The term “Forex” is a shortened blend word for “Foreign currency and exchange”. Thus, forex trading deals with the conversion of one currency into another for myriad reasons like business, international trade & commerce, foreign travel & tourism, currency risk management, etc. It is often referred to as “FX trading” that involves the buying or selling of a fiat currency pair. Fiat currencies are government-issued or sovereign currencies that are not backed by any asset.
Usually, investors engage in forex trading to mitigate the losses arising out of the devaluation of a currency vis-a-vis another currency. In other words, the currency purchased is expected to appreciate while the one sold is expected to depreciate. You can also profit by seizing currency arbitrage opportunities arising out of the exchange rate differential between two or more currencies.
In this article, we will briefly discuss the forex market and forex trading basics. Later, we will delve into how to make money from forex trading.
The forex market is a decentralized marketplace for trading and exchanging different international currencies. It is a virtual OTC (Over-The-Counter) market where traders across the globe digitally transact with each other via computer networks.
The forex market is open 24 hours Monday – Friday. The major international centers for forex trading are New York, London, Frankfurt, Tokyo, Hong Kong, Zurich, Singapore, Paris, and Sydney.
Forex markets enable both retailers and organizations to exchange international currencies daily, especially for global trade and travel. For example, suppose an Indian firm imports automobile spare parts from a German firm, the Indian firm has to incur the import cost in Euros (EUR). Assume the total procurement cost is EUR 50,000. Thus, at the current EUR-INR exchange rate of Rs 88.33, the Indian importer has to forgo Rs 44,16,700 to get EUR 50,000 to pay the German exporter.
Similarly, individuals require international currencies whenever they travel abroad. For instance, suppose you are traveling to the US. INR won’t work there as the legal tender of the US is dollars(USD). Thus, you need to convert INR into USD to manage your living expenses during your duration of stay in the US.
From the investment perspective, the forex market enables you to diversify your portfolio and hedge currency risks.
Basics of forex trading
Before you embark on the forex trading journey, you may acquaint yourself with some of the common terminologies used in the forex market. They are as follows:-
Currencies are always traded in pairs. Currency pairs can be classified into major, minor, and exotic pairs. As USD is the most popular global medium of exchange, major currency pairs will always involve USD. For example, USD/INR, USD/EUR, etc. Minor pairs do not contain USD but other major global currencies. For example, GBP/JPY (British pound sterling/Japanese Yen), EUR/GBP, etc. Exotic pairs peg one major currency against a minor currency. For example, AUD/MXN (Australian Dollar/Mexican Peso), etc.
Point In Price (PIP)
PIP is the difference between the current and previous valuation of an FX pair. Putting it differently, a pip is defined as the minutest increment or basis point by which the price of an FX pair rises or falls. For example, if the exchange rate between GBP/USD is 1.3864 and 1.3934 today and yesterday respectively, then the PIP is 0.007. As the current FX rate is lower than the previous, it implies that the USD has depreciated vis-a-vis GBP.
Base and quote currency
Consider an FX pair USD/JPY. Here the base currency is USD and the quote currency is JPY. The value of base currency always equals 1. The FX rate is always expressed as the amount of quote currency required to purchase 1 unit of the base currency.
The difference between buying (bid) and selling (ask) price of the base currency is known as a spread.
Forex trading takes place in three lot sizes – Micro (1,000 units), Mini (10,000 units), and Standard (1,00,000 units).
Different ways of forex trading
Spot market trading
In this context, the term “spot market” refers to the forex market itself. This is the market wherein you directly buy or sell an international currency. For instance, when you go long on USD/INR, it means you have bought USD by selling INR. Conversely, when you go short on USD/GBP, it implies that you sold USD for purchasing GBP.
The spot or exchange rate is determined based on various factors like current & forecasted global economic conditions, demand & supply for a currency, overall investor sentiment towards a currency, import-export volumes, etc.
In spot trading, one party delivers to the counterparty, a stipulated amount in a specific currency in exchange for an equivalent amount in another currency. Spot trades are usually settled in cash on a T+2 basis.
Futures and Forwards
Both forwards and futures are derivative contracts that execute a currency trade on a future date at a pre-determined price. However, forwards are private deals between two parties, executed in decentralized OTC markets. On the other hand, currency futures are standardized contracts executed at organized exchanges. Hence, the exchange is a counterparty to every trader. Consequently, forwards carry a higher default risk than futures.
The prime difference between currency spot and derivative trades is that derivative contracts do not involve physical currencies. They just specify claims to the underlying currencies by the contracted parties.
Forwards and futures are good currency risk-hedging mechanisms. They help you lock in a specific exchange rate for the future, especially when currency rates are fluctuating rapidly.
Currency options are derivative contracts between two parties wherein the option buyer has the right but no obligation to buy/sell the underlying currency at a pre-determined rate on a future date. Options also help in currency risk hedging. Besides, they are standardized, cash-settled agreements executed on organized exchanges.
Contract for Differences (CFD)
This is an advanced forex trading mechanism used in the derivatives market. Under this arrangement, the differences between the opening and closing rates of the underlying currency pair are cash-settled. You can trade on margin, go long if you are bullish, or go short if you are bearish.
It is a leveraged instrument. Hence, you have to pay an upfront deposit that is a small percentage of the total transaction value. This way you can take large positions in the forex market with less money in your kitty. It helps you benefit from the bidirectional movement of exchange rates. However, the magnitude of gains, as well as losses, is high with this strategy.
Forex trading guide for retail investors
Investing/trading in foreign stocks, international bonds, or mutual funds with international equity exposure, etc. are some of the easy ways for retail investors to enter the forex market. However, you have to do a few things before you can invest in these financial instruments.
First and foremost, you need to find an authorized broker who facilitates online forex trades. You may also check the commission, brokerage, and other transaction charges levied by the broker. The more competitive the pricing structure, the lower will be your forex trading costs, and consequently higher the profits.
The second step is to open a Demat and trading account with the selected broker. Once the requisite formalities are completed you may start forex trading.
The next step would be to carry out trade simulations or invest small amounts. Once you gain significant expertise, you may trade with bigger amounts. As a novice, you may refrain from excessive leverage, learn from your failures, and avoid impulsive decisions. Knowledge of fundamental and technical analysis will come in handy while selecting foreign securities for investing.
Moreover, you may master simple investment strategies before practicing complex trading strategies like margin trades, derivative trades, or investing in complex derivative instruments like currency swaps, swaptions, etc.
Forex trading has good wealth generation potential. It is also a good avenue for risk hedging and portfolio diversification. However, like any other trade, the magnitude of both gains and losses is high in forex trading as well. Hence, you may tread with caution, especially if you are a beginner. But, with focus, patience, practice, endurance, and a structured approach, you can definitely make money from foreign trading.