Is the Rupee Overly Depreciated?

 

The rupee has been in a kind of free fall: it hit 85 to the US dollar on December 19, 2024, slipped to 86.62 on January 13, 2025, despite large-scale interventions by the Reserve Bank of India (RBI), and then touched a historic low of 87.1850 on February 3, a drop of 0.67 against the dollar.  

The Indian currency remained volatile throughout January 2025 as foreign portfolio investors sold stocks worth $6.7 bn and repatriated the proceeds during January alone. The two key market indices, Nifty 50 and BSE Sensex, which peaked on September 27, 2024, were down 11% by January 13, 2025, partly due to the relentless selling by foreign institutional investors during this period.

The depreciation of the rupee is not a new phenomenon; it has been depreciating by around 3.4% annually since 2005. However, the recent fall in the currency is largely attributed to the fear surrounding the tariff plans of US President Donald Trump, and the uncertainty that accompanied them. This was evident on February 3, when the Trump administration imposed tariffs on Mexico, China, and Canada, sparking a wave of risk aversion in emerging markets. As a result, the rupee touched a low of 87.28 at one point on that day.

 In response to tariff increases, the US dollar index—the value of the dollar relative to a basket of six currencies—rose from 107.8 on January 31 to 109.8 on February 3. The imposition of 25% tariffs on Mexico and Canada and 10% on China by the Trump administration indeed hammered markets globally. Tracking the global stock sell-off, the benchmark Sensex closed down 0.4% at 77,187, while the broader Nifty 50 index declined 0.5% to 232,61. Indeed, it was the intermittent intervention of the RBI in the dollar/rupee spot market that helped contain some losses.

Persistent outflows from the capital market and the demand for dollars from oil companies are putting continuous pressure on the rupee. As the impact of the US tariffs deepens, the rupee is likely to face even more pressure.  That aside, economic theory suggests that the tariffs imposed by Trump are expected to strengthen the dollar. If he proceeds with re-imposing the paused tariffs on Canada and Mexico, the dollar could further strengthen significantly.  The rupee is already one of the worst-performing Asian currencies. Furthermore, if the RBI, as anticipated by India Inc., cuts interest rates by 25 basis points, analysts fear that the rupee could soon hit the 88-per-dollar mark. 

Amidst this evolving scenario, analysts who once advocated for the RBI to let the rupee depreciate are now calling for it to defend the rupee. They fear that further depreciation of the rupee will increase the cost of commodity imports, which could, in turn, fuel persistent inflation. Exchange rate volatility also raises risk premia, which typically exceeds the actual depreciation in emerging markets. Indeed, such volatility harms the real sector as well. Over it, if depreciation continues at a faster pace, it may even affect the foreign investor sentiment. Given all this, some analysts are urging the RBI to intervene in the market to maintain a flexible nominal exchange rate that minimizes volatility. 

Raghuram Rajan, the former RBI Governor, stated that the central bank need not intervene in the market to protect the rupee, citing several reasons. He pointed out that the rupee is not the only currency depreciating against the dollar and that there is still room for the rupee to depreciate further. He believes that the rupee remains overvalued in real terms when compared to its peers. In fact, an estimate by the Bank of Baroda suggests that under ceteris paribus conditions—where only external factors are considered—there is still room for the rupee to depreciate.

In the last few months, foreign exchange reserves with the RBI have fallen from $705 bn to $635 bn as it sold dollars to protect the rupee from sharply depreciating. As a result, the appetite for further intervention has naturally diminished. Secondly, during the recent fall in the rupee against the dollar, the rupee has appreciated relative to the currencies of other trading partners. Therefore, exports to countries whose currencies have depreciated not only against the dollar but also against the rupee, and which are denominated in those currencies, are becoming less competitive. This may be another reason for the RBI’s recent muted intervention in the forex market.

That aside, managing both the exchange rate and inflation simultaneously is a challenging task for the RBI. Nevertheless, in the context of growing global uncertainty and weaponization of tariffs, RBI should use its reserves to reduce excess volatility in the exchange market, for reserves can be rebuilt over time.   

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A Blow to Currency Derivatives Trading!

 

India’s Forex derivatives market is all set for a profound transformation. According to the notification issued by the Reserve Bank of India on 5^th January 2024, proprietary traders and retail investors will be required to demonstrate contracted or prospective currency exposure to participate in the forex derivatives trading offered by exchanges such as NSE, BSE and MSEI. It effectively means that participation in derivatives trading is henceforth restricted exclusively to hedgers. Initially, this directive was supposed to be effective from April 5, but at the representations made by the market participants, RBI has postponed the effective date to May 3, 2024.

