Forex is the world’s largest and most widely distributed market, with a daily turnover of $3.98 trillion. There is no central exchange or clearing house for trading forex. Instead, currencies are traded over the counter (OTC), with money exchanged directly between the buying and selling parties. Each currency is traded against another currency according their relative value – the two together are known as a currency pair.
In contrast, stocks must be listed and traded on exchanges. Traders can only buy or sell stocks listed with the relevant exchange. A company will usually be listed with an exchange in the country where it is registered. For example, stocks for US registered companies are generally bought and sold on US exchanges such as the New York Stock Exchange and stocks for UK-registered stocks are bought and sold on the London Stock Exchange. Stocks are traded against the currency of the country in which the trade takes place.
The forex market also differs from the stock market in that it is divided into levels of access. Essentially, the volume of a trade defines your level of access, as well as the ‘spread’ (the difference between the bid and ask price) paid. The larger the volume of the trade, the smaller the spread – which means the trader gets a better exchange rate. The top access level is the inter-bank market which consists of top-tier banks. Other access levels include small banks, corporations and institutional investors.
With stocks, there are no levels of access, but there are different types of share: ordinary shares, cumulative preference shares, and redeemable shares. Ordinary shares are the highest risk, and holders are only entitled to dividends when the company is in profit. Cumulative preference shares always receive a dividend, while redeemable shares can be bought back by the company.
Another key difference is that while the forex market operates on a continuous, 24-hour basis from 20:15 GMT on Sunday until 22:00 GMT on Friday, stock markets generally work to the business hours of the country in which they operate. So, for example, the London Stock Exchange trades stocks from 08:00 to 16:30 GMT and the New York Stock Exchange trades from 09:30 to 16:00 EST.
Crucially, stocks are a long-term investment. They can see steady growth over a period of time and investors will expect to hold onto them for an indefinite period, often a number of years before realising a significant profit. Forex, on the other hand, is ideal for short-term gains. Currency prices are subject to frequent fluctuation. The most frequent types of forex trade are ‘spot’ transactions (two days) and futures (three months). Forex trading is also characterised by the use of leverage to profit from large positions. However, with the exception of some hedge funds, very few stock market participants rely on leverage.
The relative profit margins of the two markets are also very different. Exchange rates fluctuate frequently, but often by only a couple of points. Typically, the overall change will be less than 1% intraday. Since these fluctuations represent a very small percentage of the unit price, forex traders have to speculate against large sums to realise significant profits. As a result, leverage, a form of borrowing that allows forex traders to put up only a fraction of the base transaction value, has become popular.
Stocks, on the other hand, can be subject to much larger price fluctuations, though on a less frequent basis. With stocks, the trader invests the full price of the share and is then subject to any changes in price which may occur.
There are two opportunities to make gains on a share: when the price of the share goes up, and when the share pays dividends. Both of these are dependent on the health of the company, and can vary from year to year. In a bad year, a company may not pay out any dividends at all, and its share price may also fall.
Another key difference between the two markets is that they are affected by different factors. Stock prices become susceptible to change based on news regarding the individual company or the industry in which it operates. For example, many banks suffered losses on their share prices in 2008 due to industry-wide problems, and in 2010 Shell saw its share price eroded following the Gulf Coast oil spill.
Forex rates fluctuate according to changes in world economic events. So, while a stock investor will keep a keen eye on company reports, financial statements and industry overviews, a forex trader will take a wider view encompassing anything which might affect international money flows. Factors which can affect money flows include macroeconomic conditions such as interest rates, gross domestic product (GDP), inflation and budget deficits. Data regarding these conditions is released at regular intervals, and there is usually a flurry of forex trading activity both before and after figures are released.
Thanks to their differing characteristics, the forex and stock markets attract different participants. Stocks are seen as a more secure investment and are typically owned as part of a wider investment portfolio. Major participants in the stock market are: institutional investors including pension funds, insurance companies, mutual funds, banks and hedge funds, as well as individuals. Forex is traded by banks, companies, currency speculators, institutional investors, governments, corporations and retail investors. More recently, forex trading has become an attractive means of earning a living for those with trading experience, and there are now professional forex traders.