The foreign currency market (“forex”) has a lot in common with the stock market. Both are speculative ways of investing, meaning that they offer higher risks and higher rewards than many other assets. Both markets move faster than many other investments, and like most investments, both have grown with rise of online investment platforms. These products are by no means the same thing, but for all their differences they have a surprising amount of overlap. A financial advisor can help you decide whether forex would be a wise addition to your investment portfolio.
What Are Stocks?
Stocks are equities.
What this means is that when you buy a stock, you are buying a fraction of ownership of the company which issued it. Buy a share of Google stock and you literally own a piece of Google. That fraction is generally near-infinitesimal. Large companies will typically issue millions, if not billions, of shares of stock. A single share of stock in a company like this will mean that you own one-one billionth of the overall firm.
Put together enough of those equities, however, and you can take a serious stake in the overall company. (In fact, in very simplified terms, this is what a corporate takeover is. If a company has released enough of its value on the open market in the form of publicly traded shares, then you can buy a plurality or even outright majority ownership of the company on the open market.)
A company determines how much of itself to offer in the form of stock. It also chooses how many shares to offer. Together, these two decisions help determine the value of each share. For example, a company may choose to release 1,000 shares of stock worth 20% of the company. In that case, each share of stock would be worth 0.2% of the total firm. The company itself would keep the 80% of ownership that it did not sell.
A stock can come in many different forms. The most common are private vs. public shares. Publicly traded stock is available on a market to consumers at large, meaning anyone who can legally invest in the financial markets. It has no specific restrictions. Privately traded stock is available only to specific investors. Typically a company will trade privately when it has not undergone the rigorous oversight that the SEC requires for a publicly traded firm.
Stocks can be traded in any forum, including in private deals. However, most stocks are sold on dedicated exchanges which list prices, volumes and other critical information.
The main value from stocks is what’s known as “capital gains.” This means that you sell the stock for more than you paid to buy it. In addition stocks can pay dividends, which means that the company pays a share of its corporate earnings to the shareholders that collectively own the firm. Finally, stocks can come with voting and other corporate governance privileges. The exact details of what a stock offers in terms of dividends and governance privileges are determined by the company when it releases the stocks.
A company can even offer multiple different types of stock with different access to dividends and governance. This is typically known as offering “classes” of stock (such as Class A, Class B and so on).
What Is Forex?
Forex, short for foreign exchanges, is the market for global currency. The currencies of every different global economy trade against each other at different rates. For example, at time of writing the U.S. dollar was worth 0.83 euro. This means that if you give a bank $1, you will receive 0.83 euros in exchange. If you give the bank 1 euro, you will receive $1.21 U.S. These exchange rates change constantly based on changing rates of global demand. For example, if an economy’s exports or tourist sector start booming, their currency will gain value as people look for ways to buy things from that economy. (If you want to visit Thailand, you need baht to spend on food and hotels. The more people who want to go to Thailand, the greater the demand for baht.)
The same is true as investors seek opportunities among the markets of different economies. (If you want to buy London real estate, you will need pounds to make that transaction.) Banks, meanwhile, need reserves of different currencies in order to meet the needs of spenders, savers and investors.
While an in-depth explanation of currency fluctuation is beyond the scope of this article, changing demand among economies is the short answer.
The profits of forex are expressed entirely as capital appreciation (or gains). You hope to ultimately sell your currencies for more than you paid to buy them. This happens when your foreign currency holdings gain value relative to the currency in which you do your banking.
For example, an American investor will do their banking and pay their taxes in U.S. dollars. As a result, this is the currency that defines their trading. When they buy foreign currencies, they’re hoping that the currencies they buy will gain value relative to the dollar.
When you invest in forex, you are literally exchanging one currency for another. Your goal is to hold a currency until it gains value against the currency you want. To understand that, we’ll look at an example in practice:
Current Holdings: $10,000 USD
Exchange Rate: USD 1 / EUR 0.83 || EUR 1 / USD 1.20
When we open our position, $1 U.S. will get you 0.83 cents in euros. We exchange $10,000 for 8,300 euros.
Current Holdings: 8,300 EUR
Exchange Rate: USD 1 / EUR 0.85 || EUR 1 / USD 1.176
The market moves and the dollar gains value against the euro. One dollar U.S. buys more euros, which means that one euro buys fewer dollars than it used to. If we exchange our money now, we would trade 8,300 euros and receive $9,760 USD.
So we don’t make any trades right now, since we would lose money relative to our original position.
Current Holdings: 8,300 EUR
Exchange Rate: USD 1 / EUR 0.81 || EUR 1 / USD 1.234
First of all, 1/0.81 is a fun number. It divides to 1.234567901234568.
The market moves and the euro gains value against the dollar in a fun way. Now, one euro buys more dollars. If we exchange our money now, we would trade 8,300 euros and receive $10,242 in return.
We make this trade and earn $242 in profit.
How Do They Compare?
Perhaps the biggest similarity between forex and stocks is their role in your investment portfolio. Stocks and the currency markets are both speculative assets that come with high risk and high reward. As an investor you should use these assets accordingly. Use money that you can afford to lose, to be sure, but don’t ignore the potential for strong gains.
Both stocks and forex tend to move much faster than other assets, with values changing constantly over the course of the day. However, foreign currencies are a much faster market. Investors can hold individual stocks for months or years, while it’s rare to hold currencies for more than a few hours or days. This makes currencies a far more liquid, and therefore more volatile, asset than stocks.
Currencies are also a much more complicated market than stocks. Currency prices are influenced by an enormous number of factors, to the point where the market can seem to move at random. Investors make money in the long run, but it’s difficult.
Finally, you generally need much more capital to trade on the currency market. Most fluctuations in this market move by pennies or fractions of a penny. As a result, you need to invest large amounts of money in order to make meaningful gains. Both stocks and currencies follow the basic rule that the more you invest, the more you can gain (and lose). However, currencies almost require large up-front investments.
The forex market is generally not a good investment strategy for novice and retail investors. It is very technical, difficult to understand and high risk. You can lose thousands of dollars in the space of a few hours. While there’s nothing wrong with trying this market out if you have money you can afford to lose, be very careful before investing a meaningful segment of your portfolio.
The Bottom Line
Forex is an over-the-counter or global decentralized market for foreign currencies. Traders can buy and sell currencies or exchange one currency for another. This market, which operates 24/7 and is a floating-rate market, makes international trade more efficient. It is much more volatile and complicated than the stock and bond markets. In one sense, all American stock and bond investors are affected by the forex market. That’s because U.S. securities are denominated in greenbacks, which is a type of currency.
Tips on Investing
Adding forex to your portfolio can dramatically boost returns, but there are many ways to do that. Some of those ways could be damaging to your investments. Consider working with a financial advisor about how to make such a move. SmartAsset’s matching tool can help you find a financial professional in your area to help you find these answers. If you’re ready, get started now.
If your investments pay off, you may owe the capital gains tax. Figure out how much you’ll pay when you sell your holdings with our capital gains tax calculator.
Forex trading is absolutely not a good choice for novice investors. It is one of the highest-risk segments of the market, incredibly complicated and fast paced at the same time. However, if you have a good handle on investing and some money you can afford to risk on these volatile assets, there are several outstanding online brokerages for new traders in the forex market.
Photo credit: ©iStock.com/baona, ©iStock.com/narvikk, ©iStock.com/welcomia
The post Forex vs. Stocks: Key Differences appeared first on SmartAsset Blog.
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