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CHAPTER 1
Three Must-Know Forex Facts
Forex's Top Three Lessons
The three most important lessons you'll ever learn about foreign exchange (forex) markets are:
1. Everyone needs forex diversification. Just as every competent investor needs to diversify by asset classes and sectors, so too they need exposure to assets in multiple currencies and an understanding of forex trends and what's driving them. Yet most have almost all their assets denominated in one or two currencies. Today, that is an especially fatal error, because the governments behind most major currencies intend to get out of debt by causing inflation, which allows them to repay their bonds with depreciated money. That's good for those governments, and disastrous for those holding their weakened currency and anything denominated in it. They won't admit it, but historically low interest rates and a steady stream of economic stimulus programs betray their real intentions. They want to reduce their real debt, and, in the process, your wealth, through the subtle tax of inflation. To protect yourself, you need as much of your assets as possible to be denominated in the currencies that are likely to hold their real value or appreciate in the long run, and lift your portfolio along with them. Having some commodities exposure is also a means of hedging this currency risk and playing forex trends, so both forex brokers and traders typically also deal with commodities. Thus while they're different asset classes, in practice forex tends to include commodity trading and investing.
2. Forex markets offer significant advantages over other asset markets. If trading with leverage, there is more risk, but that can be controlled and managed if you invest the time to learn and practice proper risk and money management (RAMM). You can benefit from forex without dealing with the added complications of RAMM issues (covered in Chapters 0 through 12).
3. You can succeed using forex trading or investing if you learn and practice what follows.
FACT 1: EVERYONE NEEDS FOREX DIVERSIFICATION EVEN IF YOU DON'T TRADE ACTIVELY
All those responsible for managing assets need some forex exposure and awareness of what drives forex markets.
You're Exposed: Cover Your Assets
Like it or not, you're exposed to currency risk. Every asset is denominated in some kind of currency. For example, consider the case of the US investor. Even if your portfolio has done well in U.S. dollar (USD) terms, over the past decades, the picture is less rosy against other major currencies and commodities. Because we all use imported products, this means your purchasing power and wealth are melting away if your assets are in a declining currency like the U.S. dollar.
For example, anyone whose assets are too concentrated in U.S. dollars has paid the penalty countless times whether they realize it or not. Remember oil at $10 per barrel, or gas at $0.35 per gallon? Remember the bestselling guide for frugal tourists in the late 1950s, Europe on $5 a Day? The final version came out in 2007, Europe from $95 a Day.1 Remember how in the 1960s and early 1970s durable Japanese cars were considered inexpensive?
This decline in purchasing power isn't just due to inflation. For example, the U.S. dollar has been in steady decline for decades against many other important currencies.
- Since 2000, the USD is down 32 percent versus the Canadian Dollar (CAD).
- Since 1990, the USD is down 52 percent versus the Japanese Yen (JPY).
- Since 1970, the USD is down 75 percent versus the Swiss Franc (CHF).
Today, currency diversification is no longer optional. As governments maintain historically low interest rates and assorted stimulus plans that risk devaluing their currencies and your savings, currency diversification is as essential for your portfolio as sector and asset class diversification. Failure to do so is foolhardy. You don't have to be an active trader to ride the strongest long-term forex trends. We'll show you many ways that passive, longer-term investors can protect themselves.
While Americans may be waking up to the need for currency diversification, that's hardly news to most of the world, which has dealt with this issue for years. In other areas of the world, like Japan or Italy, with histories of weak currencies, participation in forex trading is a widespread middle-class phenomenon. For example, Japanese housewives are such prominent participants in forex that they're referred to collectively as “Mrs. Wantanabe.”2
As an American student in Israel in the 1980s, I watched families run to spend their monthly pay check because its purchasing power would fall every day due to high inflation. In the mid-1980s, friends with dollars could exchange them for local currency at higher black market rates and purchase anything from cars to apartments in the local currency at a 40 percent discount.
Even Long-Term Buy-and-Hold Investors Need Forex Diversification
Therefore, just as wise investors diversify into different kinds of assets and sectors, they must also diversify into the different kinds of currencies, particularly those likely to appreciate versus their peers. As we'll discuss in Chapters 0 through 12, even long-term buy-and-hold passive investors who don't actively trade currencies can protect and grow their wealth by allocating portions of their portfolios to instruments denominated in the most promising currencies.
