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How to make money from forex trading

July 12, 2010 14:19 IST

He had an ideal, high-paying managerial job at 23 and did not need to give it up for what is generally seen as a high-risk business.

Yet, Dayanand Gupta quit his job and ventured into foreign exchange trading. The move paid off and two years later, today, Gupta is successful, with a grip on the fundamentals of the business.

Many prefer to stay away from forex trading, the largest financial market globally. Its daily turnover exceeds $3.8 trillion, three times the combined business of the equity and debt markets in United States. Like the commodities' market, the forex market trades round the clock.

How does it work?

Forex trading, simply, is exchanging one currency for another. Most are traded against the dollar. Other highly traded currencies are the euro, pound, yen, Swiss franc and Australian dollar.

The first currency quoted in a currency pair on forex is called base currency, which is generally the domestic currency. The second currency is called the quote currency and is typically the foreign currency.

For example, if you were trading in rupee-dollar, rupee would be the base currency and dollar the quote currency. The price shows how much quote currency is needed to get one unit of the base currency.

In this market, the volume of trade is expressed in the base currency. Example: In a 100,000 rupee-dollar trade, 100,000 is the face value and is a standard contract or a lot. No matter which currency you have in your account, the trading software automatically sets the exchange rate.

The profit or loss in trade is expressed in the quote currency, as the currency pair price is given in it. For instance, if you buy euro-dollar at 1.3000, and sold it at 1.3010, your profit is $0.0010 or 10 pips for each euro. A pip is the smallest measure of price move on an exchange.

Spread: Each trade has two prices - bid and ask. The bid price is the rate at which the broker buys and you get on selling. The ask price is the offer price at which the broker sells and you pay to buy. The difference between bid and ask price is the spread (broker's profit).

In a euro-dollar trade at 1.4000/1.4003, the spread is 3 pips. On trading 100,000 euro-dollar, the broker earns 100,000 x 0.0003 = $30, irrespective of your profit or loss. If the currency pair rises 10 pips (from 1.4000/1.4003 to 1.4010/1.4013), you will earn only 7 pips because you bought at 1.4003 and sold at 1.4010.

Typically, a lower spread is better for traders, as it gives higher profit.

Leverage and margin: In case of a small investor who invests, say, $1,000, if the price moves up by one per cent, you will earn $10 and your broker only $0.30. It's not a great deal for you; worse for your broker. Thirty cents will hardly justify his salary.

Ergo is the concept of leverage financing, where a trader deposits only a presumed risk (margin) and the rest is provided by the broker. Margin requirements vary from one to five per cent, depending on the broker. A margin of one per cent may translate into a trade of up to $100,000, even if you have only $1,000 in your account. The margin corresponds to a 100:1 leverage.

Applying a 100:1 leverage, as above, your and the broker's profits are multiplied by 100: you get $1,000 (100 per cent of your investment) and the broker gets $30. The flip side -- if the price falls one per cent, your entire capital is lost.

Margin call: On opening a trading position, you can designate a part of your capital as collateral on your margin, which will be set aside and protected. On a capital of $3,000, say, your margin is $1,000. You use $2,000 to trade and if you lose, the broker will close your position and you will get back the collateral.

Let's say you bought 100,000 units of euro-dollar at $1.3217, which rose to 1.3227. You immediately sell those units and get $100 back. But, if the rate declines to 1.3207, you stand to loose $100.

Some losses are inevitable for any trader. However, the key is to limit losses by using stop-loss and controlling risk. If you set a limit order, you would have realised the potential profit without having to monitor the trade closely.

Caution: Making $100,000 from $100 is possible in this trade, provided you follow the rules of the game - be careful. "However, investors tend to equate currency with stocks. A big mistake," said Pramit Brahmbhatt, CEO, Alpari India. The risk factors are more complex here. Any change in macroeconomics is a big hazard, adds Brahmbhatt.

Rekha Mishra, senior research analyst, Bonanza Portfolio, concurs: "Unlike other markets, forex is highly volatile and most liquid. One should follow certain ground rules here in order to manage risk."

You can start with analysis, fundamental and technical. Skill to anticipate can be honed only by experience over a period of time.

"A demo account may expose you to the heat of a fast-paced, decision-making process," said a forex trader. "One can also start trading with mini or micro accounts to reduce risk appetite." But, do not draw conclusions based on earlier trades.

Despite being a 24-hour market, all hours may not be equally beneficial for trading on forex. You may plan your trading to catch the highest trading hour(s) to maximise profits. Freshers can take small exposures till they gain confidence.

Prafull Shirsat in Mumbai
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