Until now, non-banking participants in exchange-traded currency derivatives were allowed to take positions, be they long or short, without having to establish the existence of underlying exposure, up to a single limit of $ 100 million equivalent across all currency pairs involving INR, put together, and combined across all recognized stock exchanges.

Given this, the stringent notification from the RBI caused a stir in the forex derivatives market. Reports indicate that the daily turnover in the currency derivatives segment of NSE has collapsed to less than one-tenth of the daily average that stood at Rs 1.46 tr since the April circular of RBI that pushed the effective date to May 3. As the market players – predominantly speculators and arbitrageurs – commenced unwinding their positions to comply with the notification, the number of outstanding contracts also has come down substantially. Even the premiums on some option contracts appeared to have surged more than 200%.

The circular had indeed ignited a significant controversy in the market that consists of proprietary traders who accounted for 62% of gross turnover followed by retail investors (19%), others (8.3%), foreign portfolio investors (6.2%), corporates (3.9%) and domestic institutional investors at 0.2%. True, FEMA regulations did say that the participants in the exchange-traded currency derivatives market have to have an underlying exposure. But what the market players arguing is that all along neither the underlying exposure nor contracted exposure was insisted upon to trade in currency derivatives at exchanges up to a limit of $ 100 mn. As a result, currency derivatives market is well established in India with trading volumes reaching $ 5 bn a day. Now with this RBI notification, speculators and arbitragers who contribute a large portion of the volume will be driven out of the market, which means drying up of liquidity.

Theoretically speaking, speculators are important to markets because they bring liquidity while assuming market risk. And, providing liquidity is the essential function of the market which alone enables individual traders, including hedgers to easily enter or exit the market. Secondly, a liquid market reduces the cost of hedging. That aside, derivatives trading in exchanges being well-regulated and transparent helps players in the price-discovery of the underlying asset.

That said, it must also be admitted that speculators, believing that a particular currency is going to increase in value, may choose to purchase it as much as possible even by resorting to high leverage, and in the process can create a speculative bubble by driving the price of a currency above its true value. Conversely, they can go short believing that the asset is currently over-priced and drive the price to fall continuously till the market stabilizes.

Perhaps, it is to avert such unwarranted swings in the currency market, particularly in the light of global uncertainties and the forthcoming entry of the nation’s bonds markets in global indexes from June that the RBI might have issued the notification restricting trading in currency derivatives in exchanges to hedgers alone.

Yet, no one can afford to ignore the unintended consequences of this restriction: one, the relevance of exchanges as facilitators of hedging forex risk without the participation of algorithmic, proprietary and individual traders who typically handle the risk of hedgers will be lost; two, with poor liquidity, hedging becomes costlier; and three, it may finally drive the hedgers to banks that offer costlier over-the counter hedging products leaving exchanges dead. It may even drive traders to shift their operations to the rupee NDF market in Singapore, Hong Kong, or Dubai, which incidentally can result in the same volatility that RBI wanted to check with its latest notification. Over and above all this, it portrays a poor image of India’s regulatory regime.  

As the fact remains that derivatives market needs all kinds of players such as speculators, arbitrageurs and hedgers, RBI may have to recalibrate its exchange rate management techniques and come up with a regulatory framework that ensures liquidity in the derivatives market while managing the swings in currency prices effectively.

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Rupee Drops to a Fresh Low: Challenges Ahead

As August inched towards its end, rupee, opening at 70.69 as against the previous day’s record closing rate of 70.59, fell by 0.21%, and what was more disturbing was: going forward the trend appears to be weak.  And the reasons for such a steep fall are not far off: the heavy month-end demand for dollars from importers, particularly from oil-importers and foreign capital outflows from the capital market, plunged rupee to an all-time low. It all started with the political turmoil in Turkey which impacted its lira vis-à-vis dollar and the contagion spreading to all other emerging market currencies. But it is the rupee that has become the worst performing currency in Asia, depreciating almost by 9% since January. It is our widening current account deficit, which is around 2.5% of GDP for FY 19 that caused continuous shortage of dollar liquidity which is primarily responsible for this fall. 

Of course, the Reserve Bank of India (RBI) has been intervening in the currency market to slowdown the fall of rupee, and in the process, its reserves have indeed come down from an all-time high of $426.88 bn in April 2018 to $400.8 bn for the week ended 17 August. Yet, some dealers opine that its intervention is not matching the kind of rising demand for dollars that the market is witnessing.

