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Liquidity Differences Between Stocks and Forex

By , Forex Trading Instructor
01 February 2012 20:22 GMT

Liquidity Differences between Stocks and Forex

Many traders coming from stocks or futures markets realize that there are quite a few differences between the two assets. After all, a stock represents one company, in one economy in the entire world, whereas a currency represents an entire economy. Stocks are denominated in currency.

Without a standardized currency to associate value, there would be no way of trading stocks. Currencies make trading financial assets possible.

But that’s not where the differences end. The Forex market, exchanging currencies between the largest economies in the world, is a 24 hour a day market. If business is closing for the day in the United States, shops are opening in Sydney preparing to begin the next day. When we’re sound asleep in New York, or Dallas, TX – the FX market is burgeoning with activity from across the Atlantic as traders and liquidity providers in Europe speculate their day away.

Let’s first start by defining liquidity. Liquidity is the ability by which an asset can be purchased or sold without affecting the price. A great way to illustrate this relationship is to imagine two different companies. Let’s say that company A is an established company that is listed on the S&P 500. As one of the five hundred largest companies in the United States, this company is widely followed with news freely available throughout the day. There are many ‘blue chip’ companies like this across stock markets around the world For the purpose of this illustration, let’s imagine you have a $10,000 investment in Company A.

Now let’s imagine another type of company. Let’s say that your friend Bob recently started a widget company. Bob really enjoys making widgets, on the weekend as a hobby, and has decided to try his hand at setting up his own shop. At this point, Bob has only shared the idea with you – so you are the only person that knows about Bob’s widget shop. Bob’s a good friend, and he seems passionate about his idea, so you decide, ‘what the heck,’ and loan Bob $10,000.

At this point, you have two investments of $10,000. One is a publicly traded stock of a Blue Chip company, while the other is an idea that only you and Bob know about.

Now, lets say that you needed to get some money very quickly – and these 2 investments are the only option we have for raising capital. So we will need to sell one of our 2 investments of $10,000.

If we wanted to sell the stock in Company A, we could easily place a sell order the following morning. Company A, being a large-cap stock in the S&P 500, should be able to transact our order at market rates with little change in price, provided that markets are open for business and performing orderly.

If the S&P 500, where Company A is listed for trading is closed, then we will be unable to sell our stock to receive proceeds.

However, our investment in Bob’s widget shop may be a little more difficult to manage. After all, Bob only told you about his business, so it may be difficult to find alternative buyers. And if you did find a buyer, liquidating your entire $10,000 may prove challenging. To convince another investor to take over your shares in Bob’s Widget Company, you may have to sell your share at a discount. Investors may be willing to buy this part of Bob’s company, but given that this is a speculative venture by someone that few investors know, you’d probably have to take a loss on the investment. You may be able to sell this share, but you may only receive $5,000 for it.

This is liquidity.

The fact that we could go out into the Stock Market and sell our shares in Company A for close to the current market price, whereas if we were selling our stake in Bob’s Widget company denote the fact that the stock is more liquid. We are able to close our position with less denigration in value. Now, let’s take this relationship a step further.

The FX Market is open 24 hours a day, with the world’s largest banks and brokerage houses trading and speculating – not just for themselves, but for their corporate customers as well.

On average, the Forex market transacts $3.98 Trillion dollars of volume per day. The entire economy in the United States is valued a little under $14.6 Trillion dollars (using 2010 World Bank figures). That means that the Forex market can transact volume larger than that of the world’s largest independent economy in 4 days. Over a week, the Forex market volume can transact business greater than the size of the economies of the United States, Australia, Canada, The Netherlands, and South Africa – and that’s on average. This is why many call Forex ‘The Most Liquid Market in the World.’

David v/s Goliath

As we looked at above, the United States economy is valued slightly under $14.6 Trillion dollars, making it the largest independent economy in the world. But within that economy, numerous investment options exist. Many traders are aware that a large portion of investment capital looks for safer investments with more stable returns than what is available in stock markets. After all, most of us have seen a stock portfolio, or a mutual fund bounce around like a pinball in our portfolios. Imagine if this was money managed for a University endowment, or a retirement plan for the employees of your company. Many of these situations necessitate a more conservative risk profile than what’s available in stocks.

