While trading the forex market you might have heard talk about the stock market.
You might only trade the forex market and yet notice many forex traders are still keeping an eye on the stock market.
Why is this?
Well, many traders consider there to be a connection whether strong or small between stocks and currencies.
In this article we will have a look at the stock market more closely and whether there is any correlation between stock and currencies.
What Is The Stock Market?
For those that are not familiar with the term Stock Market, it is a place where stocks and bonds are purchased and sold.
The stock market is where investors connect to buy and sell shares (stocks) of ownership in a company.
Market performance of major stock market indexes can be monitored by investors.
Indexes track represent a specific section of the stock market, we will go over some of the major indexes shortly.
Companies Selling Shares
An investor can only purchase shares if a company is selling some of their shares.
A company might choose to sell shares in their company to raise money for the following reasons;
- Research better ways to make things
- Create new products
- Improve the products they have
- Hire more employees
- Enlarge or modernize their buildings
So How Does It work?
When you purchase stocks in a company, you become a shareholder, meaning you own part of the company.
In the stock market, stock prices are continuously rising and falling every day.
As with trading the forex market, if the company’s profits go up, so does the price of your shares.
Likewise, if the company’s profits fall then so will the price of your shares.
The principle of trading stocks is to buy and hold when the price is low and sell when the price is higher, making a profit.
Stocks can be traded through a brokerage account in the same way as you would trade currencies.
So now you hopefully understand what the stock market is and how it works, lets now take a look at which stocks are frequently traded and why.
Major Stock Market Indexes
There are many companies in different countries selling shares, these companies are listed under certain indexes.
What Is An Index?
A stock index is a measurement of a section of the stock market.
Typically a stock index will show the weighted price average of selected stocks .
A stock market index can be classified in many ways
- World index – This can include stocks from multiple regions such as Asia and Europe.
- National index – This index represents the stock market of a given nation.
- Regional index – This index is made up of localized companies within region of a nation.
Now lets go over some of the main stock indexes that are traded.
NIKKEI 225 (Japan)
Nikkei 225 is the most widely followed index of 225 companies in Japan.
Companies such as Toyota, Sony, and Honda are listed under this index.
It is currently the most widely quoted average of the Japan Stock Market.
The S &P 500 or Standard and Poor’s 500 (US)
The S & P comprises 500 large American companies and is the most commonly followed indices after the Dow Jones.
It is considered to be the best gauge for the US stock market and US economy.
DOW JONES (US)
The Dow Jones Industrial Average or Dow for short comprises of 30 most powerful companies.
It is one of the most notable and premier indexes traded in US and is widely used to determine the industrial performance of the US economy.
The DAX is a German stock index comprised of 30 major German companies trading on the Frankfurt Stock Exchange.
Germany has the strongest economy within Euro zone economy, making German a big player in Europe.
Because of this, the index is watched closely by investors as an indication about how the Euro zone is doing.
NASDAQ is the place where most technology stocks from more than 3000 companies around the globe are traded.
Tech companies such as Microsoft, Google and Apple are listed under the NASDAQ index.
FTSE 100 (UK)
The FTSE 100 index is a share index comprising of 100 companies with the highest market capitalization listed on London stock exchange.
This index is used by investors to indicate the performance of the UK economy.
EURO STOXX 50 (EUROPE)
The EURO STOXX 50 is comprised of 50 of the most largest and the most liquid European stocks.
It is also in the watch list of all the investors out there as it is considered to mirror the overall performance of Euro zone stock market.
You can see that a lot of the stock indices are closely monitored by investors to gauge the strength of an economy.
How Are Different Markets Connected?
So we have covered a lot on the stock market but you may be thinking what this has to do with the forex market.
You might have heard the term “market correlations” used at some point.
Market correlation simply put, is a way of measuring the connection between two different financial markets.
The general idea of market correlation is as follows;
- A domestic equity market rises,
- Confidence in that specific country will then grows,
- This will lead to an increase in foreign investors,
- Demand for the domestic currency by foreign investors increases,
- Domestic currency then gains strength against other foreign currencies.
The process would be the opposite if a domestic equity market performs poorly.
Correlations are either positive or negative and the strength of the correlation can change over time.
Is The Forex Market Affected By The Stock Market?
There can be correlations between stock markets and certain currencies or pairs in the forex market.
Lets take a look at the Nikkei and the USD/JPY pair as an example.
Originally it was assumed that Nikkei stock market was a good reflection on the strength of the country.
So if the Nikkei stock market were to rally then this would lead to the yen strengthening and the USD/JPY dropping.
Likewise, if the Nikkei were to drop then the USD/JPY price would rise due to a weakening yen.
Since the 2007 financial crisis the correlation between Nikkei and USD/JPY has moved in the same direction as can be seen in the chart below.
These markets typically don’t react to each other, instead, they react in a predictable manner to external risk events.
So for example, if a central bank were to increase interest rates then this will usually do two things.
- Increase the value of the respective country’s currency.
- Decrease the value of the respective country’s stock market.
The chart below shows the strength of the correlation between Nikkei 225 and USD/JPY.
In general native currencies and stock markets tend to have a negative correlation in regards to monetary policy change.
As a currency trader it’s always good to look for correlations between other financial markets.
These links can effectively indicate price direction, which is useful when it comes to making trading decisions.
As a trader, you need to remember that there is no such thing as a fixed correlation.
Over time, economic circumstances can change which can alter existing correlations.
Stock markets and currency markets tend to react in a fairly stable manner to something like interest rate adjustments at this moment in time,
However, as economic events unfold there is nothing stopping this changing .
For example, we talked earlier about inverse correlation between the Nikkei and the USD/JPY which completely changed after the 2007 financial crisis.
As a trader, you should always be tuned into the fundamentals and understand exactly why any correlations exist.
This will help you to be aware of the underlying reasons for the any possible changes to the correations.
I hope you have found this article informative.
If you have any questions, please leave them in the comments section below.