Ease of Access to the Market
Over the past decade the foreign exchange market has become considerably more accessible to the individual investor. Anyone with a small amount of capital can now trade G-20 currencies 24 hours per day 5 day per week at a cost that approximates institutional pricing. However, the point and click ease of use of foreign exchange trading masks the complexities and differences between currencies and other more common financial instruments such as equities.

First and foremost unlike stocks, currencies do not trade on a centralized exchange like the NYSE, the LSE or the ASX. The currency market is transacted over the counter, meaning that investors trade directly against their broker/dealer, which typically makes its money from charging the bid ask spread. Therefore in FX unlike in equities it is much harder for individual investors to buy on the bid and sell on the ask because they do not have direct access to the order book. Over the past few years innovation has spawned the creation of new ECN like products in FX that approximate the open book nature of equity trading, but that segment of the market remains small and often comes with significant barriers to entry such as requirements for larger account size in order to access it.

No Minimum Requirements for Daytrading
One of the key differences between currencies and stocks is the massive amount of leverage in the FX market. Typical margin in equities is 2:1 which is expanded to 4:1 for pattern day traders who are able to put up at least $25,000 of capital. In North America the FX market allows leverage level to reach 50:1 on any amount of capital and in less regulated regions including UK leverage can expand to an astonishing 400:1. That means that an individual investor can in principle control 400,000 units of currency with only 1000 units of capital. High leverage can sometimes be a powerful tool amplifying profits by several orders of magnitude, however more often than not it can be a massive financial risk that quickly decimates capital. For example, on 100:1 leverage factor an adverse move of only 1% in the underlying currency pair would trigger a margin call and wipe out most of the account equity on a single trade. Therefore, individual traders in the currency market must be particularly attuned to the dangers of high margin and note that as a point of reference institutional investors typically trade on 3:1 to 5:1 leverage and generally never exceed 10:1 lever factor.

(click to enlarge)

One reason why margin is so high in the currency market is because the underlying instruments are relatively non-volatile. For example the average daily range in the EUR/USD is 75 basis points – considerably lower than the 100-110 basis point range in the S&P 500. Furthermore currencies are naturally bounded markets that have no upside bias. Since 1973 the value of Dow Jones Industrial Average has increased more than 25 fold. Meanwhile, during that time GBP/USD pair has oscillated between 2.10 and 1.10 tracing out wide multi year range.

Absolute Return Does Not Depend on Direction
Currencies are relative bets on the strength of their respective economies whereas equities are an absolute bet on the growth of the underlying business. That is why moves such as a thousand fold appreciation in the value of Apple stock are impossible to achieve in the currency market. Therefore currencies by nature are speculative assets with much shorter holding periods than stocks. Although they can be used to generate income especially in pairs with divergent interest rate policies they are subject to violent correction swings in the carry trade. On the other hand, currencies are an absolute return asset class allowing investors to profit from shorts as easily as they can from long positions allowing investors to diversify into an uncorrelated asset class.

On the surface currencies and equities appear to have much in common. Both financial instruments are highly liquid, easily transactable and can be volatile in times of geo-political stress. However, before entering the currency market investors should take time to understand the key differences between the two assets, most notably the much more liberal margin requirements and the bounded nature of FX trade. Doing so could help to reduce critical mistakes and set a much more realistic investment approach to the market.

Hide me
Receive Thought Provoking Forex Commentary Directly to Your Inbox
Show me