With the dollar near record lows, more American investors are starting to think about whether it's time to start dabbling in the foreign currency exchange market. Experts have one piece of advice: Be careful.
Few Americans are probably familiar with Forex, the international exchange market where the only thing traded is money. It is open 24 hours a day, five days a week, and a place where all the trades are done electronically. There is no central trading floor. Yet, at roughly $1.9 trillion worth of trades per day, it is by far the largest financial market in the world.
Some investors might look at the current currency climate as a prime time to hop onboard the Forex train. But the reasons for caution are many.
First, of course, there's hardly any certainty that the dollar will keep falling. Mark Zandi, Chief Economist of Moody's Economy.com, believes the free-fall might be slowing: "I think the dollar is near a bottom via the Euro, pound and Canadian dollar. Foreign exchange markets are already pricing in a very weak if not recessionary U.S. economy and substantial Fed easing." And while he thinks the dollar still has further to go in relation to the Chinese Yuan and other Asian currencies — he predicts another 5% to 7.5% until early in the next decade, when he thinks the Chinese-U.S. trade balance will stabilize — jumping into the Forex probably isn't the smartest way to take advantage of this environment.
Second, and more important, investing in the Forex is extremely risky — far riskier than the stock market. In the currency market, investing only a small amount of money can give the trader control over a far larger sum. That's because the fluctuation in the Forex is often so minimal that it would be difficult to see any real profit (or suffer significant loss) if trades were done in actual dollars. Brokers won't deal with you that way.
What they will do is leverage a ratio of "credit" to dollars to you. This varies from broker to broker and depends upon the size of the trade. It is usually no less than 50:1 and is typically 100:1. At a ratio of 100:1, that means for every $1,000 you invest, you're actually trading with $100,000 — that is, you are actually carrying the risk on $100,000, the difference being a loan from the broker.
This arrangement is great for the winner, "Wow, I just made $1,500 off a $1,000 investment!" But terrible for the loser, "I lost WHAT? But I only invested a fraction of that!" That's why being an individual or "retail" investor in the currency market is not for the faint of heart.
Take Robert Skiff, co-founder of the Vermont Commons School, where he is an admissions counselor and the social sciences chair. In his downtime — if the climate's right — he is an avid currency trader. "I'm not very active right now," says Skiff from his home in northern Vermont. "You have to be willing to walk away if your models aren't going to fit," and he now feels the environment is too unstable.
Skiff considers himself a "quantitative trader," which is someone who uses "rigorous computer modeling and data schemes to find advantages." He calls the other type of investors "trend followers" or "qualitative traders," those who "look at charts and 30-day moving averages" to try to beat the market.
Because the foreign exchange market is so complicated, now might be the worst time to experiment with currency trading. But both Zandi and Skiff offer investors some sensible advice on how to make the most of the recent dollar drubbing. "I think the best way for individual investors to participate in Forex is to be sure to have a significant share of assets allocated to overseas stock and bond investments, particularly in Asia," says Zandi. "For the average investor wanting to play on the dollar falling, it would make more sense to invest in an index fund in [an overseas stock market]. Then you might get a kick from the falling dollar and the stock market of that country," says Skiff.
A final bit of age-old wisdom holds up for all kinds of investments, the Forex included. Says Skiff: "When someone says it's impossible for an asset to go down, run for the hills."