Bored With Stocks? More Investors Bet on Currencies

If you're one of those who thinks a dollar doesn't go as far as it used to, then you know how currency traders feel.

Exchanging Dollars and Euros
Exchanging Dollars and Euros

A dollar might not buy as much gas and food as it did nine months ago, but it also doesn't buy as many euro, yen and pounds either.

In fact, the dollar has become the weak sister in the world currency markets, the playground punching bag that regularly gets pushed off the swingset by other denominations that have been supported by their government's monetary policies.

But such is life in the world of currency trading, where even a weak American dollar can mean a big money-making opportunity for smart investors who know when to get in and when to get out.

The currency trade has become increasingly popular as stock markets continue to move sideways and safe-haven government-backed bonds offer low yields.

"You're starting to see more people move to currency trading to try and increase their returns," says Jack Crooks, editor of two currency trading publications with Weiss Research. "People are just waking to the idea that we're very much in a globalized market right now. They're thinking more international about currencies."

Part of the trade's allure is as a hedge against inflation, while other investors like the exposure it gives them to emerging markets.

There are many ways to play the currency markets, from the safety of an exchange-traded fund to the riskiness of currency options and futures contracts.

The currency trade is done in the generic world market known as the foreign exchange, or forex. But unlike the New York Stock Exchange or any of the other bourses around the world, there is no centralized forex trading center. Forex trading occurs wherever currencies change hands.

Trading occurs at a multitude of locations, from banks to brokerages to online trading centers to the Philadelphia Stock Exchange's world currency options center, one of the more popular locales. One of the main advantages of forex trading is that you can buy and sell currencies 24 hours a day, seven days a week.

Currency trades are done in pairs, swapping one for the other. You can exchange your dollars for euros, then buy the dollars back at a later date in the hopes that you can purchase more than you sold, or trade in the euros on another currency.

And you can work with virtually any of the hundreds of currencies around the globe, though most forex trading centers on the eight major currencies--the dollars of America, Canada, Australia and New Zealand, along with the European Union's euro, Japanese yen, British pound and Swiss franc.

There are three ways you can trade currencies--spot, futures and forward.

Spot trading is done at current market prices. You exchange one currency for another and hope the one you bought goes up in value.

Futures trading involves purchasing a contract to buy or sell a currency at a set price in the future. The contract is basically a bet on which direction the currency is going to go. The difference between the price you buy or sell the currency in the futures contract and what it's worth on the spot market is your profit--or if you bet wrong, your loss.

Investment advisers generally recommend setting conservative limits, or puts, on futures trading so as to limit potential losses.

Forward trading involves private contracts that don't necessarily have to follow spot market prices.

What's the Best Way to Trade?

For most investors, however, the best way to trade currencies is through exchange-traded funds, or ETFs, which are essentially mutual funds that are bought and sold like stocks. ETFs offer exposure to the movement of currency markets without the risk of futures trading. There are plenty to choose from as well.

Some mimic the movement of individual currencies, like the RydexCurrency Shares funds for the Australian dollar, yen, the Swedish krona, Mexican peso and several others.

PowerShares even has individual funds for those bullish or bearish on the US dollar while also offering an omnibus fund it calls the Currency Harvest Fund, which follows a basket of foreign denominations.

"Investors can augment their returns by using currency ETFs," says Tom Sowanick, chief investment officer at Clearbrook Financial, of Princeton, NJ. "Investors can hedge some of their inflation risks by participating with currencies, and they can also participate in what is potentially a much longer-term revaluation of the dollar as the sole reserve currency."

With the Bush administration favoring a weak dollar and none of the prospective presidential candidates devoting much campaign time to backing the US currency, Sowanick sees the greenback continuing its weakness.

The Federal Reserve has been on an aggressive rate-cutting run since September 2007 in an effort to increase liquidity and stave off a recession. But the moves result in a weakened dollar as lower interest returns make it a less attractive investment.

The dollar has hit staggering lows against the euro, which at one point fetched more than $1.60 against the US currency. The greenback also has struggled versus the yen; the relationship between the US and Japanese currency has become a hotspot for stock market watchers, with a drop in the yen often signaling a gain in equities.

"The lame-duck administration has shown no interest in protecting the dollar and will likely continue to show no interest through November," Sowanick says. "That doesn't mean the dollar goes straight down, but there's not a whole lot of reason to expect it to appreciate."

He likes some of the major currencies but also believes the Brazilian real, Indian rupee, Indonesian rupiah and Malaysian ringgit will be solid investments as those nations continue to grow.

That presents an opportunity for those looking to make currency plays.

One of the conveniences of currency trading is the low cash requirements. Even futures trading requires less capital than, say, commodities. In Philadelphia, an investor can get involved in currency futures trading for as little as $200.

In fact, Crooks recommends starting small to get a feel on how the market moves.

"There's nothing like having a small position to concentrate the mind on the price actions in currencies," he says. "Currency markets tend to be a lot more sentiment-driven...You slowly start to understand that, and you start to understand a macro view. I think the average person can do it."