What is the difference between forex and index trading? Both are among the most liquid financial markets, although forex ranks much higher in this regard. Some unique advantages and disadvantages exist with each security that investors should consider.
Overview
Forex vs. indices, what’s your fancy? Both of these markets are some of the most followed and speculated financial instruments worldwide, with forex surpassing levels of liquidity far higher than stocks and indices combined.
Some of the questions may be whether one should exclusively trade one or both; is forex relatively easier than indices? Both instruments require the same number of years of experience to become technically proficient and consistently profitable, and we should treat both as long-term investments.
This article will cover each instrument and its relationship, some of the pros and cons of both, and what traders should invest in.
What is forex?
A portmanteau of foreign exchange, the Forex market for trading currencies is decentralized. Forex deals with the exchange of different currencies, hence being quoted in pairs instead of singularly.
Some of the most popular forex pairs are:
- EUR/USD – this pair tracks the euro’s value and the US dollar against each other. It denotes how many US dollars (quote currency) one will need to purchase one euro (base currency).
- USD/JPY – this pair tracks the value of the US dollar and Japanese yen against one another. It denotes how many Japanese yen (the quote currency) one will need to purchase one US dollar (the base currency).
What are indices?
Indices are the plural form for index (but can also be referred to as indexes). An index is a financial instrument weighted according to a basket of several other markets. This basket can include various bonds and commodities, although the most relevant and popular are stock indices. Below are some of the popular indexes:
- GER30 / DAX – this index measures the performance of the top 30 German companies on the Frankfurt Stock Exchange.
- FTSE 100 – this index measures the performance of the top 100 UK companies on the London Stock Exchange.
- S&P 500 – this index tracks the value of the 500 largest American corporations.
We should see indices as a better alternative to trading individual stocks since they expose the investor to different parts of an economy or sector with just one position. Analysts and economists will often measure the current and future performance of an economy based on a particular index, emphasizing their significance in the markets.
The relationship between forex and indices
While forex and indices seem unrelated, there are many surprising similarities traders can observe and utilize. There is a significant relationship or correlation between the two, where traders often see indices as precursors to forex movements.
For example, the dollar index tracks the value against the US dollar of six world-leading currencies: the British pound, the euro, Canadian dollar, Japanese yen, Swiss franc, and Swedish krona.
Quite frequently, USD pairs tend to follow this index’s direction, making it an invaluable piece of analytical knowledge for traders. Stocks have historically always affected how currencies move. Another example is the Nikkei or JPN225 index, which comprises 225 leading Japanese stocks on the Tokyo Stock Exchange.
The logic of why this index can affect forex markets, specifically yen pairs, is that when there is an excellent performance, transactions in yen also increase, which consequently grows the currency’s value overall. Therefore, some traders can use indices for fundamental analysis where both markets can exist side by side rather than standalone.
Pros and cons of trading forex
Pros
- The forex market is open 24/5, allowing for trading to happen around the clock.
- Brokers provide a very high leverage, accommodating cash-strapped traders to trade with as little as $10 (sometimes less).
- The Forex financial market is unbeatable whenever liquidity is concerned, with several trillions of dollars traded daily. Its liquidity far surpasses that of the indices market.
- Unlike indices, price gaps are infrequent in forex.
Pros and cons of trading indices
Pros
- Trading indices is usually a better alternative to trading individual stocks. Instead of putting your risk on one particular stock, your investment is diversified for every index.
- Brokers afford far less leverage to clients for trading indices. Trading a highly leveraged market like forex increases the chances of losing money over a shorter period if one acts irresponsibly. However, lower leverage can also be a drawback due to requiring bigger risk capital.
Cons
- Some indices, like stocks, are open for limited times, contrasting the 24/5 around-the-clock nature of forex. As a result of these ‘stops and starts,’ indices tend to have more noticeable price gaps.
- Traders need substantially more capital to trade indices than they do with forex. Most brokers offer leverage not more than 1:100, but averages between 1:50 and 1:20 (or sometimes lower).
- Some indices can have high swap fees and commissions (in addition to the spread) than in forex.
Should you trade forex or indices?
As a rule of thumb, new or beginning traders who’ve never traded any market before should start with forex. This financial asset is the most accessible in terms of capital and knowledge. Forex is also suitable for short-term traders since currencies do not stay in long-term trends often.
In the indices market, as it’s essentially a bunch of stocks, we typically see trends that last for several years with little range-bound movements. Although long-term investors can still benefit from forex, indices usually take precedence in this regard.
Most gain enough experience in forex before switching to indices, which is the logical route. Indices require bigger capital that may not be available to newbies. Some may strictly trade indices or go back and forth between the two instruments.
Both indices and forex are equally challenging markets to analyze and consistently profit from. Nonetheless, even if one does not trade the former, from an analysis standpoint, indices do provide valuable insights on the future of many forex markets.
Conclusion
Despite some differences between forex and indices, traders should treat both equally as long-term investments since each requires the same levels of patience. The natural transition for most starts with forex due to the lower entry barrier and then inclining towards indices with sufficient capital.
Even if one does not actively trade indices, they can still analyze them since they have a significant bearing on forex movements.