Although most forex market participants are short-term speculators, currencies can be excellent long-term plays, because currency pairs tend to form stronger, more stable long-term trends compared to stocks. Why? Because the fundamentals of the underlying economies that drive currency prices change much more slowly than those of individual companies. It's a longer, more complex process to change the relative growth rates of entire economies (or currency unions in the case of the Euro) than it is for an individual company. Even better, unlike stocks, currencies don't all move together in the same direction, nor do they all respond in the same way to other markets or global indexes. Indeed, some currencies move in the opposite direction, providing a genuine bear market hedge without the complications (or periodic bans) involved in shorting stocks.
In short, currency markets produce some of the most stable long-term price trends that are ideally suited for long-term passive investors, and also can provide simple, effective ways to profit in bear markets. As we'll discuss in Chapter 2, the right currency investments can provide long-term appreciation as well as steady income yields.
FACT 2: POTENTIAL FOR BETTER RISK-ADJUSTED RETURNS
There are more reasons to have forex exposure beyond currency diversification. Once you do some homework, you'll realize that forex is arguably among the most rewarding asset classes for traders and investors. Even though forex is dominated by short-term, high-risk speculators, there are investing/trading styles suitable for both:
1. More conservative active traders who use longer-term holding periods and specific methods and instruments to reduce risk.
2. Long-term investors who know how to:
- Ride stable, proven, long-term forex trends for capital gains.
- Earn steady income from “carry trades” or from investing in bonds, dividend stocks, and other income vehicles denominated in the right currencies.
Forex Markets Often Provide Advanced Warnings of Changes in Other Markets
Forex markets often react to changing conditions before other markets, providing valuable advanced warning of possible trend changes. As we'll learn later, certain currencies tend to move same direction as “risk assets” like stocks or industrial commodities, and others tend to act like “safe haven assets” like bonds. When these correlations break down, that too can often be a warning of a change in direction for other markets. We'll delve further into this kind of intermarket analysis in Chapter 9.
Forex Needn't Be Any Riskier Than Other Markets
Forex has a gotten a reputation for being excessively risky due to a combination of:
1. High failure rates due to beginner traders who failed to do their homework and understand the risks associated with the high leverage (see borrowed funds in Chapter 2) commonly used in most forex trading.
2. Brokers who failed to provide sufficient training to deal with the risks of using leverage.
However, you can reduce and manage the risks. There are:
- Brokers, like etoro.com, that allow you to adjust your leverage down to what you can handle, and they will provide guidance on the appropriate level.
- Unlevered ways to play forex, which are no riskier than an exchange-traded fund (ETF) or a stock.
- A variety of techniques to reduce risk in forex trading, as well as new instruments for simpler, safer forex trading (see Chapter 1).
As we'll see further on, making money trading forex can be easier than in stocks and other more traditional asset markets, particularly in bear markets. However, you do need to do your homework, especially if trading with leverage, which adds risk as well as reward. Part of that homework is to learn more conservative, simpler techniques that make it easier to succeed at forex than those most commonly used. Until recently, there was no single source for learning this more sensible, conservative forex. No longer. This is the only book to gather these methods into one collection.
Part of forex's reputation for excessive risk comes from stories appearing in the mainstream media. The typical plotline runs like this: Some gullible novices believed a broker's get-rich-quick pitch about how they'd score fast money with little effort or background in forex. These geniuses were shocked (shocked!) to find out otherwise. The conclusion: Forex should either be avoided altogether or is unsuitable for most people.
If you're smart enough to be reading this book, you will see the absurdity of that reasoning. Just because there are individuals who behave stupidly with cars or power tools doesn't mean that these should be avoided altogether. The same goes for forex, including the typical leveraged trading. If you've had the right preparation and have the discipline to practice proper trade planning risk and money management (RAMM), you can keep the risk to acceptable levels, just as with any other kind of investing or trading. As with driving, there are ways to simulate the experience until you're ready for the real thing, and ways to then start slowly under less challenging conditions until you're ready for more challenging conditions
No Uptick Rule: Just as Easy to Profit in a Falling Market as in a Rising One
Just as it's easier to row with the current than against it, it's easier to profit by trading in the direction of an established market trend. Unlike with stocks (and other financial markets), in forex it's as easy to profit from falling markets as from rising ones. This is a huge advantage of forex markets.
During an uptrend, when prices are rising, most traders go long, meaning they buy the asset with the hope of selling it at a higher price. They're attempting to buy low and sell high, the classic way most people view investing.
During a downtrend, when prices are falling, it's easier to profit by trading with that downtrend. So, the more sophisticated equities traders try to exploit that downward mome...