As the RBI pointed out, in the days to come, rupee is likely to be impacted by global risk factors such as: one, geopolitical developments in West Asia leading to sharp hike in crude oil prices; two, faster-than-anticipated pace of rate hike by the US Fed; and three, trade-related tensions across the major trading partners such as the US, Eurozone, China, etc., and the resulting volatility in the financial markets. 

That aside, even domestic factors such as the growing cost of the rising import of crude oil owing to rising global prices, lowering of goods and services (GST) rates on a range of consumer goods, the tax cut on small businesses and the relatively high minimum support prices declared by the government for agricultural produce are equally causing concern, for cumulatively they are certain to adversely impact the fiscal position. And, increased fiscal deficit is likely to fuel the inflation further, which in turn will have its own impact on exchange rates.

Here it is in order to recall what Raghuram Rajan, Professor from Chicago University, said at this year’s Jackson Hole get-together of Central bankers. He said that risk is building up again in the system and the trade-wars initiated by the US are potential enough to trigger the vulnerability in the system into a crisis. And, the prevailing global and domestic risk factors that India is facing are likely to expose us to such vulnerabilities.  

As commonsense would dictate, it is the importers who are very displeased with the falling rupee, for it straightaway affects their profitability. But surprisingly, this time round, even exporters are vociferously airing their concern against the depreciating rupee. They lament that in the wake of continuously falling rupee, they are finding it extremely difficult to negotiate a right price with their importers. However, at the same time, citing REER, they also argue that any depreciation of rupee is a move in the right direction, for it makes rupee more competitive among the trading partners. And this, they argue, shall in turn give boost to our exports. But this appears to be a myth, for our exports have indeed grown when the REER has grown. That aside, what exporters need to bear in mind is the impact of domestic inflation likely to be caused by depreciating rupee on the costs of their exports.  

Now, this raises an obvious question: Should the policy makers let the rupee spiral down in this manner? There is no ‘the’ answer, but the prevailing global factors warn us not to fall into the trap of exporters’ arguments. Even otherwise, the REER announced by BIS Board places rupee at 100.39, which means there is no overvaluation of rupee, while the REER of RBI calculated with 2004-05 as the base year against the currencies of China, Hong Kong, the US, Eurozone, Japan and UK currently stood at 123—meaning rupee is overvalued by 23% in relation to these economies. This difference in the estimates of BIS and our RBI demands a fresh debate on the very style of calculation of REER by the RBI.

That being the reality, the way forward is: improving our macroeconomic fundamentals and diversifying our exports. This obviously calls for requisite structural reforms on the lines that the RBI has recently asked for. Introducing short-term measures such as allowing manufacturing firms to avail external commercial borrowing of up to $50 million for one year maturities in place of the existing three-years is certainly a bad idea. For, such measures can only help us tide over the immediate crisis but are sure to create more stress in the future as the short term external debt is already hovering around 42 percent of the total foreign currency loans. Yes, imposing import curbs on non-essential goods is likely to ease to current account deficit. Similarly, government not yielding to the demand for cutting duties on petrol and diesel is in the right direction, for it can reduce demand (?) and certainly pave the way for environmental improvement. And revisiting some of the measures that RBI took in 2013—opening a special swap-window for oil importers and even inviting FCNR deposits with attractive interest rates—is no bad idea at this juncture.

So, in the ultimate analysis, the focus of the policy makers should be on long-term reforms that can improve our current account deficit. And that is what the policy makers should address fast if we wished to stop depreciation of rupee on a long-term basis.

India’s Swelling Forex Reserves

As the nation is rejoicing in the knowledge that India’s foreign exchange reserves, having touched an all-time high of $393.448 bn in the week to August 4, are surging towards the unprecedented $400 bn mark, the RBI must be rocking in the chair wondering how to keep rupee stable, make exports competitive and at the same time contain its underlying cost.

Before getting into the nitty-gritty of its effect on national economy and its effective management, let us first look at what the accumulating forex reserves portray. India, having emerged as the highest holder of Forex reserves among the countries with current account deficit, can certainly feel happy of its management of macroeconomic affairs, particularly its external sector. But these reserves do have their own costs and benefits, that too, of complex nature as they involve external security and strategic issues. From whatever information available from the reports, it becomes evident that these reserves are exposed to high currency—for mostly these assets are denominated in the US dollar—and liquidity risk, while credit risk and interest rate risk are relatively low.  In the recent past gold reserves too have gone up by $750 million to a high of $20.6 billion—a pointer towards the conservative stance (?) of the RBI.  All this could mean that the RBI must be making a negative return from these foreign currency assets.

