What is Forex trading?
Forex or foreign exchange trading is trading in currencies e.g. buying US dollars by paying Indian rupees. We need foreign currency in order to pay for imports and the foreign currency we get by selling exports also needs to be channelised efficiently. In order to have enough currency to pay for necessary imports) governments, central banks, commercial banks, firms, brokers, forex dealers and individuals participate in buying and selling as well as loaning, hedging and swapping of currencies.
Factors affecting exchange rates in forex trade:
Currencies are always traded in pairs in India e.g.: USD-INR. The relationship between the currencies is given by the formula:
Base currency / Quotation Currency = Value
For example, if base currency is USD and quotation currency is INR then the value would be roughly around 79 as the rupee is trading at around INR 79 per USD.
Exchange rates are determined by various factors depending on whether the currencies in question have “free float” or “fixed float”.
1. Free floating currencies are those whose value depends solely on the demand and supply of the currency relative to other currencies. Increasing supply of foreign currency will reduce its price ie. less units of domestic currency will be needed to buy the same quantity of that foreign currency. Similarly, increasing demand for a foreign currency will increase its price in terms of domestic currency.
The demand and supply of currencies see fluctuations due to:
a. Central Bank actions – e.g. increasing interest rates may increase inflow of foreign currency, causing appreciation of home currency
b. Exports/Imports – if exports increase or imports decrease then domestic currency will appreciate
c. Credit ratings – if the credit ratings of firms of a country improve (e.g. due to high GDP growth, efficient regulatory environment etc.) then more foreign investment will enter the country, thus appreciating the domestic currency
d. Economic/Political instability – may cause investors to leave the country, causing domestic currency to depreciate.
2. Fixed floating currencies are those whose value is fixed by the government or the central bank, sometimes by pegging it to a standard. For example, the Russian Ruble was recently pegged to gold at 5000 rubles per gram of gold.
How to make profits in forex trading
Suppose the USD is trading today at ₹79/$. You expect the rupee to depreciate and therefore, buy 100 USD (or assets worth 100 USD) with ₹7900. Tomorrow, the USD appreciates relative to the rupee upto ₹80/$, which means your USD assets are valued at ₹8000. So if you sell your USD assets, you make a profit of ₹100 in one day.
Therefore, the objective is to correctly predict the movements in exchange rates and buy/sell assets accordingly.
Derivatives such as futures and options can be used to reduce the risk exposure of traders in the forex market. For example, a person buying a call option with a strike price of ₹78/USD can choose to buy USD at that rate if the USD appreciates to ₹80/USD, but also choose to not exercise the option at all if the USD depreciates to ₹76/USD.
Bid, Ask and Spread
The currency price quoted by the potential buyers is called the bid price while the one quoted by potential sellers is called the ask price. For example, if USD/INR is quoted as 79.0563/79.5224 then sellers can sell USD at 79.0563 while a buyer will have to buy at 79.5224.
The difference between the bid and ask prices is called the spread. Due to the spread here of INR 0.4661 per USD, the kiosk dealer will make a profit of 4661 for every 10,000 USD traded.
Forex trading in India
In 1993, India moved to the free-floating exchange rate system. As per the RBI, OTC and spot markets are dominant in currency trading in India where around USD 33 billion was traded daily in 2019. Online currency trading is done regularly in forex trading platforms.
In order to start trading, you need the demat account, trading account and bank a/c linked. Only SEBI-registered brokers are allowed to trade currencies on exchanges such as NSE, BSE, MCX-SX. In India, the INR or Indian Rupee can be exchanged for four currencies viz. US Dollars (USD), Euro (EUR), Japanese Yen (JPY) and Great Britain Pound (GBP). Cross Currency trades, Futures & Options contracts on EUR-USD, USD-JPY and GBP-USD are also available. The currency market is regulated jointly by the SEBI and the RBI.
It is important to have a reliable broker in order to start forex investing who can give you informed guidance. Check out Angel One in order to start forex trading online.