FX Advantages Over Stocks and Futures – A Comprehensive Guide
Table of Contents
|Largest and most liquid market in the world||Liquidity dependent on stock’s daily volume||Liquidity dependent on month of traded contract|
|Execution Speed||Minimum slippage & order errors||Less liquidity, more room for slippage and error||Less liquidity, more room for slippage and error|
|Hours of Operation||24-hour trading action for 5.5 days a week||Less than 7 hours trading time per day||Less than 7 hours trading time per day|
|Costs||Can be low spread and no commission on many pairs||from $3 (for electronic) to $10-30 (all others)||from $5 (for electronic) to $15-$50 (all others)|
|Can profit in both bull and bear markets||Most people buy stocks instead of short-sell||Tend to have extended bearish periods|
|Can short-sell anytime||Restrictions on some traders & stocks||Trading restricted by limit up/down rule|
|Leverage||In US, 50:1; elsewhere from 50:1 to as high as 1000:1||up to 2:1 leverage||up to 30:1 leverage|
|Small min open & margin, generally: $50 for micro and $500 for mini accounts||Need > $500 for cash accounts; > $2000 for margin accounts||Open >$4000|
|Flexibility of Position Sizing||Flexible position sizing: 0.01 (10 cents/pip) to 0.1 ($1/pip) to 1 ($10/pip)||inflexible position sizing: 100+ shares, multiplied by the stock value||inflexible position sizing: 1 contract = fixed & potentially over-leveraged trading|
Let us look at the above advantages in a bit more in detail.
Larger Size & Liquidity Advantage
The Forex market has an overwhelming advantage over other markets in terms of liquidity: with an estimated daily trade volume of over 4 trillion dollars, it is over 100 times larger than all stock-exchanges combined. There are three major advantages conferred by such tremendous liquidity:
- Trade executions are instantaneous;
- Price certainty is obtained with very little slippage;
- No one entity can control or move the market.
Because of its massive liquidity and internet-based platform (no exchanges, no open-outcry pits, no floor brokers), fast order execution and instant fill confirmation are routine. You might have to absorb some slippage if you trade during news announcements or if you trade a high volume, but usually you can execute all the prices on your broker platform as they are displayed. Most brokers provide instantaneous trade executions from real-time quotes. Some of the more popular stocks and futures have moved to electronic platforms and exchanges, which greatly increase their own execution speed, but they are still vulnerable to the dramatic fluctuations of liquidity throughout their trading day and slippage and partial fills are common.
In stocks and futures, there are possibilities of larger participants stepping in or stepping away, causing the market to spike or crash. A recent example of large participants stepping away from the stock market was the “flash crash” of Thursday, May 6, 2010, where High-Frequency (HF) traders stepped away and liquidity disappeared. The crash lasted a few minutes, with the Dow Jones falling 1000 points (the biggest one-day point decline in DJ history) before bouncing back later in the afternoon. A recent example of large participants stepping in to the futures market to manipulate it dangerously upwards was the 2008 “food bubble”: Goldman Sachs (and its Commodity Index innovation for raising and leveraging speculative money) overwhelmed the actual supply and demand of wheat with hundreds of billions of new dollars, creating a virtual “demand shock” when there was plenty of supply (2008 was a bumper harvest for wheat), which drove the price of wheat and other food commodities 80% to unprecedented levels, making Goldman and a few already rich investors richer at the expense of the real world values of food being made hyper-expensive for the world’s poor, sparking food riots in more than thirty countries and increasing the ranks of the hungry by 250 million in a single year (The Food Bubble).
Because of the massive liquidity of Forex, there is no entity that has the dollar size to move the market either up or down, and so price manipulation is rather non-existent. However, combined actions may occur in which several of the major participants, such as central banks, force the market in a certain direction, but this is an exception to the rule. In the world of stocks, there are many times when large participants acting in concert can trade up or down a market in their favor, and there are other times when participants can act illegally or amorally to manipulate certain stocks: forming pools, churning trades, creating rumor runs, ramping the market, washing trades and forming bear raids.
24-Hour Global Trading Advantage
In Forex, there is the opportunity to trade around the clock, 24 hours a day except weekends i.e. trading from 20: 15 GMT on Sunday until 22:00 GMT Friday. This 24-hour trading is possible because the markets around the world open and close at different times:
|Time Zone||New York||GMT|
|Tokyo Open||7:00 PM||0:00|
|Tokyo Close||4:00 AM||9:00|
|London Open||3:00 AM||8:00|
|London Close||12:00 PM||17:00|
|New York Open||8:00 AM||13:00|
|New York Close||5:00 PM||22:00|
With the ability to trade during the Asian, U.S., and European session hours, you can customize your trading schedule. You can work a little or a lot, trade in the day or night, and pick the time that is more comfortable for you or your strategy.
