What is forex trading, and how does it work?

First, it is essential to understand what the forex market is all about. The forex or foreign exchange market is where one currency is traded for another. It’s one of the most actively traded financial markets in the world. Volumes are so huge that they’re higher than all the combined transactions in stock markets around the world.

The forex market has a global reach where buyers and sellers from all over the world come together to trade. These traders transfer money between each other at an agreed price. Through this process, individuals, corporate and central banks of countries exchange one currency into another. When we travel abroad, we all buy some currency of the foreign country. That is essentially a forex transaction.

In the same way, companies need to purchase goods and services in other countries and will require foreign currency for that. Let’s say a company in India is buying products from the United States. The Indian company has to pay the supplier of the products in US dollars. This means that the company has to exchange an equivalent amount of rupees for the dollars it needs to make the purchase.

How does forex trading work?

Now that we have understood forex trading basics, we will see why it’s done on such a large scale. The main reason is speculation: forex trading is done to earn a profit from changes in the value of a currency. Currency values keep changing because of various economic and political factors, including balance of payments, inflation and interest rate changes. These price movements make it attractive to traders, who hope profit from getting their hunches right. However, with a higher chance of gains, comes higher risk.

Like stocks, there is no central market for forex trading. Transactions take place using computer networks between traders all over the world. Currencies are traded in major financial centres like New York, Tokyo, London, Hong Kong, Singapore, Paris, and so on. So when one market closes, another opens. That’s why forex markets stay active at almost any time of the day or night.

One of the aspects of currency trading basics is that it happens in pairs – the price of one currency is compared with another. The first one that appears in the price quotation is known as the base currency, and the second is called the quote currency. For example, the USD/INR pair gives information to the trader on how many Indian rupees are needed to purchase one US dollar (base currency). For example, the USD1/INR pair on a specific date may be Rs 67.5. The base currency is always expressed as one unit. Any currency can be the base currency in forex trading.

How to do forex trading?

Now that you know how does forex trading works, it’s essential to understand three different types of forex markets in which to do currency trading.

Spot market:

This refers to a physical exchange of a currency pair. A spot transaction takes place at a single point — the trade is settled on the ‘spot’. Trading takes place during a brief period. On the spot market, currencies are bought and sold at the current price. Like any other commodity, the price of a currency is based on supply and demand. Currency rates are also affected by other factors like interest rates, the state of the economy, the political situation, among others. In a spot deal, one party delivers to another party a specified amount of a particular currency. In exchange, it receives an agreed amount of another currency from the other party, at an agreed exchange rate.

Then there are forward forex markets and futures forex markets. In both these markets, currencies don’t change hands immediately. Instead, there are contracts for a certain quantity of currency, at a specific price on a fixed settlement date.

Forwards market:

In the forward forex market, two parties enter into a contract to buy or sell a certain quantity of a currency at a specific price at a certain date.

Futures market:

Currency futures are contracts to buy or sell a particular currency at a fixed price at a future date. Such contracts have a standard size and a settlement period and are traded on public exchanges. Forex trading in India is regulated by the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI). Clearance and settlement are taken care of by the exchanges.

How to do forex trading India:

Now that we’ve seen currency trading basics, we will talk more about how to do currency trading in India.

In India, BSE and NSE offer to trade in currency futures and options. The USD/INR is the most commonly traded currency pair. However, other contracts are also becoming popular when it comes to currency trading. If you are a trader who wants to take a position on currency movements, you can trade in currency futures. Let’s say you expect the US dollar to appreciate against Indian rupees shortly. You can then buy USD/INR futures. On the other hand, if you expect the INR to strengthen against the US dollar, you can sell USD/ INR futures.

However, one needs to understand that forex trading is not for everyone. It comes with a high level of risk. Before trading in forex, it’s essential to know your risk appetite and also have the required level of knowledge and experience. When trading in forex, you should know that there’s a good chance of losing money, at least initially.