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Which should I choose? Currency ETFs versus forex, a case study

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The euro zone crisis has been going on now for two years and the worst is not over yet. This has sent traders looking for vehicles to profit from the crisis as well as hedging their portfolio. One vehicle that traders turned to has been ETFs . ETFs are a great way to gain exposure to markets with a stock market account without having a futures/commodities or forex account.

[caption align="alignright" caption="The European Parliament building - "Espace Léopold", in Brussels"] [/caption]

Although ETFs make it easy for traders to gain exposure to different markets and assets, they do have significant shortcomings because of their construction. This is especially true when it comes to ultra-short and currency ETFs compared to the counterparts they are representing.

Since the euro zone crisis the euro has gotten its share of headlines, prompting traders to take positions in both the euro in the spot market (forex) or in the euro ETF: FXE ( quote ).

Since many of our readers use these currency ETFs we thought it be a great idea to compare them to their counterparts. Let's look at FXE since it has seen largest volume since the crisis in Europe dominated headlines.

ETF's in general are expensive : ETFs are funds, not all that dissimilar to mutual funds in that they have broker fees, banking fees, fund managers with large salaries, and even reserves against lawsuits. The expenses are usually reported as the "expense ratio" in the prospectus and many online brokers list the expense ratio in the detail quote. The FXE prospectus reports only a 0.40% expense ratio.

In comparison, with the forex market - sometimes referred to as the spot market, traders pay no expenses and no commissions. In the forex market traders are simply buying or selling a currency against another currency. It's very important that traders know what they are buying or selling.

Commission : As mentioned above traders will need to pay a commission to the broker to buy and sell the FXE along with a 1-2 cent spread (difference between the bid and ask) on both sides of the trade. In the forex market there is no commission to the broker, and traders only have deal with a fraction of the spread between the bid and ask.

It is very important for traders to shop around for a forex broker as the spread is typically set by the broker and not all brokers provide competitive spreads. The spread is how the broker makes money.

Tracking Error : The FXE is not the same as trading the actual euro currency; rather it's a fund that seeks to reflect the price of the euro. This fact alone tells us there are differences between the two. The price of the FXE is determined during the open stock market by traders buying and selling the FXE itself. The price should broadly mirror the price of the euro dollar, but can and often does vary on a short term basis.

Trading FXE is like following a truck on the highway: you are not exactly traveling the same speed or on the same spot of the highway as the truck. The FXE price is close, but because it is made up futures and only tracking an index it's not perfect. This variability it called "tracking error" and can be found in every ETF due how ETFs are constructed.

Market Hours : The forex market is open 24 hours, 6 days a week. Forex markets are often referred to by traders in three sessions: the Asian, European and U.S sessions, each with its own distinct trading hours. The European session is six hours ahead of the U.S. (eastern time). This means the European business day is basically over by the time the U.S. stock market opens (when the NYSE opens at 9:30am, it's 3:30pm in Berlin, Paris and Rome) and the majority of the news has been announced by both European companies and governments.

The FXE is most likely to be disconnected to the forex market prior to the opening bell in New York. This disconnect can cause the FXE to gap up/down based on the price movement of overnight sessions. Traders can find themselves in a trade that is moving against them fast but will not be able to exit until the following trading day.

Leverage : Even with the turmoil in headlines from Europe the EUR/USD typically moves only about 1% or 2% per day, give or take a few exceptions. The move from May's high of 1.4930 to October's low of 1.3144 last year was a move of about 12% in the FOREX market. Not a huge move in terms of stock movement but it is in the currency market. If you sold FXE short from May to October you would have made about 12% minus expenses and commissions. Forex broker accounts use leverage to enhance profits (and losses) and up to 50 to 1 is available. Using a conservative 5-to-1, the return would have been around 60% for the same move in forex. The leverage account also requires less money in order to trade the euro, leaving more of your cash in reserve in these volatile markets.

Liquidity : The EUR/USD pair is the single most traded financial instrument in the world, with an average daily volume of $1.1 trillion per day in 2010, according to the Bank of International Settlements, compared to a daily average of $300 million per day in FXE over the last quarter of 2011. The greater liquidity indicates more people are buying and selling in the market, so it's easier for others to take the other side of your orders.

This liquidity tends to make for tighter bid and ask spreads and better trade execution, even for very large orders. It is very rare for the currency markets to gap, and the high volume makes finding a buyer or seller almost instant.

Anyone can sell short : In the forex market anyone can sell short. There is no account value requirement, no borrowing shares before you can short, and no need for special account status for short selling. With FXE, traders will need to find shares to borrow - and pay significant interest to hold your short trade, and you may find it hard to find shares to borrow.

Day trading : In the forex market traders can enter and exit as many times as they wish each day and not be flagged as a pattern day trader, which requires additional account funds. Trading FXE will require traders to follow the National Association of Securities Dealers (NASD) rules surrounding day trading.

In short, the forex market provides traders the best exposure to the Euro. With the limitations of FXE, why not take a look at the forex market - traders can start small and trade a micro account and most brokers provide paper trading to help to hammer out strategies.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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