The reason behind this negative return is obvious: the RBI must be paying more than what it is earning from its reserves while undertaking sterilization of dollar inflows, for the banking system is already saddled with huge rupee liquidity owing to the recently concluded demonetization. Indeed, banks are already facing the problem of paying interest on the suddenly swelled up deposits, more so in an environment where loans are not picking up. One of its unintended consequences is: the country’s largest bank has cut its interest rate on even savings bank accounts while the long-term interest rates on deposits have drastically come down.

As the RBI is struggling to cope with the demands of managing the surge in liquidity by undertaking open-bond market bond sales as well as long duration repos besides imposing additional costs on bonds under market stabilization scheme, foreign institutional investors have poured in $18.5 bn into Indian equities and bonds in the year through June. All this obviously raised stabilization costs of the RBI as a result of which its net transfer to the government in the form of dividend has almost halved from that of the budget estimates, which in turn is certain to disturb the fiscal math of the government for the fiscal 2018.

And this environment is likely to continue into the future, for India with comparably comfortable external debt indicators—external debt stood at $471.9 bn as at the end of March 2017 registering a fall of 2.7% from that of March 2016; ratio of external debt to GDP has come down from 23.5% as of March 2016 to 20.2% by March 2017; debt service ratio too has come down from 8.8% to 8.3%, while the coverage of debt provided by the foreign exchange reserves has gone up from 74.3% to 78.4%—is perceived to be among the less vulnerable countries. This trend is already palpable: outperforming its Asian peers, the rupee has gained a 16-month high of around 2% in March following the landslide victory of ruling party in the state elections.

One immediate effect of such an unabated inflow of forex is: theoretically, it raises the monetary base of the nation. It in turn means increased inflationary pressures. Obviously, to contain this inflationary pressure, the RBI must continue to sterilize its dollar purchases by issuing rupee bonds, which is an expensive affair, for the RBI gets a meagre return on its dollar reserves vis-à-vis what it has to pay on the rupee bonds.

Forex reserves thus entail a very high opportunity cost unless they are used for some productive purposes. One often resorted method of utilization is: investment in infrastructure projects, which could earn some decent return for the Central Bank besides adding wealth to the nation. This may, however, cripple the ability of the RBI in insuring against speculative attack on rupee. Further, there is also a school of thought which states that spending Forex reserves on non-traded goods is inflationary. It is interesting to know here that China, the world’s largest reserves holder—$3.12 tn— uses its reserves for investing in the overseas markets for acquiring assets.

Having said that, we cannot ignore the fact of a record Rs. 5 tn already lying as idle cash with the banking system. Which means there are no takers for bank credit. So, the need for using forex reserves for infrastructure investment does not arise. In the light of these complexities, RBI should get ready to use all its ingenuity including measures like increasing cash reserve ratio which alone can mop up liquidity with no underlying cost to the RBI, etc., to manage the swelling reserves so as to ensure that inflationary pressures are not allowed to surface derailing the growth prospects.

Appreciating Rupee : What It Means

It is, no doubt a great surprise that after sliding from 58.9 to a dollar in May 2014 to 68.7 in November 2016, the rupee has appreciated to a high of 63.93 last week—an appreciation of about 5.6% vis-à-vis dollar, all in just the last four months. And, not only is this the sharpest spell of appreciation of Rupee but it has also outperformed its peers from the emerging markets despite a spell of sea-changes—pound sterling suffering a worst hit of about 20% against dollar after Brexit polls, dollar index breaking the psychological level of 100 after Donald Trump’s victory—in the global markets.

Indeed, a few from the government are feeling elated by the strengthening rupee, for they believe it is due to ‘strong fundamentals’: good growth, low inflation, fiscal consolidation, and low current account deficits. There is of course, certain merit in this observation, but one cannot get carried away by it for there are also other factors that contributed to this sudden appreciation, such as: Foreign Portfolio Investors’ funds—during March they put $3.92 bn and in April 3 billion that cumulatively exceeds the 7.4 billion received during the whole of the calendar year, 2015—into Indian debt market that was triggered in the second week of March by the ruling party’s victories in the State elections, of course, duly supported by the passing of GST bill by the Parliament.

