeffrey Sica, president, CEO and chief investment officer of Circle Squared Alternative Investments in Morristown, New Jersey. How much is the wisest percentage? “No more than 10 percent,” he says.

The long haul may prove better than average. Financial experts talk about a process known as “mean reverting,” where prices and returns eventually move back toward an average. With currencies, that average could climb over time if economic growth increases, but that’s a big “if.” “In the long run, currency movements should be mean-reverting, while shorter-term moves can be difficult to exploit,” Jennings says.

Don’t get carried away with uncovered carry trading. Currency traders embrace the carry-trading strategy because it allows them to borrow in a low-yielding currency and invest in a high-yielding one. “Too many investors fall in love with it and don't account sufficiently for the risk of the ‘short’ [or the borrowing] currency to appreciate over time,” Bonadurer says. “As someone said, ‘Carry trading is like picking up nickels in front of a steamroller.’ You’ll get hit at some point in time.”

Speed is not what you need. Trying to beat the undulations of a currency over a span of hours or days is especially dangerous. “The foreign exchange market moves very quickly,” says Lance Roberts, editor at Streettalklive.com and chief economist, strategist and partner at STA Wealth Management in Houston. “Unless you are someone who sits in front of a screen and watches it tick by tick, you might make an investment, and an hour later be deeply in the red."

Leave your emotions at the door. Rooting for a favorite currency against all logic or evidence and hoping for a comeback is a lot like rooting for the Chicago Cubs. “Investors’ behavioral biases and emotions cloud their judgment and lead them to lose money in the forex market,” says Robert Johnson, president and CEO of The American College for Financial Services in Bryn Mawr, Pennsylvania. “Specifically, a currency investor will take a position and find the market moving against them. They have a loss, but don’t want to close it out because they’ll have to admit that they made a mistake. Such investors fall prey to ‘get-even-itis.’” The result: They lose more money than if they’d stuck to sound investment logic.

The big boys can fail, too. For decades, FX Concepts of New York City ruled the roost as the undisputed king of forex hedge funds. Yet after managing more than $14 billion in 2007, FX Concepts went bankrupt in October 2013, which was largely the result of central banks devaluing their currencies. Thus, the fund, which once boasted three dozen information technology and research employees alone, along with statistics gurus, found that its proprietary currency models didn’t work anymore. It’s hard to tell which might’ve crashed first: the forex investments or the FX computers.

The currency game is one you can win, but prepare to hang in there for the long run. Sica predicted in a January U.S. News article, "10 Investments for High Rollers," that the dollar would strengthen against the euro, which came true with the news Tuesday that the euro had reached $1.08, its lowest point in more than a decade. But Sica adds that he’d been waiting for such an outcome for close to four years.

You can find the original article here.

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