On my way home, I see a big billboard advertising a local forex broker. This got me thinking about forex in general and how it can be added to one’s portfolio. When most people hear forex, they think of scams, big banks and going abroad. But it is actually an instrument that you can invest in. Let’s find out more.
What is forex?
It simply stands for foreign exchange. It is a market place for the buying and selling of currencies like the Kenyan Shilling, US dollar, Chinese Yuan. If, for example, you are ever travelling to another country, you will need to convert your local currency (Kenya Shillings), to the currency of the country you are travelling to (e.g. the Dollar in USA) to be able to pay for the things you need.
On a larger scale, think of the billions of shillings of trade that is done between countries. This means that there is a market for currencies as, just like you needing Dollars to take a cab in America, you need foreign currency to trade with other countries. This market means that there is a demand and supply for each currency, meaning it can be traded and invested as it is a commodity. This is how:
How forex works
To invest in forex, you buy another currency with the shilling (what we call going long) and acquire the other currency. For example, if the Kenyan Shilling is trading for KES 100 to the dollar and you are investing in the dollar, you will need to spend 100 shillings to acquire each dollar. An investor with 1 million shillings will get
KES 1,000,000/ 100 = USD 10,000
Now here’s the interesting part- how to make money off of it. In the case the dollar appreciates, which is affected by many economic factors), to KES 105 to the dollar, the buyer who now has 10,000 USD can convert it back to shillings and will now have
USD 10,000*1.05= KES 1,050,000
That’s KES 50,000 profit just based on moving prices. It is this fluctuation that creates profit (and or loss) and hence return on your investment.
Forex has always had a bad reputation as a loss making venture as many find themselves being attracted by the allure of quick returns and effortless money at the click of a button, but this could not be any further from the truth.
What most people online are selling is quick money which is based on short term and many successive trades. Only a few seasoned professionals can do this on a daily basis and make a profitable income off of it. It is known as trading.
There is, however, a difference between trading and investing. While trading is over a short period, investing involves holding a position for a much longer term with a view of hodling the currency to hedge against fluctuations or for diversification purposes in your portfolio.
Benefits of investing in forex
- Opportunities to Profit
Because the markets are open 24 hours (save for the weekends), there is always an opportunity to make money. If you are of the view that a currency is going down in value, there is also the option to go short (which is to sell the currency at the current price and buy it back later at a lower price).
Not many other asset classes offer you such flexibility.
The forex market is extremely liquid, with over $5 trillion traded every day, meaning that getting in and out of positions is very easy should you have a need for cash. This helps in 2 ways, it diversifies your risk (which will be discussed in more detail in a bit) as well as reduces the cost of transactions.
Since the forex trading market is so competitive, many brokers offer low transaction costs which makes your investment more profitable over the long run.
There is a concept called leverage, where a broker can borrow you capital to increase the size of your positions. This is a feature you usually won’t find in other asset classes as it is a bit more technical and will be discussed in another post, but enables you to increase the size of your investment with the same amount of money
However you need to be extremely careful if you are going to use this feature because in as much as it magnifies your returns, it can also magnify your losses and clean you out. So because our focus is on forex as an investment and not a short term trading tool, we’ll save this discussion for another time.
- Hedging and Diversification
As discussed before, keeping a foreign currency like the US Dollar allows you to hedge against a depreciating shilling which may decrease the value of your local investments. Hence, by keeping the dollars, you can sell it when it is trading at a higher price to make profit.
Additionally, there is the added benefit of having a different asset class that does not necessarily move in tandem with your other investments. For example, if the local economy is not doing well and the stock market is tanking, therefore bleeding money from your stocks, but the US Dollar is performing well, you can sell off your dollars and generate returns which can increase your income to compensate for the rest of your portfolio.
This means you are protected from a total loss of income as compared to if you had invested in shares only.
Drawbacks of forex
- High rate of loss
Many people do not do research on the risks and technicalities of investing in forex so they lose out and end up calling it a scam. However, with the right due diligence, solid fundamental and technical analysis as well as a patient attitude towards this asset class, you can make your fair share of profit as well.
We’ll go into more detail on all of these concepts in the future, but now the question remains on how to open your account and get started.
How to get started:
- Open an account with a broker
In addition to the commercial banks, there are only 2 CMA regulated forex brokers EG Securities and SCFM Limited. Ensure you register with a regulated broker as others are unlicensed and there is a danger you might lose your money, leaving you with no avenue to seek legal redress.
To open an account you will need the following:
- Proof of address
- ID/ Passport copy
- Fill in an application form to open an account
2. Fund your account
Most of the brokers will require you to have a minimum balance to keep your account active, and in the case you make a profit on the trades you have the option to withdraw the money or increase your investments in other currencies. If you make a loss, you will be required to fund your account again to keep it active
- Start investing!
You can now use the broker’s platform to place buy and sell trades on various currency pairs. When you want to enter or exit a position, trades are usually instant, except for weekends when the markets are closed.
Forex can make you a lot of money but also has its drawbacks as discussed, so as always, do make sure you’ve thoroughly researched on it before starting to invest.
So that’s pretty much it for forex and I hope that you have learned something from it.