INVESTING IN FOREX MARKETS ? A PRIMER
-By Ajay Krishnan, Knowledge Partner EZ Wealth
It is next to impossible to trade in Forex market without knowing the right terms and definitions that make up the market jargon. You must have heard experts talking on business news channels about things like, ?The spread looks tight on this pair?, or ?How much leverage does that brokerage offer you for currency options?? etc. It may look all fancy, but without knowing these concepts you cannot understand the market well and consequently won?t be able to make profitable trades. By the end of this chapter you would be able to understand and use some of the most important definitions in Forex trading. Let?s get to it.
What is a Spread?
As you have learned, an FX quote consists of a buy (offer) and a sell (bid) price.
The difference between these prices is called the spread.
For highly traded currency pairs like EUR/USD or GBP/USD the spread will be very tight. Let?s take an example:
EUR/USD? -? Buy : 1.14977?? Sell : 1.14982
The spread in the case of the above pair is 0.00005.
Now consider a lesser traded pair like the USD/INR:
USD/INR? -? Buy : 74.0962? Sell : 74.2962
The spread is now 0.2000, which is huge in the international Forex market and shows the weakness of the INR.
You must have seen this on currency exchange counters at airports or hotels. The buy price is always higher than the sell price, because of the charges and commissions availed by the bank or exchange. Hence, the spread is also called the ?cost of entry? for a currency trade.
Spreads can vary with the Buy and Sell prices of the currency pairs offered by different entities ? Banks, Brokers, Governments etc. They are also very sensitive to economic news breaks. But since we cannot yet trade in the spot currency market in India, spreads are of lesser concern to us.
Margin
This can be a confusing concept if you are just starting out in the markets, but if you already trade equities then you would be familiar with margins.
A margin is a deposit that the trader puts in his trading account to hold a position (long or short) open. For example, if you want to short a stock, you need to have a certain amount of money in our trading account as ?margin? before you can enter the trade. This amount can be found through the margin calculators offered by your broker. In Forex, it works the exact same way as equities – to be considered along with the amount of leverage your broker offers you. We will see this in the next paragraph.
Leverage
Leverage can be seen as a partner or by-product to margins and enables a trader to place larger trade sizes on borrowed money. Traders can use this as a force multiplier to magnify their returns. Essentially, you are borrowing money from your broker to place a trade for which you don?t have the funds for ? with the margin as collateral. This money is returned when you make a larger profit, or from your own pocket if you make a loss. Once the margin is eaten up by your losses, your broker will initiate a ?margin call? (which used to be an actual phone call back in the day) and ask you to bring in more money into your trading account if you want to keep your positions open. If you are unable to do that, then the broker will square off your positions at a loss and enter the amount you owe to them in a ledger. When you add funds to your trading account next time, this money will first be deducted by the broker and the rest will be available to you for placing trades.
Most Indian discount brokerages offer 10-100 times the leverage for currencies as the danger of abrupt movements (and thereby clients losing money) in FX markets is small.
You might have heard this enough, but it behoves me to repeat it: Leverage is a double-edged sword. It can bring you larger profits but also larger losses. Make sure you do not take extra leverage and ask your broker if a certain leverage level is ideal for you, if you are not sure. EZ Wealth Brokerage? helps you in this regard by advising you on your trade positions with respect to margins and leverages.
Now that we have learned the three most important definitions of Forex trading, let us see how to use them to our advantage:
- If you trade in the spot FX markets, ensure the spread for a currency pair is on the lower side. Your cost of entering the trade is dictated by the spread. Never try to hedge your long position by a short position in the same currency pair which has a higher spread. You will lose out on both ends if the spread widens.
- Do not enter trades that you cannot cover with enough margins. Keep sufficient margin in your trading account so when you suddenly spot an opportunity (they come and go really quickly in the FX market), you have the ability to place a trade immediately.
- Never take extra leverage even if you are sure about the performance of a certain FX pair. It is easy to lose your entire corpus on a losing bet by taking added leverage.
That finishes the basic module of this Primer to Forex trading series! In the next module, I will introduce you to Currency Futures and Options in Indian markets and combining Fundamental and Technical Analysis (with charting techniques). Lots of interesting stuff! Stay tuned!
Next: Introduction to the Indian currency markets