How to cash in on foreign currency

Exchange rate fluctuations can leave you out of pocket. Kate Hughes discovers how experts cope

It's the holiday season, so someone, somewhere, is being fleeced on their foreign currency. But if you've ever thrown a few euros into the drawer only to find they're worth more in sterling when you fish them out, it's tempting to think of taking things further and using currency fluctuations to make money. There are plenty of opportunities to gain from currency fluctuations. But for the unwary, doing so is likely to be a recipe for losing money.

Why? Because there are huge risks in currency trading. It is a big gamble which, if you make the wrong choice, could see you badly out of pocket. But there are strategies to follow for holiday money, or if you plan to buy a home abroad.

If you know you will need a fistful of foreign money in a few months' time, it could pay you to buy it early. If you could buy euros at 1.50 to the pound, you'd get €1,500 for £1,000. If the euro strengthened to parity with the pound – so you only got a euro for a pound – your €1,500 would be worth £1,500. You'd have profited by 50 per cent.

Last week, when Italy and Spain were infected with debt worries, the euro fell 4 per cent against the dollar and was the worst-performing currency. The Italy and Spain debt news led to foreign exchange traders fleeing the single currency for safer homes. But few were tempted to move to sterling.

"The pound has been helped by the fact that it is not the euro, but apart from that it has little else going for it," said Michael Derks, chief strategist at foreign exchange dealership FX Pro.

In other words, if you just held sterling, you wouldn't have noticed much improvement against the euro.

As far as the currency market is concerned, there are three big safe-havens: the Japanese yen, the Swiss franc and the US dollar. With specialist dealers you can trade almost any currency against another. You could switch from sterling to the yen or US dollar to ease dangers of losing out through currency fluctuations.

Or you could take a contrary approach and switch to the euro to take advantage of a euro recovery. The fact the euro remains relatively strong suggests the foreign exchange market isn't too worried about it. Willem Sels, HSBC Private Bank's UK head of investment strategy, thinks the single currency has a positive future. "In our view, the euro will survive, and longer-term the European economy will emerge from the current crisis in much better shape."

Who's right? Only time will tell. There are no definites, and the market can swing wildly on sentiment, or on what traders predict. If you're not a professional trader, it's almost impossible to keep ahead of the game and it's easy to get your fingers burnt.

Taking a long-term view can be a good option if you plan a major buy abroad – such as a holiday home. If you find a currency deal at a rate you're happy with, it could be worth doing the deal. With the sterling-euro rate at 1.14 recently, it could be tempting to buy at €1.20 to the pound.

There would remain the risk that the euro would weaken further – to maybe 1.30 by the time you need the currency – but if you've got the currency at a good rate, that can be enough to relax and ignore ups and downs. Acting when the currency reaches a level which improves the affordability of your overseas asset can make good sense.

Cash in on currency

The simplest way to play the game is to buy hard currency via a specialist broker such as HiFX or Moneycorp for larger amounts – at least £5,000 – and keep it in a higher interest account that accepts that currency. This is popular among overseas property owners or expats as the company deals in large sums and can offer very competitive rates – often within 1 per cent of the rate banks deal with each other at – known as the interbank rate.

There are low and high-risk currencies among 150 or so on offer. You must be clued up on the macroeconomic factors affecting the currency you're investing in and the pound, particularly as foreign exchange brokers don't have to be regulated by the FSA (although the reputable ones are). But the easiest way to access currency markets is through a fund.

"It really depends on whether you need a specific currency or exposure to movements in exchange rates, how much direct exposure to a currency you want and for how long," says Paul Dimambro, currency service head at financial adviser Hargreaves Lansdown. "In general, the Swiss franc and Japanese yen tend to do better in uncertain times and high-yielding currencies such as the Australian dollar push on when commodities are up.

"For short term, investing in a derivative product could be an option, but longer term the charges add up and it would be rash to try to work to short-term forecasts as there are just too many factors which could affect movements in one way or another."

He suggests an ETF for medium to longer-term investing – an exchange- traded fund with low annual management charges that tracks an entire currency via an index, like the S&P 500. But ETFs bring with them their own risks, and you should take expert investment advice and understand the risks to your cash before going anywhere near them.

Place your bets

There's the rock'n'roll option: spread betting, where you don't own any currency, but bet on it moving up or down. The pay-off depends on how accurate you are. It is a popular choice with UK investors as there's no capital gains tax to pay on winnings, nor is there any stamp duty to pay as you don't actually own the currency.

Spread betting lets you trade on market movements to take advantage of rising and falling prices, 24 hours a day, says Mike McCudden, head of derivatives at Interactive Investor, which offers spread betting accounts.

"You might have just bought some euros for an upcoming holiday, and you are worried because you think the value of the money you have bought is going to go down before you go. With a Forex account you can place a bet – a 'short trade' – on the euro going down in value against the pound. If it does, you have protected your exposure to the fluctuations in the currency markets and made some money along the way," he says.

But this is gambling territory. To cash in you will need to know a lot about the market, must monitor your account very closely and use a stop-loss order to automatically close the spread if it starts to fall off a cliff.

Anyone who turns up at the airport before thinking about their holiday spending is likely to get stung by commission, fees, painful exchange rates, or all three, at the Bureau de Change in departures. But pre-ordering your cash for collection can help secure a better rate. On the high street, Marks & Spencer, the Post Office and Thomas Cook usually offer the best exchange rates, although online providers such as Travelex may be better still.

Watch out for seeming "best buy" rates that carry a transaction fee (from £3 to £9), check for delivery charges, and bear in mind that many currency companies won't be FSA-authorised.

Using a credit or Visa debit card to make your purchase should protect against your provider going bust. But if you charge cash to a credit card, either in sterling or the local currency, you'll pay up to 32 per cent in interest.

But relying on your usual debit or credit cards is not necessarily the best option either. Withdrawal fees can be 2.75 per cent per transaction. And that's before you take into account fees levied by the ATM providers, or the typical 3 per cent load cost to the exchange rates that many cards charge.

You'll often be better off with a credit card that won't add charges to the exchange rate. Just clear the debt as soon as you're back.

Given the choice of paying in the local currency or sterling, never pick sterling. The merchant will do the conversion, often at a worse rate than the banks.