No doubt you’ve come across references to the currency market: traders buying and selling different kinds of money to make a profit from exchange rates. The upshot of how this all works is that currency exchange traders work within a system called the foreign exchange market, or the Forex.
A lot of what they do is based on timing, on computations that take into account exchange rates, transaction size, and also just how long they’ve agreed to wait before exchanging their coin (and also what’s happened to it, in terms of exchange rates, in the interim). Sound a bit daunting? Don’t worry; it’s easier to pick up in a walk-through than it sounds in a summary.
So, let’s take a look at the currency market and how it operates.
How the Currency Market Works
Essentially, you wade into the Forex by performing what is known as a liquidating transaction. What that means is that you’re buying one kind of currency and then closing out the transaction by liquidating it for another kind -hopefully for a profit – on a specified date in the future. The contract involved is, in fact, called a future.
The components of this kind of deal are as follows:
- Bid/Ask Spreads: Say you see a currency-market dealer’s quote, and it reads: EURO/USD: 1.5230/1.5234. This tells you that you can sell a euro for $1.5234 and buy it for $1.5230. (Sometimes the second number in the quote will be abbreviated to just the two final digits: 1.5230/34).
- Marking Up the Spread: If you went to the bank, though, you might find the rate quoted to be different from what a dealer tells you. Say, for example, that it’s EURO/USD 1.5225/1.5239 at the bank. The dealer in the above scenario has marked up his or her spread by .0005. That is, they’re buying for .0005 cents less and selling for .0005 more to their traders. They’re keeping the difference as a kind of transaction cost. Other dealers might quote a bid/ask spread at the un-bumped rate, but charge you a flat fee for doing business. Some do both. So, word to the wise: read the fine print and understand the arrangement.
- Currency Futures: A future is a contract between you and the dealer. It works like this. Let’s say you have $100,000. You contract, via a future, to buy 65,000 euros from the dealer. Now, if you calculated profits based on $1.5230 per euro, spending $98,995 and then selling right away at $1.5234 you’d garner only $99,021. That’s $26 in profit. (Not so hot.) But the contract you’ve set — the future — means that you can delay the transaction in hopes of a better exchange rate. In this example, let’s say you set it for 30 days. Your goal is to sell your euros in a month’s time for a larger profit based on a hopefully increased exchange rate.
- Margins: Your dealer typically requires a security deposit before he or she allows you to control all those euros. That is, you put up a certain amount of money to secure the future. In most cases, this would be the 65,000 euros multiplied by the price of $1.5230, times what we’ll imagine to be this dealer’s 1.75% set percentage: so, your margin would be $17,324.41. That’s a bond to hold the future.
- Gaming Your Position: In the best-case scenario, let’s say the market works in your favor. The euro climbs, over 30 days, to an ask-price of $1.5244. You sell your 65,000 euros for $99,086 and make $91 on the transaction. Now, you ask: what happens if the ask-price for the euro doesn’t climb very much at all, or what if it drops? In that scenario, you might want to keep your position open with the dealer. You would roll over your future for, say, another 30 days. The catch is that interest comes into play, based on whatever the currencies’ home-country banks have set. You can earn and you can pay, when it comes to this interest, depending on what the dollar is doing against the euro. You may also have to pay a fee to the dealer to extend the contract. Again, read the fine print of your dealer’s arrangement.
All This, and a Basket Full of Currency . . .
With those basics in mind, there’s another way to approach the Forex as well. It’s called a currency basket. Instead of trading just one kind of currency for another on futures, you could buy a spectrum of currencies — say currencies from Asia — and base your computations of profit and loss on something like the average of what’s in the “basket.” The idea behind it is that you can lessen the impact on your portfolio of one currency dipping (or surging) by working with this roughly averaged collection of currencies all at once.
However you work the Forex, arm yourself with information. Different dealers deal differently, and you want to know what all your obligations are under a given future. It can’t be emphasized enough — read the fine print of those arrangements. And good luck, investors!