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Wednesday, February 27, 2013 - 08:30

Crisis Investing 101: How to Invest in Currencies the Easy Way

Wednesday, February 27, 2013 8:30 AM

In the past few weeks, I've told you about the five assets that could save your portfolio. I've shown my favorite gold and oil plays, how to protect a portfolio with commodities, how real estate provides safety in good and bad times, and how owning gold coins and bullions requires some level of expertise.

Today, I'm going to tell you about currency exchange, an investment that has become so popular, you could trade with only $1 in your account.

Like gold coins and bullion, currency trading is a traditional form of investment, because it can be physically held. For example, investors who held greenbacks instead of the euro during the euro-zone-banking crisis were substantially rewarded.

And the way investors like you and me can trade currencies is through the foreign exchange market, or Forex.

The Forex market is a global decentralized form of trading currencies that is based on the fluctuation of exchange rates between different currencies. Simply put, it's the simultaneous buying of one currency and selling of another. Decentralized means there is no actual exchange and all trading is done through dealers and banks.

Forex trading is the largest market on Earth, with more than 3 trillion dollars traded daily. Until recently, currency trading was strictly the domain of international banks, multi-national corporations, hedge funds and large speculators like George Soros.

But thanks to the growth of retail Forex dealers opening the market up to all skill levels and investor capitalization, today, the average investor can play a similar game as the big guys.

The market has been democratized to such an extent, some currency exchange dealers such as OANDA will allow investors to trade currency pairs in penny increments with only $1 in the account. The top 10 trading banks still account for about 53% of all trades in the Forex market, with Deutsche Bank (NYSE: DB) leading the pack and Morgan Stanley (NYSE: MS) taking up the 10th spot.

The Forex market has different levels of access. The interbank market is at the top and, unfortunately, retail (which is what investors like you and me can access) is at the bottom of the pecking order. One of the differences is the size of the bid/ask spread, with nearly 0 spread at times in the interbank market to three-plus points or pips with some retail dealers on the major pairs.

All about pips
The Forex market moves in increments known as pips, similar to tics or points in futures and stock markets. Most retail dealers have standard lot sizes of $100,000. Each pip moves in $10 increments and the average margin requirement is 1%. This means you only need to put up $1,000 for every lot. Some dealers offer mini accounts with $10,000 lot sizes and $1 per pip move. Amazingly, a few dealers even allow you to trade micro flexible lots down to having only $1 in your account.

No commissions
There is normally no commission paid in retail Forex. However, a few dealers have launched commission-based platforms with super tight interbank like spreads. Dealers are compensated by the spread between the bid price and ask price. This spread normally ranges from 1.5-3 pips on the major currency pairs.

What is a pair?
Currencies are traded in pairs. One currency is exchanged for another. Take the euro and the U.S. dollar (EUR/USD) for example. The first currency is the base or transaction currency, while the second is the quote or counter currency. Therefore, if the EUR/USD is trading at 1.26, then it takes $1.26 to purchase 1 euro. If the EUR/USD is going up, then the U.S. dollar is getting weaker. Conversely, if it's going down, then the U.S. dollar is strengthening.

What are the major pairs?
The most popular pair is the EUR/USD with about 28% of total spot market. The U.S. dollar and the Japanese yen (USD/JPY) come second with 18% of total market, and the British pound and U.S. dollar (GBP/USD) with about 14% of the total spot market.

Market hours
Some other basics to keep in mind, the Forex market trades 24 hours a day, for about five and a half days a week. It pretty much follows the sun around the world, with each major money center opening, closing and passing the torch to the next opening day.

The roll
One needs to remember the "roll," also known as the interest rate differential, and negative or positive carry that happens as a result of the different interest rates in various countries. Entire hedge funds are built upon capitalizing on this unique aspect of the Forex market. Depending on the pair, and whether you bought or sold it, your account will be debited or credited the roll amount.

Free analysis tools and platforms
A great thing about this market is the free access to multiple technical analysis tools and in-depth expert commentary provided by the myriad of retail Forex dealers competing for your business. Almost all dealers have free trials with demo accounts, so you can test-drive their offerings. I strongly suggest trying three or five different platforms/dealers to determine what makes you feel most comfortable. Several of the major Forex dealers are www.fxcm.com, www.GFT.com and www.oanda.com.

Risks to Consider: Because of its international nature, retail Forex is ripe with scams and frauds. Before sending your funds to any dealer, be certain to conduct due diligence by first checking the dealer's credentials. A simple Internet search should reveal whether other investors are satisfied with the service. In addition, the ultra-high leverage and low-entry costs make Forex investing only suitable for money you are willing to lose speculating.

Action to Take -- > Holding currencies can be an effective hedge against economic crisis. The past several years have proven the U.S. dollar is the currency of choice when fear grips the global economy. Holding a small percentage of EUR/USD short or purchase an exchange-traded fund that tracks the U.S. dollar, such as the PowerShares DB U.S. Dollar Index Bullish Fund (NYSE: UUP) makes sense in times of global uncertainty or when the United States starts to tighten monetary policy.

David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.