Do I need to open a special account to invest overseas?

The simple answer for 90% of people reading this is no. However, how do you know if you’re one of the 10% – or the 90%?

Image courtesy Katrina Tuliao: http://www.flickr.com/people/thewalkingirony/To answer that question you need to understand the following:

  • What is an ADR?
  • What are the benefits and disadvantages of ADRs?
  • What assets are you attempting to trade?

What is an ADR? ADR is acronym that stands for American Depositary Receipt. The basic definition is that it’s similar to a stock that trades in the United States, but represents a specified number of shares in a foreign corporation. So an ADR may contain 2 or more shares of a particular foreign company; traders need to read the prospectus and should always know what they are buying.

Trading ADRs are easy since they are bought and sold on American markets just like regular stocks, and are issued/sponsored in the U.S. by a bank or brokerage to assure the transaction. 

The pros and cons of an ADR:

The clear benefit to trading an ADR representing a foreign company is that the ADR can be traded through any standard full-service broker or an online discount broker. ADRs can also be found contained in ETFs. For all intents and purposes an ADR trades just like a stock.

However, the ADR has a disadvantage over its counterpart as it represents a foreign stock on a foreign exchange. Depending on the situation, there could be a disconnect between the ADR and the foreign stock due to events or price movement on either exchange – and the time difference.

For example last year Egypt’s stock market shut down for several days during the government protests. However, despite the Egyptian stock market being closed the ADRs here in the States continued to trade, blindly and without direction.

When the Egyptian stock market finally re-opened there was a huge disconnect between the ADRs here in the United States and the actual stock on the foreign exchange.

Although this was an extraordinary example, there are other smaller events that cause disconnects for a period of time.

Depending on the desired asset, not all foreign companies trade as an ADR on the U.S. exchanges, forcing traders to either find a substitute, or to find a broker that will allow you access to the foreign exchange where the actual stock is traded. 

Turning back to our original question: Whether you need a special account can be answered by following the below decision tree.

1) Is the company represented by a liquid and low volatile ADR?

If the answer is yes: a standard U.S. broker account is fine.

2) Is there an alternative to the ADR? An ETF or fund?

If the answer is yes: a standard U.S. broker account is fine.

3) There is no ADR, or the ADR is traded extremely thinly, or the ADR is extremely volatile:

If the answer is yes to any of these, you probably need a special account.

When opening a broker account with access to foreign exchanges consider the following questions:

  1. Do you really need to trade this particular asset?
  2. What are the commissions to trade on the exchange?
  3. What additional exchange fees are there?
  4. What is the cost to convert my U.S. dollars into the foreign currency?
  5. What is the minimum value of the account?
  6. What other fees are there?

Tips:

Always use limit orders; foreign exchanges are not as liquid as U.S. markets.

There are many horror stories about people being charged $500 in commissions for one trade on a foreign stock. Just because your broker allows access does not mean your account is ideally set up for foreign trading – and could cost you heavy fees.

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