The inflows into the Indian equity market too are significant: an amount of $6.38 bn has been received as against $3.19 and $43.18 bn during 2015 and 2016 respectively. This has lifted Nifty above 9,000 and Sensex above 30,000, simply outpacing the global indices, besides of course, strengthening rupee further. And, all this has happened as Trump’s remark that dollar is extremely strong exerting pressure on dollar, and the RBI unusually remaining reluctant to intervene in the market. Now the big question is: Is this appreciation spree of rupee good or bad? Of course, there is no ‘the’ answer to this question, for analysts are divided in their understanding of this whole phenomenon.

Nevertheless, it is true that rupee is overvalued in nominal and more so in terms Real Effective Exchange Rate (REER) against the currencies of our major trading partners. The six-currency trade weighted REER reported to be over valued around 30% in March. Any further appreciation is sure to erode the competitiveness of rupee in the international market. And this is what of course, would have prompted RBI to intervene in the currency market on Wednesday April 26th to tame rupee as it is surging to the top of currency charts. As most of our exports are of non-differentiated, commodity-kind of goods such as apparels, which are bought in the global markets mostly based on competitive price, an appreciating rupee means buyers switching over to imports from countries such as Bangladesh and Vietnam. Coming to IT firms which are already hit by the toughest visa restrictions in the US, an appreciating rupee means further erosion in their profit margins. Cumulatively, it is estimated that an appreciating rupee means shaving 4% off the earnings of companies such as IT firms, car makers, pharmaceuticals and textile firms that are dependent on exports during FY18. On the other hand, when it comes to the rest of India Inc. which uses imports for domestic operations will stand to gain from a strong rupee.

There is however a positive side to the appreciating rupee: it affords savings on imports. For instance, during FY17 India imported merchandise worth $380 bn. At an exchange rate of 68 a dollar this involves an outgo of Rs. 25.8 lakh cr. As against this at today’s exchange rate of 64 a dollar, the outgo would come down to Rs. 24.3 lakh cr, which means a neat saving of Rs. 1.5 lakh cr for the year. One may however perceive a downside to this: wouldn’t a stronger rupee make Indians crave more for imported products? Perhaps, not, for most our current imports are confine to industrial commodities and capital goods whose domestic demand is more dependent on economic activity than the exchange rate. That aside, an appreciating rupee also helps the nation in keeping the inflation at lower levels.

Over and above all this, an appreciating rupee would ease the burden of debt servicing by the corporates who have heavily borrowed from the global financial markets. According to one report, Indian banks and financial institutions had an outstanding debt of $159 bn in foreign currency while corporates had another $150 bn dues. And in their anxiety to keep their cost of loans minimal, left their foreign currency loans un-hedged. An appreciating rupee is therefore a bonanza to such corporates.

Although India’s exports are showing signs of recovery since September last year, there remains a disturbing trend:  trade deficit is not narrowing down. Which means, if imports continue to grow while exports shrink due to appreciating rupee, the trade deficit can widen further. This is certainly a negative for rupee. Yet, if FIIs continue with their honeymoon with Indian debt and stock markets, it can set off a virtuous cycle where a strong rupee attracting more inflow of foreign currency and more inflows further propping up the rupee further encouraging fresh inflows and so on….

Should this happen, rupee gets overvalued in terms of REER. This is certainly no good for the nation. For, a strong currency hurts domestic growth. Theory indicates that appreciating currency subsidises imports and taxes exports while it is the exports which create employment. On the other hand, depreciating currency functions as a kind of tariff on imports of goods and services which to that extent hurts employment domestically. So, in the long run, a strong currency may prove no good for the development of the nation.

Wanna be a Currency Trader?

Forex market is a market that never sleeps. It is one of the largest and fairest markets in the world operating across the globe. The dealings in the forex market can help one to earn a huge fortune provided one makes the right move. However, one might as well lose the same within no time. The trader has to constantly keep himself updated about the movements taking place in the market so that he ends up in a successful deal, for a host of factors have a great impact on the functioning of the market. Interested? Wanna be a currency trader? Read on to know more.

Global currency markets today offer unlimited opportunities for a trader to make money. Currency trading, quite often, appears easy, though deceptively. It makes a new entrant to the dealing room feel brilliant and invincible when he wins the bet though on the flip side it can tempt him to take wild risks. As against this, a matured dealer neither gets elated upon winning nor deflated on loss. Paradoxically, a good dealer does not aim at winning but to trade well. He strongly and, of course, rightly believes that if the trade is right, money automatically follows. In that context, trading becomes a fascinating intellectual pursuit that calls for hard work and constant honing-up of trading skills. To be on the right side of the market, a trader has to know the market, its dynamics, mechanics of trading decisions and risk management principles and that’s what the present paper shall deliberate upon.

