The Foreign Exchange market (Forex, FX, or currency market) is an over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices.
Lately, you might be coming across a lot of forex ads claiming that “My name is XYZ. Earlier I used to work day-in and day-out to earn a mediocre life. But after I opened an account with ABC Forex, I now earn lakhs within a short span of time.” These are nothing but online forex trading platforms scamming people around the world.
Before you find yourself in such a trap, make sure you know everything about what is forex market and what do you mean by forex trading? How, Where and When should one invest in Forex Trading?
Forex also is known as Foreign Exchange Market involves currency trading. Just like shares are traded in the share market, commodity is traded in the commodity market similarly, currency is traded in the forex market. As India’s currency is Rupees, USA’s currency is Dollar, UK’s currency is Pound, Japan’s currency is Yen, in the same way, every other country has their own currency in the world.
Based on the fluctuations in the currency market, can one make money by trading in currencies? The answer is yes. In the year 1992, a person named ‘George Soros’ made one billion dollars by trading in currencies. Due to this, the Bank of England had to bow down to him as well as England had to declare a ‘Black Wednesday.’
George Soros quotes, “Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.” Simply put, it means markets are uncertain and if you think like no one else thinks and you grab the opportunity you get, then you can make profits by trading in currencies as no one has made before.
Let us first understand who all participate in the forex market. Forex market includes Importers, Exporters, Banks, and Speculators. Let us understand this in detail. The banks in all the countries are supposed to maintain a specific level of Foreign Reserves.
So what do you mean by foreign reserves? Let’s see this concept. Talking about India, India does not produce everything it consumes. We are required to import a lot of things from other countries such as Crude oil, etc.
If we analyze the imports data, in the year 2018, we imported around 33% of this crude oil from outside. So consider, for example, if we are importing this crude oil from Saudi Arabia, then we cannot pay them in INR, we are supposed to make the payment in USD. As our currency is INR, our banks have to maintain USD with them. So maintaining the currency of our own country along with the currency of other countries is known as Foreign Reserves.
In India, if you wish to trade in USD/INR, you can do so on the National Stock Exchange. If you trade in Futures here, then trades here take place in lot sizes. The base lot size here is of 1000 units. Consider if $1 is trading at Rs. 70 then how many Rupees are required for $1000? It is a simple calculation 70*1000 = Rs. 70,000.
Does this mean one is required to pay Rs. 70, 000 to trade in futures here? No. In Future Market, trades take place by mean of depositing an Initial Margin. What is this Initial Margin? In order to buy a contract of Rs. 70,000 you are not supposed to pay the entire Rs. 70,000.
You can pay around 3% to 5% of the initial margin and trade. Here, Rs. 70,000 is the total amount of the contract, so 3% of Rs. 70,000 comes down to Rs. 2100. So it means you can buy the entire contract of Rs. 70,000 by just depositing Rs. 2100. By way of depositing only the initial margin, anyone can trade in futures easily.
One thing to be noted here is that if you buy the contract by paying an initial margin of Rs. 2100 and if the rate/ price of 1 USD increases by Re. 1. Then, lot size i.e. 1000* Re. 1 = Rs. 1,000, you make a profit of Rs. 1,000 here. But if the price of USD falls by Re. 1 then you face a loss of Rs. 1,000.
Understanding that Future market is a two-way sword is very important. The possibilities of making a profit as well as suffering a loss are both equal.
Now after depositing the initial margin if your trade goes wrong, you can accept the loss and leave the contract. About accepting losses, Mario Urlic, a famous Wall Street Trader says, “The most difficult decision when you are losing is to stop trading.”
Alternately, if you feel that this loss is temporary and you wish to maintain or hold your position then you’ll have to pay the amount of loss which you have suffered and you can then maintain your position. This is known as the Maintenance margin.
So now you have deposited Rs. 1000 and maintain your position. Now again, the price of the USD increases and you go wrong, so you’ll again have to deposit the maintenance margin to hold your position. In this way, by means of depositing initial margin and maintenance margin, you can trade in the futures market.
