Forex Trading: Basics of Forex Trade

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 does Forex Trading Work?

The forex (FX) trading market stands out as the sole trading market that operates continuously without any breaks worldwide. Traditionally, big banks and institutional firms controlled the FX trading market as intermediaries for their clients. However, the market has become more accessible to retail traders and investors of all magnitudes in recent times.

In essence, forex trading involves the purchase and sale of currency pairs, such as EUR/USD or JPY/GBP, as opposed to other securities like stocks. The distinguishing feature of forex trading is that it involves the exchange of one currency for another. To make a profit, you would sell one currency with the expectation that its value will decrease relative to the currency you plan to buy, which you anticipate will increase in value.

Who Participates in Forex Trading?

There are four key groups involved in forex trading:

1. Retail Traders

Individual investors who trade forex independently fall under this category. These investors open accounts with brokers and engage in buying and selling currency pairs with their own capital. Their primary objective is to profit from favorable fluctuations in exchange rates.

2. Institutional Investors

This group includes large organisations such as pension funds, mutual funds, insurance firms, and hedge funds that invest in the forex market for diversification purposes. They allocate portions of their collective capital to buy currency pairs to optimise the overall performance of their investment portfolios.

3. Corporations

Companies engage in forex trading primarily to exchange currencies for their business operations. Additionally, they use the forex market to hedge and manage risks related to currency exchange rates, especially in international transactions.

4. Commercial and Investment Banks

Banks in this sector use forex trading to manage foreign exchange risks, support international trade, and provide liquidity to the market. They also trade on behalf of their clients, including corporations and high-net-worth individuals (HNIs).

Types of Forex Market

There are four main categories of forex markets:

1. Futures Market

The futures market is a platform where participants buy and sell standardized contracts for future currency exchanges. These agreements, referred to as currency futures, specify details such as the amount, the agreed exchange rate, and the settlement date (or expiry date). As these contracts are standardised, they are traded on regulated exchanges.

2. Options Market

In the options market, traders have the opportunity to invest in currency options. This provides the right, but not the obligation, to buy or sell currency at a set price. There are two main types of options: call options, which allow the trader to purchase a currency pair, and put options, which provide the option to sell, without the obligation to do so.

3. Forward Market

A forward contract is a financial agreement that enables the trading of currency pairs at a future date at a pre-agreed exchange rate. These contracts are primarily used by corporations to mitigate foreign exchange risk. By locking in a forward contract, businesses can shield themselves from exchange rate fluctuations that could affect financial outcomes.

4. Spot Market

The spot market is the most widely utilised platform in forex trading, allowing traders to exchange currencies at the current market rate. Transactions in this market are typically settled within two business days, hence being referred to as trading “on the spot.”

Basic Forex Trading Strategies

The fundamental types of forex trades are known as long and short trades. When a trader engages in a long trade, they are wagering on the rise in the value of a currency pair in order to make a profit. Conversely, in a short trade, the trader is speculating that the price of the currency pair will drop and thus gain profit from it.

Traders can also utilise trading techniques that are based on technical analysis, such as breakout and moving averages, to adjust and improve their trading approach. Trading strategies can be further classified into four types based on the number and duration of trades made. These types include:

1. Scalp trades are characterised by holding positions for seconds or minutes, with profit amounts limited by the number of pips.
2. Day trades involve short-term positions held and liquidated within the same day, lasting for hours or minutes.
3. Swing trades involve holding positions for a longer duration than a day, such as days or weeks.
4. Position trades involve holding a currency for a long period, which may last for months or even years.

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.

Forex derivatives

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.

How to Open a Forex Trading Account?

With the right knowledge and steps, you can begin trading currency like a pro. But first, you need a forex trading account to start. Open your Forex trading account with Angel One in 4 easy steps:

Step 1: Open a Currency Trading Account

Opening a currency trading account is your gateway to the forex market, allowing you to buy and sell currency futures and options. Angel One offers two-in-one accounts, including a trading account and a demat account. While a demat account isn’t mandatory for currency trading, it can be beneficial if you plan to pledge shares for margins. 

You can easily initiate your online currency trading journey on the Angel One website at no cost, enabling you to start trading immediately.

Step 2: Submit Documents for KYC

Next, you have to complete the Know Your Customer (KYC) process. You’ll need to provide the following essential documents:

• Photo Identification Proof: Submit a valid photo ID, which can be your PAN card, voter’s ID card, passport, driving license, or your Aadhaar card.
• Address Proof: Furnish a document verifying your residential address. Options include telephone bills, electricity bills, bank statements, ration cards, passports, voter’s ID, registered lease/sale agreements, or driving licenses.
• Financial/Income Proof: Provide documentation to establish your financial status. This can be your current income tax return (ITR) acknowledgement, annual accounts, Form 16 (for salary income), net worth certificate, latest salary slips, or bank account statements.
• Bank Account Details: Share your bank account details, including account number, IFSC Code, bank name, branch address, and account type, to link with your trading account.

Submitting these documents is crucial for verification, and they ensure compliance with regulatory requirements. Verification of these documents might take a few working days, depending on the broker’s capacity.

Step 3: Fund Your Trading Account

Before you start trading, you’ll need to deposit funds into your trading account. This is a regulatory requirement in India, as a portion of your margin must be held in cash. Brokers typically offer multiple methods for funding your trading account, including net banking or digital payment platforms like Google Pay.

Step 4: Start Trading Forex Pairs

Now that your trading account is funded and verified, you’re ready to dive into the world of forex trading. In India, you can trade currency futures and options on recognised exchanges like NSE, BSE, and MSE for seven major currency pairs:

1. USD-INR
2. EUR-INR
3. GBP-INR
4. JPY-INR
5. EUR-USD
6. GBP-USD
7. USD-JPY

These currency pairs allow you to engage in synthetic positions, such as futures and options. Familiarise yourself with the basics of currency pairs, understanding how exchange rates work and how pips (four decimal places) play a crucial role in forex trading.

Remember that forex trading involves various strategies, so take the time to explore different approaches that suit your trading style and goals.

Pros and Cons of Trading Forex

Pros:

1. High liquidity: The forex market is one of the most liquid markets in the world, with trillions of dollars exchanged every day. The significant liquidity ensures that traders can execute currency trades effortlessly without being concerned about price volatility or a dearth of buyers or sellers.
2. 24-hour market: Another notable advantage of forex trading is that the market operates 24 hours a day, five days a week, enabling traders to participate in trading at any time, irrespective of their geographical location or time zone.
3. High leverage: Additionally, forex trading offers high leverage, allowing traders to open positions that exceed their account balance. Although this can lead to more substantial profits, it also exposes traders to higher risks.

Cons:

1. Limited regulations: While forex trading online is legal in India, it is not as heavily regulated as in some other countries. This can make it more difficult for traders to find reliable brokers and protect their investments.
2. Lack of transparency: The forex market is decentralised, meaning there is no single exchange where all trades are conducted. This can make it difficult to determine the true market price of a currency pair and to know whether a broker is providing fair prices.
3. High risk: FX trading is inherently risky, and traders can lose all of their invested capital if they do not manage their risk properly. This risk is amplified by the high leverage offered by forex brokers.

Conclusion

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.

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