Currency trading in India has gained momentum in recent times, becoming one of the emerging trading platforms. Investors are becoming increasingly interested in trading over currencies. In this segment, traders trade over a pair of currencies and earn profits for the fluctuation in prices. With a trillion-level daily turnover, this is set to become one of the fastest-growing markets.
Some Key Facts
Before jumping into the details of currency trading, let’s go through a quick overview of some key facts:
- In India, currency trading is done on BSE (Bombay Stock Exchange), NSE (National Stock Exchange), and Multi Commodity Exchange Stock Exchange.
- The time band for trading in the market is available from 9 am to 5 pm.
- Traders don’t need to have equity or cash for currency trading.
- In this market, one can trade futures & options.
Currency trading wasn’t a big deal in the country before the introduction of future derivatives to Forex. While Forex trading in India was available for banks and corporates earlier, future derivatives opened the market to individual investors as well. Further, liberalization offered more flexibility and freedom of holding & trading in foreign currencies to corporates and banks.
However, local and global economies got integrated as the trading regulations got softened and this gave rise to the need for managing risks associated with derivative products.
The Drivers of the Currency Market
Values of currencies, and hence, exchange rates change regularly. Numerous traders buying, selling, and exchanging currencies as well as making judgments on the worthiness of one currency over the other determine the rate of change.
Other factors that can cause significant changes to these prices include global events and news. While trading in this market, traders need to look at various cues coming in from monetary policy, currency intervention, and political & economic stability as well as natural disasters and other such events.
How Does the Currency Market Work?
In Forex trading, currencies are considered in pairs like Rupee-Dollar pair. The role of the trader is to predict which way the exchange rate will go.
And, if a trader finds cues about Rupee getting stronger against Dollar, he/she will buy Rupee. This can be interpreted in another way that the trader is ditching the Dollar.
If the prediction of the trader goes right and the value of Rupee rises, he/she can sell it to earn the profit. On the contrary, a strengthening Dollar can cause the trader to lose a part of the invested sum.
In addition to various factors, a major reason for the popularity of the currency market with hobbyist investors is its 24/7 availability. This comes from traders active pretty much from different parts of the world, living in different time zones.
Derivatives of the Currency Market
Similar to equity, the currency market also has exchange-based futures & options, referred to as currency derivatives. Traders can use these F&O contracts to exchange currencies at a future date while the price is decided on the date of contract purchase. These contracts are majorly used to hedge against fluctuations in different currencies including USD, Euro, Pound, and Yen.
To purchase an F&O contract, traders define a price per unit in terms of Indian Rupees. The contract order can be placed on 4 currency pairs including USD (US Dollar), GBP (Great Britain Pound), EUR (Euro), and JPY (Japanese Yen). Traders can trade through a broker by paying around 2-3% margin for an F&O contract of size, for example, $1000 for the dollar-rupee contract.
Currency futures are an exchange-traded futures contract that usually specify the price in one currency at which another currency can be bought or sold at a future date.
Currency futures contracts are legally binding and counterparties that are still holding the contracts on the expiration date have to deliver the currency amount at the specified price on the specified delivery date.
A currency option is a contract that gives the buyer the right, but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date. For this right, a premium is paid to the seller.
Risks Involved in Trading Currencies
Trading in this market can be as risky as complex it is. Varying regulation degrees and non-standardized instruments are some of the most influencing factors that add risk to this trading.
Here are some of the risks that traders should consider before putting their money into forex trading.
The forex market follows a different approach than equity and requires a small investment (also called margin). This leverage allows traders access to a large number of trades and even minor fluctuations can levy an additional margin on the investor. Thus, market volatility combined with aggressive leverage use can be highly risky.
Interest Rate Risks
While interest rates have a circuitous impact on a country’s currency, the differential of currency values can cause dramatic changes in forex prices.
Counterparty, referred to as an investor’s asset provider, can cause a risk if the dealer/broker defaults in any transaction. An exchange/clearinghouse doesn’t guarantee spot & forward contracts while the market maker’s solvency adds more to the counterparty risk.
A risk when any voluntary/involuntary action from a counterparty leads to non-repayment of an outstanding currency position. Though credit risk is usually concerned with banks & corporations, the risk is quite low for individual traders.
Thus, traders must be wary of these forex-related risks as well as others pertaining to the exchange rate, country, liquidity, transactional, and risk of ruin.
The Challenges of Credit Market
In this segment, there is quite a high amount of leverage allowed by dealers, banks, and brokers as compared to others. This allows traders to individually use a small amount of money to control relatively large positions.
The ratio of 100:1 for leverage is considered quite high in trading but isn’t uncommon when forex trading is considered. However, traders should understand its use as well as the risks that it brings before deploying leverage.
Trading in currencies, unlike equities, is less related to an organization/firm and more to the economic, global, and other fundamentals. If you are looking forward to trading in this segment, you should develop an understanding of how different countries and their economies are interconnected.
This, combined with global cues and other factors, can help traders make more accurate predictions.