Foreign exchange or forex is the biggest financial market in the world. It’s only accessible through online platforms 24/7. Stocks, on the other hand, are heavily regulated through physical exchanges like the New York Stock Exchange or Nasdaq, and are only traded while the exchanges are open. Each present their own unique risks.
What are the risks of the forex and stock markets?
Before deciding which to invest in, consider the risks of both forex and stock markets.
Leverage risk
Taking a forex position is not an investment in the sense of holding a security medium- to long-term for appreciation, like many investors do with stocks. Large fluctuations in exchange rates are rare. Investors in forex must take a short-term leveraged position to magnify potential gains.
Stock brokers only allow a leverage ratio of 2:1, forex platforms allow a leverage ratio of up to 50:1, or even 200:1 in some countries. Leveraging is done through borrowing money from a broker and is sometimes referred as “margin trading.”
While margin trading increases potential gains, it magnifies the risks involved. A small market movement can have an enormous impact upon the value of a forex portfolio. If an investor can’t meet the margin calls, their position is closed out. Unlike leveraging in stock trading, this closure comes without warning. All in all, leverage is risky for forex investments.
Country risk
Forex trading is riskier and is more difficult to predict than stock movement. Stock investors use the fundamentals of a company’s stock to forecast its future prices, but there are more factors that affect the value of a country’s currency.
Some of these factors are systemic, such as the gross domestic output (GDP), the Consumer Price Index (CPI) and the employment rate. However, historically it’s the unexpected or uncontrollable events that most dramatically affect exchange rates. A political situation, a decision by the country’s central bank or a natural disaster can affect an exchange rate in unpredictable ways.
In addition, a country’s currency is always quoted in relation to another currency. So, while a shareholder can focus on the financial prospects of just one company, a forex trader has to monitor two countries.
Counterparty risk
Unlike stocks, forex trades are not guaranteed clearing by a physical exchange or clearing house. This means an investor also faces significant counterparty risk. For example, their dealer might default in delivering the purchased currency.
Gap risk
Stock trading are more at risk of gaps than forex trading. Gaps occur between trading days, and it’s not uncommon for stocks or stock indices to “gap” higher or lower several percentage points in the opening minute of trading. Gapping makes stock trading more volatile and unpredictable. Though gaps can occur in forex trading when markets close for the weekend or holidays pause normal trading activity, it happens much less frequently.
Spread risk
Spreads are determined by the trading platform. It’s the difference between the buy and sell price that goes to the platform to cover its costs. Generally, the more liquid the market is for a specific stock or currency pair, the smaller the spread. So, the sheer volume of forex trading gives it the advantage in liquidity, especially over some smaller stocks that are traded less frequently. This risk can be minimized in stock trading by utilizing limit orders rather than market orders.
Though all investments are unpredictable, there are a few ways to help mitigate risk:
- Stop-loss orders and profit limit orders. Investors can use these to reduce their risk exposure in both forex and stocks. These orders close out a position if the price has reached a certain point, either a fixed or a percentage value. However, because stocks can sustain trends for much longer than forex moves, these orders are less useful in forex than in stocks.
- Hedging and diversification. Despite the risks, forex is recommended to investors looking to complement their investment portfolio. The risk characteristics and international nature of forex offers an investor two layers of diversification. And if an investor has significant exposure to a certain country or currency, forex can also be used to hedge against interest rate risks for said country’s fixed-income securities.
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Tips for comparing the risks between forex and stocks
Due to the country, leverage and counterparty risks, currencies are riskier than stocks for the private investor. It’s true that you don’t have to leverage to invest in forex, but this will render your potential gains virtually negligible. You’re better off focusing on what you can do to predict forex price movements.
- Know the countries of your currencies. With so many factors to consider when trading currencies, study the country pairs you’re trading in depth. A crucial starting point is seeing how your countries have reacted to historical events that have significantly affected their exchange rates.
- Follow the news. Closely monitor the national, regional and international news for your countries daily. Even a small event may snowball and have a dramatic impact upon an exchange rate.
- Use stop-loss orders and profit limit orders. Use these orders to safeguard your forex portfolio through automatically closing your positions. These will limit your potential gains and you may be charged a fee for them.
- Don’t risk more than you can afford to lose. Many currencies have recently experienced a rollercoaster ride of movement. Understand that if you’re unable to meet a margin call, your position may be closed immediately and you might not be able to recover any of your initial investment.
Both stock and forex markets involve a range of risks, but forex is riskier due to the leverage involved and the number of factors that influence currencies. Though it’s an easy option for your investment and can help diversify your portfolio, only consider it as a part of your retail investor portfolio with both the knowledge and appetite for risk.
Help reduce your risks by learning more about trading, gaining experience and implementing risk management strategies. And your choice of a stock trading or forex trading platform can help you do all three.
