Updated: Oct 25, 2021
How you invest your money, and what you invest in, are personal choices based on a number of factors: your risk tolerance, time horizon, investment skills, interests, and goals. Want to back sustainable businesses or invest in a range of industries? Stocks and ETFs might be for you. Interested in different global currencies? Forex could be calling your name.
But making these decisions can be difficult without knowledge of all the investment options that are available to you. If you haven’t considered forex trading versus stock trading before, let this article be your starting point to get to know the foreign exchange market.
What is forex?
The forex — or foreign exchange — market is an international marketplace where numerous national currencies are traded. Open 24 hours a day, five days a week, this electronic exchange connects banks, brokers, and financial institutions to facilitate more than $5 trillion in trades daily.
Through the forex market, investors can buy, sell, exchange, and speculate on currencies like the dollar, euro, yen, and more. It’s the largest and most liquid financial market in the world and trading in it offers many benefits — but also presents risks and requires skill.
Trading stocks is different from forex.
While you may already be aware of what stocks are and how they work, a refresher never hurts. A stock is an investment security that represents an ownership share in the company it’s issued by. When you purchase a stock in a business or corporation, that equity makes you a shareholder. Stocks are typically bought, sold, and traded on stock exchanges, such as the New York Stock Exchange (NYSE) or NASDAQ.
You can make a profit on stocks by receiving regular dividend payments, (if a company’s stock issues them), or by selling your shares on the stock market for a higher price than you bought them.
While some stocks are riskier than others, this type of security often makes up the majority of investors’ portfolios. Most stocks see the best performance when held for a longer period of time, as in many years, so they have time to recover from possible short-term market volatility.
Basics of Forex Trading
When you invest in foreign currency, it works a little differently. For one thing, the trades are listed in pairs. For example, in forex trading you might see EUR/USD or CAD/USD, which represents the euro (EUR) vs. the U.S. dollar (USD) and the Canadian dollar (CAD) vs. the USD, respectively.
In the pairs, the first listed currency is called the base currency, and the second is the quote currency. All forex trades involve the purchase of one currency (the base) and the selling of another (the quote).
Each pair has a bid, or buy price, which is how much of the quote currency you need for the base. So, if a pair EUR/USD had a price of 1.2500, you would need to exchange 1.25 dollars for 1 euro.
When selling a currency pair, you sell the base and receive the quote currency. For example, if you sell EUR/USD, you are technically selling euro and purchasing dollars. The price for this transaction is called the ask, and it represents how much of the quote you will get for selling a unit of the base.
Remember, when you buy or sell one currency, you’re always doing the opposite with another. You make a profit or loss on the difference between prices in the transaction.
To invest in forex, you’ll likely go through a broker, bank, or investment firm.
Pros of Trading in the Forex Market
Once you feel confident and comfortable trading currencies, you can explore the many benefits of trading in the forex market. Not only is it the largest financial market in the world, it’s also the most liquid. Its high liquidity is because buyers and sellers are constantly trading, making it easier to make trades and turn assets into cash with generally low transaction costs.
Transaction costs in the forex market are usually built into spreads, or the difference between the bid and ask price of a currency. Most brokers are compensated through this spread and many do not charge commissions.
Because the forex market is open 24 hours a day, 5 days a week (with the exception of the major traditional holidays), it also offers more flexible trading hours for investors who may not be able to trade during normal stock exchange hours.
Another advantage of the foreign exchange market is the ability to use leverage. Leverage is an investment strategy that uses borrowed capital to potentially increase the return on an investment. Typically, in U.S. stock trading, you can trade with a maximum of 2:1 leverage. But in the forex market, you can trade with 50:1 leverage — meaning you could trade up to 50 times more per dollar in your account. But, as always, keep in mind that increasing leverage also increases risk.
The forex market also offers opportunities to make a profit during market declines. Since all trades involve a purchase and a sell, you can short-sell (sell when you think an asset will decrease in value) just as easily as you can go long (buy when you predict an asset will increase in value). In the stock market, selling short is more complicated and potentially more risky.
Risks of the Forex Market
No matter if you invest in forex or stocks, there will be risk involved. One of the biggest risks in the forex market is the use of leverage. While leverage can bring in significant returns, fluctuating market conditions can result in losses far more than your original investment.
Because forex trading involves the currencies of other countries, you also face the risk of changing interest and exchange rates, as well as economic and political shifts in other nations. You could wake up one morning to find a foreign currency has dropped in value significantly overnight because of an unforeseen political issue, so it’s important to know your potential upside and downside. Having an understanding of the economies of the countries whose currencies you’re trading may be beneficial to lessen these risks.
Stocks are often the go-to investment. But when you explore new markets and investment vehicles, like foreign currencies, you may find new investing opportunities you never knew existed. While trading in the forex market takes time and skill — and the understanding that it involves significant risk of loss and might not be suitable for everyone — it also opens up new avenues to expand your investment portfolio and meet your financial goals.
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Article initially published on ally.com
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