Forex vs Stocks - Key Differences

Adam Lemon

The object of any type of trading is to make as much money as possible. When looking for assets to trade, too often traders don’t give much thought to where they’ll have the best opportunity for profit. They don’t adequately evaluate whether stock trading or Forex trading is a better option, they tend to just decide randomly, and then pursue it. However, it’s a good idea to think seriously about whether stock or Forex trading is more suited to your investment style and your financial goals – and decide whether it is better for you to trade Forex or stocks.

 

What is Forex?

Forex stands for “foreign exchange” and describes the market in which one currency can be exchanged for another. Most currencies today are traded freely in the open market, although all are subject to government or central bank manipulation as governments and central banks control the supply of currency and can create new currency out of nothing whenever they want to. There is no centralized market for Forex, and the market is dominated by central banks and four large banks. Foreign exchange is the largest market in the world, with approximately $4 trillion of currencies exchanged every day on average. Liquidity is excellent in the major currency pairs, especially during the London / New York sessions overlap, although there was an incident in 2015 lasting about an hour when it was impossible to exchange a Swiss franc, showing that even a relatively major currency is not guaranteed liquidity. More than half of all transactions by volume in the Forex market involve the U.S. dollar, which is by far the most important currency in the world..

The major market influences on Forex are central bank or government monetary and economic policies such as interest rates and asset purchase programs, as well as supply and demand for the various currencies.

What are Stocks?

Stocks are shares of ownership in companies. Almost all countries have a major stock exchange which organizes and regulates trading in the stocks of the largest and publicly quoted companies. Shares in publicly quoted companies must always be traded through centralized exchanges, therefore unlike in Forex, volume data is always available.

Trading on major stock exchanges is usually highly liquid although less so than in major Forex currency pairs. Occasionally dramatic events happen concerning a single company and liquidity can dry up or trading might even be suspended for a while. Deeper and smoother liquidity can usually be found trading indices based upon large numbers of stocks, such as the S&P 500 Index.

Although publicly quoted stocks are highly regulated, short-term market manipulation is more common in stocks than in Forex (despite being illegal in the stock market) due to smaller volumes and number of key buyers and sellers. A stock’s price will be influenced to a large degree by the financial health and anticipated future revenue stream of the individual company but can also be strongly affected by wider economic conditions in which a rising tide can lift even shaky boats, or vice versa.

Why Trade Forex Instead of Stocks?

There are two ways to trade stocks with the best stockbrokers. You can buy or sell actual stocks at a stockbroker, or you can trade CFDs with CFD brokers (contracts for differences) based upon underlying stocks. The latter tends to be the option offered by retail Forex and CFD brokers.

If you do not have at least $10,000 to deposit, then it will probably make financial sense to trade stocks using CFDs. However, the total spread plus commission charged on a Forex trade is much lower than the equivalent trade in an individual stock CFD. As I researched this topic, I checked the advertised spread at a well-known retail Forex brokerage for EUR/USD and a CFD based upon Glencore PLC, a publicly quoted company on the FTSE 100. The spread for EUR/USD represents about 0.02% of the instrument’s value, while the spread for Glencore represents 0.23% of its value. That is a large difference in trading cost.

There is also the question of overnight financing at non-Islamic Forex or CFD Brokers. Typically, the interest charged in holding a Forex currency pair overnight might amount to about 3% of the position’s value if it were held for a period of one year. With stock CFDs, the interest charged is typically a little higher. If you are buying real stocks, you will not pay any overnight interest. CFD brokers often (but not always) pay dividends though, just as you would receive if you owned the underlying stock directly.

There is no doubt that the costs of trading stock CFDs with retail brokers are significantly higher than the costs involved in trading Forex.

In summary, there are three major reasons why it might make sense to trade Forex instead of stocks: firstly, Forex tends to give superior risk-adjusted returns to competent traders; secondly, much higher leverage is available in Forex than in stock trading; thirdly, executing “real” stock trading requires a higher amount of capital than Forex trading does.

Forex vs. Stock Market

It makes sense to trade something where the price is going to fluctuate by a lot. After all, you need the price of something to move significantly to make any profit buying and selling it. The easiest way to make money is by trading something where the price goes straight up or straight down, although of course it is rarely as straightforward as that.

