Investing In Forex Markets- A Primer

– By Ajay Krishnan, Knowledge Partner EZ Wealth

Introduction

Everyday, we see on the news various reports about how our currency is faring against other currencies like the US Dollar, Euro and the Japanese Yen. Have you ever wondered how the Rupee is valued against the other currencies? Or even why our currency is always at such a premium to other nations? currencies? For these fundamental questions to be answered, you need to know how currencies are valued and traded.

In this primer, we aim to educate you about one of the most exciting financial markets of the world ? The Foreign Exchange Market. The foreign exchange market ? or Forex for short ? is the buying and selling of currencies, and it?s one of the fastest growing markets in the world. ?It would be prudent to note that this is also the largest among all asset classes globally, trumping the equity and commodities markets by a humongous margin. The average daily turnover of the Forex market as of today is around $5 trillion. Yes, you read that right. That is more than twice the GDP of India, being traded every day.

Fig. 1 – Average Daily Turnover of global FX markets

Why trade Forex?

Everyday, more and more traders are entering the Forex market. Some of them are new and some of them are veterans of other asset classes like equity (stocks), commodities and government bonds. This is mainly due to a variety of reasons:

i) Forex can be traded 24 hours a day, 5 days a week in global markets.

ii) The huge geographical dispersion makes it attractive to diversify your risk (we will learn more about risk later in the series) across countries and currencies.

iii) The opportunity that exists in such a huge market with high volumes and liquidity.

iv) High amounts of leverage offered by the brokerages, which means you can take a position worth almost 10-100 times your initial margin or deposit. This can give you considerable returns on a relatively low investment.

You must also keep in mind that India is currently the fastest-growing economy in the world, and its currency is slowly rising in the world stage due to the enormous amount of trade and investment opportunities that come with such growth.

Forex trading comes with the inherent risks of any asset class but is usually free from large abrupt movements (both up and down). We shall see the reasons for this in detail later in this series, but for now it is sufficient to say that value of most currencies stays within a certain range for the most part. This is an in-built risk management system which enables the brokerages to provide high amounts of leverage to Forex traders.

Another reason why traders switch to Forex trading is the fact that unlike in equities, you don?t have to go through the long process of ?picking the perfect stock?. It?s far simpler to participate in a meaningful trade involving currencies. A currency does not have a P/E ratio, Dividend yields, P/B or Earnings per share to keep track of. It is mainly based on fundamental data (and a few technical indicators, which we will see later) like GDP, interest rates, unemployment numbers, inflation etc. which can be easily tracked and understood by the common man. It?s that simple ? if country A?s economy is doing better than country B, then its currency is going to be at a premium to the currency of country B. In this series, we will learn about all the important factors that affect the currency of a country, so we understand exactly how the Forex markets work. Because if you don?t understand the market then you are going to lose your money!

The FX Quote and Currency Pairs

If you have been following the Forex market, then you would be familiar with currency pairs. But if you are not, then let me introduce you to the most basic element of Forex trading: The FX Quote.

In Indian markets, the FX (forex) quote consists mainly of three components. The base currency, the cross currency and the price. It looks like this:

USD/INR = 70.1458

This is not that different from a stock quote, which has the scrip on one side and its current market price (CMP) on the other which you are familiar with:

Reliance Industries Ltd. (RIL) = 1300.10

Now, what does the FX quote mentioned above mean?

It simply means this: ?One US Dollar BUYS 70.1458 Indian Rupees.

Here, the USD is the base currency and the INR is the cross currency. Together, they make a currency pair. What this means to us (whose currency is the INR) is that if you have to BUY a US Dollar, then you have to SELL 70.1458 Indian Rupees to get that one dollar. Therefore, whenever you are buying a currency, you are also simultaneously selling another currency. Let us take this in contrast to the stock quote of Reliance Industries Ltd (RIL). If we want to buy one share of RIL, we have to pay INR 1300. Similarly, when we buy one US Dollar, we pay (or sell in this case) INR 70.1458. This is not very different from buying a stock at all.

In international markets, the FX quote usually has another element to it. This is denoted as under:

USD/INR?? =?? BUY 70.1458?? SELL 0.0142

As you can see with the last section of the quote, this just means that you have to SELL 0.0142 US Dollars to BUY one Indian Rupee.

If you can comprehend this one simple element of FX trading, you are already set up for success. A lot of people wonder how we can buy and sell at the same time, but in Forex that is the norm. In the above example, when I?m buying the USD/INR (this actually means you are buying the USD and selling the INR) my view is that the USD (base currency) is going to strengthen and the INR (cross currency) is going to weaken. That is when I make a profit. Similarly, if I were to sell the USD/INR (this actually means you are selling the USD and buying the INR) then my view would be that the USD would weaken, and the INR would strengthen thus making me a profit.

In India, the most traded currency pair is the USD/INR. This means it?s also the most liquid (easy to buy and sell with more participants) in the Indian FX market. Globally, the most traded currency pair is the EUR/USD accounting for almost 40% of the transactions. Needless to say, you will see the USD on both sides of the most traded pairs in the world ? almost 80% of global forex market involves the USD. Maybe now you understand why the Dollar is called a ?safe haven?. The world economy is dependent on it so much that a massive dent in value of the USD can perpetrate the same on the rest of the world and make it come crashing down.

Before you proceed further, I would suggest you go online and pull some live FX quotes and try to reinforce the basic concept of buying a currency while simultaneously selling the other. This is very important if you want to start off your journey in Forex trading right, because with the right knowledge and understanding, you can be on your way to earn handsome returns in a market that is just coming of the age in India.

Next : How do we make money by trading money?