Forex market is open 24 hours a day, 5 and a half days a week when currencies are traded worldwide electronically over the counter. This is called foreign exchange market.
What are the ways of trading forex?
Spot market: Where one party delivers an agreed amount of currency at an agreed rate to other party. Settlement is made in cash after the position is closed. The whole process usually takes 2 days.
Futures market: Unlike spot market, actual currencies are not traded instead contracts of delivering/buying the currency are traded.
Forward market: Contracts are the same as future contracts with some differences.
What is the difference between forward and futures?
Futures
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Forward
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They are exchange traded contracts.
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They are private contracts.
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Regulated.
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Non-regulated.
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Rigid terms and conditions as defined by exchange.
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Not rigid terms and conditions.
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Clearing houses guarantee the completion of contract.
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High chances of default due to absence of any clearing house.
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They are settled market-to-market which means that any gain or loss occurred are settled daily with the margin amount.
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Settlement occurs at the end of the contract.
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Futures are used mostly by speculators so delivery usually never happens as contracts are closed prior to maturity.
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Forward are used by hedgers i.e. who want to eliminate or minimize their risk. Delivery usually takes place.
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Is it illegal to trade forex in India?
It is illegal to enter into contract with unregulated overseas foreign exchange market which more often make fake promises of higher guaranteed returns. Any person residing in India collecting and remitting such payments outside India is liable to be proceeded for contravention of FEMA, 1999; Know your customer (KYC) and anti-money laundering standards (For more on money laundering, read my other article on money laundering).
The RBI clarified that "a person resident in India may enter into currency futures or currency options on a stock exchange recognized under section 4 of the Securities Contract (Regulation) Act, 1956, to hedge an exposure to risk or otherwise, subject to such terms and conditions as may be set forth in the directions issued by the RBI from time to time".
How to read FOREX quote?
I will give basic definition along with an example.
USD/INR – Currency on the left is called base currency (always equal to 1 unit) and currency on the right is called quoted/counter currency. Here USD/INR means 1 USD = Rs. 62.720 as mentioned. This is an indirect quote where the domestic currency is the one on the right side (for India). A direct quote would be INR/USD for India as a domestic country.
Bid/Ask – In simple words, bid means the price at which the market will buy currency from you and ask means the price the market will sell the currency to you. Bid price is always smaller than the ask price and the base currency is traded. In the given example, base currency is USD so the quote Bid/Ask: 62.710 / 62.730 means 1 USD can be sold for Rs. 62.710 i.e. at the bid price and can be purchased for Rs. 62.730 i.e. at the ask price in the market.
Spread - Spread is the difference between bid and ask price calculated in Pips i.e. Percentage in points. 1 pip can be 0.001 or 0.0001 unit depending upon the number of decimals. Here, as the currency is quoted up to 3 decimals, 1 pip = 0.001 unit. Spread is 20 Pips in the given example.
Cross currency (EUR/JPY) – When one of the currencies traded is not USD we call it a cross currency quote. In the given example EUR/JPY is the cross currency and bid price of 1 EUR is 135.1800 Japanese yen and ask price is 135.2400 Japanese yen.
What is leverage? How can it affect the risk and rewards in forex?
Leverage is a tool used to multiply risk and rewards. In forex, leverage is a margin percentage of the actual contract provided by broker to the investor. For e.g. – if leverage is 100:1 it means that for trading 100,000 units of currency, one has to deposit only 1000 units of currency i.e. 1% of the actual trading amount.
The way it affects the risk and rewards is visible. If there is a decline of even a smaller amount say 0.5% then the portfolio will come down by 0.5%*100,000 = 500 units and your half of the margin money is gone and if there is 1% decline in the portfolio, you will lose all your money.
In the other case if the same is appreciated by 1%, you will double your investment from 1000 units to 2000 units of currency.
How can I avoid that much risk?
Risks can be minimized with the help of 2 techniques – stop and limit orders.
Stop orders – It is an order to buy or sell a certain security when its price falls below a certain limit as specified by the investor. For e.g. – if you have currency account worth Rs. 100,000 and you are moving out for holidays so you won’t be able to monitor your account then you can ask your broker to put up a stop limit of Rs. 80,000 so whenever gross price will hit the 80,000 mark, your security will be sold. It is generally used to limit the losses.
Limit orders – It is an order to buy or sell a certain security when its price surpasses a certain limit as specified by the investor. For e.g. – if you have currency worth Rs. 100,000 and you want to maximize your profits then you can impose a limit by telling your broker that whenever the currency’s worth reaches Rs. 120,000 it should be sold. It is generally used to maximize the profits. It is costly than the market order.
Difference between stop and limit orders is that the stop order is used to minimize losses while limit order is used to maximize returns.
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