What to know when investing in foreign currency

If you want more diversification and international exposure for your portfolio, one option is to invest in foreign currencies. 

This strategy requires research and carries more risk than traditional investments. When done correctly, and in alignment with your risk tolerance, it can potentially yield high returns.

Basics of investing in foreign currency

With foreign currency trading, you buy and sell different currencies based on their exchange rate. For example, let's say the current euro to USD rate is 1.098. That means one euro costs $1.098. If you think the value of the euro will go up, you can sell dollars and buy euros.

You can also make investments outside your own currency. For example, if you're American, you can invest based on the value of the Japanese yen to the euro or on the Canadian dollar against the British pound. You sell the currency you think will lose value and buy into the one you think will go up.

Ways to trade foreign currencies

Some investment brokers specialize in foreign currency trading. You deposit money into their account, and then you can use their platform to research, buy and sell into different currencies. There are a few different ways to actually trade these currencies.

• Spot trading: With spot trading, you buy and sell currencies based on the current exchange rate at the time of your transaction.
• Forward and futures trading: In forward and futures trading, you and another investor agree to make a trade on a currency exchange rate in the future. For example, you agree to sell $10,000 USD at an exchange rate of $1.101 per euro in a week. It's a contract, so you must make the trade.
• Currency ETFs and funds: If you don't want to handle the investing yourself, you can use a foreign currency mutual fund or an exchange-traded fund (ETF). The fund manager builds a portfolio of many different currencies on your behalf.

Foreign currency versus other investments

Investing in foreign currency has a few key differences versus other investments like stocks, bonds and mutual funds.

Trading is available at most times

You can only trade stocks, bonds and mutual funds when the markets are open, which is during normal business hours in the US. With foreign currency trading, you can make these investments any time a foreign currency market is open somewhere in the world, which is most of the time.

Leverage is common

Leverage is when you borrow money short-term for an investment. This may increase your gains, but also your losses. It's more common to see leverage with currency trading, so that small price moves lead to bigger results. For example, you might use 50-to-1 leverage, so a 0.1% increase in your exchange rate could lead to a 5% investment gain.

You have the chance to make many trades

Currency markets are constantly in flux, especially when you consider all the countries in the world with exchange rates. As a result, it's an active market with lots of trading, versus stocks and mutual funds where it's more common to buy and hold. Just bear in mind that more opportunities to trade also means more potential costs you might incur in fees—be sure to monitor these to avoid letting your overall costs get too high.

The risks may be higher

When you factor in leveraging and the volatility of international markets, foreign currency trading can be fairly high-risk, depending on the economic environment. Taking a more cautious approach will help you avoid large losses.

When foreign currency investing can make sense

Foreign currency can be a good fit for sophisticated investors willing to put in lots of research. You'll be competing against some tough investors, including Wall Street professionals, so you need the skills to keep up.

Investors typically need to have a high risk tolerance for investing in foreign currency. If you're scared to lose money and don't want a complicated trading strategy, investing in foreign currency likely isn't the right fit. And if you're new and just starting to invest, you might want to master the fundamentals before you invest in foreign currency.

Ways to learn about foreign currency investing

There are many courses and videos online to explain foreign currency trading. They can teach you the basics along with investment strategies. You can contact your financial advisor to see if they can give you advice and recommendations about foreign currency trading. You could also use a currency fund and leave this trading in the hands of the fund manager.

Whichever way you go, use foreign currency trading as an addition to your portfolio, not the core strategy. This way, you can safely use these funds to potentially gain some extra upside without risking the bulk of your savings over compromising the overall health of your financial plan.