The foreign exchange market ,known as the forex market, is the international market for exchanging foreign currencies. It is the world’s largest financial market and it can greatly influence the price of daily-use items. Forex trading is also referred to as currency trading, and its popularity is steadily increasing in India but many investors do not have a clear understanding of what it is.
You can go through this beginner’s guide to forex trading to learn how you can make decent profits from it.
Forex Trading – Definition
Foreign exchange or Forex is defined as the exchange of currencies, i.e. the changing of one currency into another. Tourism, commercial reasons, and international trade are some of the important avenues where foreign exchange plays a crucial role. If you have bought any foreign-made goods or exchanged currencies for travelling abroad, you have taken part in forex trading.
It is important to understand the underlying concept of forex trading before delving into more details. Firstly, Forex trading takes place in the forex market, the largest and most liquid financial market in the world. Secondly, to carry out forex trading in India, traders typically make use of currency derivatives such as futures and options.
In India, forex trading is regulated by both the Reserve Bank of India (RBI) and the Securities Exchange Board of India (SEBI). It takes place primarily on 3 exchanges—Bombay Stock Exchange (BSE), the National Stock Exchange (NSE), and Metropolitan Stock Exchange of India Limited.
Participants of Forex Market
Some of the main players in the forex market include the following entities:
- Governments and central banks
- Commercial banks
- Brokerage firms
- Hedge funds
- Retail forex traders
Important Forex Trading Terms
Detailed below are some of the crucial terms associated with forex trading. Knowing these terms would make it easier for you to participate in the forex market:
- Currency Pairs
Forex trades involve a currency pair, i.e. a forex market transaction takes place when there is a simultaneous buying and selling of two currencies. There are 3 different groups of currency pairs—major currency pairs, minor currency pairs, and exotic currency pairs.
Major currency pairs drive the forex market and are the most commonly traded. Its examples include EUR/USD, GBP/USD, USD/JPY, and USD/CHF. The US dollar is not a part of minor currency pairs which are generally less liquid than major currency pairs. Exotic currency pair involves one major currency & one minor currency and are considered to be riskier and less liquid & have a wider spread
Percentage In Points (PIP) is the smallest price movement within a currency pair. It is an important term because, in the forex market, prices are quoted to a minimum of four decimal places (the only exception being the Japanese Yen and the Thai Baht where pip is the second decimal place). The minimum pip is equal to 0.0001.
Often, currency trades of very high amounts take place in the forex market. So, even the smallest price difference can be equivalent to significant profits or losses.
- Bid and Ask Price
The highest price at which a forex trader is willing to buy a currency is called the bid price. It gets provided in real time and constantly gets updated because the forex market is a live market.
Meanwhile, the ask price is the lowest price at which a forex trader accepts to sell a particular currency. Just like the bid price, the ask price is also provided in real time and undergoes constant change influenced by market forces.
- Lot Size
Currency derivatives are traded in lots like stock derivatives. The minimum unit that forex traders can buy and sell under a contract is known as lot size. Globally, the lot size is typically 1,00,000 currency units. But, micro (1000) and mini (10,000) lots are available as well for forex trading.
The difference between the bid price and the ask price is known as the spread. Market exchange rates are determined based on the maximum amount traders are willing to pay (bid price) for buying a currency and the minimum amount that sellers are willing to accept (ask price).
- Leverage and Margin
Smaller traders often fail to take part in forex trading when they see huge lot sizes. Here is where the concepts of leverage and margin help retail traders participate in the forex market.
The underlying concept of leverage is that traders need to pay only a fraction of the amount instead of the entire amount. Margin is the amount traders need to pay upfront as a deposit to access leverage facilities. In other words, with leverage, traders can trade for more than what they hold in cash.
- Base Currency and Quote Currency
Every currency pair consists of a base currency and a quote currency and a backward slash separates these pairs. While base currency is the one on the left, the one on the right side of the slash is the quote currency.
Traders can purchase or sell in exchange for base currency and it is for one unit of base currency. For instance, in EUR/USD, USD is the quoted currency and depicts how many US Dollars traders can get for 1 unit of EUR, which is the base currency.
Why Is Forex Trading Important?
Detailed below are the benefits of forex trading:
- It Is good for beginners
The Forex market is a good option if you are a beginner and wish to invest a small amount. Many brokers offer demo accounts to traders, which is a major advantage for beginners. You can use this account to experiment with currency trading in market simulation before initiating real trades.
- Exposure to a large and global market
The forex market is the largest financial market with traders from all over the world participating in it. Huge amounts of money get exchanged in the currency market daily and so, traders can make good profits from favourable price movements. The forex market is also transparent and offers a very efficient price discovery.
- Option of liquidity
Financial experts and traders consider the forex market to be the world’s most liquid market. Assets can be considered very liquid if traders can buy and sell them with minimum or zero impact on their value. Liquidity enables forex traders to participate in the market with a nominal risk of delay.
