April 28, 2021 | by sandeep
Understanding Liquidity, Spreads & the Advantages of the Spot Forex Market
Forex is often misunderstood when compared to the stock market. Many people simply associate Forex with people exchanging money to go on holiday.
As currency traders, we know this is far from the truth.
The main reason why currency traders are attracted to Forex vs. the stock market is liquidity.
Forex is the largest financial market in the world. Its average daily traded volume is $6 trillion a day. This is 100 times larger to the average traded volume of the three largest stock markets in the world in London, Tokyo and New York.
Among the three stock exchanges, the New York Stocks Exchange (NYSE) is the largest in the world but its size dwarfs in comparison to that of Forex.
To set the record straight, the $6-trillion-a-day size of the Forex market actually covers the entire global foreign exchange market. Within this market cap, retail traders like yourself cover about a $1.5 trillion market cap.
Why Does the Size of the Forex Market Matter?
It matters because liquidity is very important to the currency trader. For example, it is much easier for someone to manipulate the price of a company’s stock. But due to the enormous size of the Forex market, it is very difficult for a high net worth individual or even a bank to manipulate the price of a currency.
Let’s say we want to manipulate the price of a stock like Marks and Spencer’s, which is hypothetically trading at around £2 a share. If we wanted to buy 1000 shares, that might be a problem. But if we buy a million shares, there might only be 50,000 shares available at £2 pounds. The next best price could be at £2.10 for 5,000 shares. And for £2.20, we might get 10,000 shares. £2.30 might even get us 70,000 shares.
The point is, it is easy for someone with a few million dollars to manipulate share price. However, this person would not be so successful in manipulating foreign exchange. It’s estimated the EURUSD needs about $100 million just to make it move 1 pip. That’s one-hundredth of a penny. We all would agree that’s quite a huge liquidity, which means that any order under market conditions is executed instantly.
It also means we are very much on an even playing field. It’s not so easy to manipulate the price of a currency when liquidity is beyond anything you’ll ever see in the stock market. So the next time you find a rumor about a stock or an analyst on TV or a broker recommending a stock, be sure to remember that they can often influence the price of that stock, sometimes unjustifiably.
Spreads & Why Forex is Better than the Stock Market
The next reason why Forex appeals to the currency trader is the spread.
What are spreads, you ask?
The spread is the difference between the buy price and the sell price of a particular asset.
For example, we’ve got a Eurodollar with a sell price of 1.1044 and a buy price of 1.1046. The difference between the two prices is called the spread. So, in this example, the spread is two points or pips, as they’re called in Forex. Pip stands for point in percentage and it’s the smallest recognized move in Forex. So, here we’ve got a two-pip difference between what we can sell and the price that we can buy.
In Forex, the broker usually doesn’t charge us a commission when we place a trade. Instead, the broker is compensated for this difference between the buy and sell price. They may take our order to buy Eurodollar at 1.1046 but, as a broker, they get a slightly better deal and they end up paying maybe 1.1045 or 1.1045 and a half. Hence, the broker is compensated by the difference in the spread.
However, when we trade stocks, we might end up paying a commission on top of the existing spread. We might incur some other hidden fees depending on the broker. We might also have to pay some fees for transferring the shares both into and out of accounts. There might be some clearing fees. The fees might not be huge but they will add up and, as traders, we might not want that.
We don’t face any of these troubles with Forex. Because of the market’s liquidity, particularly with regards to the major currencies, the spread is much smaller than what we’re going to see for stocks and shares. We even have an option to pay smaller commissions and trade on what is called an ECN type of account, which gives us very tight spreads and sometimes no spread at all. Our overall costs of trading are much lower in Forex.
Forex’s Friendly Working Hours
The duration of the Forex market is another reason that appeals to the currency trader. The Forex market is open 24 hours, 5 days a week, whereas the stock market has set trading hours and is traded in a specific place and location.
On the contrary, the spot Forex market doesn’t have any kind of physical foreign exchange location and that’s because it’s run between banks. So as long as there’s a bank open somewhere in the world, then we can exchange currency and do this all electronically, 24 hours a day, from when Tokyo wakes up on Monday morning until the Americans finish work on Friday afternoon. Throughout that time, there is going to be a bank open somewhere in the world allowing us to trade.
If we are trading stocks, we’ve got to do it within the hours that the stock market is open. The point is that stocks and shares are limited to when the actual exchange is open.
Greater Flexibility in the Spot Forex Market
Since the Forex market is open 24/5, these flexible hours can be particularly helpful for the novice trader.
In the beginning, we might not make the choice to be a full-time trader as we might also be at work during the day. With this flexibility, this schedule won’t be a problem because the Forex market will be open whenever we’re home. We will be able to practice our skills on a demo account and trade after our day job. We can trade on a part-time basis even in the evenings.
Currency traders are also attracted to the spot Forex market because it’s flexible and allows them to trade smaller lot sizes. In the spot Forex market, we are allowed to trade 100 troy ounces on NYMEX gold futures. We can also trade silver futures in lot sizes of 5000 ounces.
In comparison, if we trade Forex in the Futures Market, we’ve got a standardized contract size of 100,000 units, depending on whatever currency we are trying to trade. They’re not quite as liquid and certainly not as flexible as what we can get in the spot Forex market. Some brokers allow us to trade as low as $50. This flexibility has its advantages, especially for the novice trader, over fixed lot sizes imposed by assets, which are traded on a stock exchange.
Another advantage that currency traders have is that there are no short selling restrictions in the spot Forex market. This means that we can actually sell first and take profit if we find that the price of a traded asset is going down.
In the stock market, however, there are some restrictions. A typical rule that was implemented in February 2010 was the uptick rule. This was implemented by the Securities Exchange Commission (SEC) in the US, which restricts the trader from short selling a stock unless there has been an uptick in price. So, for example, only if there is an upward tick in price from 12 to13, we are allowed to sell a specific stock. We’ve got similar regulations in the UK imposed in November 2012.
The fact that we can freely trade currency pairs in any direction, at any time, without any restrictions, is something that we are going to find very useful and can use to our advantage.
There are also fewer assets that we need to specialize in if we are trading the Forex market.
In the stock market, we’ve got many different companies listed, and when we’re looking at one, we need to study them in depth to be able to make the right trade decisions. It’s important to understand how each company is managed, who their competitors are, the nature of the company’s worker-management relationships, potential threats to their market share, and many more. And that’s for each individual company. This could also mean that we might have many companies on our radar when trading in the stock market.
In Forex, we don’t really need to focus on a huge amount of currencies. We’ve got eight major currencies. We could quite easily make a very handsome living following just four or five of these. Understanding and knowing everything about four to five currencies and their economies is far more manageable than following, say, 20 or 30 companies in a couple of sectors.
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*Any opinions, news, research, analyses, prices or other information contained here are provided as general market commentary and do not constitute investment advice. FXPRIMUS does not accept liability for any loss or damage, including without limitation to, any loss of proﬁt, which may arise directly or indirectly from the use of or reliance on such information.