While foreign currency trading has the potential to make a lot of money, it also has some inherent risks like other asset classes. This section will take you through various benefits of forex trading as well as various risks associated with it. In addition, we are also going to discuss various differences between equity and forex market to help you understand the inner workings of forex market.
Pros and Cons of Forex Trading
In the previous sections, we have already covered various factors including volatility, global structure as well as size of the forex market that have all contributed to its popularity. The highly liquid nature of foreign exchange market allows investors to trade extremely large amounts without affecting the underlying exchange rate. Most of the brokers in this industry allow traders to trade at a low margin and this is the reason that traders can take big positions in this market.
For instance, a trader can create a position of US$100,000 by making a deposit of only US$1000 up front as the rest is lent to him or her by the forex broker. Easy availability of huge leverage has made this market extremely attractive for speculators. However, huge leverage offered by forex brokers should be used judiciously. It is a double-edged sword as it allows investors to make big gains while investing a small amount but it also has the potential of massive losses when the market moves against the trader.
Another advantage of foreign exchange market is that it is open 24 hours a day and there is decent liquidity for major currency pairs throughout the day. In fact, it is the only market that operates at all times. This makes it an optimal market for traders who have a busy schedule or a day job. The major trading hubs in the currency trading market are spread across various time zones which mean that a trader does not need to wait for opening or closing to trade. When markets in the east are closing, the US market opens allowing traders to transact throughout the day.
Huge leverage and 24-hour operations make forex market exciting for investors but it is also risky when compared to trading in equities. Ultra high leverage in the foreign currency trading market also means that big profits can quickly turn into huge losses and your account may be completely wiped out within a matter of minutes.
New traders in the forex market need to understand that there are a lot of players in this market and those players bring huge money with them. Huge liquidity in the forex market also means that the currency prices move sharply whenever any new information is released into the market as serious players react quickly to any significant news.
As far as the movement in currencies is concerned, these do not tend to move quickly when compared to equities but the availability of huge leverage in the spot trading market results in volatility. On the other hand, bad news can lead to huge loss of valuation in case of equities.
For instance, if you invest $1000 in the forex market and have a leverage of 100:1, you have a trading capital of $100,000. If the market moves against you by just 1%, the value of the trade will decrease to $99,000 which means that you will lose $1000. In other words, your investment is completely wiped out or you have lost 100% of your capital.
Equities market work in a different manner as most of the traders in that market do not use leverage. So, when they make a bet of $1000 in the equity market and the market moves 1% against them, they will lose only $10. Therefore, it is extremely important for beginners to understand the risks involved in the forex trading before they decide to begin.
Differences in the Forex and Equity Market
One of the biggest differences between equities and forex market is the availability of traded instruments. For instance, there are thousands of stocks available for trading in the equities market whereas only a few currency pairs are regularly traded on the forex market. Most of the forex traders trade in seven different currency pairs of which four are labeled majors including USDJPY, USD/CHF, GBP/USD and EUR/USD. The three others are labeled commodity pairs and these include USD/CAD, NZD/USD and AUD/USD. Other currency pairs are also available for trading but they are just different combinations of these currencies and are known as cross currencies. Limited number of traded instruments in the forex market makes it easier to follow as compared to choosing gems in equities with more than 10,000 options. The only thing forex traders need to do is to keep up to date on political and economic news of eight countries.
Another major difference between these markets is that there is often a lull in the equities market that leads to low volumes and activity. This makes it hard for traders to open and close positions when they desire. Also, it is extremely difficult for an equities investor to make money in a declining market. Short selling equities in the US equities market is a difficult process as there are a number of strict rules and regulations governing this process.
On the other hand, a trader can easily make money in the forex market with both rising and declining currencies. In forex, buying and selling happens simultaneously which means that short selling is an inherent feature of forex trading. Also, huge liquidity in the forex market means that traders do not need to wait for the rates to move up before shorting as is the case with equities market.
Extreme liquidity in the forex market also ensures high leverage and low margins. On the other hand, equities market cannot offer such low margin rates. In fact, investors typically need to deposit at least 50% of the value of the trade with their broker before they are allowed to trade on margin. Most of the forex traders can trade up to 100 times their investment.
Forex market also has much lower commissions as compared to the equities market. In case of equities, traders often need to pay a commission fees to the brokers in addition to the spread along with the fees to the exchange. On the other hand, brokers make their money only from the spread in the spot forex trading market and there are no other fees.