- No restriction on directional trading
In the forex market, traders engage in purchasing or selling currencies depending on the market situation. So, if you predict a price change, you can go long or sell short easily, because there is no restriction on directional trading.
- Low transaction charges
You can start forex trading with small capital. Most importantly, the transaction costs are not huge. It only includes the broker’s fee. Traders can also use percentage points or pips to measure the impact of spreads.
- Advantage of technology
With the development of new technology, forex trading has become more accessible. Multiple software programs and mobile applications are available that facilitate easy forex trading across the world.
How to Trade Forex in India?
Step 1: Open a Currency Trading Account
The first step is to select an appropriate forex trading broker platform and open a currency trading account. In India, you will not be able to engage in forex trading without this account. While opening a Demat account is not necessary, most brokers provide traders with a two-in-one account, i.e. when traders open an account they receive the facility of both trading and a Demat account.
Step 2: Submit KYC Documents
You need to submit all the documents required to complete the KYC process. You will need to submit proof of identity, address, income, and bank account details. Once you submit every necessary document, the forex trading platform will take some time to verify your application. Shortly after, you will receive a mail informing you of approval or rejection.
Step 3: Choose a Currency Pair
As mentioned above, currency trade takes place in pairs. Generally, beginners trade the most commonly offered pairs of major currencies. But, if you are willing and have enough funds in your trading account, you can trade any currency pair of your choice.
Step 4: Read the Quote
When you engage in forex trading, you will get to see two prices, i.e. bid and ask currency. It is important to analyse the price quote properly. While the first price is the one with which traders buy a currency, they sell a currency with the second price.
Step 5: Pick a Position
Study the market movements well and pick a position. Forecasting currency movements is an important part of forex trading. Suppose you see INR strengthening against USD, you might wish to buy it for profits. But, you will likely take losses if your predictions turn out to be wrong.
It is important to keep in mind that successful forex trading requires knowledge and experience, both of which traders gain over time.
Risks Associated With Forex Trading
- Leverage Risk
Forex traders may need to pay additional amounts as margin if the price fluctuates and results in margin calls. In a volatile market, aggressive usage of leverage may result in losses.
- Interest Rate Risk
An increase in interest rate increases the demand for and value of the currency of the particular country. However, a sudden decline in the interest rates will drastically bring down the currency value due to the rapid withdrawal of investments.
- Transaction Risk
Transaction risk, which is the result of time differences between the commencement and settlement of a contract, is a significant risk associated with forex trading. Internationally, forex trading takes place round the clock and exchange rates can change any time before the settlement of a trade.
Exchange rate fluctuations result in more transaction costs and a long duration between entering and settling a trade translates to greater transaction risk.
- Country Risk
The exchange rates in many developing countries are influenced by a major currency, like the USD. The central bank of the developing nation must have enough reserves to maintain the exchange rate. The currency of the developing nation may experience a considerable devaluation if there are ongoing payment deficits. In turn, this has an impact on FX market prices.
To sum up, the forex market, which deals with the exchange of foreign currencies, is the largest financial market in the world. In India, both the SEBI and the RBI regulate forex trading. Trading of currencies offers multiple benefits to investors including large-volume trading, high liquidity, and low transaction costs.
In this blog, we have discussed the important terminologies and other basic details of forex trading, with the aim of making this topic easier for beginners.
Frequently Asked Questions
Where can I trade forex in India?
Resident Indians can engage in forex trading with established and recognized exchanges like NSE, BSE, and MCX-SX. People can consider opening a forex account with a regulated broker to gain access to a recognized trading platform.
What is a currency future?
A currency future is a futures contract that enables traders to exchange a particular currency for another at a specific date in the future. The price at which the exchange will take place is generally fixed on the day of the purchase. Currency futures contracts enable traders to hedge against foreign exchange risks.
Can I open a forex trading account in India?
Yes, any Indian can open a forex trading account through brokers approved by the SEBI. Trading currency derivatives is completely legal in India and a forex trading account enables people to purchase and sell futures and options easily.
Can I trade forex without a broker?
In India, people will not be able to trade currency pairs without an authorised broker. SEBI has mandated that resident Indians can engage in buying and selling forex derivatives through approved brokers on authorised exchanges.
RBI has stated that resident Indians can engage in forex transactions only with authorised persons. Who are authorised persons?
The Reserve Bank of India has authorised entities to deal in forex. These entities can be authorised dealers, money changers, off-shore banking units, or any entity authorised by the RBI under Sub-Section (1) of Section 10 of FEMA.
Darshan is an up-and-coming Investment analyst making headway in the field of capital markets. He has completed his Chartered Accountancy and CFA Level 1 exam. He is currently working as a Credit Associate in Wint Wealth.