The cost of trading forex
What is the cost of trading forex?
The cost of trading is the overall expense that a forex trader has to incur in order to run their trading business. There are optional costs for things that the trader may wish to purchase, such as news services, custom technical analysis services and faster connections, and compulsory costs, which are expenses that every trader must pay.
For every trade that you place, you will have to pay a certain amount in costs or commissions for each trade that you place with a broker. These costs vary from broker to broker, but they are usually a relatively low amount. These are usually the only cost of trading that you are likely to incur.
This may sound like a simple enough process, but many traders overlook these costs of trading and thus underestimate the challenges to generate a long-term profit.
For many forex traders, failure to make a profit is not always down to not being able to trade well – sometimes a mismanagement or underestimation of the costs involved can lead to failure when the trading results should, in theory, lead to success.
By taking a look at the main costs of trading, a trader can be more prepared to manage their capital.
Forex spreads and commissions
The most common costs associated with trading are the spread and commission fees charged by the broker for each trade placed. These costs are incurred by the trader regardless of how successful those trades are.
What does the term “spread” actually mean?
The easiest way to understand the term spread is by thinking of it as the fee your broker charges you to trade. Your broker will quote or give you two prices for every currency pair that they offer you on their trading platform: a price to buy at (the bid price) and a price to sell at (the ask price).
The spread is the difference between these two prices and what the broker charges you. This is how they make their money and stay in business.
To illustrate, let's say you want to make a long (buy) trade on the EUR/USD and your price chart shows a price of 1.2000.
The broker, however, will quote two prices, 1.2002 and 1.2000. When you click the buy button, you will be entered into a long position with a fill at 1.2002. This means that you have been charged 2 pips for the spread (the difference between the price 1.2002 and 1.2000).
Now say you want to make a short (sell) trade and again, the price chart shows a price of 1.2000. The broker will fill your trade at 1.2000, however, when you exit the trade – in other words buying back the short position – you will still pay the spread. This is because whatever the price shows at the time you want to exit your trade, you will be filled two pips above that price. For example, if you wanted to exit at 1.9980, you will in fact exit your trade at 1.9982.
Therefore, the spread is a cost of trading to you and a way of paying the broker. The bid price is the highest price the broker will pay to purchase the instrument from you and the ask price is the lowest price the broker will pay to sell the instrument to you.
In order for a trader to make a profit or avoid making a loss on a trade, the price must move enough to make up for the cost of the spread.
Variable rate spreads
It is also worth noting that the spread you pay can be dependent on market volatility and the currency pair that is traded. These variable spread fees are commonplace in markets where there is higher volatility.
For example, if a market is quiet, i.e. there is not much market activity and the volatility is low, the broker may charge a +2 pip spread. But if volatility increases or liquidity decreases, the broker/spread dealer may change that to incorporate the additional risk of the faster, thinner market and so they may increase the spread.
Some brokers also charge a commission for handling and executing the trade. In these circumstances the broker may only increase the spread by a fraction or not at all, because they make their money mainly from the commission.
What is commission and how is it calculated?
A commission is similar to the spread in that it is charged to the trader on every trade placed. The trade must then attain profit in order to cover the cost of the commission.
Forex commissions can come in two main forms:
- Fixed fee – using this model, the broker charges a fixed sum regardless of the size and volume of the trade being placed. For example: With a fixed fee, a broker may charge a $1 commission per executed transaction, regardless of the size involved.
- Relative fee – the most common way for commission to be calculated. The amount a trader is charged is based on trade size; for example, the broker may charge “$x per $million in traded volume”. In other words, the higher the trading volume, the higher the cash value of the commissions being charged.
With a relative fee, a broker may charge $1 per $100,000 of a currency pairing that is bought or sold. If a trader buys $1,000,000 EURUSD, the broker receives $10 as a commission. If a trader buys $10,000,000 the broker receives $100 as a commission.
Note: The relative fee is, in some cases, variable and based on the amount that is bought or sold.
For example, a broker may charge $1 commission per $1,000,000 of a currency pairing bought or sold up to a transaction limit of $10,000,000.
If a trader buys $10,000,000 EURUSD, the broker receives $10 as a fee. However, if a trader buys more than $10,000,000 EURUSD, they will become subject to the new fee. Usually the commission is on a sliding scale to encourage larger trades, however, there are different permutations from broker to broker.
Additional fees to consider
There are also hidden fees with some brokerages. Some of the fees you should look out for include inactivity fees, monthly or quarterly minimums, margin costs and the fees associated with calling a broker on the phone.
Before making a judgement on which commission model is the most cost-effective, a trader must consider their own trading habits. For example, traders who trade at high volumes may prefer to pay only a fixed fee in order to keep costs down. While smaller traders, who trade relatively low volumes, may tend to prefer a commission based on trade size option as this results in smaller relative fees for their trading activity.
Leverage is a tool that traders use as way to increase returns on their initial investment. One reason that the forex markets are so popular amongst investors is because of the easy access to leverage. However, when factoring in spreads and commissions, traders must be careful of their use of leverage because this can inflate the costs of each trade to unmanageable levels.
When trades are held overnight there is another cost that should be factored in by the trader holding the position.
This cost is mainly centred on the forex market and is called the overnight rollover.
Every currency you buy and sell comes with its own overnight interest rate attached. The difference between the two interest rates of the currencies you are trading will give you the cost of holding the position overnight. These rates are not determined by your broker, but at the Interbank level.
For example, if you buy the GBP/USD, then the rollover will depend on the difference between the interest rates of the UK and the USA.
If the UK had an interest rate of 5% and the USA had a rate of 4%, the trader would receive a payment of 1% on their position because they were buying the currency from the nation with the higher interest rate – if they were selling this currency, then they would be charged 1% instead.
Aside from the transactional costs of trading, extra costs should be factored in by traders when calculating their overall profitability.
Data feeds help the trader see what is happening in the markets at any given time in the form of news and price action analysis.
This data is then used by the trader to make important decisions:
- When to enter and exit the market
- How to manage any open positions
- Where to set stop losses
This data is therefore directly linked to the performance of the trader; good efficient data is vital in order to maintain a constant edge in the markets.
These costs are usually a fixed price charged monthly. The costs vary between providers, as does the quality and nature of their data feeds. It is important that traders determine which kind of feed they feel most comfortable and confident using before committing money to any feed provider.
Other additional costs to a trader may include subscriptions to magazines or
television packages, which enable access to non-stop financial news channels. The cost of attending exhibitions, shows or tutorials may also need to be considered if you are a novice trader.
Aside from this are the obvious necessary costs of owning a reliable PC or laptop, and cupboards stocked with plenty of coffee!
In this lesson, you have learned that:
- not paying attention to all of the costs can limit your ability to make a profit.
- there are optional costs and compulsory costs.
- compulsory costs include spreads and commissions charged by the broker.
- optional costs include additional data feeds and news services.
- other costs involve overnight rollover fees, which is the difference in interest rates between the two countries of the currency pairs you are trading.
- leverage can magnify gains, but also magnify the cost of trading.