Global Forex Markets

Foreign exchange market is an over the counter market in which currencies of different countries are bought and sold against each other. It is quite deep and highly liquid.  It is the investors seeking the highest return on their funds who generate most of the currency trading. It is quite decentralized—participants like market makers, brokers, corporates and individual customers are physically separated. They communicate with each other via telephone, telex, computer network, etc. It is the commercial banks that offer such exchange conversion facility through their dealing rooms.

The cross-border capital movements have accelerated since the 1980s extending the market continuum through Asian, European and American time-zones. Forex market has thus become one of the largest in the world and a 24-hour continuous exchange that never closes. It is described as the “fairest market on earth”, for it is so large that no one player, not even a large government can completely control its direction. With the kind of technology at his command today, a trader can work from home or office at his chosen hours of work.

What Moves Currency Markets?

One of the most important factors influencing the returns from investing in a particular currency is the yield it offers relative to other currencies. Higher interest rates on a country’s currency will help to attract capital spurring its appreciation. Numerous other factors can also influence the demand for investments in a currency, such as, a rise in a country’s exports, its productivity or a resource discovery that may confer a competitive advantage on that country and attract investments. On the other hand, high levels of foreign debt can deter inflows of new funds, resulting in pressure on the currency to depreciate.

One may as well doubt the ability of the butterfly flapping its wings in Brazil setting off a tornado in Texas, but none can ignore the ability of innocuous minor happenings in the financial circles across the globe or statements made by financial power centers to generate turbulence in currency markets. It is essential for a trader to keep a constant vigil on some of the known important market movers such as:

• Global market movers—oil prices, G-7 Country decisions
• Movement in global stock markets—change in Dow Jones, Nikkei, Hang Seng, FTSE, DAX - 30 etc.
• Balance of payments—war and threat of war, dollar value etc.
• Business and industrial market movers—GNP, Industrial Production Index, Business Failures etc.
• Unemployment rates—status of labor force, total employment, seasonal adjustments, non-form pay-rolls etc.
• Consumer market movers—Consumer Price Index, Consumer Confidence Index, Personal Income, Auto Sales, Housing Status etc.
• Monitory and Financial Market Movers—Interest Rates (both Short-term and Long-Term), Yield Curve, Lombard Rate, Discount Rate, Base Rate Inflation and money supply, too much of money in circulation, open market operations of Central Bank, Taxation hikes, etc.
• People known as market movers (words of wisdom)—Statements made by people who enjoy tremendous political/financial power like, President of US, Fed Chairman, Chairman of ECB, Summit/Trade Talks etc.

Besides these well-established movers of the market, certain events such as internal troubles, coups, scandals, major oil discoveries, bandwagon effect are also known to influence market behavior. A trader has to keep his eyes and ears open for any happening in these sectors and factor that information into trading decisions.

How to Make Trading Decisions?

A trader basically enters the market to make profit but every deal need not necessarily result in profit, for the market can always move against one’s expectations. As “there is a tide in the affairs of men, which, taken at the flood level leads to the fortune”, there are trends in currency markets that need to be taken note of while making trading decisions else, “all the voyage of their life is bound in shallows and miseries.” This is feasible only through the dint of hard experience. Nevertheless, by following a few cardinal principles viz. trading with the trend, cutting the losses short, running profits longer and managing risk appropriately, a trader can safely sail through.

Trade with the Trend

To make money, a trader has to trade with the trend than against it. There are mainly three types of trades: Long trade, where market participants are actively buying a currency over a period expecting it to appreciate; short trades in which market participants are actively selling the currency over a period expecting it to depreciate and side ways trade where there is no trend for the currency moving up and down, of course within a specific range. Here, the simple logic is, when the trend is up, buy at support and if the trend is down, sell at resistance.

However, there is always a danger of a trader jumping at the wrong point on seeing an up-trend not knowing the exact support level and exiting at wrong resistance without making profit. It is sensible for an individual trader to trade and trend in the short term, which could be a week to fortnight, with of course, a clear understanding about the trend, the support and the resistance levels. Moving average indicator is a very good signal for a short-term trader. If the trend is up, the trader has to invariably be long and, if the trend is down one has to be short.

