Lesson 3: What Is the Relationship of Stocks and Forex Market?

The forex market and stock market are most popular and heavily traded financial instruments. And interestingly, these two greatly affect each other's market movement.

But really, who calls the shot? Is it the forex market that affects the stock market behavior, or is it stock market moving the forex market? 

In this lesson, you'll center yourself on the century-running debate of egg and chicken but in a stock-and-forex context.

Lesson Highlights

• The stock market and forex market have an interesting relationship: They impact each other’s movement. However, many economists and traders are still debating whether the forex market affects the stock market or the other way around.

What Is the Forex Market? 

The forex market is the largest, most liquid, and, as per traders, the most profitable financial market due to its accessibility and volatility. 

When you trade forex, you're buying and selling a currency pair, hence the word trading. Why does it have to be a pair? It's because you capitalize on the changes in the pair's exchange rate. Whether the forex appreciates or depreciates, you can still gain profit if you position your trade properly. 

Assume you trade EUR/USD and are in a long (buying) position. When the EUR/USD trends upward, you'll profit from your position. If it goes downward, you'll run at losses. If you're in a short position, you'll generate profit if the market depreciates. If it appreciates, you'll run at a loss. 

Basically, the currency pair is your asset in the forex market. A currency pair includes; 

1. Base Currency: The first stated currency in the pair (ex. USD). This currency can be the one you're selling or the one you're buying. 
2. Quote Currency: The second stated currency in the pair (ex. JPY). This currency is the one that you receive or the one you sell. 

But how do you position your trade? Well, one aspect you must constantly look for is the economic outlook of the currency's host country. The outlook of an economy greatly drives the value of the currency market. If it's positive, the currency appreciates; if it's negative, it is likely to depreciate.   

What Is the Stock Market 

The stock market (also known as the "Stock Exchange") is a financial marketplace where traders buy and sell the shares of public companies.  

The stock market of a certain country serves as the benchmark for its overall economy. If the S&P500 index performs well in the market, the US economy performs well. On the contrary, if it's performing badly, the US economy and USD will likely depreciate.  

When you want to enter the stock market, you may do it through formal Exchange or Over the Counter (OTC).  

1. Formal Exchange is where you connect to the stock seller or buyer yourself to transact. It's an organized and regulated market to ensure a safe, transparent manner.  
2. Over the Counter (OTC) is a more digitalized and globalized way of trading stocks. OTC traders buy and sell their stock shares via their devices.   

Did you know? The first recorded stock exchange dated back to the launch of the Dutch East India Company in 1602. After the company became available public, the traders began trading the company shares.  

Stock and Forex Market: The Egg and Chicken Dilemma 

Okay, enough with the market introduction. Let's now look at the interesting side of this lesson.  

During the market introduction, you've learned two important things about stock and forex market: 

1. The forex and stock market are two different financial markets with different trading opportunities. However, using one financial market to predict the movement of the other is one known strategy to profit from both markets.  
2. The economic outlook of the currency's host country is the primary market mover in forex. The stock market relies heavily on the performance of the public companies; however, the stock market performance of a country directly impacts the economic outlook of the currency.  
3. When the currency market of the country has high demand for forex, an influx of foreign investors is likely to happen due to their confidence in the stock index performance.  

So, which really moves which? Is it the forex market that affects the stock market? Or is it the stock market that moves the forex market?  

Overall, both markets are interconnected and can influence each other. However, the forex market typically plays a more direct role in driving stock market movements, especially in the short term. Why? 

How the Stock Market Affects the Forex Market? 

The basic idea here is the moment the domestic stock market appreciates; the confidence of the country rises. The increase of the country's confidence will translate to an inflow of funds from international investors.  

The influx of foreign investors would drive the economy of the market as well as the market sentiment, which leads to buying pressure and an increase in currency value.  

On the other hand, when the stock market of the country performs terribly (say Japan's market), economic confidence falters. This causes investors to shy away from converting their funds to JPY.  

When this happens, the JPY market in forex will experience high selling pressure, resulting in a decline in the JPY market.