Stock Trading vs. Forex Trading

Most people who start out in trading start in stocks. It’s pretty easy to see why. Stocks are always in the news! CNBC almost exclusively talks about stocks and any time a market is in the news, stocks are the focus. And it’s easy to see why. Stocks are easy to understand because investors like being able to own a share of companies they use or know. When the average investor looks at their 401k or talks with their financial advisor, there is no mention of other asset classes, only stocks and stock funds.

Many of the investors that start out in stocks eventually get exposed to other asset classes at some point and it usually causes them to be curious as to what other markets are out there. They find options, futures, commodities and of course our favorite, Forex. It can be a little intimidating at first if a trader chooses to switch instruments so we thought we’d spend some time discussing the difference between trading stocks and trading forex.

One of the questions we get asked all the time is “how is forex trading different from trading stocks”?

Trading the Forex market has some similarities and some big differences to taking trades in the stock market and we will give you a brief overview here.

Obviously, both asset classes trade on exchanges where buyers and sellers come together, and through traditional forces of supply and demand, trades are made and ownership of financial instruments changes hands.

In both markets, the majority of the speculative trading is done with two different types of analysis: technical analysis and fundamental analysis. Let’s look briefly at the difference between these two in relation to their specific markets. In the stock market, fundamental analysis is done by understanding metrics like earnings and financial projections of a company. This type of fundamental analysis applies to all individual stocks as well as baskets of companies if you use ETFs or mutual funds. Fundamental analysis in the forex market, on the other hand, is based on interest rate differentials of central banks. In other words, what’s the interest rate being paid by the Central Bank who controls one country’s currency versus another. Here’s a chart of the current interest rates around the globe:

These interest rates are set by the central bank and they hold meetings almost every month to confirm their interest rates or change them based on changing economic conditions.

The difference in these rates creates a natural demand for hedge funds, corporations and other players to want to borrow in low interest rate currencies and invest in assets of the countries with higher interest rates. This is the fundamental driver of the carry trade. There are a few really good books about this if you’re ever interested in studying it more in depth.

Technical analysis is the more common way for speculators to analyze markets and make trading decisions and is usually very similar for both markets. Traders use price charts and a variety of combinations of different indicators to create trading systems that allow them to take advantage of either momentum trading which is trading with the market or reversal trading which is trying which tends to be a countertrend method that trades when an instrument is overbought or oversold according to the trader’s analysis.

The real differences between buying or selling a stock or an option on a stock and buying or selling in the forex market really comes down to two major concepts: pairs trading vs individual symbols and shares(stocks) vs. contracts(forex).

First, we will discuss shares vs. pairs. Stocks trade shares of a company and forex trades in pairs. fact that forex trades in pairs which means when you take a trade in the forex market participants are trading the value of one currency versus another. When Forex is quoted, a trader will always see two currencies listed. For instance, USD/JPY or GBP/CAD with the second currency being the base currency of the pair. So, if someone is trading USD/JPY, they are making a trade based on what the US dollar will do versus the Japanese yen. The trader will go through their process of technical or fundamental analysis and makes the case that the JPY will strengthen, then they would sell the US dollar versus the Yen and take on a short position and vice versa if they believe that the JPY will weaken, the trader would buy the US dollar versus the Yen.

When a trader buys a stock however, they are buying a single company most of the time and making a trade based on whether the stock of that company will increase in value or decrease in value based on the projected performance of that company or some form of technical analysis. Which is why when you play stock trades there’s only one symbol. AMZN for example is the company Amazon. If a trade is placed to buy AMZN.

If a trader buys AMZN, they are buying and selling shares of a company. How do we get shares? Companies do an IPO which places an enterprise valuation on that company and then divides that total value into shares allowing an investor to have fractional ownership in that company. From that point on, when companies increase earnings or increase productivity the share price can go up increasing the value of the company and increasing the investors value of their ownership in that company. Forex is a little bit different in that instead of comparing a company to itself and its future performance and capabilities, you’re comparing one country’s currency to another country’s currency and most trading in the Forex market is based on technical analysis. This tends to make the forex market more volatile and more attractive to speculators and shorter-term traders whereas the stock market tends to attract long-term investors.

When trades are taken in the forex market, instead of shares a trader basically owns the actual currency. So, if you were to take a buy trade and bought a standard lot (1.0) of EUR/USD the trader would be owning $100,000 USD of real currency. By buying this contract, the trader is simultaneously buying the EUR and selling the USD. For this trade to be profitable, the EUR must gain in value against the USD. To short the EUR/USD pair would mean the exact opposite. The trader would be long the USD and short the EUR and expect the EUR to lose value against the USD.

To wrap this up, trading in forex versus trading in stocks is very similar when we simply look at the fact that we’re buying assets, be it a share of a company or a contract of a country’s currency and we make or lose money based on the movement of that asset price. The major difference comes in when we understand that forex is traded in pairs, one country’s currency versus another country’s currency and a stock trade solely based on the anticipated performance of a single company. At the end of the day though, once we learn the intricacies of shares versus pairs, it all boils down to having a sound trading strategy and becoming an expert at managing risk. 

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