Much of this investment is geared towards fixed-income instruments such as Bonds. As a matter of fact, considerably more investment capital in the United States is based in these more conservative assets. The Bank of International Settlements estimates the value of the U.S. bond market at $35.2 Trillion (That’s correct – more than twice the value of the entire U.S. economy).

When foreign investors want to buy into this U.S. bond market, which currency do you think they will need to exchange into before doing so?

That’s right – before they can ever affect a transaction in the U.S. Bond market, they will need to exchange Euros, or Yen, or Australian Dollars for U.S. Dollars.

This is just one of the reasons for affecting a Forex transaction, but the difference in size between these markets is undeniable. Forex is a true Goliath within the financial industry. Remember, we classified liquidity as the degree to which you can close your trade without affecting the price. So in many ways, trading the Forex market gives you this benefit of liquidity by default. But for traders not used to this mannerism of liquidity, a few high points populate the benefits.

How can liquidity help me?

First, the Forex market is open twenty four hours a day. You have the ability to close or manage Forex positions around the clock. When you have a stock investment or a futures contract on a regional exchange, you are locked into the period with which they will allow you to open or close your trade.

Anyone that has traded stocks before knows the feeling of seeing bad news during the evening, only to watch your investments dive when the market opened the following morning after everyone in the world has had the chance to digest this bad news.

Forex is worldwide and traded 24 hours a day. If you see a bad news report on Tuesday evening, you can probably close or manage your trade by simply pulling up your platform.

This is a huge benefit that can save traders considerable sums of capital, and frustration.

In Forex, because of the 24 hour, worldwide nature of the market – Gap risk is GREATLY decreased by the simple fact that there are fewer market closes.

Forex Markets can offer deeper levels of volume on the assets you trade

A trader experienced with equities trading is probably familiar with a level 2 pricing. This is a feature available on electronically traded stocks from exchanges such as the NASDAQ that show the various ‘amounts,’ available from various participants and the price which they are willing to buy or sell. This is a great feature in markets, as traders can see the prices above and below the current market price to idealize if there may be more support on the bid or resistance on the ask.

But as we pointed out above, the stock market is much smaller than the Forex market. After all, stocks are denominated in currency; currencies are the basis of every financial transaction that takes place in the world. Most Forex volume takes place in the most commonly traded currency pairs, often called the ‘major pairs,’ such as the EUR/USD, GBP/USD, USD/JPY, AUD/USD, USD/CAD, USD/CHF, and USD/CAD.

With stocks, we are looking at quite a different scenario as there are literally THOUSANDS of options for investors and traders. For instance, one of the more popular indices in the United States is the S&P 500. This is the largest 500 companies in the US; but this is just one segment of the stock market: Large cap (Large capitalization stocks). The S&P 500 completely ignores mid-caps; they had to create a separate index for them, called the S&P Mid-Cap 400. With these two indexes we’re looking at 900 stocks, and we still haven’t even begun to count the thousands of small and micro cap companies.

Now imagine all of these sub-divided markets, offering bids to buy and asks to sell spread amongst thousands of companies.

Stock markets, because of the sheer number of available investment options, are much smaller and quite a bit more fragmented than what we see in FX. This means, with smaller sums in each of these ‘sub-markets,’ there could be much lower liquidity (fewer traders trading with far fewer dollars = less competition).

When markets are moving fast, liquidity can be greatly decreased to the point where the trader is seeing large slippage on their trades; disabling their abilities to adequately close or manage their positions even while markets are open.

The additional volume available in FX could enable these same traders a greater source of liquidity, which can offer a greater degree of price protection in fast markets.

--- Written by James B. Stanley

To contact James Stanley, please email Instructor@DailyFX.Com. You can follow James on Twitter @JStanleyFX.

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Additional Resources:

Support and Resistance – On-Demand Video Course

Money Management module -- On-Demand Trading Course

“What is the Number One Mistake Forex Traders Make?”

“In-Trade Management”

http://forexforums.dailyfx.com/dailyfx-education-videos-forex-trading-strategies/105716-dailyfx-trading-support-resistance.html

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01 February 2012 20:22 GMT