Foreign Exchange - A Gentle Investing Strategy

This is the first section of a two-part article on currency investing. In next month's Newsletter I'm going to be looking at the long-term potential of some of the individual currencies as well as suggesting ways that investors can take advantage of their price movements.


Currency Trading - Short Term Is Not The Only Way To Play

The trouble with foreign exchange is that most people view it as a game of speculation. Obviously it is one of the biggest speculation arenas on the planet but it doesn't always have to be approached this way.

The Dollar is sharply higher this week, the Yen down, Sterling taking a battering over the last few days. All these movements are of great interest to the short-term players but often meaningless when looking at the bigger multi year picture.

So rather than trading foreign currencies, consider long-term investing in them. There are a few advantages to long-term investing in currencies.

The most notable one is that they can't go to zero nor anywhere near that level, unlike investing in a company which can easily lose 75%, 90% or even 100% of its value over a short period of time. In effect your risk of suffering horrendous losses is greatly reduced but only if you use little or no leverage, which is what I strongly advise.

Of course over decades currency crosses can rise or fall considerably. This is highlighted at present with the Dollar/Swiss Franc where over the last 20 years the dollar has lost nearly 70% of its value as seen in the chart below.

But decades is not what we should be interested in, one or more years is the time-frame.

Long Term Cycles Play A Major Role In Currency Movements

Right now the Dollar is and has been in a steady decline over the last 5 years but I'd bet that at some time over the next 5-10 years it will come back. Perhaps not as strong as it once was but far stronger nevertheless. Just normal foreign exchange cycles at work.

Sterling also enjoyed a good run of strength for several years (mid 1990s to 2000) but now, especially against the Euro, it is struggling. Soon after the Euro was introduced hardly anyone gave it a chance and many anti-euro sceptics were smirking at its sorry plight as it plunged to 0.80 against the dollar. But now it's around 1.60, an increase of 100%.

Of course though there are normally two sides to a currency story. This means it is possible for two currencies to be weak (or strong) but one is far weaker than the other, as we're now witnessing with Sterling against the Dollar around 2:1. However, if you look at sterling against many of the other currencies its form is generally poor.


Economic Policy Plays A Dominant Role But Doesn't Move Quickly

Ultimately currency movements are dictated by economic policy, either global or country specific. However the effects of economic policy are often not felt in the short-term. For example, tax cuts, increases in budget deficits/surpluses, rises/falls in unemployment have little if any effect on day-to-day movements but do carry significant weight over many months and years. And it's these dominant trends that are of interest to the long-term currency investor.


How To Invest In Currencies - Pick Your Spots

In my view the best way to invest in currencies is, unless you're a good reader and interpreter of macro economics, is to use long-term charts.

Many people don't like charts for various reasons. However I have found that if simply used, ie just look at the shape of the chart and past history, they can often be a good guide of when and when not to invest.

One of the areas which has worked well in the past with currencies is to pay special attention to extreme price levels and then start to ease into a currency if/when those levels are breached. The term 'easing in' means to initially buy or sell in small amounts and then add to that position if the market continues to go against you to build up an average priced position.

Look at the chart below, the dollar/yen cross rate. The market is now trading around 103 but there's a massive and seminal low at 79.80 from 1995.

That level is a long way off (23%) and I'm not suggesting that's where the cross is heading, but who knows what will happen over the next few years in the current economic climate?

So the 80 level is one where I would probably start buying Dollars and selling Yen. I would then continue to buy Dollars/sell Yen as the market moved lower. I'm not sure exactly where I would stop buying but if the market was trading around those levels at present I would have formed a definite plan.

I would then hold that position for possibly a few years as it would almost be a certainty the two currencies and economies would work out their differences and the Dollar would bounce back most probably to 100 or higher.


Summary

This style of investing is slow and trades can take many years to set up. But right now with the world looking like it might slip into economic turmoil expect some major currency movements to occur over the next few years offering some excellent investing opportunities.

In next month's newsletter I'll be going into greater detail about how to invest in the currencies using spread bets, but using little or no leverage which is the curse for most investors/traders. I'll also be analysing some of the currency crosses that I've got on my radar right now.

• I got the charts for this article from www.DailyFX.com, no need to sign up or login in