Generally speaking, the stocks and futures markets are tradable at specific hours of the day, usually during the working hours of their respective exchanges located in NYC (9-5 EST) or Chicago (8-4 CST), each one lasting less than 7 hours. Outside of these hours, called pre or after-market hours, one might still be able to trade in some electronic exchanges, but the volume and liquidity has dramatically tapered off, making trading opportunities more risky due to increased slippage. Because volume is a little better during the exchanges working hours, it is commonly advised to trade during the working hours of New York (for US stocks) or Chicago (for Futures). Added to this constraint, traders have to deal with the problem of price gaps occurring because of the frequent closing and opening of their markets and the consequent difference (or gap) in prices between close and open, especially during overnight news announcements: For example, if the price of a share reaches a low of $35 on Monday and opens at $30 on Tuesday, that is a $5 downward price gap, good for the short traders who held their positions overnight, but dangerous for the long traders. These gaps in price can also be problematic for plotting one’s technical analysis because all indicators and oscillators become skewed on these gaps.
Long/Short Flexibility: Can Profit From Both Bull And Bear Markets
Some traders, especially those who only trade stocks, think that they can only make money when a market goes up. In the FOREX market you have opportunities to make money when the market goes up or down. When you think the market is going to go higher you go long (buy) and when you think the market is going down, you go short (sell). There have been some traders that always favor the market to go up, and other traders who always expect the market to go down. It is best to be able to trade the market either way since that is what markets do, which affords more opportunities. The money you make or lose is counted the same way. It is the difference between what you paid and what you sold the currency for. Whether you sell first and buy later, or do it the other way, does not matter.
Since there are numerous currencies that can be traded, there are almost always some volatile moves. It does not matter if the news is good or bad because we can, and will, be able to trade them both. Floods, famine, drought, wars, political change and corruption, as well as economic activity, or lack of, interest rates, inflation, and deflation all have an impact on the relative value of two currencies. There may be differences of opinion just what the impact upon the currency might be, but there will always be some volatility.
It is also possible with currencies, and with some brokers that allow it, to trade long and short the same currency at the same time, called hedging. Hedging capabilities can have a couple of advantages, one more distinct than the other. One obvious advantage is that it can allow the customer to decide whether to close a trade or offset the trade to reduce risk. However, this becomes less an advantage when you consider that whether you close a trade or offset it with another in the opposite direction, the profit and loss is exactly the same, and you pay twice as much spreads because you made two trades. A more interesting advantage of hedging is that you can play multiple strategies in the same account, on the same currency, and because at times your one strategy might be long when the second initiates a short, you do not want to be forced to close your long strategy position when it has not yet completed its maneuver, nor do you want to restrict the second from entering into its position. You want to allow both the long and short positions to enter and exit their setups on their own terms, without outside interference from anti-hedging laws. Also, some strategies or EAs depend on the ability to hedge or partially hedge as an integral facet of their success and profitability, and so a trader wanting to work with such EAs should seek out a broker with hedging capabilities.
Forex Short-Selling Advantage
In Forex it is just as easy to take a short position as it is to take a long one. Since currencies are traded in pairs, each currency being priced in terms of another, short selling on a currency pair is identical to going long on the stocks.
But in the stock market there are restrictions imposed on selling short. In the U.S., short sellers were blamed for the Wall Street Crash of 1929 and so government regulations were imposed to ban short sellers from selling shares during a downtick, which was known as the uptick rule (which prevents traders from shorting a stock unless the immediately preceding trade was equal or lower than the price of the short sale). That rule was in effect from 1938 till July 3, 2007, when it was removed by the SEC (SEC release No. 34-55970). Recently, in Sept 2008, short selling was seen as a contributing factor to the market fall, and it was banned by the SEC for 799 financial companies for three weeks in an effort to stabilize those companies. Even without government regulatory restrictions, not all stocks are available to be shorted, the broker has to inform you which ones are, and even then, not all investors have the margin eligibility to borrow from their broker to short a stock.
In stocks, it is also important to note that selling short carries more risk than trading long. In going long, losses are limited (the price can only go down to zero), but gains are unlimited; in short-selling, this is reversed, possible gains are limited (the stock can only go down to a price of zero), and the seller can lose more than the original value of the share, for there is no upper limit. Short sellers must also be aware of the potential for a short squeeze.
Low Transaction Costs
When trading FOREX, the costs are minimal. Most brokers do not charge commissions, but rather, keep the width (called “spread”) between the bid and ask prices, which can be quite small in the major currency pairs, ranging from 2-5 pips. When they do charge commission, as with an ECN broker, the trader often receives an overall lower transaction cost because of the greatly reduced spread.
Stocks and futures, in contrast, charge commission on every trade, and frequent trading can become quite expensive. Discount online brokers have entered in of late to competitively reduce commissions in dramatic ways relative to regular brick and mortar brokers (charging as low as $4 per stock trade instead of $20, for instance), but even their much lower commissions cannot compete with the competitive spread / commission pricing of forex brokers.