Long-term traders usually enter a position based on a confirmation of a long sustaining trend, may be for periods ranging from 6-9 months. These traders use various theories like the Dow theory and keep off from taking positions in choppy trading. They see at least three higher highs and three higher lows in the pattern to initiate a position. They mostly rely on weekly charts to spot the trend. On the other hand, intermediate traders spot the trend through the moving averages pattern during a period of 45-60 days.

To judge whether an indicator is a bona fide signal, one need to look for short- as well as long-term trend. When both are up, it is a good buy. When prices consolidate and create a shelf, it gives a signal for exit. There are traders who try to find out if there is a conspicuous pattern of consecutive higher highs and higher lows (up trend) or lower highs and lower lows (down-trend) on a weekly chart.

An intra-day trader, who does not trade for large profits nor is able to sustain huge losses, should never ever trade against the trend.

Cut Losses

A decision to cut loss is the saddest event for a trader as it could trigger a huge hole in his profit or ability to trade further. As a trader learns the nuances of trading to make profits, he has to build-up the mental-frame to adjust to the realities of cutting a loss position too. One can decide upon stop-loss positions based on chart-based stops: On a long position, one has to leave the “stop” below the support level and on a short position it could be above a major resistance.

In the course of business, many deals end-up in profits, however small they may be. At times, a trader even after making ten deals in profit and one deal in loss, may end-up in a net loss position. This could be due to the fact that the trader had run the loss position for long. Hence, it is very essential to have small losses or cutting short losses, that too with speed. Conversely, small losses accumulated in a month could be wiped out by a single large profit (hence, learn to allow the profits to run till the trend reverses) enabling a trader to balance a portfolio to run in profit.

To be continuously losing small amounts and not making profits on deals tantamount to wrong interpretation of the market. It is wiser to build a portfolio and build currencies as a natural hedging mechanism to eliminate losses in one of the portfolios. It is always advisable to initiate a position at a support level/resistance level based on chart trends and devise a cut loss formula below or above the same in order to sustain in trading for longer periods. Of all the principles of trading, cutting losses should be observed very stringently.

To have a decent sleep after initiating a position and leaving the same attended to by a banker i.e. leaving overnight positions to correspondent, wherever possible, in the 24 hour market, the “stop” has to be fixed fairly based on the principles mentioned above. It is prudent not to wait for more than 30-40 points on a one million position. Again, it depends on the risk reward attitude one decides to adopt. Successful trading is a result of a combination of both risk and reward.

One could always be a winner if only one know when to strike a deal and when to exit to book profits, failing which one could lose the game. Entry point is the deciding factor in fixing the stop losses than anything else. Volatility stop means placing a stop based on the volatility trends. In conclusion, a dealer has to always remember and be guided by the mantra—“cut losses”, “cut losses”, “cut losses”.

Run Profits Long

As Will Rogers once said, “Even if you are on the right track, you will get run over if you just sit there”. A dealer should know how to book profits before reverse sets in. Here, speed is the essence. It’s like wrestling a gorilla: you rest when the gorilla wants to rest; you come out of a position when it is moving towards rest. Similarly, when one is on a winning position, it makes sense not to risk the portfolio further by initiating additional position/trading or pyramiding the position.

A trader should also realize that once he is out of a position and especially if there is a big move, it is difficult to initiate a position afresh as in a one way moving market it is difficult to get the right price. Systems like the trendsetter do give indications as when to book the profit, when the position is in profit and when not to be a short-but a long-term trader.

Long-term moving averages do indicate an exit signal where one has to take profit and hence this needs to be watched every day. This is called withholding taking of profits by fixing a “trailing-stop” on winning position by using say, chart points which help to indicate weekly reversals etc. It is often said that it is not thinking that makes big money but it is sitting (sitting on positions—but not at a loss).

In case one—“trailing stop” prematurely gets hit and the market rebounds, the re-entry point becomes very crucial. Suppose one had fixed one’s profit taking by giving a trailing stop of 200 bp over one’s position based on assessment and presume there is a deep trend reversal. This necessitates re-entry at the right time, that too more quickly. However, this strategy does not work in a ranging market but does work in a rallying market. It is here that one may have to see whether the RSI has reached an overbought or oversold level and fix up a tight trailing stop. The rules of reentry have to be less rigorous but stop loss on such positions could be tight. The trader has to reenter the position only if the indicators are still in alignment with the original view based on which the position was initiated.

There would be occasions when a trader pulls out of profits based on a false break-out or in a quiet, calm and illiquid market when some trader dumps sufficient volumes to pull down the price. One has to survive this onslaught or one may not survive a long-term move.

