In this section, we'll take a look at some of the benefits and risks
associated with the forex market. We'll also discuss how it differs from
the equity market in order to get a greater understanding of how the
forex market works.
The Good and the Bad
We already have mentioned that factors such
as the size, volatility and global structure of the foreign exchange
market have all contributed to its rapid success. Given the highly
liquid nature of this market, investors are able to place extremely
large trades without affecting any given exchange rate. These large
positions are made available to forex traders because of the low margin
requirements used by the majority of the industry's brokers. For
example, it is possible for a trader to control a position of US$100,000
by putting down as little as US$1,000 up front and borrowing the
remainder from his or her forex broker. This amount of leverage acts as a
double-edged sword because investors can realize large gains when rates
make a small favorable change, but they also run the risk of a massive
loss when the rates move against them. Despite the foreign exchange
risks, the amount of leverage available in the forex market is what
makes it attractive for many speculators.
The currency market is
also the only market that is truly open 24 hours a day with decent
liquidity throughout the day. For traders who may have a day job or just
a busy schedule, it is an optimal market to trade in. As you can see
from the chart below, the major trading hubs are spread throughout many
different time zones, eliminating the need to wait for an opening or
closing bell. As the U.S. trading closes, other markets in the East are opening, making it possible to trade at any time during the day.
| Time Zone |
Time (ET) |
| Tokyo Open |
7:00 pm |
| Tokyo Close |
4:00 am |
| London Open |
3:00 am |
| London Close |
12:00 pm |
| New York Open |
8:00 am |
| New York Close |
5:00 pm |
While
the forex market may offer more excitement to the investor, the risks
are also higher in comparison to trading equities. The ultra-high
leverage of the forex market means that huge gains can quickly turn to
damaging losses and can wipe out the majority of your account in a
matter of minutes. This is important for all new traders to understand,
because in the forex market - due to the large amount of money involved
and the number of players - traders will react quickly to information
released into the market, leading to sharp moves in the price of the
currency pair.
Though currencies don't tend to move as sharply
as equities on a percentage basis (where a company's stock can lose a
large portion of its value in a matter of minutes after a bad
announcement), it is the leverage in the spot market that creates the
volatility. For example, if you are using 100:1 leverage on $1,000
invested, you control $100,000 in capital. If you put $100,000 into a
currency and the currency's price moves 1% against you, the value of the
capital will have decreased to $99,000 - a loss of $1,000, or all of
your invested capital, representing a 100% loss. In the equities market,
most traders do not use leverage, therefore a 1% loss in the stock's
value on a $1,000 investment, would only mean a loss of $10. Therefore,
it is important to take into account the risks involved in the forex
market before diving in.
Differences Between Forex and Equities A
major difference between the forex and equities markets is the number
of traded instruments: the forex market has very few compared to the
thousands found in the equities market. The majority of forex traders
focus their efforts on seven different currency pairs: the four majors,
which include (EUR/USD, USD/JPY, GBP/USD, USD/CHF); and the three
commodity pairs (USD/CAD, AUD/USD, NZD/USD). All other pairs are just
different combinations of the same currencies, otherwise known as cross
currencies. This makes currency trading easier to follow because rather
than having to cherry-pick between 10,000 stocks to find the best value,
all that FX traders need to do is "keep up" on the economic and
political news of eight countries.
The equity markets often can hit a lull, resulting in shrinking
volumes and activity. As a result, it may be hard to open and close
positions when desired. Furthermore, in a declining market, it is only
with extreme ingenuity that an equities investor can make a profit. It
is difficult to short-sell in the U.S.
equities market because of strict rules and regulations regarding the
process. On the other hand, forex offers the opportunity to profit in
both rising and declining markets because with each trade, you are
buying and selling simultaneously, and short-selling is, therefore,
inherent in every transaction. In addition, since the forex market is so
liquid, traders are not required to wait for an uptick before they are allowed to enter into a short position - as they are in the equities market.
Due to the extreme liquidity of the forex market, margins
are low and leverage is high. It just is not possible to find such low
margin rates in the equities markets; most margin traders in the
equities markets need at least 50% of the value of the investment
available as margin, whereas forex traders need as little as 1%.
Furthermore, commissions in the equities market are much higher than in
the forex market. Traditional brokers ask for commission fees on top of
the spread, plus the fees that have to be paid to the exchange. Spot
forex brokers take only the spread as their fee for the transaction.
(For a more in-depth introduction to currency trading, see
Getting Started in Forex and
A Primer On The Forex Market.)
By
now you should have a basic understanding of what the forex market is
and how it works. In the next section, we'll examine the evolution of
the current foreign exchange system.
