What Are The Key Differences Between Trading Forex And Shares?
Or to put it another way can someone who profitably trades shares also make money with spot forex. The answer is yes, but with some caveats on trading style and with an acknowledgement of the differences between the two types of market. By its nature spot forex tends to favour short-term trades for reasons that will be explained later.
But the first major difference between spot forex and shares is where they're traded. Stocks trade on exchanges such as the London Stock Exchange, whilst the spot forex markets trade Over The Counter, that is transactions take place directly between big banks, brokerages and other large institutions.
The other major difference is trading hours. Forex is 24/7 whilst most stocks are only tradeable during hours set by the exchange. However, in practice forex is usually active only during certain times of the day. The market usually sees a big pick-up in activity from around 7AM London time as Europe wakes up and London is the biggest forex market and Asia comes towards the end of its working day. Then from around 1PM onwards the market typically sees a jump in liquidity again as the US comes online. It is also during US hours that big data items the markets most watches are released. US data tends to move forex markets as the US is the world's biggest economy and the US dollar is the world's main reserve currency. For forex day traders these are the best hours to be trading as liquidity is good and trends tend to develop. But by 5PM UK time the forex markets tend to go quiet again.
Whereas on various stock exchanges around the world there are 100s of large companies with shares that are very liquid, think S&P 500 (500 largest listed US companies) or FTSE 100 there are only three major currency pairs where most of the action takes place in forex: EUR/USD, USD/JPY and GBP/USD. USD/CAD, AUD/USD and USD/CHY are also very important pairs. Spreads, the difference between buy and sell prices, on these major pairs are the narrowest and hence the most suitable for day traders and scalpers as the transaction costs are lowest. However, for longer term traders interesting opportunities can develop around more exotic currencies such as NOK, SEK, SGD and NZD. However, spreads will be wider on pairs involving 'exotics' as liquidity is much lower.
This concentration on a few currency pairs gives traders the advantage of being able to specialise. So for instance, some will only trade EUR/USD or GBP/USD and become very expert on just one of those pairs. Stock market traders can decide to specialise just in a few very liquid stocks such as Coca Cola or Vodafone. However, those strategies also typically involve having to monitor the major equity indexes, such as the S&P 500 or Dow Jones in the US or the FTSE 100 in the UK, which makes the set-up a little more complicated. Others can simply chose to chase the momentum stocks of the moment, which means searching among 1,000s of listed stocks. There are software programmes that can locate those fast moving shares, but a lack of specialisation in those stocks can leave traders open to making losses.
The other factor is that spreads on the major currency pairs tend be wafer thin and narrower than on stocks and this makes for lower transaction costs. Also, there usually aren't any commissions to pay on forex trades. No doubt this reflects that the forex market is many times bigger than the world's equity markets. And also competition between forex platform providers is intense and in recent years spreads on the major forex pairs have narrowed considerably, which very much benefits day traders and scalpers.
Shorting shares via stock brokers can be difficult and even costly. However, shorting shares can be very dangerous and far more so than for currencies. Consider shorting the shares of a company where a takeover bid is announced after trading hours, meaning a trader can't cover their short position until the market reopens. Takeovers usually happen at a premium to the day's share price and can even lead to bidding wars – it's not uncommon for shares to rally 50% even 100% under such circumstances, which can be devastate a trader's capital, especially if leverage is involved.
The other major difference is leverage – on forex the leverage typically allowed is significantly higher than for stocks. This of course comes with advantages and disadvantages. The downside of lots of leverage is that risk has to be very carefully monitored as far more can be lost than the initial deposit. However, the main currency pairs tend to exhibit less volatility than stocks, consider that a corporate profit warning can instantly wipe 10% off the market capitalisation of a major company, whilst EUR/USD will not move 10% in a split second.
Higher margins tend to favour shorter term trading styles, such as day trading or scalping. Most of the technical analysis tools, which can be used for analysing share price movements, such as moving averages, Bollinger bands, chart patterns and RSI, also work well with currencies. However, higher levels of leverage do mean that picking entry points for trades needs to be more precise and money management needs to be tighter.
But there are a number of upsides. Greater leverage and lower transaction costs means that it is possible to trade profitably with less capital than required for stocks. Also, the typically shorter time frames on trading forex means that carrying out fundamental analysis is a lot less important than technical analysis – though a basic understanding of how such factors influence exchange rates is good to know. That in a way makes trading currencies simpler. Successful traders or investors in shares looking for long-term positions usually do look at fundamentals such as a company's prospects and financial strength and combine that with some form of technical analysis.
Beware of central banks
Another major difference is central banks. Yes their actions certainly do influence the stock market, but they're often felt first and sometimes disproportionately in forex markets. Often, as the Bank of Japan does regularly, they'll intervene to drive down the value of the national currency and they do that by intervening directly in the forex markets. So if JPY starts getting too strong the Bank of Japan can sell vast amount of JPY to push its value down. These days central banks are very active as a result of trying to manage the fall-out from the financial crisis. So the US Federal Reserve, which tends not to focus as much on the value of the US dollar, can nonetheless greatly influence its value by engaging in quantitative easing programmes to help boost jobs. However, that also has the effect of driving USD lower.
Stocks versus forex
So which is better? Stocks or currencies? It would be unfair to make a categoric judgement in favour of either one. It really is down to the individual, their character and their preferences. Some traders naturally feel more comfortable with stocks whilst others with spot forex. For the long-term trader stocks may well be a better choice, they can make spectacular price moves and the lower levels of leverage means entries don't need to be quite so precise – there's more forgiveness in getting in a bit too early for example. But for traders looking to do scalping and day trading then forex, with higher levels of leverage available, should be a serious consideration. It also requires less capital, it offers an opportunity to specialise and in some respects, as discussed earlier, forex is simpler than shares. If you have never traded forex, then a good way to get a feel for it is to simply open a demo account and experiment.