The importers and exporters by way of using initial margin and maintenance margin, tend to hedge their positions in the international market.
Let’s understand this hedging using a simple example, consider you wish to give your girlfriend a beautiful imported diamond ring which costs about a USD 100. Currently, the price of 1 USD = Rs. 70, so the ring costs around Rs. 70,000 (Rs. 70 *100 = Rs. 70,000). In order to buy this ring, you’ll require around a month to gather this Rs. 70,000.
After a month you successfully gather Rs. 70,000 but till then the rate of 1 USD goes up to Rs. 75, so now the ring will cost you around Rs. 75, 000 ( Rs. 75*100 = Rs. 75,000). But now you only have Rs. 70,000 with you, you are short of Rs. 5000.
At the beginning of the month, only you could’ve hedged your position by buying the USD/ INR contract on the exchange, as you know that you are only required to pay initial margin to buy the futures contract.
So consider, you had paid Rs. 2100 of initial margin and also, kept around Rs. 3000 to 4000 for maintenance margin. By the end of the month, the price of USD went to Rs. 75 per dollar, which meant that there you made a profit of Rs. 5000 (Rs. 75*100 = Rs. 75,000).
It means that by the end of the month, you had gathered Rs. 70,000 and including this Profit of Rs. 5000, you would’ve had a total of Rs. 75,000 with you and you could easily buy that ring even by paying Rs. 75,000.
So, you and your girlfriend both would be happy. This was possible because you had already hedged your position by way of buying the contract on the exchange at the beginning of the month.
In this manner, be it a bank, importer or exporter in the currency market who wish to hedge or anyone who thinks there’s an opportunity to trade in currencies due to the fluctuations taking place there, can do so.
Talking about share market and USD/ INR, whenever the share market has collapsed from higher valuation, USD has increased and performed well. In the year 2008, when the PE of the market went to 28 and the market collapsed from higher valuation by around 60%, the USD/ INR increased by 28%.
Similarly, in the year 2011, when the market collapsed from a higher valuation by 23%, the USD/ INR increased by 22%. Even in the year 2015-16 when the market collapsed from higher valuation by 31%, the USD/ INR performed 30% therein as well.
Therefore, it means that whenever the market moves in a bearish direction and the market is falling down from a higher valuation and you find an opportunity in USD/ INR, one can invest there and earn profit accordingly.
The legend of Wall Street, Mr. Warren Buffet in this regard has quoted, “We don’t have to be smarter than the rest; we just have to be more disciplined than the rest.”
Why does it happen that whenever the stock market collapses, the USD performs well? This is because whenever the share market falls from a higher valuation, the Foreign Institutional Investors (FII’s) have always gone on a selling spree and after selling the shares the money which is received is in INR which is of no use to them, so they convert it into USD and because of the fact that they convert it to USD, the demand for USD increases. So whenever such a situation occurs, one can go to the National Stock Exchange and trade in the USD/ INR futures.
In India, RBI and SEBI allows trading in currency futures with authorised brokers at the authorised exchange in the pairs namely, USD/ INR, EURO/ INR, GBP/ INR and YEN/ INR as well as in cross currencies such as GBP/ USD, EURO/ USD and USD/ YEN only on the authorised exchange.
Trading with brokers and foreign brokers other than authorized brokers is a crime. According to the Foreign Management Act, 1999; if we transfer money to any foreign broker for margin funding, it is considered to be a crime and if we are transferring this amount via credit card then it amounts to another crime.
Most of the foreign brokers label themselves as authorized brokers but it’s of no use because they are authorized by self-regulated bodies and not actual governments. Also, they are based out of far-away islands so that nobody reaches them.
Hence, if you find an opportunity to trade in currency futures, you can do so on the authorized stock exchanges. This was all about forex trading. Until our next blog...
Happy Trading, Happy Investing!!!
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