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Dr. Don Taylor, CFA, Bankrate.com advice columnistTrading foreign currency has risks

Dear Dr. Don,
I've heard that foreign currency trading is one of the best investments to make, having great returns. What's your take on this?
-- Shanna Spot-Market

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Dear Shanna,
Trading isn't investing, at least how I define the two terms. It's more speculative in nature. I believe there's room for some speculative assets in a portfolio, but it should be a small percentage of the overall portfolio -- less than 5 percent of portfolio assets.

Foreign exchange, or forex, offers such high potential returns because you can leverage your money. Leveraging your account balance by 100 to 1 means you can capture the change in value of $100,000 worth of a currency with only $1,000 in your forex margin account. Some accounts offer 200 to 1 leverage. In contrast, a homeowner that puts 5 percent down on a home purchase only has 20 to 1 leverage. A currency move can force liquidation of open positions if adequate margin isn't maintained in the account.

There are different types of trading, from day trading to position trading. For retail investors, the bid-offer spread in the cash-foreign exchange market can be too wide to make day trading currencies a realistic option.

The bid is the price at which you sell the base currency to buy the other (counter) currency. The offer is the price at which you can buy the base currency with counter currency. The spread is quoted in pips, defined by Forex.com as, "The smallest unit of price for any foreign currency. Digits added to or subtracted from the fourth decimal place, i.e. 0.0001." The wider the bid-offer spread the harder it is to be successful in trading currencies. Position trading, where you are in the currency for a period of time, includes the interest income/interest expense of the foreign currency position.

Getting away from trading currency in the cash (spot) market, you can also speculate on changes in currency values by using exchange-traded currency options or currency futures.

Use a trading simulation to test your skills as an forex trader before opening an account. Most shops offer demo accounts that allow you to do this. Some brokerage firms also provide demo accounts for options and futures trading. One problem with the demo accounts is that you tend to be a lot more courageous when you're not really taking a loss.

If you've got a fully funded emergency fund, have made decent progress toward building an investment portfolio for retirement or other financial goals and want to take a flier on trading Forex for fun and profit, go ahead. Just show some aptitude for it first by using a simulated trading account and don't commit more than a small percentage of your investable assets.

To ask a question of Dr. Don, go to the "Ask the Experts" page, and select one of these topics: "financing a home," "saving & investing" or "money."

Bankrate.com's corrections policy -- Posted: April 27, 2006
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