There are a variety of currency trading strategies available. However, most of the strategies fall into one of two broad categories: hedging and speculating.
When companies sell goods or services in foreign countries, they are normally paid in the currency of the country in which the sale occurs. However, currencies continually fluctuate, causing the sale to be valued (in the home country) at less than hoped for or expected profits.
However, companies can hedge, to avoid possible losses from fluctuating currencies by trading currency pairs. Protection against the possibility of adverse currency movements helps companies focus on generating revenues without worrying about loss in value.
Other investor activities will fall under the broad category of speculation, which involves buying or selling a financial asset. This is usually done with expected higher-than-ordinary risk, in order to take advantage of an expected move.
Speculators in the currency market wager that, in the future, the value of a currency will move higher or lower relative to another currency. Speculators in the currency market can include hedge funds, commercial banks, pension funds or investment banks, in addition to individual investors.
Currencies are traded in pairs, so in any given transaction, a trader is wagering that one currency will rise, while the value of the second will fall.
Additional trading strategies
Beside the trades that focus on the relative value between two currencies, there are several other popular types of currency trades. Arbitrage trades are trades where the investor simultaneously buys and sells the same currency at slightly different prices, in the hopes of making a small, risk-free profit.
Even though this is a very attractive and prefered trading strategy, arbitrage opportunities are very rare in efficient markets because there are many other investors who are also watching out for these opportunities. This means that any arbitrage possibilities that do exist disappear quickly.
Investors who are interested in arbitrage opportunities need to monitor market developments closely and when the opportunity appears, they need to act quickly. When the opportunities do appear, the price differential is usually very small. To generate a substantial profit, investors need to trade in large enough quantities to increase their profits.
Another popular currency trading strategy is the carry trade. This strategy involves selling the currency of a country with interest rates that are very low and investing the proceeds in the currency of a country with high interest rates. This strategy allows the trader to generate a profit as long as the relationship between the two currencies is relatively stable.
The carry trading strategy is usually performed by large, sophisticated investors, like hedge funds, and is extremely popular during times of low market volatility. During high volatility, large fluctuations in the value of currencies and other financial assets can quickly overwhelm the traditionally slow-and-steady profits found in the carry trade.