Forex Trading: The lay of the land - Outside View

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Forex Trading: The lay of the land
Aug 31, 2010

What "new" idea or fact can I share with you, Gentle Reader, which has not already been done to death? What can I talk to you about that you already do not know? After much scratching of the head, I have narrowed down on the following topics, which might be useful to those who are new to the forex market, especially for someone who is coming in from the equity market:

  • Comparison of returns and volatility between equity and currency markets
  • Disadvantages of overleveraging in currency markets
  • Role of Forward Premium
  • Importance of technical analysis in currency markets
Before venturing to trade in any market, it is important to get a lay of the land, so to say, and the above topics would be useful in understanding the topography of the forex market. For example, before going to the USA, it is useful to know that cars drive on the left side of the road and electric switches are turned UP to switch them on, rather than turned down, like in India.

So, here are some ground realities of the forex market that you might want to keep in mind when you trade this exciting market.

Comparison of Returns and Volatility between Equity and Currency markets
Perhaps the first thing an equity trader would notice is that the currency market moves much less than the equity market. This is clear from the table below, which compares the average movement in different time frames between the two markets:

Comparison of average percentage movement (range between high and low) in two markets:
Time Frame Equity Market (Sensex) Dollar-Rupee Market
1 Year 89.00% 9.80%
1 Month 8.85% 3.01%
1 Week 5.64% 1.00%
1 Day 1.82% 0.30%

Clearly, the currency market is less volatile, more stable, than the equity market. The biggest reason for this is that the currency market is a wholesale market and is the closest you can come to the economic concept of "perfect competition". In comparison, the market for individual stocks (certainly) and even the stock index (to an extent) is not a perfectly competitive market. This distinction between the two markets is applicable to India also, after the RBI has reduced its interventions and volumes in the currency futures market have soared. Large, high volume markets tend to be less volatile than smaller markets. Since everybody trades only Dollar-Rupee in the Dollar-Rupee market, whereas many different people trade many different stocks (or indices) in the equity market, volatility in the currency market is bound to be lower.

It would also be good to remember here that currencies are similar to commodities in nature. Thus, one would tend to "trade" in commodities and currencies, as opposed to "investing" in equities. For instance, in the currency market, you might need to take in smaller profits on a larger number of trades, if you want to generate the same kind of returns as you are used to in the equity market. Buy and hold opportunities might be lesser. Please do not be misled into thinking that you are an "investor" (in the true sense of the word) in the forex market.

Another way to make larger profits in the forex market would be to have greater leverage on your funds. High leverage is not only a necessity that you will feel, but happily it is also something the broker is willing to grant you. This is possible because given the lesser volatility in the forex market, there are lesser chances of huge losses, and so brokers are willing to allow trading on smaller margins, or higher leverage. As a result, you will find that margin requirements in the currency market are only about 2-5%, as compared to 10-30% margin that you might need to put up in the equity market.

It is important to be aware of these differences between the two markets, because if you are used to the equity market, you might need to modify your trading style a bit when you enter the forex market.

High Leverage - double edged sword
We have just seen that higher leverage is a normal feature of the currency market. But, it must be remembered that leverage is a double-edged sword. While high leverage can lead to higher profits, it can also lead to higher losses.

In the hands of a skilled and prudent trader who swears by the basic tenets of money management, it can be a powerful way to grow profits. In the hands of the unskilled, imprudent and impetuous trader, however, the same leverage can turn out to be an effective way to commit hara-kiri. This is an important warning because there can be a tendency among new currency traders to take excessive leverage, lured by the hopes of making big money fast, fast, fast.

If you are entering the forex market for the first time, it would be good to go slow and trade small, in order to get a feel of the market first. For instance, in the equity market you might not be used to "opening gaps", or the difference between yesterday's Closing and today's Opening price. But this is quite common in the Dollar-Rupee market. Although the Dollar-Rupee market closes at 5.00 PM, the opening at 9.00 AM the next day is influenced by overnight movements and developments in the global currency markets, leading to the "opening gaps".

And, these gaps can tend to be quite large. If you are overleveraged you might find yourself in sorry situation. Something you might want to keep in mind.

Role of Forward Premium
Another thing you might need getting used to when you trade Dollar-Rupee, is the effect of Forward Premia.

