Because this is an investing for beginners series (check out my last post on stocks), today we’re going to cover a different market – the currency market.
You might not believe this – the stock market is actually one of the smallest markets out there! That’s why some large investment funds (hedge funds, banks, etc) need to trade currencies – the stock market is just not big enough to absorb all their cash! On the other hand, the currency market is huge – trillions of dollars are traded every day, meaning that there is massive liquidity in this market. There are several ways to trade Forex, directly, via spread betting or CFDs, even buying physical currencies, although you wouldn’t be able to trade on margin.
The Difference Between Currency Trading and Investing in Stocks
When you’re investing in stocks, you’re making an absolute bet. You’re betting that the price will go up (or down, if you’re shorting a stock. “Shorting” is a concept we’ll cover later on).
Currencies, on the other hand, is a relative bet. You’re betting that one currency will perform better relative to another country’s currency. Here’s an example. Let’s look at a hypothetical situation involving the world’s two dominant currencies: the Euro and the USD (U.S. dollar).
- Euro goes up, but the USD goes up even more. Thus, relative to the USD, the Euro weakened.
- Euro goes up, but the USD goes up a little bit less. Thus, relative to the USD, the Euro strengthened.
- Euro goes down, but the USD goes down even more. Thus, relative to the USD, the Euro strengthen
- Euro goes down, but the USD goes down less. Thus, relative to the USD, the Euro weakened.
That’s why currency trading is more difficult that investing or trading stocks. Instead of considering one single variable (will Stock A’s price go up or down), you’re considering two variables (how will currency A perform relative to currency B?).
Thus, when you trade currencies you’re always buying a currency and selling another currency. For example, if I buy the Euro and sell the USD, I’m betting that the Euro will appreciate relative to the USD. Oppositely, if I buy the USD and sell the Euro, I’m betting that the USD will appreciate relative to Euro.
Currencies are Listed in Pairs
A currency does not have an absolute value. A currency such as the Euro is always written as relative to another currency. For example, if you hear “the value of the Euro today is $1.35” on the news, it’s saying that the Euro-to-USD ratio is 1 Euro = $1.35 USD. Thus (if you do the calculation), the USD-to-Euro ratio is 1 USD = 0.74 Euro’s.
Because of the 1994 Bretton Wood agreement, all currencies around the world are priced in USD (making the U.S. dollar the global reserve currency). Thus, Yen (Japan’s currency) is listed in USD, the Euro is listed in USD, the CAD (Canadian dollar) is listed in USD, and so on. In order to convert from e.g. Yen to Euro, one must first convert from Yen to USD and then USD to Euro (taking the USD as the “middleman”).
Two Types of Currencies
Because of the pecking order of our world, currencies around the world are generally classified into 2 types: major currencies and exotic currencies. As you can probably guess, major currencies are the currencies of the large countries: Euro (for Europe), the CAD (for Canada), the Yen (for Japan). Believe it or not, the Yuan (China’s currency) is not considered a “major currency” because the Chinese government pegs the Yuan to the USD, thus not allowing the Yuan to float.
On the other hand, exotic currencies are the currencies of small (and often volatile) nations. This includes the Mexican peso and the Russian ruble.
As a rule of thumb, most currency traders stay away from exotic currencies – those nations often have unpredictable governments that can easily hurt investors and currency traders.