In this respect, stock trading typically offers much better opportunities than major Forex currency pairs, no matter how well you understand Forex trading basics. To prove this, see the below table showing the maximum annual absolute percentage value movements in the EUR/USD currency pair and the world’s greatest stock index, the S&P 500 Index, over the last fifteen years:

 

S&P 500 Index

EUR/USD

2005

12.29%

13.78%

2006

17.42%

12.16%

2007

15.54%

12.74%

2008

49.46%

23.13%

2009

68.23%

21.58%

2010

25.34%

21.56%

2011

22.20%

13.26%

2012

17.20%

10.71%

2013

31.61%

9.02%

2014

18.64%

13.54%

2015

14.20%

11.99%

2016

25.82%

10.88%

2017

20.04%

16.95%

2018

20.21%

10.67%

2019

32.90%

5.97%

2020

71.55%

15.74%

Average

28.92%

13.98%

We can see that from 2005 to 2020, on average, the S&P 500 Index has moved by slightly more than double the range of the EUR/USD currency pair. The EUR/USD moved by a greater range than the S&P 500 Index in only one of those sixteen years (2005). Additionally, individual stocks can move much more than their Index will. So, it is obvious that much more profit is potentially available when you trade stocks than in trading Forex, on an unleveraged basis.

One extremely important difference between the Forex market and the stock market is that stock markets have a long-term long bias – the price of the market overall will go up over time. Traders and investors can attempt to exploit stock markets by sailing in the direction of the prevailing wind: long. In Forex, the market is directionally neutral, typically reverting to a mean even if it takes a few years to happen. This important difference means that trading Forex and trading stock markets successfully requires you to be more focused on trading long in the stock market while being neutral on long or short trading in the Forex market.

Stock Leverage vs. Forex Leverage

How much leverage can and should be used is a very important question for retail traders. Let’s start by looking at stock trading, taking the example of the U.S. Securities and Exchange Commission. If you are purchasing real stocks from a licensed broker, your maximum leverage at the end of the day you buy the stock is 2:1. You must put up at least half of the cost. If you are selling stocks short, the rules range from slightly over 3:1 to 1:1 depending upon the price of the stock. You will pay something like an annualized interest rate of 4% (typically calculated as LIBOR plus 2.5%) on the leverage, meaning that the stock must move by at least 4% in value per year on average for the leverage to be worthwhile.

Of course, retail brokers offering CFDs that are based upon the price of the stock are far more generous with leverage, but generally the leverage they offer in Forex trading is even more generous. Typically, a Forex broker might offer a maximum leverage of 100:1 on Forex currency pairs in offshore centers (capped at 30:1 in Europe and Australia), but only 20:1 on individual stocks. This means you can potentially profit five times as much on a Forex movement than you can on a stock movement, on a like for like basis.

Differences Between the Forex and Stock Markets

If you are looking to hold trades for a long time, buying well-chosen individual stocks at the start of a strong bull market is probably the most profitable approach that can be made. However, if you can only afford a retail CFD broker, the cost of holding the position for a long time is likely to be considerable, and if you are over-leveraged, any strong adverse movements – which are common in stocks – could be frightening and costly.

Forex tends to be less volatile, and less manipulated by high-frequency trading algorithms. Due to the lower cost of frequent trading and higher leverage, if you are going to be day-trading, it is probably easier to day trade Forex than stocks. It should also be considered that there are no “short” positions in Forex, and short positions in stocks can be subject to restrictions. Forex markets are also open 24 hours per day during the week, unlike the stock market, and brokers often shut down their stock markets meaning you can be stuck in a position with no effective stop loss overnight if you hold a position that long.

Bottom Line

If you have a lot of money, i.e., a large 5-figure amount in U.S. dollars, and you have a long time horizon, you will probably be able to make maximal profit by buying real stocks through a stockbroker you could find in our stockbroker reviews in a strong bull market. At this level, the commission/spread is much more reasonable because it is a fixed dollar amount.

If your account is smaller and you are looking to trade on shorter timeframes or just to day trade, then you will probably have a better chance trading Forex through a broker you could find in our listing of our best Forex brokers. However, if you have done research and really favour a few individual stocks in a bull market, you can probably benefit from short-term holdings of these stocks, but you should be very careful in managing your total exposure.

FAQs

Is Forex riskier than stocks?

Forex, especially involving the major currencies, is generally much less volatile than stocks, so it is less risky. It is possible to trade Forex with much higher leverage than stocks, which unfairly gives Forex trading a risky reputation.

Is Forex trading better than trading stocks?

Forex trading has historically offered better risk-adjusted returns than trading stocks has. Whether trading Forex or stocks is better for you will depend upon your trading style, personality, fundamental approach towards investing, and available funds you are able to risk.

Are stocks or Forex more profitable?

Major stock markets usually fluctuate in value by about twice as much as major Forex currency pairs, indicating that profits are generally easier to obtain in the stock market. However, relative to risk and trading style, there may be little difference between these two asset classes.

Adam Lemon

Adam Lemon began his role at DailyForex in 2013 when he was brought in as an in-house Chief Analyst. Adam trades Forex, stocks and other instruments in his own account. Adam believes that it is very possible for retail traders/investors to secure a positive return over time provided they limit their risks, follow trends, and persevere through short-term losing streaks – provided only reputable brokerages are used. He has previously worked within financial markets over a 12-year period, including 6 years with Merrill Lynch.
Learn more from Adam in his free lessons at FX Academy

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