Why an Economic Downturn is the Best Time to Trade Currencies

Trading Strategy
This is a guest post by Ally T

It’s true that the stock market on average tends to return meagre profits during economic slow times, but for the clever investor, an economic downturn can sometimes signal a good opportunity to trade in foreign currencies, on what is commonly know as the Forex market.

A quick overview of how Forex trading works

The Forex market, which stands for “Foreign Exchange” is a marketplace where investors can conveniently and quickly buy and sell currencies from around the world. The purpose of buying or selling one country’s money in favour of another is essentially to take advantage of their relative rise and fall in value. On any given day a US dollar might be worth anywhere up to several cents more or less than it was worth on the previous day, and by using this system of buying and selling, successful Forex traders are often able to greatly multiply the amounts of money they are trading with.

It’s a little like playing the stock market

In some ways Forex trading is like playing the stock market – experts are often able to predict when a country’s economy will boom (typically making its currency rise in value), or fall into recession, resulting in a weaker currency. And just like playing the stock market, it can be extremely confusing working out who to listen to and trust for advice.

Banks discourage you from trading currencies through their system

Really, trading on the foreign exchange market is just like going to your local bank and asking them to exchange your cash into another country’s money. Except you’re doing it without the bank. Now, if you were using the bank, then you could hold onto that foreign cash and wait until it becomes worth more, and then take it back to the bank and change it back making a profit (although in practice banks discourage this by applying hefty fees to cash money exchange). The difference when trading on the Forex market is simply that all trades occur electronically, on a centralised system which is very fast and accurate.

Medium and long-term trades are best for the layperson

Some people like to trade currency with a high turnover rate, preferring to conduct trades every day or even several times a day. Others prefer a buy-and-hold strategy. Both methods have advantages, but generally, only professional traders make significant gains out of constant small trades. Medium and long term trades, where a currency is held for anything ranging from a few weeks to a few months, is the best way to begin trading on the Forex market.

How can you use economic downturns to your advantage?

So how exactly can you use an economic downturn to your advantage when trading in money? As already mentioned, it all revolves around the relative values of different currencies, and the key to making money in this business is to buy currency when it is weak, and sell (or just cash it) when it is strong. To understand why times of slow economic growth can work out as an advantage, let’s have a look at what makes a currency weaker or stronger.

What makes for an economy that is weak, or strong?

A country’s currency is a reflection of its economy. A strong economy is one which can maintain a strong cash flow – generally from taxes based on being able to produce and export goods or services to other countries. With strong cash flow a country can invest in its infrastructure, education, and healthcare, and continue to grow and care for its population. As the country becomes more productive, it becomes more valuable as a whole, and as a result its money becomes worth more in a global sense. On the other hand, a country which has excessive debt to foreign banks, or has a high unemployment rate, or has no valuable goods or services to offer, will NOT generate a strong cash flow. Being unable to repay international debts and with no money to invest in employment opportunities for the future, this country becomes “worth”less – and as a result its currency becomes less attractive.

In the event of a widespread recession, where there is reduced economic activity, a strong economy should be able to preserve the value of its currency, since it has not only reserve cash, but an infrastructure that allows it to continue supplying to its own population and other countries with products they want or need. Unfortunately, an economy that is already weak can often suffer doubly under a recession – with even less money flowing, taking on more debt and hoping to ride out the downturn is often the only solution.

Traditionally strong economies have included the Japanese Yen and the German Mark (which has obviously now been replaced by the European Union’s Euro). So during an economic downturn, if you happen to own a lot of strong currency (which isn’t likely to take a downturn) then you are able to buy plenty in the weaker economies. (As we said, during tough times a weaker economy’s money essentially becomes worth even less.)

So what’s the point of buying stacks of money that isn’t worth much?

Economies typically behave in a cycle – what goes up must come down, and what goes down eventually comes back up again. The idea of a long-term (anything more than a few months) currency trade is that when the financial climate improves again, the money that you bought a lot of (that wasn’t worth much at the time) will again become quite valuable.

An example of how an economic downturn can be a good time to trade currencies

Here is a good example of a medium-long term trade that would have paid of handsomely:

Let’s go back to 2008, into the heat of the Global Financial Crisis (GFC) and let’s say you held American US dollars. Maybe 10,000 USD for a nice round figure. During 2008 Australia was being hit hard by the GFC, with their traditionally-strong mining industry and primary industries unable to preserve the value of the dollar. The USD on the other hand was holding its value quite well. Towards the end of 2008 you could have afforded to buy at least 1.30AUD with every 1.00USD, so your 10,000USD would have bought 13,000AUD. Half way into 2009, the AUD recovered significantly, climbing back to being worth over 94 US cents. Your money is now worth 12,220USD. This is a gain of $2,220 over about half a year, or a growth of over 22% – not bad at all!

Ally is part of the team that manages Australian Credit Cards, a free business credit card tips and platinum credit cards comparison service in Australia. Before joining ACC, she was a Media Planner with McCann Worldgroup Philippines, Inc., with award-winning executions, including the Levi’s 501 “Live Unbuttoned” global campaign.

Comments

Great article thanks for sharing, i never thought of looking at what the share market is doing in order to trade the forex market.

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