The principles behind foreign exchange are simple: every country on earth has its own currency, and those currencies have different values. These rates are changing constantly, creating a speculatory market similar to trading futures in the US stock market.
With the speed and hyper-connectivity of the Information Age, foreign exchange has gotten a lot more complicated while also yielding copious opportunities for small businesses. Foreign exchange for entrepreneurs can be just the thing to help them get their business off the ground or take their business to the next level.
We talked to Gonçalo Moreira, research expert for the company FXStreet, to learn the ins and outs of foreign exchange - how to get started, what the risks are, and what the potential of foreign exchange is for entrepreneurs.
First of all, can you talk a bit about what foreign exchange is and why it's important to understand in today's globalized climate?
The foreign exchange market was established in the early 70s as a cash-bank market when the US Dollar went off the gold standard and began to float against other currencies. Unlike other asset classes, the foreign exchange market is made up of a network of players clustered in various hubs around the globe, rather than organized in centralized exchanges.
Among its several functions, money serves as a unit of measure. In domestic economic terms, this is relatively easy to understand. But in today's globalized world, with its fast communication channels, it becomes increasingly complex. People can perceive the price of many things being bought and sold around the planet, and immediately evaluate those prices in terms of the money they are using domestically.
People then transact upon this perception of imbalances among relative prices, and the resulting money flows as a reflection of their thinking (with all their fears, expectations, desires, etc.) and clashes against the maneuvering of central banks. These institutions seem fixated to do "whatever it takes" to manufacture their own course of the human cycle by way of stimulus, guidance, controls, and ever more debt.
This will most inevitably lead to a global sovereign debt crisis that sends massive shock waves across the global economy. In such an environment, the currency world turns out to be "the" asset class to better perceive the fair value of all other assets, and to follow the capital trends which will try to survive the passage from an old inefficient system to a new, hopefully, equitable one.
Where are the most common places to trade currencies? What are the advantages and disadvantages of each?
Currencies can be bought and sold, i.e. exchanged, through the use of different instruments. These can be traded in centralized or decentralized markets. The biggest amount of transactions is done over-the-counter in the form of cash, mainly between big financial institutions. A smaller amount is traded through derivative instruments such as future contracts or options on exchanges. Other instruments such as forwards are used mainly by financial institutions, while ETFs are gaining a lot of traction among smaller investors.
All these instruments were initially created to fulfill a specific need, like covering the risk in a commercial deal, for instance. But from a pure speculative perspective, the choice of instrument has more to do with the style of trading, level of capitalization, and time horizon of the transaction.
On the retail front, there are many brokerages that enable the access to these instruments; and in the spot market specifically, they also offer different intermediation models to choose from - from pure market making to agency models. No one is better than another, but careful study is needed to make a sound choice.
It's been suggested that foreign exchanges, such as OFEX, are easier and less expensive to get started in than the United States stock exchanges. How can entrepreneurs take advantage of foreign exchanges to take their business to the next level?
As for trading costs, it's true that the non-exchange traded currency market offers lower costs and margin requirements. But from an analytical and strategical point of view, it's not easier than trading stocks or commodities. In fact, even if many of the techniques used to perform price forecasts are the same, it's quite a different world. Currencies are traded in pairs where one currency quote is more like a relative strength ratio rather than a "price." But being a bidirectional market, this means also that profits can be obtained equally in up and down trending markets.
Concerning the advantages of foreign exchange trading for businesses which are in some way exposed to foreign exchange, it's basically about understanding the currency risk and managing that risk to a sustainable level. Common techniques like hedging and instruments such as options, futures, and forwards can be used to mitigate this risk.
For entrepreneurs operating overseas, it's possible to work with a foreign exchange specialist and lock in an exchange rate in advance. How might someone go about doing that, and why would they want to?
Yes, there are products to lock in a rate in advance which you can get by working with a commercial or trading bank or a chamber of commerce. Recently, there have also been innovative companies such as Kantox that offer peer-to peer solutions at very affordable prices. In any case, working with a foreign exchange specialist is a must for most companies operating overseas, since you need someone capable not only of making logical price forecasts, but also to estimate and measure any changes in volatility conditions - besides knowing when to cover risks and which instruments and strategies to apply. At FXStreet, we collaborate with many companies that offer these kinds of services.
When you ask export-oriented companies what factors prevented them from increasing their export levels, fluctuations in exchange rates are the number one factor mentioned. Small and medium-sized companies, in particular, lack the basic knowledge to manage foreign exchange risk.
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Have there been any particularly well-performing or reliable foreign exchange investments that you've noticed - like pounds to dollars, for instance?
The main trend we are observing right now is the US dollar appreciation against most of its peers, which was exhibited during the later part of 2014. From a price perspective, constructive trends or even lateral moving prices in USD-denominated assets could be interesting to overseas investors as they would perceive positive relative returns in those assets should the trend resume, and we have strong reasons to believe it will based on the scenario mentioned in the first question.
A bull market in the USD would create massive havoc in many areas of the world where currencies are pegged to the USD and debt has been issued in USD. This may accelerate the trend enormously and create a lack of liquidity without precedent. In turn, a strong USD will ultimately cause many internal problems in the USA which will revert back and serve as an argument for depreciation. We have to understand that a strong currency is not inherently positive like a strong priced stock. It can hurt an export-oriented economy with all its consequences on growth and labor.
So, while the likelihood for a USD bull market to develop is high, profiting from it may be not so easy to master with a simple trend-following approach. Lack of liquidity and increased volatility can put a high risk upon any FX trading business, be it a market user or a market maker.
What are some of the risks of getting into foreign exchange unprepared or having unrealistic expectations?
The biggest risks I've seen traders undergo while working in the retail sector for many years have to do with being undercapitalized, underestimating leverage, and overestimating their skills. With a too small account, it becomes realistically difficult to mitigate the effects of leverage. Besides, big investment firms get slaughtered with lower effective leverages than the ones seen in most retail accounts. These are dangers most aspiring traders (and not so aspiring) are rational enough to understand. But they still expect to rely on their skills to compensate for the lack of capital and the high gearing, falling prey to the human tendency to have overconfidence in one's beliefs and skills. There are many behavioral theories which explain this phenomenon.
What are a few steps you'd recommend for entrepreneurs who are just getting started with foreign exchange?
There is always an abundance of profitable trading opportunities, so I would recommend to take your time and never rush into the market; and once in, never rush into trades. Take time to observe, measure, test, and learn. On our website, users can access a complete FX trading course for free, the Learning Center; and for those searching for an academic certification, we have partnered with Essex University Online to offer a Financial Trading Analysis (FTA) program, which also features a Masters-level introduction to finance.
On the practical front, I would recommend to explore trading strategies which capitalize not so much on trend following but on the oscillating and fractal nature of prices. This will free you from the most difficult endeavor there is: to forecast the direction of a price trend and estimate the turning points accurately. Spending time in the market can prove much more lucrative than timing the market.
Finally, on the personal level, I would recommend to dissect your mind and personality to a point where you know exactly why you want to participate in such a difficult environment, and sincerely assess if your have the right profile to do it.
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