Forex and stock market: what’s the difference?
Speaking about trading in financial markets, each type requires a particular approach from market participants. Financial markets embrace equity markets, crypto markets, Forex, and different commodity markets, including the gold market. You cannot consider one market outside others because all developments in the global economy are interrelated. The stock market situation can impact the currency rates on Forex that can influence in its turn the gold market. Opposite statements may be true as well. However, in this chapter we will expand on the foreign exchange market and stock market in an effort to figure out their advantages and disadvantages for participants (brokers, dealers, traders).
Prior to this chapter, we have already learned the basics of the currency exchange market. Now let us gain an insight into the stock market. Stock instruments or securities are traded in stock markets. A security is some evidence of ownership of assets, control over which is given to others on a permanent or temporary basis for the right to share the profit made by this capital. In other words, a stock market instrument is the document containing a legal title that can be exercised on demand. Shares, bonds, derivatives (warrants, futures, options), certificates of deposit, and notes comprise the group of securities. Let us describe briefly each type of them.
Shares are the main type of securities. They determine ownership rights of the holder for the part of the profit of a joint stock company. A shareholder posesses one’s own equity stake in the capital of a corporation. There are personal shares, share warrants, ordinary and preferred shares. The first two types are self-explanatory. Ordinary shares give the voting right at a general meeting of shareholders, and the amount of dividends paid is determined by annual financial results of a company. Fixed dividends are paid to preferred shares' holders, but they do not give the voting right. As you can see, shares entitle their holders to own the part of the capital and get profit in the form of dividends.
Bonds are debt securities. They confirm the fact of giving a cash loan to the issuer (who issues bonds in circulation) in exchange for the right to make a profit in a previously agreed way. As a rule, the profit is derived from a fixed annual interest rate of the bond issue cost or of a nominal bond cost. There are also government and corporate bonds. Government bonds are more reliable but less profitable. The corporate bonds are, on the contrary, more gainful but less reliable. As in any other case, the profitability and risk are directly interrelated – the higher the risk is, the more a holder yields.
The stock market also has its derivatives, as well as the forex market. So, stock derivatives include warrants, which are the securities that define the right to buy/sell shares under certain conditions or exchange for other shares.
Futures are standard contracts for buying/selling a certain number of shares in the future at a price fixed at the moment of making a contract. Both buyer and seller must fulfill the future's terms. In order to guarantee fulfillment of conditions, both parties must pay a security deposit, the size of which is determined by the stock market and is stored on the exchange where the transaction takes place.
Options are securities similar to futures contracts, except that they do not impose obligations on the buyer, but just give the right to buy or sell a specified number of securities at a specified price. American options can be exercised anytime between a purchase date and an expiration date. European options may only be redeemed at an expiration date. The option seller is obliged to fulfill the contract terms; that is why he/she bears a risk. Besides, an option buyer pays an option seller a premium. If an option buyer refuses to fulfill the deal terms, he/she will not get back the premium. In order to guarantee the deal terms fulfillment, a seller deposits a pledge, similar to futures security deposit. The pledge size is set by the stock exchange and stored there. In fact, the premium amount paid by a buyer is the object of option trading.
Securities also include certificates. A certificate is proof of funds depositing written by a bank. A certificate gives a depositor the right to receive a deposit amount and the accrued interest for it upon expiry of the contract. A certificate of deposit is given in case a depositor is a legal body. A savings certificate is given if a depositor is an individual.
Bills are a type of a debt instrument that gives its buyer the right to demand payment of the indicated amount upon bill expiration. There are bills of exchange and promissory notes. A promissory note is a promise of paying a certain sum, which is drawn by a debtor and given to a creditor. A bill of exchange is drawn by a creditor and must be accepted or protested by a debtor. In case of acceptance, a debtor agrees to repay the amount specified in the bill of exchange.
Now after getting an insight into financial instruments of the exchange market, let us point out specifics of such trading. Unlike Forex, the stock market has location restrictions. The place of trading is a stock exchange. Stock exchanges are located in the world’s major financial hubs; share types and market quotes may vary in different stock exchanges. However, with the Internet development stock exchanges have an opportunity to exchange their quotes fast in order to minimize the execution of arbitrage transactions. Arbitrage transactions assume a share purchase at one stock exchange with further selling on another one at a more beneficial price. Arbitrage operations are impossible on Forex, because the currency market does not have centralized location of trades.
For buy/sell operations on a stock exchange, it is necessary for a buyer and seller to find each other. Due to this fact, the number of participants of the stock exchange is limited; the share operations liquidity is much lower compared with a trade volume on Forex. You may not find a buyer for your shares on a stock exchange, thus bearing significant losses, if your shares fall dramatically. In contrast to Forex, in the stock market you can gain profit from speculative operations only through stocks appreciation. In other words, you have to buy shares at a lower price in order to sell them higher. It is impossible to sell the shares you don’t have, although there are some schemes of avoiding such restrictions. For example, one can make a fictional deal of selling securities without having them actually, with an obligation to carry out a reverse repurchase transaction – such service is provided by exchange intermediaries to private traders of the stock market.
In the stock market, you cannot take advantages of margin trading as in the forex market. You can buy shares only for available funds. The shares can be bought not only for the purpose of speculation. As it was mentioned above, shares give the owner the right for possessing a part of a company’s capital, allow taking part in voting at a general shareholders meeting and receiving dividends. That is why you can buy shares not only for further selling. In that case, such terms as "opened and closed position" and "leverage" become irrelevant.
In contrast to Forex, which works clock round, the stock market operates certain working hours. The hours are determined by work schedule of a stock exchange (typically 8 hours per weekdays). If you trade online on a stock exchange and you are not in one time zone with it – that brings some inconveniences for trading. Working hours of the stock exchange may fall on night time in your region and can make you suffer from lack of sleep. Thus, you have more opportunities to trade 24 hours on Forex.
For successful stock trading, it is not enough to use market analysis which is common on Forex. The technical and fundamental analysis can be used for forecasting dynamics of stocks, but microeconomic factors that influence the company's activity are also of great importance. To make the right decision on a buy/sell deal, you need to have access to financial statements, information about personnel changes in a company, and government orders for its products. As for foreign countries, such information is available only from foreign sources: television, newspapers, magazines, financial periodicals. Besides, this information is published in a foreign language that can be difficult for many people to understand.
Importantly, in contrast to forex financial instruments, the above-said financial instruments of the stock exchange have their own advantages, for example, the right to receive dividends for shares, opportunity to participate in the management of a company, redemption of government securities, and coupon payments on bonds. These benefits partially reduce the risk of losses while trading on a stock exchange.
In this chapter we have compared the forex market and stock market. We have found out that each of them has its own pros and cons being attractive for investors in its own way. In the next chapter, we will take a detailed look at how these markets are related and explain how forecasting one market can help in making a trading decision on another one.
Chapter 16 Forex and stock market: what’s the difference?
Forex and stock market: what’s the difference?