Interestingly enough, because the transaction cost of Forex is pro rata to the lot size used, it is also more fair and consistent. For instance, if you traded 1 micro lot of GBPUSD with a spread of 4 pips, your transaction cost would be only 40 cents (4 pips X 0.10 cents). That’s it. Any transaction of stocks or futures, even at the smallest sized transaction, would have to be at minimum 100 times that amount (min $4), and then you would only get that “fair” cost at a deep discount online brokerage.
Low Minimum Account Opening
A huge advantage of Forex is that you don’t need a massive amount of capital to start trading. Most brokers will allow you to open an account and start trading with less than $500 USD, with many allowing for as little as $50.00. Thus forex is well suited for the smaller capitalized trader.
Compare this low capitalization requirement to the virtual fortunes one needs to trade stocks or futures. They allow you open up accounts with as low as $2000, but because of the fixed position sizing and inflexible leverage options, you would be taking on a much greater risk trading with this minimum account size. It would be safer to trade with greater than $10,000 with stocks or $100,000 with futures, as we shall see below.
Flexible Leverage And Lot Sizes
Both stocks and futures markets require sizable initial deposits to safely trade them, given their fixed leverage and lot sizing.
In the stocks market, because most brokers only allow you to purchase blocks of 100 shares, you would need a large initial account size to safely trade stocks that are priced at $25 or more. For example, since most brokers only allow one to purchase blocks of 100 shares, if you buy 100 shares of ABC Company for $50 per share, you would need $5000 ($50X100) to trade that company. At 1:1 leverage (without borrowing), any drop in the stock’s price by 10 dollars would represent a loss of 20% of your position ($10X100=$1000). And if you borrow on margin, at 2:1 leverage, putting up $2500 in order to purchase the stock, then if the stock falls 10 dollars from $50 to $40, you would have lost $1000 of your $2500 initial (which would represent a 40% loss), and a further drop in price would risk getting a margin call from your broker to put more securities or cash into the account to restore the 50 percent balance.
In the futures markets, leverage is significantly higher than stocks, and because lot or contract size is also fixed, this greater leverage magnifies the danger and thus necessitates much large account sizes to safely trade it. For example, one futures gold contract (of $4000 margin) controls 100 troy ounces; thus, if gold is trading at $1200/ounce, the value of the contract is $120,000 ($1200 X 100 ounces), which makes it 30:1 leverage. In terms of points, 1 point = $100. Because the contract is fixed with that large leverage and point value, you are stuck with a dangerous and inflexible leverage. You would need an account many times larger than your margin in order to withstand gold’s weekly vacillation of 100 points (100 points X $100 = $10,000). If gold moved against your position, your $10,000 could be evaporated in a couple days. If a futures trader wanted to trade with less money and risk, his only option would be to trade the gold mini contract (33.2 ounces instead of 100; 1 point = $33) at the e-CBOT exchange, which would reduce his leverage and risk by a third, though a 100 point move against his position would still represent a sizable $3000 damage. Futures traders of mini gold contracts would need over $50,000 to be able to withstand a series of losing trades.
With both flexible leverage AND flexible lot sizing, Forex can be opened up with much small initial capital amounts and be safely traded with small lot sizes. For instance, if you had only $1000 to invest, you would open up a micro brokerage account with 200:1 leverage, and though you could potentially trade 200 times your capital, or 2 standard lots (1 standard lot = $100,000; 2 standard lots = $200,000), the smarter thing to do would be to trade the minimum lot size, 1 micro lot (0.01 =$1000), which would in effect be using zero leverage. Yes, zero leverage. The reason for this is that currencies generally vacillate 100 pips or more, and one can more easily handle a 100 pip move against your position by having already decreased the value of the pip through lot sizing. Because 1 pip using a standard lot equals $10, then a 100 pip adverse move would represent a $1000 loss (wiping out all your account if you were dumb enough to employ such leverage!). However, if you used a 0.01 lot size (1 pip using a micro lot costs $0.10), then a 100 pip adverse move would represent only a $10 loss (just a scratch, a minor 1% loss of your account). In this scenario, you would be able to withstand a series of losing trades and still be in the game, unlike in futures markets where your account would have already blown up. The potential leverage of 400:1 can then be put in reserve in cases of exceptional opportunity or emergency, as we will discuss in other sections.
FX Advantages In Sum
Forex allows you to execute fast and accurately (within a tremendously liquid environment), trade 24 hours in long and short directions with low spreads and/or commissions, with the potential of using very safe and flexible starting amounts, lot sizes and leverage. Stocks and futures, in contrast, have a far more limited trading window in terms of trading hours and direction, with far more possibilities of execution delay, slippage and price manipulation, trades can be costly in terms of commissions, and more risky in terms of their fixed starting amounts, lot sizes and leverage.