The Difference between Forex and Stocks

The greatest distinction between stocks and currencies is in the characteristics of the product. Having stock in a business like Royal Dutch Shell will make you part owner of the company (don't go barging into Shell headquarters in The Hague, Netherlands, though, behaving like you own the place; although you do). However, possessing 10,000 Euro in cash won't provide you ownership of anything (other than the cash itself).

Not An Investment Market But A Speculative Market

A forex position has no innate value, which is why you can't really invest in it. A Standard Lot EUR/USD is valued at nothing if the price isn't going in your direction. But in many instances you will be compensated dividend when you own Royal Dutch Shell stock and the company has made a profit (after all, owning stock makes you part owner) even when the value of Shell stock hasn't changed at all, or even decreased.

Because the worth of a currency on the forex is always established in relation to other currencies, it usually varies more than the price of stocks. The price of a openly traded, financially strong company, will usually rise in the long run, because the fundamental value of the stock the company itself increases over time. In comparison, the price of the EUR/USD will more likely move back and forth than rise in the long term, because the price of this currency pair is not just reliant on the economic health of the Eurozone, but on the economic health of the Eurozone compared to that of the United States, which may very well vary with time.

The candlestick down below, of the EUR/USD between 2009 and mid 2011, demonstrates this. The price progression of the EUR/USD in this time period is typically a ranging one, meaning shifting sidewards; every trend is only temporary.

The forex is consequently much more a assuming market than an investment market. The forex trader makes his money by estimating on the temporary rise or fall of a particular currency. That is not to say there aren't a lot of speculators proactive on the stock market too, but the central of the stock market players always have been investors, looking for long term opportunities.

Extra: That it is nonetheless possible to ‘invest' in the forex for a lengthier period of time, has been verified by the investing expert Warren Buffet, who took huge long positions on the EUR/USD in 2002, when the rate was pivoting around 0,80.

Buffet had that this rate was much too small and did not effectively express the relation between the United States and Europe. When Buffet ultimately closed down all of his long positions, in August 2008, the EUR/USD had risen to $1,5950, a rise of 88%.

Not Based On Physical Ownership

Another substantial difference with the stock market is that a currency trader seldom takes ownership of the currency he buys. In that respect, the forex is more like the options- and futures market, which are similarly more about the right / responsibility to buy a certain amount of a product at some point, then about having that product actually shipped to your backyard. It's consequently no coincidence that forex brokers in the United States are governed by the National Futures Association (NFA)

Physical ownership is unnecessary to a currency trader; in the end, he can only turn a profit when the rate goes in his direction. There is no dividend, no innate increase in the price of the product itself, whereas a business like Shell does increase in value over time, making its stock more valuable as well.

The vast number of currency positions are closed within just 48 hours after they are opened. For most currency traders, the long term isn't all that fascinating.

Trading Stocks Is More Expensive

Finally, two other crucial differences are that you will need much more capital to trade in the stock market, and that small stock traders have to prevail over relatively high costs to turn a profit.

Trading stocks with a total capital of $1,000 is practically never worth your while. It would only acquire a couple of stocks, and on top of the administrative expenses, bank and brokers also bill you for each transaction. Small-scale traders would therefore have to realize 5% ROI (Return On Investment) just to break even.

But $1,000 does give you a real place at the table on the forex. This is particularly true since the introduction of the Micro Lot (where 1 pip is valued at about 10 cents) which allows you to open a position for a couple of dollars. And through the use of leverage, you can significantly increase your ROI. (of course leverage can also work against you; more about this later on)

A forex broker charges nothing outside of purchase costs, the spread. No administrative costs, subscription costs, or anything like that. A couple of brokers charge you for moving funds to your bank, but the vast majority of brokers only charge spread.

Similarities

Of course there are also resemblances between currencies and stocks. With just a little bit of thoughts you could point out that a currency is a representation of the economic condition of the country that uses it, just like stocks are a function of the economic state of the company that released them. When Royal Dutch Shell publishes unsatisfactory results and states it will pay a lower dividend, the price of Shell stock will most likely fall. Just as the price of the Euro will likely fall when the growth of the biggest economy in the Eurozone, Germany, falls short of expectations.

Other factors that can impact the worth of a currency on the forex are: unemployment figures, consumer confidence, consumer spending, export figures, production figures and producer confidence.

When looking at it like this, the foreign exchange market does mimic the stock market relatively, and in a way currencies really are a representation of the underlying value of a organization of sorts (even if it's not as direct a relationship as with stocks). But keep in mind that despite the fact that the price of a currency is inspired just like the price of a stock by the underlying value of the economic system it represents, the basic difference stays that currencies are paired against one another while stocks are only traded based on their very own underlying value. If the stock market ever changes to a system where you can trade in Shell/BP, Toyota/Ford and Apple/Microsoft the stock market and foreign exchange would be much more identical, but the likelihood of this taking effect is just about equal to that of the United States switching to a Chinese style dictatorial state capitalism.

Why Recessions Don't Matter To The Forex Trader

Because currencies are traded by pairing them against each other, it doesn't make a difference for forex trading whether or not a particular economy or even the whole global economy is in recession. In the end, the drop of one currency in a currency pair would instantly mean the increase of the other currency in that pair.

This is not to say that recessions can't have an effect on the price of a currency because they can and most certainly do but they do not really modify anything for the currency trader. When the British Pound drops because the United Kingdom has got into a recession, the forex trader sells GBP/USD and goes long the EUR/GBP. Is the Eurozone faring even worse than the United Kingdom? No problem, the trader basically shorts the EUR/GBP!

Needless to say you can go short on the stock market too (although several governments have restricted this practice these days). Buying put options allows traders to speculate on the fall of a specific stock, and the more unclear the economic times the more stock market traders will go back to shorting the market. But, the longer the time period the more unavoidable the upward trend of the stock market also gets. The reason is basically that publicly traded companies normally turn a profit and grow (when they don't for a longer period of time, they'll at some point fade away from the stock exchange)

The basis of the stock market is consequently created by investors holding stocks as an investment; to profit from the annually paid out dividend and/or the Return On Investment of the stock itself when they sell it off. A recession affects these investors, because businesses will sell less, turn smaller sized profits or suffer losses, and might even go out of business (rendering the stock useless).

No uptick rule

As mentioned above, the likelihood of going short on the stock market is frequently limited by financial authorities, because it is believed that hedge funds et al. would ruin healthy companies in unstable economic times by shorting them into oblivion. During the first months of the financial crisis of 2008, going short on the stock market was consequently banned in several countries (including the United States and Germany, and the like) for some time.

Up until 2007, short selling had been restricted in the United States through the so called ‘uptick rule', which claims that one can only go short when the price of a share has risen by at least one tick. This much criticized rule has since been swapped out by the SEC by ‘Regulation SHO', regulating what is recognized as naked short selling. However, the SEC allegedly also has the reintroduction of the uptick rule under evaluation.

Thankfully you don't have to stress about these type of anti-capitalistic rules when trading on the forex. No one will raise an eyebrow when you go short on the forex in times of economic problems, because all forex traders frequently short currency pairs, whatever the global economic tide.