The Dollar is generally quoted at a premium to the Spot in the Forward or Futures market. We will not go into the theory of forward premia here, or into why the Dollar is quoted at a premium in the first place. What is important to note is that the Forward or Future Rate is usually higher than the Spot, especially at the beginning of the period.

For instance, at the time of writing (11:48 AM on 27-Aug-10), the interbank Spot is quoting at 46.85 and the Futures maturing on 27-Sep-10 is quoting at 47.0425, at a premium of 19.25 paise. This premium will reduce progressively over the coming month till it stands at Zero on the day of maturity, i.e. 27-Sep-10.

This is a COST to be incurred by the person buying the Dollar, and is an INCOME for the person selling the Dollar. If the market is volatile and trending up, it might not really matter. If the Dollar rises fast after a person has bought it, the gain on the Spot would make up for the premium cost incurred. But, if the market ranges sideways, the forward premium paid by the Dollar Buyer would be a wasted cost for him. On the other hand, it would be free money for the Seller of the Dollar. Indeed, this has been the case in the last three months, during which Dollar-Rupee has traded sideways between 45.50-47.40.

Forward Premium on the Dollar is like "contango" (or badla) in the commodity markets. Contango and Backwardation (undha badla) are common features of the commodity markets. However, they are not very frequent or significant in the Equity markets. As such, equity traders might want to get used to the Forward Premium in the Dollar-Rupee market, because it is a factor that can influence the profitability of a trade, especially when the market is ranging sideways.

Importance of Technical Analysis
Finally, please do not take me amiss when I make this generalisation, but a remarkable thing about the forex market I have noticed over the years is that anybody who is evenly remotely connected with it has a tendency to argue and rationalize the market movements like an economist, of no less a caliber than Dr. Manmohan Singh, the RBI Governor or the Chairman of the Federal Reserve.

Now, there are several economic and fundamental arguments that can be put forth to justify a particular price movement in the currency market and an equally large number of weighty arguments can be brought in to say that it is unjustified. Which argument is to be believed, which one is true, which one is applicable? Truth be told, even the professional currency traders can seldom say which argument or logic is correct.

It does not help that correlations between the many different variables that influence the forex market, keep changing. I will mention just one example. Everybody knows that the Sensex (or Nifty) and the Rupee have a positive correlation. Strength in the equity market has been known to lead to strength in the Rupee. However, this correlation has been breaking down recently. The Rupee has been weakening even while the stock market has been going up. Naturally, people are flummoxed. What do you do? I know, it is indeed confusing.

All this is being said to bring home the point that analyzing the forex market from a fundamental/ economic point of view is not the easiest of things to do for most people. It can lead to confusions, contradictions and crazy positions. Avoidable.

Technical Analysis, or the study of charts, can be a more objective way of trying to figure out what the trend is, where the market is headed and how you might want to trade it. This is because technical analysis is given to much lesser ambiguity and anyone with a reasonable amount of skill can use it to determine the market trend.

Please note that I am not rubbishing fundamental analysis here and am not trying to re-ignite the fundamental v/s technicals debate. All I am saying is, one might be well served using charts to forecast and trade the forex market. And, in case you did not know, even the people at RBI and the Fed look at charts.

It is useful to know that you should open your shoes when entering a temple, gurudwara or mosque, but that you can keep them on when entering a church; and that you should cover your head when entering a gurudwara, even if you are not a Sikh. Similarly, the idea behind this article was to give you an idea about some of the contours of the forex market, some things you might want to be forewarned about.

To recap:

  • The currency market is less volatile and thus has higher leverage
  • But, excessive leverage can be injurious to the trader's health
  • Forward Premia can affect the profitability of your trades and so you should know how they work
  • Charts can be more helpful in keeping your head above water in the forex market than economics

Finally, may the force be with you when you trade currencies. Its really great fun, especially if you get it right. Just remember, it's a little different from equities.

This article has been authored by Vikram Murarka. He is the Founder of and Chief Currency Strategist at Kshitij Consultancy Services, India's first forex website, started back in 1998. Vikram has been forecasting and trading currencies since 1991.

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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1 Responses to "Forex Trading: The lay of the land"

Wahidur Rahman

Sep 5, 2010

how to play forex trading and how joint it

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