How do we make money by trading money?

Forex Trading

INVESTING IN FOREX MARKETS ? A PRIMER

-By Ajay Krishnan, Knowledge Partner EZ Wealth

We all understand how the stock market works. A company goes public to raise more money for their operations, you buy a share (or a bunch of them), the company does well, its share prices go up and you make a profit. It?s simple, right? Forex markets works on a similar principle. Let?s see how:

You read in the news that the US economy is doing well ? higher GDP growth, less unemployment and better trade balances. You also read that Indian economy is slowing down a little ? higher current account deficit, lower trade balances and higher unemployment. If you read my last blog post, you know that this means the US Dollar is going to be stronger in the near term vis-?-vis the Rupee. The current FX quote for the USD/INR pair looks like this:

USD/INR = 70.1458

Just like the stock market, you follow the same basic guidelines for a profitable trade: you buy lower and sell higher. So, you go ahead and buy the USD (say 1000). Why? Because your view on the USD is bullish. Two days later, you see that the quote looks like this:

USD/INR = 71.2300

Bingo! Your view was right! The USD has actually appreciated against the INR bringing you a profit. How did this happen? Simple, the economic indicators (more on this in detail later) that you evaluated for the US economy were positive and hence the same reflected on the US Dollar. So, instead of buying a stock at its CMP, you just bought the USD at its ?quote? price. And when it appreciated (against the INR), you sold it at the higher quote price and made a handsome profit.

But in the forex market, we can trade the other direction as well. So, we could sell the USD/INR, effectively selling dollars and buying rupees. With that trade, we would want the USD/INR exchange rate to fall so we can buy back the dollars for less rupees than we originally sold them for and lock in a profit.

This is all FX trading is, in its most basic form. Instead of buying a part of a company (shares), you are buying a part of that country?s economy (currencies).

So, what is the catch? Is it that easy to make money in the FX market? Absolutely not. One needs to be careful about volatility (which will be explained in detail in the next chapter), which is the sudden fluctuations in price that happens in FX trading along with keeping a tab on economic indicators. Concurrently, you need to have a sound trading strategy that enables you to work the price action in your favour. These are very important concepts that we will learn soon in this series.

From this discussion, we can come to the following conclusions:

i) Just like a stock appreciates/depreciates in value, a currency does the same.

ii) Just like a stock, a currency can be bought at a lower value and sold at a higher value to make a profit. The same applies when you are shorting a currency when you think its value will fall, and then buying it back for a profit.

iii) Instead of earnings numbers, ROE, ROI and production growth etc. that gives value to a stock, a currency derives its value from its economy and its relationship with other economies.

iv) Just like stocks, currencies are traded in exchanges using the same BUY/SELL mechanism.

Do these conclusions ring a bell? Of course, they are the same principles/mechanisms used in equities and commodities! I hope you now understand that a currency can be traded just like anything else ? even be used as an underlying asset when it comes to derivatives (more on that later). Now that you have understood how to make a profit (or a loss!) by trading currencies, let us learn the most important factors by which currencies are valued and priced.

Next: How are currencies priced and valued?

2 thoughts on “How do we make money by trading money?”

  1. Ajay…. you have this amazing skill of simplifying things to a novice level. And that makes me love your posts the most. Great going. Looking forward for more such posts.

Leave a Comment

Your email address will not be published. Required fields are marked *

Scroll to Top