Today's investors and active traders have access to a growing number of trading instruments, from tried-and-true blue chips and industrials, to the fast-paced futures and forex markets. Deciding which of these markets to trade can be complicated, and many factors need to be considered in order to make the best choice.
The most important element may be the trader's or investor's risk tolerance and trading style. For example, buy-and-hold investors are often more suited to participating in the stock market, while short-term traders, including swing, day and scalp traders, may prefer markets where price volatility is more pronounced. In this article, we'll compare investing in the forex market to buying into blue chip stocks, indexes and industrials. (Learn about the forex market and get to know some beginner trading strategies; check out Forex Trading: A Beginner's Guide.)
TUTORIAL: The Ultimate Forex Guide
Forex Vs. Blue Chips
The foreign exchange market is the world's largest financial market, accounting for more than $4 trillion in average traded value each day as of 2011. Many traders are attracted to the forex market because of its high liquidity, around-the-clock trading and the amount of leverage that is afforded to participants.
Blue chips, on the other hand, are stocks from well-established and financially sound companies. These stocks are generally able to operate profitably during challenging economic conditions, and have a history of paying dividends. Blue chips are generally considered to be less volatile than many other investments, and are often used to provide steady growth potential to investors' portfolios.
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Volatility is a measure of short-term price fluctuations. While some traders, particularly short-term and day traders, rely on volatility in order to profit from quick price swings in the market, other traders are more comfortable with less volatile and less risky investments. As such, many short-term traders are attracted to the forex markets, while buy-and-hold investors may prefer the stability offered by blue chips.
Leverage is another consideration. In the United States, investors generally have access to 2:1 leverage for stocks. The forex market offers a substantially higher leverage of up to 50:1, and in parts of the world even higher leverage is available. Is all this leverage a good thing? Not necessarily. While it certainly provides the springboard to build equity with a very small investment - forex accounts can be opened with as little as $100 - leverage can just as easily destroy a trading account. (For more insight, see Forex Leverage: A Double-Edged Sword.)
Another consideration in choosing a trading instrument is the time period that each is traded. Trading sessions for stocks are limited to exchange hours, generally 9:30am to 4pm Eastern Standard Time, Monday through Friday with the exception of market holidays. The forex market, on the other hand, remains active round-the-clock from 5pm EST Sunday, through 5pm EST Friday, opening in Sydney, then traveling around the world to Tokyo, London and New York. The flexibility to trade during U.S. Asian and European markets, with good liquidity virtually any time of day, is an added bonus to traders whose schedules would otherwise limit their trading activity. (Just because the forex market trades 24 hours a day doesn't mean you have to. See How To Set A Forex Trading Schedule.)
Forex Vs. Indexes
Stock market indexes are a combination of similar stocks, which can be used as a benchmark for a particular portfolio or the broad market. In the U.S. financial markets, major indexes include the Dow Jones Industrial Average (DJIA), the Nasdaq Composite Index, the Standard & Poor's 500 Index (S&P 500) and the Russell 2000. The indexes provide traders and investors with an important method of gauging the movement of the overall market.
A range of products provide traders and investors broad market exposure through stock market indexes. Exchange-traded funds (ETFs) based on stock market indexes, such as S&P Depository Receipts (SPY) and the Nasdaq-100 (QQQQ), are widely traded. Stock index futures and e-mini index futures are other popular instruments based on the underlying indexes. The e-minis boast strong liquidity and have become favorites among short-term traders because of favorable average daily price ranges. In addition, the contract size is much more affordable than the full-sized stock index futures contracts. The e-minis, including the e-mini S&P 500, the e-mini Nasdaq 100, the e-mini Russell 2000 and the mini-sized Dow Futures are traded around the clock on all-electronic, transparent networks. (To learn more, check out Forex Minis Shrink Risk Exposure.)
The volatility and liquidity of the e-mini contracts is enjoyed by the many short-term traders who participate in stock market indexes. The major equity index futures trade at an average daily notional value of $145 billion, exceeding the combined traded dollar volume of the underlying 500 stocks. The average daily range in price movement of the e-mini contracts affords great opportunity for profiting from short-term market moves.
While the average daily traded value pales in comparison to that of the forex markets, the e-minis provide many of the same perks that are available to forex traders, including reliable liquidity, daily average price movement quotes that are conducive to short-term profits, and trading outside of regular U.S. market hours.
Futures traders can use large amounts of leverage similar to that available to forex traders. With futures, the leverage is referred to as margin, a mandatory deposit that can be used by a broker to cover account losses. Minimum margin requirements are set by the exchanges where the contracts are traded, and can be as little as 5% of the contract's value. Brokers may choose to require higher margin amounts. Like forex, then, futures traders have the ability to trade in large position sizes with a small investment, creating the opportunity to enjoy huge gains - or suffer devastating losses.
While trading does exist nearly around the clock for the electronically traded e-minis (trading ceases for about an hour a day to enable institutional investors to value their positions), the volume may be lower than the forex market, and liquidity during off-market hours could be a concern depending on the particular contract and time of day.
While outside the scope of this article, it should be noted that various trading instruments are treated differently at tax time. Short-term gains on futures contracts, for example, may be eligible for lower tax rates than short-term gains on stocks. In addition, active traders may be eligible to choose the mark-to-market (MTM) status for IRS purposes, which allows deductions for trading-related expenses, such as platform fees or education. In order to claim MTM status, the IRS expects trading to be the individual's primary business; IRS Publication 550 and Revenue Procedure 99-17 cover the basic guidelines on how to properly qualify as a trader for tax purposes. It is strongly recommended that traders and investors seek the advice and expertise of a qualified accountant or other tax specialist to most favorably manage investment activities and related tax liabilities. (Trading forex can make for a confusing time organizing your taxes. These simple steps will keep everything straight. Check out Forex Taxation Basics.)
The Bottom Line
The internet and electronic trading have opened the doors to active traders and investors around the world to participate in a growing variety of markets. The decision to trade stocks, forex or futures contracts is often based on risk tolerance, account size and convenience. If an active trader is not available during regular market hours to enter, exit or properly manage trades, stocks are not the best option. However, if an investor's market strategy is to buy and hold for the long term, generating steady growth and earning dividends, stocks are a practical choice. Regardless of which instrument(s) a trader or investor selects, the decision should be based on which is the best fit.