It makes business sense for a short term trader to take profit by fixing aggressive trailing stops during the first few days of the move and then get back into the position to catch the long-term move of the movement. It is always an advantage for a trader to stay focused on a single currency that he watched and meditated upon most than dabbling around many.

A trader on his entry into the dealing room should first know the closing price of the previous day, watch the chart signals and based on this, re-fix his trailing stops or initiate further position, for it is a small percentage of the total trades done that runs into profits to sustain the major losses. Of course, it does not mean that the trader has to wait for such windfalls without early shutting out of loss making positions. A trader has to allow the profits to run longer based on the volatility trends/chart pattern. He has to initiate a base position and as the market starts rallying, should gradually move the “stop” below the major support areas or below a Fibonacci pull back. A trailing stop could also be fixing of a limit on the profit making itself. Some of the traders, in fact, believe in having profit target, which is as crucial as a predetermined stop loss point.

A matured trader won’t mind stepping out of his position and for that matter stop trading, if the day was found to be wrong where decisions are turning against him, for after all not all days are bad.

Manage Risk Properly

The ultimate deciding authority for a winner or loser is the risk management. A dealer has to decide which are the markets to be traded, the number of markets and exposures that one can trade and how to diversify the portfolio. The management should decide as to how much of the capital could be exposed to the risk with what level of diversification. Senior management should establish, enforce and regularly review a risk management framework, clearly specifying authorities, limits and polices. The risk management procedure should be fully approved by the Board of Directors and senior management should be made accountable for its implementation.

A separate system for independent monitoring to ensure compliance with the risk management framework should be in place. There must be complete segregation of duties between the front, middle and back office activities. Regular internal audits independent of trading and risk management functions should be carried out to ensure early identification of internal control and weaknesses, if any.

Professionalism of the highest standard should reflect in every operation of the dealing room. A priority to minimize deal input cycles, errors and down time should be in force. There should be a regular review of internal processes to identify and rectify weaknesses, disjoints and failures.

There should be appropriate system for timely documentation, processing and reporting. A technology policy to plan systematically for adequate systems support should be in place. A fully tested contingency site ready for back-up should be available.

A functional department should mark trading positions to market on a daily basis, independent of trading. The frequency of position valuation should be increased where justified by market volatility, volume and the institution’s own risk profile. Valuations should be verified against independent sources wherever possible. There should be a robust process for evaluating any off-market transactions. The risk measuring methodology used should be based on generally accepted statistical practices and approved confidence levels. Market models should be validated before implementation.

Risk positions should be regularly evaluated under stress scenarios. Volatility measures should be continually updated. The importance of market liquidity conditions should be considered before entering into transactions. The potential costs of unwinding up of positions, especially in illiquid markets should be assessed. A liquidity contingency plan for implementing in crisis situations should be in place for both on-and-off balance sheet instruments.

Returns should always be measured against market and other risks and against risk weighted capital with a corresponding measure on regulatory capital taken into account.

There should always be rational diversification of trading and customer activities to reduce risk. The highest standard of conduct with clients should be promoted. No trader should knowingly conduct business with clients involved in business activities known to be illegal or inconsistent with generally accepted standards of ethical or social behavior in the community.

Proper documentation for all transactions and counter parties should be in place. Prior to entering a transaction, the dealer should ensure that customers and counter parties have the legal and regulatory authority to transact. The terms of contracts must be legally sound and enforceable. Confirmation of all transactions should be dispatched on time and tracked for compliance.

How to Be a Successful Trader?

A dealer has to examine his trading motives and accordingly design a method that matches his personality. He should realize that he is responsible for the trades he undertakes. He needs to be independent and confident of his acts. He should accept that losing is a part of the game and should be open to new ideas/opinions. He should be patient and not worry about looking stupid should a deal turn out to be a losing bet. He should learn to be disloyal else he cannot cut losses in time. Lastly, a dealer should believe that there is more to life than trading.

A dealer’s quote must possess three major qualities: one, fast reply to the request for the quote; two, narrow spread and three, willingness to deal a reasonable amount at the quoted rate. In any case, a dealer should never ever resort to loading losses incurred elsewhere into the merchant quotes.

It is based on one’s view on price movement that a dealer should take a bullish/bearish or conservative/aggressive posture. Here it makes sense to remember that even the best traders are known to lose 60% of the time and make money 40% time only. They should set clear goals beforehand under money management—position of the size, stop losses, reward risk and tactics of trading.

Importantly, they should cultivate their own way of dealing with success or adversity: Grass grows in inches but dies in feet.